“It’s laissez-faire until you get in deep shit.” This is how Michael Lewis ends his latest book, The Big Short. This pretty much sums up his feelings and how the book unfolds.
What we learn as we go through this page-turner is those who bet against the subprime fiasco won, and won big. They made a lot (as in hundreds of millions of dollars) of money. What is also true is that those who bet big for it and lost also made huge amounts of money. How could this be in the zero sum game world of finance? Isn’t finance based on the fact that one party’s gain must be their counter party’s loss? Well, yes and no.
The difference here is the U.S. Government changed the math. They came in after the fact and, when the financial world as we know it was on the brink of collapse, “bailed out” the same firms who caused the collapse. Goldman Sachs, Morgan Stanley, AIG, Citicorp—all received billions, yes that is with a “B,”in assistance. This assistance came in the form of loan guarantees, asset purchases, and loans. All with little to no collateral or cost to the firms.
Who will pay the cost? The taxpayers. “In Eisman’s view, the unwillingness of the U.S. government to allow the bankers to fail was less a solution than a symptom of a still deeply dysfunctional financial system.” This quote from one of the few who saw the collapse coming early on and made his short bet against the market, is a damning indictment of our system. And he is correct.
But we are getting ahead of ourselves. Mr. Lewis weaves his tale by focusing on the stories of a hedge fund called FrontPoint, lead by Steve Eisman; Scion Capital, headed by Michael Burry; and Cornwall Capital Management with Charlie Ledley, Jamie Mai, and Ben Hockett. These last three gentlemen are the most unlikely of participants setting up shop in their own garage. Yet all these contrarians ended up doing spectacularly well for themselves.
There is one more indirect player in this very high-stakes poker game: Greg Lippmann of Deutsche Bank. He is their lead bond salesman, yet becomes intrigued with what he is hearing from Eisman and understands the potential of the subprime swaps market long before any of his contemporaries. His challenge is convincing his clients that this is the opportunity it appears to be. This is partially due to the fact that it seems everyone sees bond salesmen being willing to do anything for a sale.
To many people the economic collapse appears to be a once-in-a-lifetime event. The worst recession (depression?) in 70 years, claims the media. But is it? Didn’t we just recover from the Savings & Loan debacle? Or was it the leveraged buyouts of the 80s & 90s? Is there a pattern developing here? Is it true that the brightest graduates go to Wall Street, those who can’t go to the rating agencies, and those who can’t make it at the rating agencies become regulators?
There are some very bright and dedicated regulators. However, the one common thread in the last three economic collapses is that the regulators did not do their job. Why not?
Too big to fail? These words indicate a moral, not an economic decision. Any firm can fail financially. However, when a government fears that a firm’s failure will have a devastating impact on an entire industry, or worse, an entire economy, they can choose to step in to save the firm. The U.S. Government decided to save the financial industry. The same financial industry that had created financial instruments so complex that virtually none of the people creating them even understood them. Because if they understood what they were trading in, buying and selling, they never would have put themselves in such a ridiculously poor position—a no-win. Heads, you win; tails, I lose.
Fundamentally, most investors invest assuming the stock or bond they buy will go up. This is taking the “long” position. When an investor buys a financial instrument in anticipation of it going down they are taking the “short” position. Although the vast majority of Wall Street firms were long on mortgage bonds, our participants went short. Why? They thought they spotted something that very few others did. In the bond markets the short position is a credit default swap (CDS). Essentially this is an insurance policy. The investor holding the short position will pay an annual premium on a bond by buying a CDS. If the bond continues to be healthy, the investor pays the premium; if it fails, the investor gets the payout.
Now here is where it gets tricky. What makes these bets so huge is the use of leverage. The investors we follow in the book primarily bought collateralized debt obligations (CDOs). These CDOs are in essence assets created out of pools of different sub-prime mortgages. This is where our “heros” saw through the smoke when almost no one else did. The CDOs were rated as financially sound, yet were made up of layers of subprime mortgages of varying quality.
These subprime mortgages were offering at low “teaser rates” that would rise to market rates after two years and required little or no evidence of the ability to repay. Market rates are the rates the borrower would normally have to pay. Eisman saw the evidence of this in his own staff. His housekeeper was buying a town house in Queens. His baby’s nurse owned five town houses in Queens, refinancing her loans with each consecutive mortgage. “By the time they were done they owned five of them, the market was falling, and they couldn’t make any of the payments.” The book included another example of a laborer in Bakersfield making $15,000 a year who received a $750,000 loan!
(What came to mind when reading this was the old story of the Wall Street broker who was given a stock tip from his young shoe shiner. He then knew it was time to sell all of his stocks.)
A much larger percentage of these mortgages defaulted (did not pay as agreed) than usual for mortgage-backed bonds. By the time the sub-prime market imploded, in 2008, the IMF estimated that the losses on U.S.-originated sub-prime assets had amounted to a trillion dollars.
Did Goldman Sachs and others conspire to inflate the price of mortgage-backed securities well into 2007, even when they knew the true value was falling, only marking them down in value after their own hedging strategies were in place?
"In the course of trying to figure it out,” said Ledley, “we realize that there’s a reason why it doesn’t quite make sense to us. It’s because it doesn’t quite make sense.”
This book is a good read—albeit an eye opening and cautionary tale.
Reviewer Daniel Feiman, MBA, CMC, is Visiting Professor, Managing Director of Build It Backwards, whose most recent book is The Book on Improving Productivity by Fair Means or Foul.