A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation

PREFACE

What a mess. In the year since A Demon of Our Own Design was published, we seem to have moved from a world where mortgage brokers, bankers, and traders had everything figured out into one of a bottomless crisis—a crisis that could serve as a case study for the risks I set forth in my book. Many profess surprise that Lehman Brothers and Bear Stearns, once Wall Street titans, were wiped out; that Merrill Lynch traded its independence for survival; that many banks have failed while yet others teeter on the abyss. Those caught in the trap set off by the subprime mortgage debacle often speak of the crisis by describing 20 standard deviation moves and 100-year floods, usually in a tone of: “Who could have known? It was a 100-year flood. We can’t be held accountable for such an unforeseeable, rare event.”

Oh yes you can. No one should have been surprised to see this crisis engulf us, because it wasn’t anything we haven’t seen before. Look at the speculation leading up to the collapse of hedge fund Long-Term Capital Management in 1998, or the junk bond defaults earlier that decade. Nor is there anything unusual about the current crisis spreading from CDO issuers and investors to money-center banks or bridging the barrier between Wall Street and Main Street. Look back to the Savings and Loan crisis or the Latin American debt crisis before that. Or look beyond the United States to the Asian meltdown in 1997 or Japan’s “lost decade.” All the talk about 100-year flood events is either ...