Finance Lessons From a Curved World

Despite the panicked gravity of the credit crisis and the troubled bailout attempt in recent weeks, David Smick must have watched the events unfold with a tinge of bemusement. Smick, chairman and CEO of Johnson Smick International, Inc., might have been puzzled that so few other financial experts saw this mess coming as clearly as he did, as evidenced by his new book, The World Is Curved: Hidden Dangers to the Global Economy (Portfolio, 2008).

"So many people were saying that we have a credit crisis because there was over-aggressive lending to poor people," says Smick from his Washington office in between nonstop interviews with NPR, U.S. News & World Report, and numerous other media outlets eager for his insights. "Well, that occurred, but how does this bring the global financial system to its knees in a way that the world has not seen since the '30s? Something far more fundamental occurred. This is an enormous failure of risk management, both by the financial services companies themselves and by the regulators."

Smick, who edits and publishes The International Economy quarterly, is difficult to pin down politically. He worked on former Republican congressman Jack Kemp's staff, supported Democratic senator Bill Bradley's presidential campaign, and counts many well-connected influencers on both sides of the political divide. This is refreshing because his insights are sharp and candid.

"This shows you the power of the financial services industry," he notes. "Any other industry that pulled this kind of marginally legitimate approach would be run out of town or locked up. I'm not saying that the people are criminals -- yet here they are, getting a bailout. It's pretty amazing. You can see why there is outrage from both the right and the left."

Smick's analysis of the credit crisis is useful to corporate finance executives and their staffs outside of the financial services sector; a discussion with him produced the following insights:

• No one is eating our salad. Thanks in large part to the easing of the Glass-Steagall Act via the Gramm-Leach-Bliley Act in 1999 (passed with the bipartisan consent of the U.S. Congress and the support of the Clinton administration and Republican-appointed Federal Reserve Chairman Alan Greenspan), the banking sector fundamentally shifted how it conducted business. Syndicated banking gave way to the process of securitization.

"This was a big move because it allowed for a very effective process for assessing risk and handling and distributing capital -- unless the entire system of securitization came under attack. And this is what has obviously happened now," says Smick.

He favors a food analogy when describing the mortgage-backed securities that corrupted so many balance sheets. Investment banks have been "making up a giant salad of asset-backed securities," Smick explains. The salad has been tossed and looks delicious, but there's one problem: Lurking beneath the lettuce are various pieces of poisonous leaves. "If you eat that piece you die," he adds. "The problem is that the United States has gotten to the point where the world isn't ordering any salad because they don't know where the bad stuff is."

As a result, bank CEOs don't trust that their counterparts at other banks know what's on their balance sheets. And central banks around the world have a similar, and understandable, crisis of confidence.

The purveyors of these salads, or structured investment vehicles (SIVs), made fundamental miscalculations: They believed that they did not need to measure the risks inherent in these new securities too carefully (because they would be sold and resold quickly), and they seemed to believe that if the SIVs did encounter trouble, the fallout would not find its way back to the companies where they originated before they were financially engineered into a so-called "independent" structure.