Monday, March 21, 2011

The Big Short: Inside the Doomsday Machine

Felix Salmon in writing a review in Barnes and Noble Review of The Big Short[1] stated, “The Big Short is not the story of the crisis, as the crisis is commonly understood. The failure of Lehman brothers and of Fannie Mae and Freddie Mac; the stock-market crash; the bail-out of Detroit; the fevered all-nighters pulled at Treasury and the New York Fed; the fears that the entire global financial system was on the brink of collapse -- little if any of that is in this book.

Instead, Lewis has found a different story -- one which he started mining for a spectacular cover story in the December 2007 issue of Portfolio magazine, and which has culminated in this book, over two years later. It's the story of what used to be called the "subprime crisis" before it metastasized into something much larger and more dangerous than that. And it's also, like all Michael Lewis tales, a human story, which takes us deep inside unique characters like Steve Eisman and Mike Burry.

On the face of it, there's almost nothing sympathetic about these men. Their social skills are all but nonexistent; they live in a world of arcane financial analysis which might as well be a different planet for all that it has any bearing on the way that most of us live our lives; and they made their outsize profits by wagering hundreds of millions of dollars on the proposition that Americans across the country would end up being thrown out of their homes after they found themselves unable to make their mortgage payments.

What these men did was not "socially useless," to quote the chairman of the UK's Financial Services Authority, Lord Turner. It was worse than that: it was actively harmful, since they provided the fuel which kept the subprime mortgage furnace burning even when the country was running out of new junk mortgages to write.”

This is a well written story that every thinking person needs to read. We have been on a journey for a number of years that has now taken us to the position that we have two economies – the real economy and the financial economy. Coupled with that we have discovered that procedural innovations (changes in the way people interact with people) is a lot easier that product or process innovations. As a result a lot of the creative talent and innovative energy has been devoted to innovations in financial instruments so complex that they have become WMDs (weapons of mass deception). Not only did they deceive the general public, but their peers and themselves as well.

Lewis has a quote at the beginning of the book that touches on the blind faith almost everyone had in these financial instruments:

The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.

-Leo Tolstoy, 1897

The unbelievable size of the transactions and greed lead inexorably towards the tragedy it was born to be. Unfortunately, the game was rigged, the ones who perpetrated the deception walked away with tens of millions of dollars while the rest of us paid. And the people who paid dearest were those who defaulted on their mortgages and lost their homes.

Quoting Salmon, the book “is that rarest of beasts in a world drowning in financial-crisis books: a new book which actually breaks news. For instance, Lewis uncovers what could possibly be the single greatest trade that any Wall Street banker ever made: in December 2006 and January 2007, Deutsche's Greg Lippmann paid an insurance premium of 0.28 percentage points to take out insurance on $4 billion of triple-A-rated bonds from Morgan Stanley's Howie Hubler. Less than a year later, that $11 million bet paid off to the tune of a whopping $3.7 billion. I'll save you the math: that's an annual return of more than 33,000%.

There's lots more where that came from: this is an assiduously-reported and beautifully-written book. There aren't many reasons to be happy about the global financial crisis, but here's one: that it brought Michael Lewis back to his roots, to produce what is probably the single best piece of financial journalism ever written.”

Here are a few excerpts from the book:

Whatever Eisman was meant to be doing got pushed to one side. His job became a single-minded crusade against the Household Finance Corporation. He alerted newspaper reporters, he called up magazine writers, he became friendly with the Association of Community Organizations for Reform Now (ACORN), which must be the first time a guy from a Wall Street hedge fund exhibited such interest in an organization devoted to guarding the interests of the poor. He repeatedly pestered the office of the attorney general of the state of Washington. He was incredulous to learn that the attorney general had investigated Household and then been prevented, by a state judge, from releasing the results of his investigation. Eisman obtained a copy; its contents confirmed his worst suspicions. "I would say to the guy in the attorney general's office, 'Why aren't you arresting people?' He'd say, 'They're a powerful company. If they're gone, who would make subprime loans in the state of Washington?' I said, 'Believe me, there will be a train full of people coming to lend money.'"

Really, it was a federal issue. Household was peddling these deceptive mortgages all over the country. Yet the federal government failed to act. Instead, at the end of 2002, Household settled a class action suit out of court and agreed to pay a $484 million fine distributed to twelve states. The following year it sold itself, and its giant portfolio of subprime loans, for $15.5 billion to the British financial conglomerate the HSBC Group.

Eisman was genuinely shocked. "It never entered my mind that this could possibly happen," he said. "This wasn't just another company -this was the biggest company by far making subprime loans. And it was engaged in just blatant fraud. They should have taken the CEO out and hung him up by his fucking testicles. Instead they sold the company and the CEO made a hundred million dollars. And I thought, Whoa! That one didn't end the way it should have." His pessimism toward high finance was becoming tinged with political ideas. "That's when I started to see the social implications," he said. "If you are going to start a regulatory regime from scratch, you'd design it to protect middle- and lower-middle-income people, because the opportunity for them to get ripped off was so high. Instead what we had was a regime where those were the people who were protected the least."

What prepared him to see what was happening in the mortgage bond market, Paulson said, was a career of searching for overvalued bonds to bet against. "I loved the concept of shorting a bond because your downside was limited," he told me. "It's an asymmetrical bet." He was shocked how much easier and cheaper it was to buy a credit default swap[2] than it was to sell short an actual cash bond-even though they represented exactly the same bet. "I did half a billion. They said, 'Would you like to do a billion?' And I said, 'Why am I pussyfooting around?' It took two or three days to place twenty-five billion." Paulson had never encountered a market in which an investor could sell short 25 billion dollars' worth of a stock or bond without causing its price to move, even crash. "And we could have done fifty billion, if we'd wanted to."

What struck them powerfully was how cheaply the models allowed a person to speculate on situations that were likely to end in one of two dramatic ways. If, in the next year, a stock was going to be worth nothing or $100 a share, it was silly for anyone to sell a year-long option to buy the stock at $50 a share for $3. Yet the market often did something just like that. The model used by Wall Street to price trillions of dollars' worth of derivatives thought of the financial world as an orderly, continuous process. But the world was not continuous; it changed discontinuously, and often by accident.

Event-driven investing: That was the name they either coined or stole for what they were doing. That made it sound a lot less fun than it was. One day Charlie found himself intrigued by the market for ethanol futures. He didn't know much about ethanol, but he could see that it enjoyed a U.S. government subsidy of 50 cents a gallon, and so was supposed to trade at a 50-cent-a-gallon premium to gasoline, and always had. In early 2005, when he became interested, it traded, briefly, at a 50-cent discount to gas. He didn't know why and never found out; instead, Charlie bought two rail cars' worth of ethanol futures, and made headlines in Ethanol Today, a magazine of whose existence he was previously unaware. To the intense irritation of Cornwall's broker, they wound up having to accept rail cars filled with ethanol in some stockyard in Chicago-to make a sum of money that struck the broker as absurdly small. "The administrative complexity of what we were doing was out of proportion to our assets," said Charlie. "People who were our size didn't trade across asset classes."

A guy from a rating agency on whom Charlie tested Cornwall's investment thesis looked at him strangely and asked, "Are you sure you guys know what you're doing?" The market insiders didn't agree with them, but they didn't offer persuasive counter-arguments. Their main argument, in defense of subprime CDOs, was that "the CDO buyer will never go away." Their main argument, in defense of the underlying loans, was that, in their short history, they had never defaulted in meaningful amounts. Above the roulette tables, screens listed the results of the most recent twenty spins of the wheel. Gamblers would see that it had come up black the past eight spins, marvel at the improbability, and feel in their bones that the tiny silver ball was now more likely to land on red. That was the reason the casino bothered to list the wheel's most recent spins: to help gamblers to delude themselves. To give people the false confidence they needed to lay their chips on a roulette table. The entire food chain of intermediaries in the subprime mortgage market was duping itself with the same trick, using the foreshortened, statistically meaningless past to predict the future.

"No," said Eisman. "It's a zero. There is zero probability that your default rate will be five percent." The losses on subprime loans would be far, far greater. Before the guy could reply, Eisman's cell phone rang. Rather than shut it down, Eisman reached in his pocket and answered it. "Excuse me," he said, standing up. "But I need to take this call." And with that, he walked out of the speech. The caller was his wife.

"It wasn't important at all," she says with a sigh. "I was a prop." After that something must have come over Eisman, for he stopped looking for a fight and started looking for higher understanding. He walked around the Las Vegas casino incredulous at the spectacle before him: seven thousand people, all of whom seemed delighted with the world as they found it. A society with deep, troubling economic problems had rigged itself to disguise those problems, and the chief beneficiaries of the deceit were its financial middlemen. How could this be?

It was in Las Vegas that Eisman and his associates' attitude toward the U.S. bond market hardened into something like its final shape. As Vinny put it, "That was the moment when we said, 'Holy shit, this isn't just credit. This is a fictitious Ponzi scheme.'" In Vegas the question lingering at the back of their minds ceased to be, Do these bond market people know something we do not? It was replaced by, Do they deserve merely to be fired, or should they be put in jail? Are they delusional, or do they know what they're doing? Danny thought that the vast majority of the people in the industry were blinded by their interests and failed to see the risks they had created. Vinny, always darker, said, "There were more morons than crooks, but the crooks were higher up." The rating agencies were about as low as you could go and still be in the industry, and the people who worked for them really did not seem to know just how badly they had been gamed by big Wall Street firms.

Don’t be surprised if you see this book as a movie. (His earlier book The Blind Side was made into a movie.)It would make a compelling one, and I hope that that happens. This message needs to be understood by a larger audience than the ones willing to read this great book.

By the way, although the book never mentions this, at the core issues resides our friend complexity. But that’s another story.

The Big Short: Inside the Doomsday Machine, Michael Lewis, Norton, 2010, 291pp

[1] In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. Wikipedia

[2] A credit default swap (CDS) can almost be thought of as a form of insurance. If a borrower of money does not repay her loan, she "defaults." If a lender has purchased a CDS on that loan from an insurance company, the lender can then use the default as a credit to swap it in exchange for a repayment from an insurance company. However, one does not need to be the lender to profit from this situation. Anyone (usually called a speculator) can purchase a CDS. Wikipedia

1 comment:

  1. Written By Matthew Nickels If talk about financial derivatives and economic indicators makes your head spin, this is the book for you. Michael Lewis writes in a way that makes you feel smart. By the end of the book I kept wondering why I didn't predict the looming crisis. Very engaging and thorough.