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September 1999 - Volume 31 Issue 8

A MONEY, GREED, AND RISK By Charles R. Morris Times Books, $25

Dumb lending is usually at the heart of any financial crisis," writes Charles R. Morris towards the end of this mercifully short, surprisingly engaging review of financial crises down through the ages. His specific reference is to one of the most recent financial crises -- the near collapse last summer of giant hedge fund Long Term Capital Management, the blame for which he correctly lays as much on the firm's imprudent lenders as on the principals themselves. But his larger point is this: When it comes to big-time financial crises, there's really nothing new under the sun. We only think there is.

Morris is one of the more original thinkers around. Of his eight previous books, several -- including The Cost of Good Intentions, a meditation on unintended consequences, and Computer Wars, a look at the forces that brought IBM low some years ago -- are considered minor classics. Money, Greed and Risk is not in the same league as those books, but it has its share of rewards for the patient reader.

Though the book starts slowly, with an excessively detailed look at the financial machinations of the Robber Baron Age, it becomes increasingly illuminating after Morris jumps to the modern age of finance and begins tackling such topics as Michael Milken, the S&L crisis, the leveraged buy-out craze of the 1980s, and last year's Asian currency crisis. Gradually, guided by the author's sure hand, one begins to see the pattern, what he calls "the recurring cycle of financial innovation." Here's how he describes it:

"Technological, demographic, or industrial change creates an essentially new financial demand. After a few false starts, some new invention ... brilliantly meets the challenge. An exuberant development period follows, as more and more firms pile in to take advantage of the sudden opportunity. Exuberance quickly becomes gross excess, precipitating a crisis. The subsequent crash burns off the excess, buyers and sellers adjust their expectations, regulators update their rules and alarm systems, and yesterday's brilliant innovation becomes just another of the industry's workaday departments."

As Morris shows, this is the pattern that allowed for the rise of both the railroads and the steel industry back when J.P. Morgan and Jay Gould were the great financiers of the age. Gould, for instance, devised railroad debt instruments that were snapped up by European investors. Eventually, the whole thing got out of hand, as more and more instruments were issued -- and bought -- until finally it was clear that there was no way they could be repaid through the railroads' cash flow. At which point, the investors made a wild stampede for the exits, the whole structure collapsed, and the American economy suffered -- much like the modern Asian economies have suffered -- as capital was withdrawn from the system. Still and all, the railroads got built, and debt instruments became a common form of American finance.

How different is that, really, from the modern crises involving junk bonds and LBOs? Not very, it turns out. While Milken has long been given credit for inventing junk bonds, Morris points out that his "high yield" debt instruments weren't all that different from Gould's railroad bonds. Each was backed by future cash flow rather than hard assets, and each paid investors a high rate of return because of the higher risk that entailed. What's more, Milken's junk bonds -- like Gould's railroad bonds -- served a worthy purpose, providing capital for the thousands of companies that did not have access to the bond market, which was then reserved for the biggest and most prestigous of American corporations.

And what happened then? Other firms raced to set up their own junk bond departments. Investors raced to buy them up. As junk bonds became increasingly prevalent, they were used to underwrite LBOs and hostile takeovers. Standards were lowered, cash flow projections became ever more pie-in-the-sky -- and sure enough, the whole thing finally blew up into a full-fledged crisis, as one company after another could not back the debt ("dumb lending etc, etc."), and wound up in bankruptcy.

But then the other part of Morris's formula kicked in. Regulators moved in, forcing better disclosure, the system cleaned itself up, and because junk bonds really were a useful innovation, the market for those bonds eventually bounced back. Today, "high yield" bonds are an extremely common form of financing -- so much so that they've become pretty boring as a financial instrument. The Wall Street smart guys have moved onto more exotic instruments.

One question this continuing pattern raises is whether financial crises are avoidable. The answer would seem to be "yes" -- after all, when you've seen this pattern enough times, you ought to be able to predict how it's all going to play out, and stop it before it gets out of hand. But Morris implies the opposite: that no matter how many times they've happened before, financial crises will inevitably keep breaking out. Partly that's because the smart guys always think that this time, with this new financial instrument, it'll be different. They scoff at the doomsayers who predict it will all end badly -- and then when it does end badly, they're shocked. Although Morris doesn't put it this way, human nature is the real reason that financial crises will alway be with us.

Perhaps more dismaying, Morris believes that there is little financial regulators can do to get in front of a financial crisis. "That regulators should be always in the position of sweeping up broken glass after the event is hardly surprising, given the cycle of innovation and crisis," he writes towards the end of the book. The system, he adds, is responding "spontaneously to new demographic, economic or technological developments" -- and there's simply no way regulators can keep pace. Only when things go awry can the regulators -- and everyone else, for that matter -- see clearly what needs to be fixed.

Morris does, however, have one tongue-in-cheek suggestion that might allow regulators to get ahead of the game. "Regulators should ask the dozen or so top financial services firms to fill out a simple questionnaire at the end of each year that shows what their most recent crop of top business school hires are working on," he writes. After all, the hot new talent tends to gravitate to the hot new financial instruments or area -- and that's where the next crisis is likely to occur.

And what is that area right now? From where I'm sitting, it looks like financing for Internet startups is the hottest of the hot areas.

Don't say you weren't warned.

Joseph Nocera is an editor- at- large at Fortune magazine