How They Broke the Machine

In the America of the 1850s a steam boiler blew up almost every four days. Boilers sat in factories, in mills, on riverboats, and every one of them was a little bomb with a pressure gauge. In 1865 the boilers of the steamboat Sultana went up on the Mississippi, and more than eighteen hundred people died. There has never been a worse disaster of its kind.

Ban steam? Nobody suggested it. Steam turned the whole country. They suggested something else. A group of young men in Hartford who worked with steam engines themselves had argued about one idea in their club for years, and in 1866 they founded a company. It insured boilers and inspected them too. The logic was simple. The insurer doesn’t want to pay for an explosion, so he sends an inspector. The owner doesn’t want to be refused cover, so he fixes whatever the inspector finds.

The boilers kept blowing up. But less often. And then less often still.

I’m starting a book about money with a boiler because that’s how you should look at money. Money, banks, exchanges, insurance, bonds—they’re not morality and they’re not a conspiracy. They’re machines. People invented them for their own jobs, and like every new machine, first they blow up, then they get fixed, fitted with gauges and handed over to inspectors. The man who understands how the machine works lives longer than the man who curses steam.

The Machine They Took Apart Bolt by Bolt

Here’s the most recent explosion. You’ll remember it.

In the early 2000s American banks handed out mortgages to almost anyone, because house prices kept going up, and it seemed that if the borrower didn’t pay you could always sell the house for more. The loans were bundled into packs, the packs sliced into layers, the layers given handsome ratings and sold to investors all over the world, and plenty of people along the chain took a commission and passed the risk on. Whoever made the loan often held it for so short a time that he never had a chance to get scared. Someone else had to do the getting scared: the banks and funds where those layers finally came to rest, and bought with borrowed money, at that.

The first crack showed in the summer of 2007. Two Bear Stearns funds stuffed with this paper began to go under. Merrill Lynch, which had lent money to those funds, seized eight hundred and fifty million dollars of collateral and tried to auction it off. It found buyers for a hundred million. The rest, it turned out, nobody wanted at any price. In mid-July Bear Stearns admitted that both funds had lost nearly everything.

Notice what broke. The houses were still standing, though some borrowers had already stopped paying, and that rot was real. But more collapsed than had rotted. Yesterday the paper was worth a dollar, today nothing, because nobody knew how much rot was in it, and nobody would take it even for what it was worth. Two troubles came together: bad loans cut the payments, and fear killed the market itself. The machine worked as long as people believed in it. They stopped, and it stopped. In less than a year Bear Stearns itself went down, then Lehman Brothers, then everything else. How that happened we’ll go through in detail when we get to houses and neighbourhoods.

For now one thing matters. Mortgages, securitisation, ratings—they’re ordinary inventions, like the steam boiler. They didn’t blow up for just one reason, but one reason you can see straight away: somebody took off the gauge. Borrowers were checked any old how, because whoever made the loan sold it on fast. The risk didn’t vanish. It travelled on and piled up with the people who’d bought it on credit. And nobody wanted to be the inspector while the commissions were coming in. Why would they?

The Invention Everyone Copied

Financial inventions have one nasty feature: you can’t patent them. A scheme that works gets copied by everyone who sees money being made on it, and usually copied badly.

An example from our world. In New York at the start of the twentieth century some extortionists began signing their letters to shopkeepers “the Black Hand”. Dickie writes that the idea clearly owed something to the ever-present press. The name travelled to Chicago, San Francisco and New Orleans, and for a while you heard it more often than the word “Mafia”.

Then came what the legitimate economy calls brand dilution: Black Hand letters were no longer written only by gangsters. Jealous neighbours sent them, and rival traders, and working men at the end of their rope, and plain jokers. Anyone could sign. In 1905 a San Francisco paper reported that the “organisation” had thirty thousand members and branches in a dozen cities. Petrosino, the best Italian detective in New York, laughed at that. There was no organisation. There was a label, and anybody could pick it up. But Black Hand bombings and attacks went up fourfold between 1903 and 1907.

In Sicily, Dickie notes, cheapening the brand like that was unthinkable. There the gangs kept a tight monopoly on intimidation. An outsider started scaring people in their name, and they didn’t fuss with him for long. So you get a choice every financier knows. Keep the invention under control and you keep the quality, but you’ve made yourself a monopolist. Let it go and it spreads round the world, and half the copies are knocked together in somebody’s back yard.

Before 2008 mortgage paper was churned out by everyone who’d watched the neighbours making money on it. A lot of the copiers had nothing but a blank form and an appetite.

When the Machine Stalls

One last thing about financial machines: you can’t abolish the function.

Saviano describes the Camorra putting its money into legitimate business in Naples and even in Aberdeen, in Scotland, and investigators found a pattern there. When legitimate business is in crisis, illegitimate business throws a party. Ran out of cash—they printed fake banknotes. Needed capital in a hurry—they sold forged securities passed off as government bonds. In Aberdeen, Saviano writes, this system is called “the scratch”. Like a DJ: you hold the record with a finger for a second, let go, and it runs faster.

Remember that the next time someone proposes abolishing banks, banning credit or shutting down the exchange. People still need to borrow, to save, to insure and to share risk. Break the honest machine or ban it, and a fake takes its place. And fakes don’t come with inspectors.

Don Vincenzo understood this better than a lot of economists. When they put a steam boiler into the second laundry, the salesman offered an insurance policy with an annual inspection thrown in. The Don agreed to the inspection before he agreed to the insurance. Strange? No. Every spring a man from the insurance company in a grey jacket came round, spent half a day crawling about the boiler, swore at the gaskets and left. We were paying him to spoil our mood. The Don called it the best money of the year. No joke. The boiler worked for thirty-one years and never once blew up, and the insurance was never once needed. I said once that it looked as if we’d been paying for nothing. The Don looked at me like a man who’s come in dry out of a downpour and is cursing his umbrella. It was the grey jacket that kept us dry, not the policy. The policy is for the day the jacket misses something.

The Bottom Line

If someone offers you a machine with no inspector, ask yourself: who pays when it blows?