Sterling Astray

Bruce Sterling is the superlative science fiction writer, co-founder of cyberpunk, who wrote Holy Fire. The novel combines advances in medical science that extend life with "the miracle of compound interest" to produce a society in which the old are the "haves" and the young are the "have nots." The novel is beautiful, as are most of Sterling's. And the novel relies on compound interest--which is so unusual, that the story is even better!

But Bruce is barking up the wrong tree with his recent blog post, which links to an interview which blamed the current financial mess on financial engineering. Maybe Bruce does not know so much about finance. Financial engineering involves breaking up various risks and returns from a business activity and selling them off, piecemeal. So maybe you buy a bond and sell off the risk that the issuer might default on the bond, while retaining the risk that interest rates might rise, lowering your bond's price. But financial engineering is in no way to blame for the current crisis.

Bruce, why did financial institutions make loans to people whom they knew could not repay? If you cannot answer this, then the explanation cannot pass the smell test. As I have posted before, the answer is pretty basic.

Government required banks to make loans to people who could not pay through 1977's Community Reinvestment Act. They made this crazy lending painless for the institution by requiring the government giants, Fannie Mae and Freddie Mac to buy lots of those bad loans and package them into securities (the bank gets rid of their risk, the government assumes the risk, then sells government guaranteed risk). Finally, Alan Greenspan cut interest rates too low for too long encouraging a real estate feeding frenzy--many warned at the time.

Bruce, this answer passes the smell test--heck, it is compelling. Self-interested politicians ramped up risk in order to put their poorer constituients in homes. Barney Frank even confessed that he was "rolling the dice" in ramping up this risk.

Without the rot underneath the leverage and derivative pricing, there is no story.

We are currently looking at a government mess, not a free market mess. The pioneers of financial engineering, Miller, Modigliani, Scholes and Merton (to which I will add Fischer Black) discovered fire. Beginning with Fannie Mae's creation in the Great Depression, the U. S. government took a flamethrower to the free market.