U.S. financial asset markets recovered from the Armageddon of 2008 more rapidly than other financial markets around the world. As can be seen in Charts 9.1, 9.2, and 9.3, since the beginning of 2013 financial assets have traded in the United States at spreads that are near (or even below) the complete market bands near the bottom of each graph.

Trading in this range represents attainment of the financial market equilibrium Adam Smith envisioned in 1776. As a consequence, the response of U.S. capital markets has been in line with the projections shown in the complete market row (top row) in Table 9.1. Complete market conditions mean that the cost of operating Smith’s great wheel of circulation is sustained at the minimum price necessary to keep it functioning—ideal conditions for growth of productive sector capital and wealth generally.

It is in these conditions that bubbles are most likely to develop and spawn the fear that creates new crises. Bubbles pose, therefore, a long-term challenge to the theory of financial stability. As credit spreads rise above equilibrium, it is clear that the ability of an economy to grow is impaired. As that rise becomes more rapid and significant, moreover, a financial crisis occurs. By observations made between 2005 and 2014, the United States now has sufficient experience with policies that benefit and harm markets to handle future crises of fear caused by high and rising risk spreads.

A final question we should address, therefore, is: Can the world sustain equilibrium in finance without generating future crises?

To answer affirmatively requires a commitment to continuous improvement that has proven elusive in the past, and an understanding of how the mathematics that drives financial market values changes at equilibrium. The first part is a moral, legal, and social issue. The second part is a difficult intellectual challenge for investors who see mathematics as the ultimate unchanging certainty of science.

Thus, the hardest part of explaining financial stability is to (1) show that the same laws of mathematics that assure the world’s capacity to regain stability during a crisis guarantee instability at equilibrium, and (2) convince investors that this is just fine.

At equilibrium, we must sustain financial stability by balancing mathematically assured instability. That is why we must end too-big-to-fail and pursue the elimination of fraud. We must burst bubbles while they are small (knowing that others will grow), and take steps to ensure no bubble becomes too big to burst on its own. That is how long-term financial market stability is assured.

Let’s start the discussion of this apparent contradiction with an English nursery rhyme

Oh, the grand old Duke of York,

He had ten thousand men;

He marched them up to the top of the hill,

And he marched them down again.

And when they were up, they were up,

And when they were down, they were down,

And when they were only halfway up,

They were neither up nor down.

       (“The Grand Old Duke of York,” traditional nursery rhyme)

and a story.

Before he headed AIG Financial Products, Tom Savage, the PhD mathematician who built that business and ran it until 2001, worked at a New York investment banking firm. In the early 1980s, he provided the mathematical foundations for stand-alone CMOs. But his work also showed that despite the mathematical precision of cash flows and prepayments involved in a CMO, there is also a great deal of uncertainty.

While writing the prospectus for the first stand-alone CMO, drafters encountered a problem calculating the rate of return for holders of the equity tranche. Owners of that class are sometimes required to pay taxes in addition to their initial investments, while at the same time receiving distributions that often (but not always) offset future payments. As a result, they are investing and receiving returns at different times throughout the 30-year life of the structure.

A prospectus writer’s calculator kept showing different rates of return on the owners’ investments even though he was using identical data inputs for each calculation.

When Savage was consulted he told the stunned writer, “all your answers are correct.” He explained that whenever an investment turns from inflow to outflow more than once, return on investment has more than one solution.

Savage offered an example of a leveraged lease with multiple investments. Bankers had sold it as an investment providing a 30 percent rate of return. A disappointed buyer showed them that it was yielding only a 6 percent rate of return (using the bankers’ stated assumptions) and demanded rescission for fraud (recall that rescission does not require a showing of intent to defraud, only a misrepresentation that is, in hindsight, material). The mathematician proved both answers were correct.

Now, let’s go back to the nursery rhyme. The duke’s army knew what was up and what was down but “when they were only halfway up they were neither up nor down.”

So it is with financial stability. Under the law of compound interest, when spreads are heading up we know that’s bad and when they are heading down we know that’s good. But when credit spreads are at equilibrium near their minimum sustainable levels, they go neither up nor down to any appreciable degree.

In these circumstances, investors move money in and out of investments all the time. When they do both more than once, the ability to say, with certainty, how their investment fared terminates by the same laws of mathematics that give absolute certainty to returns when money is only (1) invested and (2) returned.

When spreads are narrow, moreover, investment brokers face an ever-increasing incentive to create more and more transactions. For investors, each new transaction has an ever-increasing risk of being one that suffers because expectations of gain eventually prove to be exaggerated. Thus, very few periods of sustained low credit spreads have ever ended well.

Under the laws of mathematics, that’s axiomatic. The science of physics also teaches us that a stable state is not a usual condition. So how do we sustain financial stability when we know stability is unstable?

The first sustainer is diversification. The second comes by a recognition that instability and fraud increase in tandem. Therefore, there must be an ever-stronger commitment to overcome fraud when times are good. At low spreads, more and more investments are made that create ever-changing risks. That means more and more fraud will be committed because more and more investments require multiple cash inputs and create multiple rates of return. That assures an increase of investments that use two (or more) measures, the fundamental duplicity that for 4,000 years has defined fraud.

In the leveraged lease example, the way to have avoided fraud would have been a disclosure that the rate of return would be both 6 percent and 30 percent, depending on the buyer’s perspective. That’s a much harder sell than advertising a 30 percent return, but it’s the only sell that will prevail when events make it profitable for the investor to seek rescission.

Too-big-to-fail also comes into play when spreads are low. When fraud increases, brokers want the government to guarantee any returns that could later become the basis for rescission by investors.

So, mathematics assures an ever-increasing amount of fraud and ever-rising pressure for government support as policymakers achieve financial market equilibrium. Consequently, the world can sustain financial market stability by eliminating too-big-to-fail and maximizing pressure to avoid fraud.

The result is a balance between inflating and bursting tiny bubbles—ones that do not create systemic risk—rather than permitting enormous crisis-generating bubbles. That is what distinguished the dot-com bubble of 2000–2001 from the crisis of 2007–2009. Investors lost a lot of money when the Internet bubble burst, but there was no systemic risk of 1930s-style debt deflation necessitating the application of nationalization cum monetization to restart the system.

The source of too-big-to-fail is the linkage of fraud to entities with government guaranteed liabilities (banks, brokers, and pension funds, to name a few). By guaranteeing liabilities, government enhances stability in normal times by assuring investors that it has an interest in avoiding crises in which guarantees become forced expenditures. The process, however, is easily contaminated.

Politicians quickly learned that cash invested by the high-risk S&Ls of the early 1980s created just as many new jobs as an equivalent amount of government expenditures, but without the need to budget the costs. In short, investments by artificially inflated S&Ls quickly generated an off-balance sheet Ponzi scheme sponsored by the U.S. government. That led to a political crisis in 1988–1989 as the insured deposits came due and speculating S&Ls went broke.

That process was repeated in the late 1990s and early 2000s using fraudulent SIVs and financial-asset sales that were allowed by the FDIC even though they were not true sales. Both created off-balance sheet liabilities of numerous types of United States–guaranteed entities. This invisible added leverage boosted short-term economic growth but also embedded instability into the system. The Great Recession, moreover, involved uninsured entities (e.g., AIGFP) that became so intertwined in the financial affairs of insured entities, such as Citigroup, that they created systemic failure risks because of the number of insured and guaranteed entities that relied on them for solvency.

The fraudulent use of SIVs largely ended with the recognition that the liabilities of an entity managed by another entity that also supports an SIV’s unexpected loss are debts of the manager. Fraudulent sales will end when the accounting and legal professions universally and uniformly accept and apply the very high true-sale standard that the U.S. Financial Accounting Standards Board adopted in 1997, and that the FDIC accepted in 2010. The appendix to this book includes (1) a worksheet for auditors to monitor the six circumstances that must be addressed to create a true sale (within and between enterprises), and (2) the form of legal opinion that demonstrates that a transferor has achieved that standard.

Sustained financial stability can, therefore, be attained. The process to do so, however, cannot be assured without achieving worldwide cooperation among financial professionals, regulators, and investors. Only when these three constituencies agree to do the right thing can we hope to achieve some semblance of long-term financial stability.