The long-awaited All the Devils Are Here: The Hidden History of the Financial Crisis has arrived, marking the end of a nearly two-year-long stretch of books commissioned in the months after Lehman Brothers fell. Like many titles, this one is mildly hyperbolic. If the history of the crisis was "hidden," it was hidden away in plain sight in the pages of newspapers, magazines and books. That said, Bethany McLean and Joe Nocera have done an impressive reporting and synthesizing job, and they provide the most complete, serious and sophisticated description of the genesis of the real estate bubble we now have. They reveal no new smoking guns or moral transgressions; their thesis seems to be that the bubble was a complex phenomenon, fed by diverse streams and motivations, from commonplace greed to the drive for power, achievement and market share to sheer ignorance and error. Indeed, ignorance and error predominate, particularly when it comes to judgments about that abstraction du jour, risk.
All the Devils Are Here provides necessary context for books as disparate as Gregory Zuckerman's The Greatest Trade Ever and Michael Lewis' The Big Short, to Andrew Ross Sorkin's Too Big to Fail and to the pile of tomes about the fall of Lehman and Bear Stearns Cos. Its strength lies in its clarity and sheer explanatory power. Nocera and McLean dig deeply into the real estate problem, exploring its roots in the formation and evolution of government-sponsored enterprises, through the thrift crisis and into the era of securitization and subprime. The book is best when it hews closest to real estate. Its discussion of broader currents of deregulation, Federal Reserve monetary policy and trade imbalances -- all of which played a role in the bubble -- is perfunctory or absent. Its thumbnail portraits of major characters are briskly and professionally done, but offer few revelations: There's lonely golfer Stanley O'Neal, hot-tempered Joseph Cassano, man of action Hank Paulson. The book also feels thinner as the material grows more familiar: Once the crisis broadens out to threaten Wall Street, you begin counting pages to the end. And they fail to say much that clarifies their own thoughts about what happened and what needs to be done. Their epilogue focuses more on the Obama administration -- the populist rage against Wall Street and Goldman, Sachs & Co. and the Dodd-Frank legislation -- than a thorough conclusion. Maybe they ran out of time.
Still, this is a book that demands to be read closely and pondered. This is no cartoon of good and evil, no reduction of complexity to caricature, no polemic: It's a real book for adults. Like Michael Hirsh's recent Capital Offense, which examines the Washington end of the crisis -- more deregulation and economics than real estate -- All the Devils Are Here tries to break down episodes of blindness and miscalculation into human terms. Why did this happen to folks who were supposedly so brilliant? (McLean's earlier book on Enron, The Smartest Guys in the Room, had a similar thrust.) Again, the title is a reach: There really are few "devils," that is figures of pure evil, here, if that term refers to people rather than to allegorical sins like Cupidity, Greed, Error or Blindness. Even a clearly bad guy like Roland Arnall of subprime lender Ameriquest comes off as shrewd, gracious and smart -- if also slick, heartless and venal.
The two are sophisticated enough to understand the difficulties of white-collar criminal prosecutions, and they don't spend much time trying to drag folks to jail (though in the case of Arnall, you wish someone had). But whether it's Countrywide's Angelo Mozillo or American International Group's financial products chief Cassano or the folks running Merrill Lynch & Co.'s mortgage desk, the emphasis returns again and again to failures of judgment and analysis -- mistakes often (but not always) born from overweening ambition, hubris and passivity. They do not fixate on the pay issue -- most major players make the kind of compensation that can either drive you mindlessly forward or provide the freedom to see clearly. There are too many other explanations that make more sense. Hanging like a backdrop over everything is the question: Why would anyone with foresight willingly create a cataclysm that threatened to destroy them all? The answer: Many truly believed that crap could be turned into gold. Magical thinking remains far from dead.
At the heart of All the Devils Are Here lurks the intellectual failure of risk management. McLean and Nocera trace the history of risk management to the pre-Chase J.P. Morgan & Co., which developed both "value at risk" as a risk management concept, only to see it widely adopted and misused, and using many of the same financial tools, derivatives like credit default swaps, which also migrated from useful to toxic. Morgan's chairman Dennis Weatherstone in the early '90s possessed a deep understanding of markets, and Morgan became a skilled and creative shop on both the risk and product sides, as Gillian Tett pointed out in Fool's Gold. But good ideas can go seriously bad.
VaR was one of them. They show how a skilled executive like Weatherstone understood what VaR could and couldn't do (as did a disciplined firm like Goldman Sachs). VaR helped bolster the common perception that the black swan of a nationwide real estate decline was so improbable as to be ignored. And in ignoring that possibility, the less-than-triple-A tranches in securitized mortgage-backed bonds were magically transformed into the triple As of collateralized debt obligations and then, the ultimate abstract financial tool, into the intensely speculative synthetic CDOs. Along the way, these instruments, which mushroomed in size, complexity and abstraction, were vetted (in theory) by credit rating agencies and by investors hungry for product. In fact, these "analysts" increasingly passed these complex bundled vehicles mindlessly through their models, scrubbing them "clean," then allowing them to wildly proliferate.
This was an enormous and ubiquitous intellectual error (and powerfully persuasive because of its ubiquity), and, like a computer virus, a self-propagating one. It was a megaerror that, in the fertile mix of money, power, complexity and performance in finance, blew up into an enormous bubble. Mere criminality could not create such a vast bubble; it required a kind of true belief, not only in efficient markets, but in diversification, securitization, and the "known" realities of real estate -- not to say the gospel of home ownership as the embodiment of the American dream. What was the nature of this error? Who is truly accountable? Are homeowners who took out mortgages either without knowing their full destructive effect or in the belief that they could always refinance morally better than institutions or Wall Street firms that depended on conflicted credit raters to analyze pools of mortgages that they believed were too complex to tackle themselves? Who is really to blame in a process in which so many, large and small, believed they were profiting?
McLean and Nocera return to these themes again and again. Even as far back as the "first" subprime crisis of the '90s, they write, "there was a legitimate debate over who was more culpable: the lender or the borrower. After all, borrowers often wanted to get their hands on the money every bit as much as lenders wanted to give it to them. Not everyone was being gulled; many borrowers were using the rising values of their homes to live beyond their means. And there were plenty of speculators, betting that they could outrun their mortgage payments by flipping the house quickly. The line between predatory lending and get-rich-quick speculating -- or a desperate desire for cash -- was often difficult to discern." McLean and Nocera remind readers more than once that refinancings overwhelmed new home purchases -- a fact that undercuts the stereotype of subprime buyers as innocent seekers of the American dream.
Another motif they pursue is the notion of "a race to the bottom." Again and again, they point out instances of supposedly "good" competition leading to bad outcomes. The steady slide of subprime from a business pursued by a few shady predators to larger entities with "standards" like Countrywide to, eventually, the GSEs, which had always eschewed "nonconforming" mortgages, is one long race to the bottom. So too is the deleterious effect of regulatory competition, which opened the door to regulatory arbitrage, and nudged regulators from being overseers of banks to seeking bank "customers." This eventually produced a pernicious form of regulatory capture that mimicked the belief that someone "else" -- credit raters, the market -- would take care of business: a systemic forfeiture of responsibility. "Here was the ultimate consequence," they write, "of the delinking of borrower and lender, which securitization had made possible: no one in the chain, from broker to subprime originator to Wall Street, cared that the loans they were making and selling were likely to go bad. In truth, they were taking on huge risks in granting these terrible loans. But they were making too much money to see it. Everyone assumed that someone else would be holding the bag."
How could we miss all this? At several points they step back to suggest that more folks understood what was happening than many of the commentators have suggested. It wasn't just John Paulson, Michael Burry, Goldman Sachs and a handful of others trying to short mortgages in 2006 and 2007. They argue that a number of hedge funds were getting in on the action, which drove mortgage indexes for one last wild ride. But many still believed, while others were isolated in their bureaucratic cells and the politics of all this was brutal. In subprime, they recount multiple attempts by state and local officials to rein in lending excesses -- attempts foiled by the policy of pre-emption, which left any bank overseen by a national regulator like the Office of the Comptroller of the Currency and the Office of Thrift Supervision immune to state and local laws. "In theory, preemption makes sense -- companies always want to play by one set of rules, instead of having to adopt 50 different rules in 50 different states," they write. Alas, there was no federal law to check abusive lending. And so lenders flocked to sign up with the OTS (which, post-S&L crisis, essentially lost its franchise) and the OCC, including even, toward the end, Countrywide itself (which was then punished when it needed its old regulator, the Fed, to save it). In this case lender competition grew entangled in regulatory competition and dragged each other down.
All the Devils Are Here is a clear-eyed introduction to the post-industrial jungle with its networks, frictionless interchanges, murky sense of accountability and unexpected consequences. This is the deep background of the financial crisis -- an explanation as to how such highly trained, quantitatively expert practitioners could go so wrong. Complexity undermines accountability: Credits that seem to have no home, but that morph and proliferate in often opaque networks, are dangerous and occasionally lethal. Size militates against control -- and creates abstractions out of harsh tangible realities. Bureaucracies seemingly designed to evade accountability arise. The end of these highly evolved networks of finance is often not a race to the top or the diffusion of risk, as a race to the bottom, a correlation of risk. The scariest thing about All the Devils Are Here is not so much that business schools have sent thousands of self-interested souls into the world, it's that, for all their training and all their skills, they represent a vast failure of analysis and judgment. It's hard to say what's worse: Enron-like venality or the sheer blindness, stupidity and capacity for self-delusion required to inflate a bubble.
Robert Teitelman is editor in chief of The Deal.
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