The Big Short by Michael Lewis
What does one do all day down in responsibility-free Florida? Well, I just read a marvelous book about the financial collapse of 2008, The Big Short by Michael Lewis, Norton, 2010. Ordinarily, I wouldn’t even attempt to read a book about the complex workings of Wall Street, but this book is a character-driven narrative. It has a plot, and even though you know when the climax will occur and what it will be, the journey to it is marvelously engaging.
So it reads like a novel—but a novel that is packed with information, not only info about the technical stuff of the Wall Street bond market, but about the greed, mendacity, arrogance and stupidity of a great many of the highly-paid officials of Wall Street investment corporations.
Lewis follows the lives and investments of three small time investors (and the companies they form) who, at least four years before the collapse of 2007-2008 saw that the entire world of sub-prime mortgage bonds was a house made of cards. He walks along side them as they discover more and more about how little anyone on Wall Street really knows about the complicated instruments they are so blithely selling, tracing their growing flabbergastation at each new revelation of stupidity. What drives this narrative also, is our curiosity about how their gamble to short these CDOs eventually turns out.
Here are a few quotes or paraphrases that get at the heart of the story. The three “characters in this story by mezzanine CDOs to sell short.
What is a mezzanine CDO? Wall Street investment banks conned the rating agencies [Moody and Standard and Poor] into blessing piles of crappy loans; this enabled the lending of trillions of dollars to ordinary Americans; ordinary Americans happily complied and told the lies they needed to tell to obtain the loans; the machinery that turned the loans into supposedly riskless securities was so complicated that the investors had ceased to evaluate risks; the problem grew so big that the end result was the crash that culminated in September, 2008 (243).
But worse than that, “the credit default swaps, filtered through the CDOs were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. . . . They weren’t satisfied getting lots of unqualified borrowers to borrow money they couldn’t afford. They were creating them [the CDOs] out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the subprime loans (Steve Eisman quoted by Michael Lewis in The Big Short , 143).
The CEOs of every major Wall Street firm were on the wrong end of the gamble, yet “all of them, without exception, either ran their public corporation into bankruptcy or were saved from bankruptcy by they United States government. [Yet]they all got rich” (256).
To explain how this could happen, Lewis, in his conclusion, takes us briefly to 1981.
“John Gutfreund [CEO of Salomon Brothers]had done violence to the Wall Street social order—and gotten himself dubbed the King of Wall Street—when, in 1981, he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation. . . . He and his partners not only made a quick killing: they transferred the ultimate risk from themselves to their shareholders. . . . The shareholders who financed risk taking had no real understanding of what the risk takers were doing. . . . All that was clear was that the profits to be had from smart people making complicated bets overwhelmed anything that could be had from servicing customers, or allocating capital to productive enterprise.
“No investment bank owned by its employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs to be sold to its customers. The short-term expected gain would not have justified the long-term expected loss (Lewis 257-258).
Lewis concludes that nothing has been fixed on Wall Street because the financial institutions are still public corporations, and so the people running them do not bear any of the financial risk. Think what would happen if you could engage in risk free gambling.
So it reads like a novel—but a novel that is packed with information, not only info about the technical stuff of the Wall Street bond market, but about the greed, mendacity, arrogance and stupidity of a great many of the highly-paid officials of Wall Street investment corporations.
Lewis follows the lives and investments of three small time investors (and the companies they form) who, at least four years before the collapse of 2007-2008 saw that the entire world of sub-prime mortgage bonds was a house made of cards. He walks along side them as they discover more and more about how little anyone on Wall Street really knows about the complicated instruments they are so blithely selling, tracing their growing flabbergastation at each new revelation of stupidity. What drives this narrative also, is our curiosity about how their gamble to short these CDOs eventually turns out.
Here are a few quotes or paraphrases that get at the heart of the story. The three “characters in this story by mezzanine CDOs to sell short.
What is a mezzanine CDO? Wall Street investment banks conned the rating agencies [Moody and Standard and Poor] into blessing piles of crappy loans; this enabled the lending of trillions of dollars to ordinary Americans; ordinary Americans happily complied and told the lies they needed to tell to obtain the loans; the machinery that turned the loans into supposedly riskless securities was so complicated that the investors had ceased to evaluate risks; the problem grew so big that the end result was the crash that culminated in September, 2008 (243).
But worse than that, “the credit default swaps, filtered through the CDOs were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. . . . They weren’t satisfied getting lots of unqualified borrowers to borrow money they couldn’t afford. They were creating them [the CDOs] out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the subprime loans (Steve Eisman quoted by Michael Lewis in The Big Short , 143).
The CEOs of every major Wall Street firm were on the wrong end of the gamble, yet “all of them, without exception, either ran their public corporation into bankruptcy or were saved from bankruptcy by they United States government. [Yet]they all got rich” (256).
To explain how this could happen, Lewis, in his conclusion, takes us briefly to 1981.
“John Gutfreund [CEO of Salomon Brothers]had done violence to the Wall Street social order—and gotten himself dubbed the King of Wall Street—when, in 1981, he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation. . . . He and his partners not only made a quick killing: they transferred the ultimate risk from themselves to their shareholders. . . . The shareholders who financed risk taking had no real understanding of what the risk takers were doing. . . . All that was clear was that the profits to be had from smart people making complicated bets overwhelmed anything that could be had from servicing customers, or allocating capital to productive enterprise.
“No investment bank owned by its employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs to be sold to its customers. The short-term expected gain would not have justified the long-term expected loss (Lewis 257-258).
Lewis concludes that nothing has been fixed on Wall Street because the financial institutions are still public corporations, and so the people running them do not bear any of the financial risk. Think what would happen if you could engage in risk free gambling.
I also read this in the last 6 months, and agree that it does an excellent job of weaving story and detail.
ReplyDeleteFor the amount of greed and deception that is laid out in this book, the scarier part to me was the massive amount of naivety. Well intentioned services that accidentally or blindly misled people into financial wrecks.
A version of "follow the money" only Lewis wants us to follow the incentives to determine how this happened. For example: lenders benefit if you are going to refinance in 5 years to avoid your balloon payment (another loan to process and fee), but the homeowner has an incentive too since they have cash now to pay down high interest debt, a lower interest rate for those 5 years, and their house is going to increase in value anyway. Right?
And then it doesn't increase in value and all the cards fall. And only the homeowner loses their incentive. Everyone else got to keep theirs.
Thanks for putting me on the trail of good book, Dave. I spend most days these days in a neighborhood with a 25% of homes/households foreclosure rate, and have friends/colleagues in ministry who are "losing our house". The effects of the American free greed system are not pretty closeup.
ReplyDeleteHave you read an earlier Michael Lewis book, Moneyball? I've been a Oakland fan for 42 up and down years (more down)and never understood Oakland's/ B. Beane's system. Michael un-inscrutes the inscrutable. Linda and I enjoyed the movie of the same name also.
Be well. If you don't get back to Iowa soon you will miss spring. I'm deer and rabbit proofing the green stuff coming out of the ground NOW, March 6th.