Niall Ferguson had the unfortunate luck of writing The Ascent of Money just before the unveiling of the 2008’s Great Panic. At the time he finished writing the book in May 2008, only $318 billion of write-downs had been acknowledged.
I was interested in the book because of its focus on the development of our financial institutions. If we want to understand the present and hope to have some insight to the future, then we need to understand the past.
Ferguson starts with the origin of money, “the crystallized relationship between debtor and creditor.” Effectively turning counting into wealth. Once you had money, then you needed banks and clearing houses to aggregate borrowing and lending.
Then the government got involved and introduced government bonds (largely to wage war and pay for the extravagant spending of the monarchies.) This lead to the securitization of streams of payments and highlighted the need for the regulation of securities markets.
Then the sixteenth century brought the rise of the joint stock companies and the market for the trading of these equity interests.
The rise of insurance funds and pension funds in the eighteenth century used the economies of scale and the laws of averages to provide financial protection.
The nineteenth century saw the start of option and future contracts. These eventually morphed into the more sophisticated derivatives seen as a central player the Great Panic.
The last piece was the emphasis on real estate ownership that became a central policy for the twentieth century. This policy, combined with more sophisticated derivatives, became the maelstrom of the 2008’s Great Panic. At the time, the creators and sellers of these products boasted of allocating risk to those “best able to bear it,” when the reality was more that it was being allocated to “those least able to understand it.”
He ends the book with a lengthy afterward called “The Descent of Money.” Those with the pitchforks and torches chasing the bankers will not like where Ferguson ends up. “[F]inancial markets are like the mirror of mankind, revealing every hour of every working day the way we value ourselves and the resources of the world around us. It is not the fault of the mirror if it reflects our blemishes as clearly as our beauty.”
We need to remember that the ascent is not a straight line. It is full of rapid drops, rising bubbles and death-defying falls. “If stock market movements followed the ‘normal distribution’ …, an annual drop of 10% would happen only once every 500 years, whereas on the Dow Jones it has happened about once every five years.”
He spends some time looking at Long Term Capital Management and their collapse in the late 1990s. These quant traders used sophisticated models to identify correlations and uneven pricing. Ferguson focuses on a flaw in their data for their downfall. Their models worked on just five years of data. If they had gone back 11 years, they would have captured the 1987 stock market crash and seen the volatility and unseen correlations.
This fatal flaw sounds much like the flaw in the Gaussian copula function that failed in assessing the risks for mortgage backed securities. They used ten years worth of data in that formula. Unfortunately, the last real estate crash predated that data.
A failure to understand history lead to yet another fatal flaw.
Ferguson does a great job of shedding light on the origins of finance. If you have an interest in finance, then you need to understand the history of finance. The Ascent of Money is worth the time spent reading it.