Panic

Edited by Michael Lewis, this anthology collects journalism, government reports, interviews, and analysis written before, during, and after four major financial panics between 1987 and 2008. Lewis frames the collection with original introductions to each section, arguing that these crises share a common intellectual root and that panic has become a routine feature of modern financial life.

In his introduction, Lewis identifies the Black-Scholes options-pricing model as the theoretical foundation of modern risk management. Portfolio insurance, a strategy derived from Black-Scholes, promised investors protection by increasing short positions (selling borrowed assets to buy them back cheaper) as markets fell. The flaw was that when markets crash and no buyers remain, selling becomes impossible, and the attempt drives further declines. Despite this failure, the financial industry never abandoned the model, and by 2006, $415 trillion in derivatives—financial contracts whose value is tied to underlying assets—existed without a satisfactory pricing framework. The introduction presents Nassim Nicholas Taleb, author of The Black Swan, as a leading critic who contends Black-Scholes systematically underestimates the risk of rare, extreme events. Lewis frames the subprime crisis—stemming from high-risk mortgage loans extended to borrowers with weak credit histories—as this problem's most democratic expression: Both Wall Street professionals and ordinary homeowners made the same bet that real estate values would never fall.

Part I covers the stock market crash of October 19, 1987, which Lewis calls the first of a new breed, suggesting disastrous consequences but producing no serious long-term economic effects. A Time piece from July 1987 captures the bull market's euphoria. Accounts from the Wall Street Journal and the Brady Commission, a presidential task force, reconstruct Black Monday. The panic began in Chicago's stock-index futures pit, where S&P 500 futures (contracts tracking the stock index) plunged into free fall as portfolio insurers dumped massive quantities of contracts, at one point representing 41 percent of public trading volume. The Dow fell from above 2,000 to 1,738. The next morning, New York Stock Exchange (NYSE) Chairman John Phelan coordinated with floor directors to open stocks sharply higher and ban program trading, the computer-driven bulk trading of many stocks at once. Lewis's excerpt from his memoir Liar's Poker describes the scene at Salomon Brothers, where bond traders cheered while the equity department sat in despair.

Post-crash analysis reveals competing explanations. Economist Lester Thurow argues computers were not to blame, pointing to stocks being overvalued relative to bonds. Yale economist Robert Shiller's survey research shows the crash was a self-reinforcing vicious circle of price declines feeding on previous declines. Reform efforts stalled as the Securities and Exchange Commission (SEC), the Brady Commission, and the Federal Reserve fought over jurisdiction. Economist Franklin Edwards concedes that, after thousands of pages of studies, no one knows what caused the crash.

Part II traces the 1997–98 Asian financial crisis and the collapse of Long-Term Capital Management (LTCM), a prominent hedge fund—a lightly regulated investment partnership drawing capital from wealthy individuals and institutions. When the Thai government devalued the baht in July 1997, capital flight spread across Southeast Asia. Paul Krugman writes in Fortune that the crisis was worse than anything since the early Depression, arguing the International Monetary Fund's (IMF) strategy of demanding high interest rates and austerity had failed. The crisis spread to Russia, which defaulted on its government bonds in August 1998, and economist Jeffrey Sachs criticizes the IMF for inadequate assistance during Russia's transition from communism.

Lewis's New York Times Magazine piece on LTCM traces the fund to John Meriwether's group of quantitative traders—analysts who use mathematical models to identify pricing discrepancies—at Salomon Brothers. Meriwether founded LTCM in 1993 to apply mathematical models to exploit pricing inefficiencies in bond markets. The fund's collapse unfolded in two stages: First, Russia's default caused Wall Street firms to liquidate positions identical to LTCM's. Then, as word spread of LTCM's weakness, other firms allegedly preyed on its known positions. The fund lost $550 million on a single day. A consortium of 14 Wall Street firms ultimately injected $3.6 billion in exchange for 90 percent of the fund, while LTCM's partners, who had invested $1.9 billion of their own money, were wiped out. Retrospective articles document lasting effects: Developing countries accumulated massive foreign reserves as insurance, the five most-affected Asian nations saw their growth rates fall, and South Korea's suicide rate nearly doubled.

Part III chronicles the Internet boom and bust, from Netscape's August 1995 initial public offering (IPO) through the Nasdaq crash of 2000. Lewis argues the boom was fueled not just by greed but by genuine idealism. Netscape, a 15-month-old company that had never turned a profit, saw its shares open at $71 on a $28 offering price, giving co-founder Jim Clark a stake worth half a billion dollars. Lewis's excerpt from The New New Thing describes how the Internet formula turned traditional capitalism on its head: Companies persuaded people to invest first and hoped profits would follow.

Jack Willoughby's March 2000 Barron's article serves as the crash's catalyst, documenting that at least 51 of 207 publicly traded Internet companies would burn through their cash within 12 months. John Cassidy's excerpt from Dot.con reconstructs the collapse: The Nasdaq peaked above 5,000 on March 10 and by April 14 suffered its worst week in history, falling 25.3 percent, with $2 trillion in market wealth destroyed. Other pieces expose the era's excesses, from analysts covering more than 35 stocks while their firms sought banking business from the same companies, to dot-coms spending millions on Super Bowl ads. Lewis's post-crash essay defends the boom, arguing it produced real economic benefits while the scapegoating of Wall Street analysts distorted history.

Part IV covers the subprime-mortgage crisis and housing bubble. Lewis distinguishes this panic by the sheer number of people involved and the impossibility of identifying a single culprit. The section opens with humorist Dave Barry's satirical take on the American belief that real estate is an easy path to wealth. A 2002 Wall Street Journal investigation reveals how inflated appraisals enabled mortgage fraud. John Cassidy's November 2002 New Yorker article presciently warns of a housing bubble, noting prices had risen 40 percent since 1997 and that Fannie Mae and Freddie Mac held $4 trillion in combined assets, concentrating enormous risk in institutions with thin capital cushions. Senator Christopher Dodd's March 2007 hearing statement chronicles regulatory failure: Regulators identified deteriorating credit standards in late 2003 but did not finalize guidelines until 2006. Financial journalist Roger Lowenstein reveals how credit rating agencies assigned triple-A ratings to subprime securities using models that assumed housing prices would keep rising, then had to downgrade more than 5,000 securities when those models failed.

New York Times reporter Peter Goodman's December 2007 dispatch from Cape Coral, Florida, documents the human toll: The city eliminated building inspector jobs, foreclosure filings quadrupled, and families waited in darkened homes. Kate Kelly's Wall Street Journal profile reveals that Bear Stearns CEO James Cayne was playing bridge in Nashville without a cellphone during 10 critical days of his firm's hedge fund crisis in July 2007. Coverage traces how two Bear Stearns hedge funds pioneered a new form of collateralized debt obligation, a security assembled from pools of debt, that tapped money-market funds (low-risk investment vehicles) to channel capital into the mortgage market. The resulting structure collapsed, helping spark the broader credit crisis. Paul Krugman argues this crisis differs because the problem is not temporary illiquidity but genuine insolvency, with more than 20 million homeowners potentially owing more than their homes were worth.

Gregory Zuckerman's Wall Street Journal profile of hedge fund manager John Paulson reveals the crisis's biggest winner. Paulson's funds rose 590 percent in 2007 by purchasing credit-default swaps, a form of insurance against debt defaults, that the market had priced cheaply because it underestimated mortgage risk. Paulson earned an estimated $3 to $4 billion personally, the largest one-year payday in Wall Street history.

Lewis closes by questioning whether the recurring cycle of euphoria and panic reflects not a system that needs fixing but the fundamental nature of global capitalism, with financial markets growing ever more opaque, ever more complex, and ever faster in their oscillations between boom and bust.