Michael Lewis, author of Liars Poker, Money Ball: the Art of Winning an Unfair Game, and The Blind Side: Evolution of a Game, has once again put forth an important work that yields keen insight into the inner workings of Wall Street.

Lewis has compiled an excellent anthology of articles from modern day financial crises. Lewis reprints (along with some of his own commentary) some of the seminal news articles, white papers, interviews and government reports from past financial panics such as: the 1987 Stock Market Crash, The Asian Currency Crisis of 1997-1998, The Russian Debt Crisis of 1998, the Collapse of Long Term Capital, The “Dot-com” Crash of 2000, culminating in the current Sub-Prime Mortgage Crisis which unfortunately is not quite over.  Lewis lays out the articles in a way that captures the mood and sentiment before, during and after each crisis.

A few things are striking about the book. The first is the format. The anthology format allows the reader to skip around and focus on areas which are the most interesting to him. For example, I enjoyed the finer points of the policy dilemmas facing monetary officials during the Asian Debt Crisis. Do you raise interest rates to defend your currency (at the expense of already weakening exports), or lower them (and risk massive capital flight and deleveraging?) Lewis’s experience as a bond trader at Salomon Brothers yielded some very interesting insights into the debacle at Long Term Capital (“How the Egg Heads Cracked” which Lewis personally wrote for the New York Times in 1999.)

The second is how eerily similar each crisis seems to unfold. It’s almost as if there is a custom made template for financial panics. All you need to do is fill in new dates, the new financial instrument and change the names. The story is almost always the same: 

• A new financial innovation or asset class gains prominence.
• There is a view the innovation has tamed risk.
• The innovation produces fantastic gains for institutions.
• There is a central figure who rises to “rock star” like status and fame (think: Henry Blodget, Jack Grubman, and Michael Milken).
• Stories of ordinary citizens getting obscenely rich proliferate through the main stream media (“dot-com” day traders, Beardstown Ladies, condo flipping bar tenders etc.).
• A prominent member of the financial community stands up and warns of impending risk.
• They are ridiculed and dismissed.
• The bubble bursts.
• Panic ensues.
• The fall out is viewed as destabilizing to the overall financial system and the real economy.
• Congressional hearings begin.
• Society spends considerable resources trying to figure out how this could happen. It turns out no one knows how the first domino falls. The only common denominator seems to be a massive under pricing of risk. Lewis’s opening commentary on quantitative risk management (Value at Risk, Black Scholes etc) is particularly on point.
• Most importantly, once the panic ensues, in almost all cases, there is a prevailing view that the crisis is absolutely insurmountable.
• The storm passes.
• A new bubble forms.

My only complaint about the book is that it did not address the Real Estate Crisis of the early 1990’s, or the bursting of Japan’s Real Estate Bubble, both of which are much more akin to what is happening in America now.  Much of the book revolves around panic surrounding financial and quantitative innovation, however.

What are some of the broader perspectives investors can take away from reading the book? Risk cannot be tamed through mathematical models. They simply cannot predict how humans will react and adapt while under stress.

Panics crashes as well as opportunities have been around for centuries. The list of panics is long and they happen with alarming frequency.  The names, faces, dates and values change from crisis to crisis, but the story line stays the same. While this current crisis is a nasty and deep one, investors would be wise to remember the predictable story line of “Panic” also includes the word “Recovery.”

-Gerard Mihalick, CFA