Panic:
The Story of Modern Financial Insanity
edited by Michael Lewis
W. W. Norton, 352 pp.

or those of us who enjoy watching twenty-two behemoths maul each other on autumn weekends, no figure of speech beats a good football simile. So helmets off to Michael Lewis for coming up with a classic in his 1999 New York Times Magazine account of the collapse of Long-Term Capital Management, a tale now anthologized in Panic: The Story of Modern Financial Insanity. A hedge fund that specialized in fixed-income arbitrage, LTCM was run by ex-academics who were widely considered too brilliant to lose money, let alone preside over one of history’s greatest financial disasters. Lewis had worked with several of these LTCM eggheads during his days on Salomon Brothers’ bond desk, and he recalls the humbling experience of asking them to elucidate one of their arcane trades. Minutes after receiving a step-by-step explanation, Lewis realized that he had barely understood a word.

"My brain," he writes, "felt like a beaten cornerback watching the receiver dancing into the end zone."

The simile perfectly captures what it feels like to be hopelessly outsmarted. Yet raw intelligence, like raw athletic prowess, is no guarantee of success, especially when it’s tempered by hubris. According to Lewis, the "young professors" of LTCM goofed by underestimating the probability of a supposedly 1-in-50-million event—a sudden, unprecedented divergence in the prices of bonds they’d shorted versus bonds on which they’d gone long. When Russia defaulted on its debt on August 17, 1998, that "black swan" became a reality; four days later, LTCM lost $550 million in a single trading session.

The Federal Reserve rushed to arrange a $3.625 billion bailout for the floundering company—peanuts compared to the current round of government largesse, but a whopper at the time. Lessons were supposedly learned about the perils of mathematical trading strategies, and Wall Street’s mandarins vowed to avoid the temptations of excessive risk.

Yet here we are a decade later, struggling to overcome a much graver calamity caused by similar blunders. As Lewis, Panic’s editor, writes in his sharp introduction, such crises have become the norm because, like LTCM’s young professors, we’ve developed an unhealthy faith in the system’s inherent stability. Lewis thinks this is because we put too much stock in the genius of statistical wizards, who have a disturbing tendency to discount the likelihood of destructive events.

"Events that are meant to occur once in a millennium now seem to occur every few years," Lewis writes. "Could this be because the financial system was built on an idea that badly underestimates the risk of catastrophes—and so conspires with human nature to create them?" Panic, an eclectic collection of fifty-five articles, book excerpts, and oral histories, attempts to answer that question by examining four big crises of recent vintage: the stock market crash of 1987; the Asian and Russian crises of 1997–98; the dot-com flameout; and the ongoing credit crunch. Like most scattershot anthologies, a fair chunk of Panic is tedious and skippable. But entertaining gems abound, especially those written by Lewis himself.

Panic is broken down into four sections, one per crisis. Lewis cleverly begins each section with a selection describing the irrational exuberance that typically precedes hard times. A Time piece from the summer of 1987, for example, merrily tracks several do-it-yourself investors making a killing off the bull market, often by leveraging themselves to the hilt. (One of the interviewees reveals that his foolproof strategy is to invest only in companies whose products he enjoys, a policy that led him to go long on a manufacturer of microwave popcorn.) Nearly ten years later, the New York Times sings the praises of emerging markets, letting fund managers pop off about the solid returns available to investors willing to chance Thailand on the eve of the baht’s disastrous devaluation.

These vignettes are followed by stories from the thick of the ensuing havoc, as contemporary commentators stumble around looking for answers. In the case of 1987, Panic never makes clear what caused the
Dow to crash on Black Monday; conflicting pieces both indict and clear computer trading, and an excerpt from the Brady Commission report reads like a snack-cake ingredients list. The section’s main takeaway is that regardless of what caused the Dow to start plummeting in the first place, the crisis was exacerbated by simple distrust between financial institutions—the big reason that global credit markets gummed up last fall, too. "Nobody would pay anybody if they suspected somebody wouldn’t pay them," notes Leo Melamed, then head of the Chicago Mercantile Exchange. "So fear was the gridlock."

The section on the Asian and Russian crises is much more illuminating, particularly a Fortune analysis penned by Paul Krugman, who convincingly pins much of the blame on corruption and bloat. (Dispiritingly, he also frets over the fact that Asia’s economies were highly leveraged, which he defines as debt exceeding equity by four or five times. By contrast, Lehman Brothers’ leverage ratio was more than 30 to 1 before its immolation.) The other two highlights of the section are both Lewis’s handiwork: the LTCM postmortem, which includes a wonderfully lucid explanation of the fund’s arbitrage strategy; and a brief Bloomberg News dispatch in which he lampoons the idea that the market gives a whit about the pronouncements of politicians. Traders, Lewis states,

have no interest in what Bill Clinton or Boris Yeltsin say about the Russian ruble, or many other financial matters. On finance, they prefer to hear from George Soros. Think of it! If the President of the United States wished to manipulate the world’s financial mood, he could do it more effectively by calling Soros and asking him to say a few words. This is the world we live in.

This is one of Panic’s most sobering thoughts, not because Soros’s wisdom shouldn’t be respected—as clearly it should—but because it hints at the financial industry’s increasing disconnect from the tangible world. Lewis is disturbed by the retreat of traders into the realms of their Bloomberg terminals, an existence that skews their perception of risk. They become enamored of allegedly foolproof strategies for dispersing risk, yet can’t foresee the obvious pitfalls because of their immersion in the esoterica of derivatives. And thus the average investor wakes up one morning to learn of the existence of a multitrillion-dollar market in something called credit default swaps, which absolutely no one claims to understand fully.

Despite building some nice momentum throughout its Asian-Russian section, Panic loses steam as it delves into dot-com excess. This is partly because that crisis seems so mild in retrospect. I don’t recall too many earnest newspaper accounts of former "paper millionaires" being dragged from their foreclosed homes. On top of that, the bubble was pretty straightforward—folks got overly excited about companies whose worth couldn’t be accurately gauged, seeing as how they’d never made a thin dime. That’s a lot easier to grasp than the rampant currency speculation that forced Thailand to devalue the baht, or how LTCM’s arbitrage strategy was exposed by Russia’s debt default. As a result, Panic’s dot-com section works only as a hit of nostalgia, rather than shedding any new light on the financial system’s foibles.

Lewis bravely tackles the credit crunch in the book’s final section, and does an admirable job given that we’re still sorting through the wreckage (and, perhaps, preparing for more debris to be added to the pile). He gets creative by including a Dave Barry satire of house flipping and a blog post about a California family that managed to buy a $1.2 million mansion for $270 down, as well as more prosaic Wall Street Journal and BusinessWeek articles about the perils of sub-prime mortgages.

The section’s standout, however, is Roger Lowenstein’s 2008 New York Times exposé on Moody’s, the bond-rating service that stamped many high-risk mortgage securities with its vaunted "triple A" rank. Lewis’s
thesis about risk dovetails perfectly with the well-reported, well-written evidence that follows. Moody’s was the backbone of the mortgage economy, assuring investors worldwide that the securities they were buying were extremely unlikely to morph into junk. Lowenstein senses more than a whiff of impropriety in Moody’s miscalculations, noting that the agency reaped massive financial rewards by playing the Pollyanna. But there also seems to have been simple hubris at work—a belief that, if structured correctly, mortgage-backed securities could survive a wave of defaults on their sub-prime elements. Ooops.

Panic could have used a few more contributions like Lowenstein’s, as well as an extra dose of Lewis’s witty, cogent musings on the consequences of traders’ vanity. But given the accelerated pace of the boom-and-bust cycle, perhaps Lewis will get to compile a sequel in the not-too-distant future. Because once some small measure of prosperity returns, so, too, will the self-styled magicians who claim they can make risk disappear. And we will get fooled again.