17th century tulips from Gottorfer Codex
On February 5, 1637, speculators gathered in a college in Haarlem. This wasn't the kind of college that handed out degrees, but a college in the old sense—a group of professionals gathered together to do business, and this Haarlem was not the neighborhood in the borough of Manhattan, but the municipality in the Netherlands. The setting for their meeting might not have seemed all that professional, located as it was in the back of a large tavern. The business they were about was odder than then setting. All these men, men from respectable backgrounds, men dressed in the somber dark clothing of their day, men whose version of Calvinism was so strict that it taught them to disdain things as frivolous as nearly all art and even most church music, men whose city was at that very moment enduring an outbreak of the Black Death... were there to sell tulips.
Actually, that's not quite right. They were there to sell the idea of tulips. The promise of tulips. What was going on at the Haarlem bar was not a tulip trading market, it was a tulip derivatives market, trading on flowers that did not yet exist.
The group of men gathered in Haarlem was only one of several such colleges spread over the Netherlands. There was no central organization. No fixed means of brokering trades between different location. No rules beyond what each group of men drafted between beers. The people who gathered there were for the most part not professional traders. They were blacksmiths and fish mongers, school teachers and pig farmers. All of them had left their jobs, and many of them had sold all they had, on the chance to participate in trading scraps of paper bearing the names of future flowers.
On June 22, 2007 investment bank and securities trader Bear Stearns was headquartered in a spiffy officer tower along Madison Ave. It was not exactly a tavern, and was (to put it mildly) several blocks from Harlem. There were plenty of other differences between the people inside the octagonal high rise and those black-cloaked figures shuffling into a back room in the Netherlands. These were no amateurs. None of these men had any job
but the exchange of fiscal information. Even scraps of paper was too blunt an object for their attention, they dealt in wisps of fiscal data.
They still dealt with futures, the promise to buy or sell an asset at some coming date, but that wasn't the core of their business. They still dealt with options, contracts that gave the choice to buy or sell at a given price during a future period, but that wasn't the core of their business. They had moved on.
A big part of what Bear Stearns sold were swaps, contracts in which obligations of one fiscal instrument are traded for obligations against another. These swaps came in a bewildering array of variations. There were asset swaps and currency swaps, swaps that behaved very like a loan, and swaps that allowed someone to lay a bet on the return or loss associated with some other form of financial instrument. Among that last kind, the kind of swap where you could gamble on the outcome of another instrument, was one called a Credit Default Swap. Bear was selling a lot of those. So were a lot of other people.
That June, Bear Stearns borrowed a bit of money from some of its fellow banks by using Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund as collateral to cover debts owed by the Bear Stearns High-Grade Structured Credit Fund. Actually, it was more than a bit. It was $3.2 billion dollars—quite a lot, considering that Bear Stearns had originally seeded the fund with a relatively meager $35 million. Both of these funds were CDOs (collateralized debt obligations), a type of fund that promises to pay investors a rate of return based on the value of the assets held by the fund. Funny thing was, though both funds were still valued in the tens of billions of dollars, both seemed to be running out of dollars to make their payments.
It might have signaled some concern, but after all. These men were professionals. Besides, a lot of people were doing similar things. And worse things.
We only have pictures to go by, the actual flower is long gone, but by all accounts the tulip that went by the name of Semper Augustus was exceedingly lovely. Snow white teased by feathery flames of intense scarlet, there's nothing like it to be had today. That certainly accounts for part of the reason a bulb of this tulip once sold for 2,500 florins—about 15 times what a skilled worker in the Netherlands at that time could expect to bring home in a year, and about the price of a lovely canal-side home in a fashionable neighborhood.
Of course, it wasn't just the flower's beauty that gave it such a price. It was also exceedingly rare. That bulb that went for so much was one of two known. The owner or the other example turned down an offer of four times as much. If it sounds like a lot, think of what people are willing to pay for a Honus Wagner baseball card, or an Action Comics #1, or square of canvas decorated by someone like 19th century Dutchman, Vincent van Gogh. All of these objects have their own form of beauty, but it's the rarity, the cachet of owning something that no one else can have, that adds all those extra zeros to their price.
The tulip market started out being about beauty. It went from there into a competition over rarity. It eventually became something else.
In 1636, Dutch tulip traders began to broker trades for the right to buy tulips that had not yet been produced. They had created a futures market. It was at this point that the market really exploded. The price of tulip futures edged up, and up, and up. Men who had never had a tulip in their own garden gambled all they owned on paper promising bulbs the following spring. If they couldn't buy all of a contract, they could still buy part. As more and more people rushed in, the prices continued ever upward.
At this point, the market was no longer about beauty, not longer about possessing rarity, it was simply about money.
At the start of the market for Credit Default Swaps, there was a rather prosaic purpose to these instruments. They acted as private insurance, particularly for objects or events that might be tough to insure by normal means. Exxon bought credit default swaps against the potential payout from the Valdez oil spill. JP Morgan developed a form of credit default swap that acted like a sort of a waste bin into which banks could sweep their existing debts.
The origin of credit default swaps has neither the beauty of a flower, nor the rarity of something like a Semper Augustus bulb. However, it did have something in common with the tulip. It had flexibility. If Dutch growers found tulips easily transformed into different shapes and colors, Wall Street bankers found that credit default swaps were even more amenable to change. They could twist swaps into any form they liked, particularly once they made the most critical change—divorcing the ownership of the swap from the ownership of the underlying instruments.
Once it was possible to buy a swap against someone else's deal, then the same core fiscal instrument could become seed stock for dozens, or hundreds, or thousands of swaps. A few million in actual assets could turn into billions of theoretical dollars. In early November of 2008, there were $62.2 trillion in credit default swaps outstanding—equal to the GDP of the entire planet. And actually, that's probably a huge understatement. The real number that brokerage firms ware carrying in the form of default swaps may have been two times higher, or ten times higher.
The biggest reason that we don't know for sure is that credit default swaps carried another similarity with the tulip trade. They were almost completely unregulated. There was no central clearing house, no one to verify the value of what was being traded. Most of the trades were (like those 17th bulb futures contracts) carried out directly between two parties rather than between a party and a regulated exchange. Often the same banks that participated as one or both of the parties involved, also acted as the broker for the deal. Which was an excellent means of inflating net worth beyond all reason. As happened at Bear Stearns.
The credit default swap market started out as insurance, and became a matter of convenience. It turned into a game of musical chairs for the highest stakes imaginable.
It's that last point where tulip traders and investment banks really come into alignment. When you're selling a flower or insurance, you're providing an item that has at least a little underlying value. When you're selling the opportunity to participate in a contract against something as ephemeral as beauty, or rarity, or the chance to make a fortune, the only thing that gives such a deal value is the confidence that someone else values it even more highly than you do.
If I have a dozen cows, and I fail to sell them today, I still have the cows. Maybe I'll sell them tomorrow. Maybe I'll eat them myself. They have value even if they don't get traded. On the other hand, if I have a contract that pays out based on the number of calves with white noses born next spring, the value is all in the speculation.
The value of something like that calf contract exists only if someone is willing to buy it from me. If you buy it, it may be because you've got some insight into the genetics of my herd, but more likely it's because you think you can sell your contract to someone else for still more money. There's a very accurate name for the power behind such investing: the greater fool theory. You're willing to pay a price for something with no intrinsic value, because you're betting that somewhere out there is someone willing to pay even more—a greater fool than you.
However unlikely it may seem, the pool of available fools is limited. By February of 1637, all those people rushing to get into the tulip futures market found that there was no one left waiting to buy. Contracts that had been selling for higher and higher prices didn't just decline, the failed to sell at any price. By the time tulips actually appeared that spring, some were destroyed in anger, many were left uncollected, few held any value.
The spring of 2008, with the domino collapse of Bear Stearns, AIG, and other major players in the credit default swap market should be another good example of the non-inifinite supply of fools, but for one thing. That market found its fools. It found us.
Rather than take their lumps, the investment banking business convinced our proxies in the government, both Republican and Democrat, that we needed them to get by; that a general collapse of the investment banking sector would doom the economy. The truth is, they're probably right. We do need institutions that provide business loans, offer investment opportunities, broker arrangements between buyers and sellers, and all those other actions needed to ensure that dollars are available to business and individuals. Without credit and opportunities for investment, the economy might not die, but it would certainly be a very stagnant, slow-moving place.
The thing is, nothing says we need these institutions. Nothing says we have to tolerate the level of self-congratualtory arrogance that pays million dollar bonuses from bailout funds. Nothing says we have to reward incompetence with guaranteed profitability, or mistake institutionalized gambling for free enterprise. Nothing says we have to accept that instruments of fiscal destruction are equivalent to "creativity," or buy into the argument that only the people who have turned Wall Street into a financial sewer know where the shut-off valves are hidden.
We can't do without institutions that promote growth and investment, but we can certainly do without institutions that lionize greed, arrogance, and recklessness. The threat that they might fail should be no threat at all.
In fact, what we should be looking for from Wall Street is reasons why we shouldn't take them apart. Repeated experiments in giving the investment community rope, whether it's savings & loans or investment banks, have demonstrated their willingness to hang the whole nation. Given that evidence, the smart thing to do is stop giving them rope, damn it. Instead, look at ways to trim back their influence.
Many people went broke during the tulip trade. A few got very rich, but the wealth of the nation did not increase. It didn't increase during the collapse, but it also didn't increase during the rise of tulip prices. After all, whether we're talking tulip futures or credit default swaps, these are instruments of wealth concentration, not wealth creation. At the end of the deal you have no more value than what came into the market from outside, it's just in fewer hands. What happened is that people who had been doing productive work that created items of lasting value, instead turned to the market as a way to make a living. Even in good times, that's a net loss.
Somewhere along the line Wall Street has decided that among the hands involved in the markets, theirs should never come up empty, but writing in the Harvard Business Review, Umair Haque makes an excellent case for discounting the value of Wall Street.
If I had to pin those realities down, I'd say the following deserve a place on the list: That the wealth of a nation isn't merely the sum of its tradable riches; that a thriving marketplace isn't a big box store; that industrial output matters less than human outcomes; that work that matters yields accomplishments that endure; that Goldman Sachs probably shouldn't be as profitable as Apple, because builders should earn more than shufflers; that the worth of an enduring achievement is denominated in more than mere profit; that how we feel about our lives is worth more than how enviably glamorous they look; that tomorrow matters more — not less — than today.
The idea that we can not live without the current generation of Wall Street institutions is as much an illusion as the value of Semper Augustus... and a lot less pretty.
NOTE
If you're interested in learning more about tulips, the tulip market, and why 17th century varieties of this flower were so much more appealing than the monocolor blobs that pop out of your garden in the spring, a terrific place to start is with Michael Pollan's The Botany of Desire.
I'd also urge you to go to the Harvard Business Review and read Umair Haque's article, which contains a lot more of value than I've quoted here. In fact, if you happen to be on Wall Street today for... reasons of your own, you might want to read it aloud.