After the Fall: Saving Capitalism from Wall Street and Washington [Hardcover]

Nicole Gelinas (Author)

Book Description

Publication Date: November 24, 2009

Robust financial markets support capitalism, they don't imperil it. But in 2008, Washington policymakers were compelled to replace private risk-takers in the financial system with government capital so that money and credit flows wouldn't stop, precipitating a depression.

Washington's actions weren't the start of government distortions in the financial industry, Nicole Gelinas writes, but the natural result of 25 years' worth of such distortions.

In the early eighties, modern finance began to escape reasonable regulations, including the most important regulation of all, that of the marketplace. The government gradually adopted a "too big to fail" policy for the largest or most complex financial companies, saving lenders to failing firms from losses. As a result, these companies became impervious to the vital market discipline that the threat of loss provides.

Adding to the problem, Wall Street created financial instruments that escaped other reasonable limits, including gentle constraints on speculative borrowing and requirements for the disclosure of important facts.

The financial industry eventually posed an untenable risk to the economy -- a risk that culminated in the trillions of dollars' worth of government bailouts and guarantees that Washington scrambled starting in late 2008.

Even as banks and markets seem to heal, lenders to financial companies continue to understand that the government would protect them in the future if necessary. This implicit guarantee harms economic growth, because it forces good companies to compete against bad.

History and recent events make clear what Washington must do.

First, policymakers must reintroduce market discipline to the financial world. They can do so by re-creating a credible, consistent way in which big financial companies can fail, with lenders taking their warranted losses. Second, policymakers can reapply prudent financial regulations so that markets, and the economy, can better withstand inevitable excesses of optimism and pessimism. Sensible regulations have worked well in the past and can work well again.

As Gelinas explains in this richly detailed book, adequate regulation of financial firms and markets is a prerequisite for free-market capitalism -- not a barrier to it.

Editorial Reviews

Review

“When it comes to our flawed financial system, most writers generally lob big bombs and hope for, at best, maximum splatter. Nicole Gelinas by contrast sends a precision missile that neatly and elegantly takes the thing to pieces—and lays the ground for a better structure. Hail Gelinas.”

&mdash Amity Shlaes, Senior Fellow, Council on Foreign Relations and author of The Forgotten Man: A New History of the Great Depression

“A powerful analysis of how the too-big-to fail policy has undermined public trust in markets.”

&mdash Luigi Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance, University of Chicago-Booth School of Business and author of Saving Capitalism from the Capitalists

“Nicole Gelinas has done the country a great favor by explaining concisely and cogently the origins of the financial crisis of 2008 and how—if we have the political will—we can avoid a repeat in the future. After the Fall is an instant classic that should be required reading in both Washington, D.C. and Wall Street.”

&mdash John Steele Gordon, author of An Empire of Wealth: The Epic History of American Economic Power

“Nicole Gelinas has written a fine book about the long prehistory of financial catastrophes that culminated in the extraordinary collapse of the banking industry in September of 2008. The book is lucid and sober, simple but not simplistic, and essential background to understanding the inherent vulnerabilities of modern finance.”

&mdash Richard A. Posner, U.S. Circuit Judge and author of A Failure of Capitalism: The Crisis of ‘08 and the Descent into Depression

From the Inside Flap

Robust financial markets support capitalism, they don't imperil it. But in 2008, Washington policymakers were compelled to replace private risk-takers in the financial system with government capital so that money and credit flows wouldn't stop, precipitating a depression.

Washington's actions weren't the start of government distortions in the financial industry, Nicole Gelinas writes, but the natural result of 25 years' worth of such distortions.

In the early eighties, modern finance began to escape reasonable regulations, including the most important regulation of all, that of the marketplace. The government gradually adopted a "too big to fail" policy for the largest or most complex financial companies, saving lenders to failing firms from losses. As a result, these companies became impervious to the vital market discipline that the threat of loss provides.

Adding to the problem, Wall Street created financial instruments that escaped other reasonable limits, including gentle constraints on speculative borrowing and requirements for the disclosure of important facts.

The financial industry eventually posed an untenable risk to the economy -- a risk that culminated in the trillions of dollars' worth of government bailouts and guarantees that Washington scrambled starting in late 2008.

Even as banks and markets seem to heal, lenders to financial companies continue to understand that the government would protect them in the future if necessary. This implicit guarantee harms economic growth, because it forces good companies to compete against bad.

History and recent events make clear what Washington must do.

First, policymakers must reintroduce market discipline to the financial world. They can do so by re-creating a credible, consistent way in which big financial companies can fail, with lenders taking their warranted losses. Second, policymakers can reapply prudent financial regulations so that markets, and the economy, can better withstand inevitable excesses of optimism and pessimism. Sensible regulations have worked well in the past and can work well again.

As Gelinas explains in this richly detailed book, adequate regulation of financial firms and markets is a prerequisite for free-market capitalism -- not a barrier to it.

See all Editorial Reviews

Product Details

• Hardcover: 250 pages
• Publisher: Encounter Books; First Edition edition (November 24, 2009)
• Language: English
• ISBN-10: 1594032610
• ISBN-13: 978-1594032615
• Product Dimensions: 6.1 x 1 x 9.1 inches
• Shipping Weight: 1.1 pounds (View shipping rates and policies)
• Average Customer Review: 4.7 out of 5 stars  See all reviews (21 customer reviews)
• Amazon Best Sellers Rank: #810,366 in Books (See Top 100 in Books)

More About the Author

Nicole Gelinas, a Chartered Financial Analyst (CFA) charterholder, is a Manhattan Institute senior fellow and contributing editor to City Journal. She lives in New York City.

Most Helpful Customer Reviews

97 of 97 people found the following review helpful

5.0 out of 5 stars A concise explanation of what happened. November 9, 2009

By Michael T Kennedy VINE™ VOICE

Format:Hardcover|Amazon Verified Purchase

First, I am not a financial analyst or even a very sophisticated investor. I just wanted to know what happened and, after reading this book, I think I know. Ms Gelinas is a financial analyst and seems to have spent quite a bit of time thinking about what happened and how we might start to put things back together. It began with the changes in banking in the 1980s, largely I believe (although she does not say so) due to inflation. For decades, the savings and loan had a business model of borrowing from savers at four percent interest and lending to homeowners at six percent interest. All that changed when inflation drove those savers, including me, to look for higher returns to compensate for the loss of value from inflation. Most of the evil that followed, in my opinion not hers, can be traced to this phenomenon. Now that I have demonstrated how naive I am, let's consider her book.

She describes the history of the crash in 1929 as a consequence of irrational exuberance and unregulated financial manipulation during the 1920s. She describes, for example, the fall of Sam Insull who built Commonwealth Edison into a modern utility but lost track of all the financing until, in the wake of 1929, it collapsed and took thousands of savers' investments with it. She compares Insull to Enron, a valid comparison, I think. She describes the regulatory steps that were taken by Roosevelt's administration and how it stabilized the financial world for 70 years.

The story of the 2008 collapse begins in 1984 with the rescue of the Continental Illinois Bank. Here began the "too big to fail" story. Two things happened here that led to the crisis. One was the decision to bail out all depositors, including those whose deposits exceeded the FDIC maximum. Secondly, the FDIC guaranteed the bond holders, as well. Thus began the problem of moral hazard. Another feature of this story was the role of Penn Square Bank, which had gone under two years earlier in the wake of the oil price collapse, which devastated many of its poorly collateralized loans in the oil industry. Both banks had been caught seeking higher returns through risky investments. Penn Square, however, had been allowed to collapse. Continental was rescued and that began a trend that the author lays out in detail through most of the rest of the book. It was here, in Chapter three, that I began to underline and take notes. Continental had relied on large amounts of short term money from uninsured depositors. That would be seen again and again in the years to come.

The fact that large banks would be rescued placed small banks at a disadvantage and they complained. Congress, in the first of many well intentioned but useless measures, passed a bill that prohibited the FDIC from protecting uninsured depositors but they added the fatal proviso that exempted "systemic risk" situations. At this point, Charles Schumer, then a Congressman, opposed allowing banks to enter the securities business. The 1984 legislation ignored his concern and the wall was lifted a bit between investment banks and conventional banks. By 1999, when the Glass Steagall Act was largely repealed, Schumer had switched his position to favor the change.

The investment banks took a major step as they became publicly traded companies. This began with Dean Witter in 1972 and Morgan Stanley took the step in 1986. Now, the traders would be risking someone else's money and this was a fateful decision. The author points out that Brown Brothers Harriman remained a partnership in which partners risk their own capital and it has not gotten into trouble with the speculation of the 90s and beyond. By 1993, the six largest commercial banks earned 40% of their profits in trading. Corporate financial services became a larger and more powerful part of the economy. I'm sure I am not the only one who has noted the coming and going of major New York financial figures to and from administrations of both parties.

The next step was the securitization of debt, especially home mortgages but also credit card debt and auto loans. She points out how this resembles Insull and Enron in that long term obligations were rolled into securities and sold to acquire immediate profits. No longer did banks service their own loans. More money could be earned by lending the money several times over. Initially, the risk of the securitized mortgages was early retirement of the debt to refinance at lower rates. In 1986, a drop in interest rates brought an early crisis. At the time, no one dreamed that the next big crisis would be not the risk of early repayment but the risk of default.

She describes the junk bond phenomenon and the development of derivatives. Finally comes the credit default swaps and the stage was set. An opportunity was missed in 1999 and 2000 when the head of the Commodity Futures Trading Commission, Brooksley Born, tried to regulate over-the-counter derivatives. Congress passed the Commodity Futures Modernization Act, which barred such regulation and set the stage for the next act, the real estate bubble and collapse. By 2000, the unregulated OTC derivatives markets, which had not existed a decade before, totaled $95 trillion. These were unregulated and there were no margin or capital requirements.

I would have to summarize the whole book, which is only 250 pages, to describe all the points she makes about how this happened. Read it yourself. I will summarize her suggestions for next steps now that the fall has taken place.

An opportunity was missed in the summer of 2008 when Merrill Lynch sold some mortgage backed assets at 22 cents on the dollar. The price was low but nobody knew what the right price was. Allowing these fire sales to proceed would begin to establish a market for these securities. The TARP plan put a stop to this as no one would sell to private bidders when the government would pay a higher price. That was a big mistake and it was soon decided to merely give the banks the money as valuation proved impossible without a market. Some banks that were not in dire straits were forced to take money to conceal which banks were the most shaky. All these were mistakes. Artificially inflated asset values are part of the problem and will delay resolution.

There needs to be a mechanism for bankruptcy of these interconnected institutions. She discusses some options. The markets have been weakened by changes in contract law, especially the Chrysler bailout when senior creditors were forced to the back of the line. She points out that there would have been no outcry about AIG bonuses if the company had been liquidated in some modified bankruptcy proceeding. She wants better disclosure of risk and part of that is regulation of all the exotic derivative products that will remain. There is no possibility that we could go back to the era of Glass Steagall. Times have changed. To big to fail must end. With all the interlocking financial instruments like CD Swaps and other derivatives, that will require a complex system to unwind such networks. On page 177, she recommends a division of failed institutions into two entities, one holding the toxic assets. I believe this is the Swedish "Bad Bank" concept although she doesn't use that term.

The bubble was also stimulated by errors on the part of bond rating agencies that "rented" their AAA ratings, in her estimation. This allowed abuse of the securitization process as tranches of weak loans were sold paired with tranches of "good" loans and the capital requirements differed between the "good" or AAA rated tranches and the lower rated tranches. When the crisis came, the ratings did not work and she recommends that capital requirements for institutions holding such instruments be the same regardless of rating.

For a very inexperienced amateur in finance, this has been a very interesting book and a quick read although I have marked places to read again. I could also see it as very useful for college courses in basic finance. I highly recommend it.

46 of 46 people found the following review helpful

5.0 out of 5 stars Understanding the financial meltdown in less than 200 pages November 22, 2009

By R. Pollard

Format:Hardcover|Amazon Verified Purchase

There are dozens of books analyzing the recent financial meltdown and prescribing measures to guarantee that it never happens again. But this one is special. In less than 200 pages, Gelinas gets to the core of the problem - the government adoption of "too big to fail" and the consequent weakening of market discipline. In the final chapter she discusses measures that could prevent or ameliorate future crises, but doesn't offer much hope they will be adopted. Even when discussing complex financial instruments or accounting, her writing is concise and as jargon-free as possible.
If you have only limited understanding of financial markets, this book is a great introduction to recent events. But even financial professionals will benefit from the insight and perspective she brings.

20 of 21 people found the following review helpful

5.0 out of 5 stars Brilliant history of "too big to fail" May 7, 2010

By J. Seidman

Format:Hardcover

I have to say that this book was very different from what I expected based on the description. The bulk of the book consists of an insightful look at how we got into the current mess. Starting with the measures instituted during the Great Depression, Gelinas walks us through the steps that brought us to the financial crisis.

Reading about bailouts and regulatory policy is usually pretty dry stuff. Fortunately, Gelinas has an writing style that makes it incredibly easy to absorb the information. If the subject matter weren't so depressing and infuriating, I would even say that the book was fun to read. Gelinas manages this without oversimplifying anything or glossing over the non-intuitive points.

After completing this background lesson, she provides her recommendations on how to fix the system. I tend towards the libertarian when it comes to regulation, so I expected to disagree with most of what she said. I was surprised to find that, with only a very few exceptions, her suggested remedies sounded effective, prudent, and well-considered. While this section of the book was comparatively small, it was as big as it needed to be; the analysis and history presented earlier lays such firm groundwork that she doesn't need much more argument to be convincing.

Even if you're reading this after a financial reform bill makes it through Congress, I'd still highly recommend this book. It's well worth it to learn what went wrong in our financial sector, and Gelinas's book is the best I've seen on the topic.