For April & After: Michael Lewis' 'The Big Short' [ Edited ]

[L_Monty]

I'm sorry to start this thread late, owing to dead computers, bad RAM chips and excessive downtime on my part. I was lucky to be able to turn in blog posts by working around those hardships, but the hassles of board log-in glitches worsened things. No more. I am back, and I am glad to be here. It is time to be here with a vengeance.

For April — and, realistically, a little bit of May, since we all need time to get the book and read it before riffing on it — we will be reading

The Big Short by Michael Lewis. The author's name should be familiar, as we read his book Liar's Poker almost a year ago. I am loath to recommend the same author multiple times, because I don't think this site or this forum should be a vehicle for a single person, but in this case I felt that he was an ideal choice, for multiple reasons.

One, Lewis is very funny. He makes the dry aspect of finance and market shifts enjoyable. Two, he embraces simple examples and intuitive models to make even abstruse financial transactions limpid and even workaday for the lay reader. There are many books on the meltdown from 2007-8, but I question whether they have the same ability to provoke laughter and induce understanding the way Lewis does. This is, after all, a guy who took 20 years of marginal statistical thought about baseball and made it so popular that it became the mainstream baseball thought in half a decade. That's some powerful 'splainin' ability.

Owing to the computational woes I explained above, I don't have the book either. So we are all in the same boat. However, as soon as I get it, I'll pose some questions and offer some opinions. I hope you'll join me. Lewis is often not the final authority on anything — despite his ugly accuracy with Liar's Poker, he was also wrong about some stuff in Moneyball — but he's a wonderful starter read. From there, all of us can wander into new texts better forewarned and armed.

Finally, here's a New York Times Review of the book

No one writes with more narrative panache about money and finance than Mr. Lewis, the author of Liar's Poker, that now classic portrait of 1980s Wall Street. His entertaining new book does not attempt a macro view of the financial crisis, but instead proposes to open a small window on the calamities by recounting the stories of some savvy renegades who cashed in on their conviction that the system was rotten…Mr. Lewis does a nimble job of using his subjects' stories to explicate the greed, idiocies and hypocrisies of a system notably lacking in grown-up supervision, a system filled with firms that "disdained the need for government regulation in good times" but "insisted on being rescued by government in bad times."

[L_Monty]

Those who might not be inclined to pick up this book, let me tempt you.

The following is an excerpt from an article that Michael Lewis wrote in November, 2008 (the italics are mine):

Then came Meredith Whitney with news. Whitney was an obscure analyst of financial firms for Oppenheimer Securities who, on October 31, 2007, ceased to be obscure. On that day, she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. It’s never entirely clear on any given day what causes what in the stock market, but it was pretty obvious that on October 31, Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of had shaved $369 billion off the value of financial firms in the market. Four days later, Citigroup’s C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.

Now, obviously, Meredith Whitney didn’t sink Wall Street. She just expressed most clearly and loudly a view that was, in retrospect, far more seditious to the financial order than, say, Eliot Spitzer’s campaign against Wall Street corruption. If mere scandal could have destroyed the big Wall Street investment banks, they’d have vanished long ago. This woman wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.

If you don't have any interest in the book, read that article. I am confident that you will change your opinion within about two pages.

[L_Monty]

It took me a while to get this in and then a few days before I had enough time to really sit down with it. Apart from the Prologue, which was taken from the Portfolio article I linked above, I wound up reading the whole thing in a single sitting. I could make a bunch of jokes out of my first impression, but the most basic one is: if I'd actually underlined every bit that seemed totally outrageous, I'd have gone through half a pack of Pilot rollerballs before I finished.

What I think is smart about Lewis is that, even though he disapproves of much of what he's talking about, he doesn't get outraged. He explains why you should be, but he foregoes ranting or raving. Instead, we follow the people on the inside of this broken machine, and they are the ones that rave. Ask most people who've read his books, and I think you'd find they'd all say that Lewis is pretty levelheaded and fair.

That's interesting to me, because he's written a bunch of hot-button books. Liar's Poker, Panic! and Moneyball all have as a core message, "These guys are doing it wrong." And it's remarkable that outside a few cranks who out themselves as sort of irrationally wedded to assumptions (I'm thinking of Joe Morgan and Moneyball here), the books have quickly been accepted as just part of the canon of books on the subject. You have to read LP to learn about 80s bond trading (along with other books); you can't read about baseball without reading Moneyball. And yet this comes in spite of the fact that these are topics that people are very protective and prideful of; these are topics that have lots of conventional wisdom that people get very hidebound about.

[Psychee]

Monty, is there any mention of the Goldman-Sachs (alleged) fraud in that book?

[L_Monty]

Oh, yeah. The Goldman coverage is great, and they're all over the second half. There's no other way to say this, but they were basically the masterful evil of the ugly second act of the bond market explosion.

Basically, at the start, the engine that fueled these mortgage-backed securities (MBS from now on) was home sales, right? You couldn't sell a bond based on a bunch of bundled-up home loans without home loans being made. The trouble was, even with essentially crooked mortgage companies making absurd liar-loans to people who would default by payment #1 or by payment #25 (when the adjustable rate ratcheted way up at the beginning of year #2), the market for new homeowners and house-flippers had maxed out by about 2006-7. In order to keep manufacturing debt — basically inventing things to sell made up out of things other people owed — Goldman created a whole (excuse me) buttload of synthetics.

This is a lot harder to get into, and the book does a better job than I will, but here goes. A credit-default swap is basically a form of insurance against a loan going bad. Someone says, "I will insure you against the possibility that you will not be paid back for the loans you're expecting to pay you back." CDS's themselves aren't inherently evil. They were just a bet that a MBS was gonna tank and a means of protection against it, for which you'd pay a yearly premium. (This is a whole other issue, but it's a really messed-up commentary on an allegedly self-regulating market that literally nobody had come up with a way to bet against the housing market until a guy, who's prominently featured in Lewis's book, insisted on structuring a CDS to bet against a housing market that he thought was a profoundly stupid time bomb.) Thus far, the engine that's running things is home loans. Loans are made and bundled into MBS's. Then the market creates some balance when CDS's can wager that the MBS's will fail.

The thing is, this is still sort of anchored in reality. A loan is real, about a piece of property, and a bond made out of loans is a structured bond pertaining to real things. A CDS is a piece of insurance against something happening in reality, to people who've paid money for or against something real happening. What Goldman promoted and sold in abundance were things called Synthetic Collateralized Debt Obligations (CDOs), which are bundles of CDS's, basically a wad of bets on bets on something happening. The thing was, the synthetic nature of this kind of meta-bond was such that it bore no relevance to an actual balance sheet or anything happening in reality. It was a collection of bets on an event, something that you could bet on or against. Worse, CDOs started being composed of other CDOs, in effect becoming something you could bet for or against, which itself was a collection of bets for or against a collection of insurance policies on something that might or might not happen to something related to a loan.

In effect, Goldman untethered the bets from anything anchored in a material and objective existence. They took wagers on obligations, and turned those wagers into other obligations that someone could wager on. They sliced these wagers up into different levels of risk (tranches) that were essentially meaningless, rated in a vacuum unaccountable to real measurement.

It's this stuff that gives the lie to the talking-point canard that "a bunch of lazy people who wanted a house for nothing, even though they couldn't pay for it, bankrupted the economy." The dollar amount of home mortgages was in the billions. The bets for and against those loans, the bets for and against bundles of bets against those loans, and the bets for and against the bets for and against the bets for and against those loans stretched into the tens of trillions. Some dumb migrant worker who didn't know his mortgage payment was going to triple in two years didn't make Merill and Lehman leverage themselves forty-to-one. They did that because they thought they couldn't lose, and in any case, they were making sick bonuses while waiting to find out. It wasn't some yahoo who couldn't balance a checkbook who created synthetic securities based on the absence of any real good; it was our buddies at Goldman.

[Psychee]

Rolling Stone had an interesting article about them entitled "The Great American Bubble Machine". They describe it as "a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money." http://www.rollingstone.com/politics/news/;kw=[3351,11459] They did a more recent report on crooked Wall Street dealings here: http://www.rollingstone.com/politics/news/;kw=[3351,11470]