Frequently Insightful but Often Misleading
By David Henderson
That’s the title of my review of Jonathan Kay’s book Other People’s Money. It appears in the latest issue of Regulation.
Here’s my introductory paragraph:
I can’t give a AAA rating to John Kay’s new book on finance; it’s closer to a BBB+. Other People’s Money is full of insights and, unfortunately, is sometimes misleading in important ways. His big-picture arguments are basically correct: that the financial sectors in the United States and the United Kingdom are overly complex and out of control; that this helped cause the 2007-2008 financial crisis; and that much of the dysfunction can be traced to regulation. Unfortunately, he misunderstands key events in U.S. economic history, and that detracts from his analysis. And some of his proposed reforms are too vague to be useful; they sound more like wishes than reforms.
Here’s my comment on one of the book’s strengths:
One of his most important insights is that much of the complexity of financial instruments is due to government regulation. He lays out, for example, how the Basel Accords, which most of the world’s major wealthy countries pledged to follow, led to some mischievous, but totally predictable, “regulatory arbitrage.” Kay writes, “The basic rule on capital requirements is that a bank must have equity capital–the money that can be lost before a business is forced into insolvency–equal to 8 percent of its assets.” Forget for a minute that, as Kay points out, 8 percent seems awfully low; the situation gets worse, and the reason has to do with the risk-weighting of assets. Mortgages carried a risk weighting of 50 percent, meaning that the capital requirement on such mortgages was 4 percent (8 percent × 50 percent) of the mortgage principle. But–this is my example, not Kay’s–mortgage-backed securities (MBS) carried a risk weighting as low as 20 percent.
Can you see where this is going? Kay does, but an example would have been helpful. Here is mine: Imagine that a bank has 10 high-quality mortgages on its books for $100,000 each, for a total of $1 million. On those mortgages, it must hold capital of $40,000. The bank manager would like to relax that constraint, so what does he do? He packages the mortgages into an MBS, which requires that the bank hold only $16,000 (8 percent × 20 percent × $1 million) in capital on that security. The risk hasn’t changed, but the capital requirement has fallen by 60 percent.
And my comment on one of the book’s weaknesses:
Kay also misleads readers about two relatively recent financial-industry heavyweights, Michael Milken and Frank Quattrone. He points out correctly that Milken helped invent “junk bonds.” But Kay’s tone is one of disdain and he ends his short section on junk bonds with the sentence, “Milken went to prison.” Most readers will probably conclude that Milken should have gone to prison. However, though he did break several laws, those breaches appear to have profited him very little and cost others very little. In 1991, federal Judge Kimba Wood, who had earlier sentenced Milken to a stiff prison sentence, told his parole board that the total loss from his crimes was $318,000. In the 2011 book Three Felonies a Day, one of his defense lawyers, Harvey Silverglate, wrote, “Milken’s biggest problem was that some of his most ingenious but entirely lawful maneuvers were viewed, by those who initially did not understand them, as felonious precisely because they were novel–and often extremely profitable.” Although Silverglate clearly was an interested party, that statement fits the facts that I have been able to ascertain over the years. Milken was unfortunate enough to have been targeted by a politically ambitious U.S. attorney named Rudy Giuliani, who wielded the Racketeer Influenced and Corrupt Organizations Act to intimidate Milken.
Similarly, Kay writes that Frank Quattrone of Credit Suisse “expected favors from friends and clients in return for allocations of hot stocks.” But Kay gives no citation for this claim. I think there’s a good reason for this: a lack of evidence. For what really happened in the Quattrone case, see my “Hurray for Frank Quattrone: Rotten Tomatoes for the Media” (TCS Daily, August 28, 2006), and the even more extensive article, “The Case for Frank Quattrone,” by Roger Donway (Atlas Society, July 1, 2004).
And I can’t let pass his comment about “well-educated young white men baying for money and praying for liquidity.” Did he really need to mention the race, age, and gender of market participants? if they were old black women, would their actions be less deserving of criticism?