Saturday, March 7, 2009

A Financial Crisis Reading List

From Louise Francis at Actuarial Review:

Stories related to the current financial crisis have come to dominate our media. Because of its widespread impact on both individuals and businesses, it is no longer a subject just for the business pages. As individuals and as insurance professionals, we are affected by it. The crisis has damaged a number of insurance companies including some that insured subprime and unconventional mortgages or invested in derivatives based on pools of mortgages or indulged in the now infamous credit default swaps that insured subprime mortgages. For the interested business reader, the crisis provides a high-profile example of the failure of risk management procedures and financial product valuation models.

I recommend the following annotated reading list for those who wish to broaden their understanding of financial crises, the causes, consequences, and possible solutions. The list includes books dealing with past financial debacles, such as The Great Crash, and books specifically addressing the current crisis, such as Chain of Blame. In general, the books on this list are not burdened with a lot of technical detail and a number are highly entertaining.

The Great Crash of 1929 by John Kenneth Galbraith
The greed, irrationality, mass delusion, and excessive use of leverage and exposure to risk that brought about the Great Depression of the 1930s is described in this book. It is entertaining reading and describes everything that is happening in the current crisis, though specific details of the manifestation of irrationality and chicanery have changed.

When Genius Failed: The Rise and Fall of Long Term Capital Management by Roger Lowenstein
This is the very entertaining morality tale about the failure of Long Term Capital Management in the late 1990s. It also describes a great example of the colossal failure of a risk management program due to greed, overconfidence, and the modelers’ (including a couple of Nobel Prize winners) naïve belief that reality should conform to their models, rather than considering how well the model approximated the real world.

Chain of Blame: How Wall Street Caused the Mortgage and Financial Crisis by Paul Muolo and Matthew Padilla
In this book, two financial investigative reporters provide many previous unknown details about the key actors in the mortgage and credit crisis, from well known players like Angelo Mozilo to the more obscure Roland Arnall.

Reinventing Collapse: The Soviet Example and American Prospects by Dmitry Orlov
This short book by a Russian immigrant who witnessed the collapse of the Soviet Union describes how Americans might respond if faced with a similar crisis.

Financial Armageddon: Protecting Your Future from Four Impending Catastrophes by Michael J. Panzner
The first edition was written before the subprime blowup, but predicted it. Aimed at the individual investor, the author warns of four threats to one’s financial well-being: public and private debt, mortgages and mortgage-backed securities, hidden promises that will not be met, and the retirement time bomb. The author predicts a deepening of the current financial crisis and believes a depression is likely, providing advice for surviving it.

Crash Proof: How to Profit from the Coming Economic Collapse by Peter D. Schiff and John Downes
This book—targeted at a general audience—predicted the bursting of the housing bubble and the current financial crisis. The author compares the United States to a playboy who inherits a huge fortune and then dissipates it. He explains how the economy evolved to its current crisis state and predicts a further worsening of economic conditions. The book contains specific investment advice for individual investors.

Irrational Exuberance by Robert J. Shiller

The Subprime Solution: How Today’s Global Financial Crisis Happened and What to Do about It by Robert J., Shiller
Robert Schiller coined the term “irrational exuberance” in the mid-1990s. Unfortunately his warnings about the bubble created by irrational investor behavior were ignored, and we experienced the bursting of the tech bubble after this book was written. This is still a classic that is relevant to the current crisis, and a second edition was published in 2006. In the Subprime Solution, Shiller provides an overview of the causes of the current crisis and his proposed solutions. One of his theories is a worldwide bubble psychology social contagion that spreads in a manner similar to that of a disease epidemic.

Speculative Capital: The Invisible Hand of International Finance, Vol. 1. by Nasser Saber
This book provides a critique of modern finance theory. It also describes how the global economy has shifted to one increasingly dominated by speculative capital. According to the author, speculative capital, under the guise of arbitrage, may reduce the financial system’s exposure to certain kinds of risk, but the price is that exposure to global systemic risk is greatly increased. This book explains how the current structure of financial markets will almost inevitably result in financial crises.

Fooled by Randomness: The Hidden Role of Chance in Life and the Markets by Nicholas Taleb

Black Swan: The Impact of the Highly Improbable, by Nicholas Taleb
Both of these books describe the behavior that led to the current financial crisis. Fooled by Randomness is more concerned with overconfidence and self-delusion on the part of managers and traders that cause them to take on excessive risks that inevitably lead to disaster. Black Swan is more concerned with extreme events and the widespread tendency to ignore the possibility of their occurrence. It addresses the ubiquity of the use of normal/lognormal distributions despite their inapplicability to real-life situations. Taleb is one of the most widely quoted experts on the current financial crisis.