Risk management litmus tests for the next generation of Wall Street brains...

The NOBEL PRIZE panel granted its top award to seven leading economists – whose theories went on to cost investors trillions of Dollars in losses.

This story – as well as some of the other top financial fiascos through the ages – is detailed in the new book, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System, written by Martin Hutchinson, a former merchant banker and Money Morning columnist, and Kevin Dowd, an economist and respected academic.

Here, Money Morning executive editor William Patalon III sits down with Hutchinson to talk about the book...

Money Morning: Congratulations, Martin. Alchemists of Loss is a great book. What prompted you guys tackle this topic. Was there a single incident or event that motivated you to do it, or was there kind of an "epiphany" moment?

Hutchinson: I did a piece on risk management for Financial Engineering News in late 2006, which the editor sent to Kevin Dowd to review (my article said that Wall Street had it all wrong and should be using fuzzy logic). Kevin sent a lengthy reply, through which we discovered we agreed on a lot; so we became buddies and agreed we should do a project together. When the crash happened, it looked like an excellent opportunity, and much to my joy, he had the contacts at the publisher, John Wiley & Sons Ltd, to get it accepted.

MM: What major conclusion, or conclusions, did you come to in your research... as well as in the book itself? What's the most important conclusion you reached?

Hutchinson: Kevin may disagree, but my favorite section is Chapter 15, which is about risk management. There we propose two "litmus tests" for extreme risks that Wall Street should be using today to weed out CDO squared, credit default swaps and the other rubbish the "quants" may come up with in the future. We think our "litmus tests" are strong enough to catch anything they can come up with, but recognize that we could always be surprised!

Of course, our overall conclusion that they granted seven Nobels for a spurious set of theories was also an enjoyable one! Tracing how the modern finance theory virus got into Wall Street was interesting – Kevin knew all sorts of stuff that I didn't, and vice versa.

MM: Did this experience change your views on global finance, investing, and the lot? Or did it reinforce your views? In either case, what was that key view?

Hutchinson: I think it crystallized and reinforced my view that Wall Street has gone wrong in the last 25 years, and that misguided incentives and agency problems are crucial in explaining why it went off the rails. I did a piece, "The rent seekers of Wall Street," in April 2006, so I was already thinking along these lines, but doing the book made it all much clearer. Chapter 7 (mostly Kevin) on managerial versus shareholder capitalism was also key to explaining what had gone wrong.

MM: Did anything surprise you in your research? In other words, is there something you found out, or discovered, that created a "holy cow!" moment?

Hutchinson: There were several. Among the most illuminating was the discovery that Overend, Gurney & Co. (a London wholesale discount bank that was known as "the banker's bank), which had gone bust in 1866, had made essentially the same mistakes as Lehman Brothers!

MM: Is there anything else about this experience, or your research, that you'd like to mention?

Hutchinson: Books, particularly with a really good collaborator (so you have someone to discuss it with, apart from the unfortunate wife and family), and a publisher you have confidence in, are enormously satisfying to write, because you feel (somewhat spuriously, of course) that you've done something permanent. Journalism, let alone blogs, doesn't do that.

Years from now – say, in 2300 – the book will still be in the British Museum Reading Room and the Library of Congress. So some future economic history student can get his Ph.D through rediscovering it!

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