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A Daisy Chain of Financial Malfeasance
on April 22, 2014
Michael Lewis's brilliant book "The Big Short," is billed as a sequel to his earlier biographical effort "Liar's Poker" which covered his 1980s experiences on Wall Street. It's a great example of why Malcolm Gladwell has called Lewis "the finest storyteller of our generation."
Subtitled "Inside the Doomsday Machine," the book chronicles the 2008 market collapse from the perspective of those who saw it coming and bet against the subprime mortgage market at the height of the housing bubble. The protagonists, whose foresight earned them fantastic profits, are a colorful lot, including: Steve Eisman, Danny Moses and Vincent Daniel (of FrontPoint Partners, owned by Morgan Stanley); Michael Burry (of Scion Capital); Charlie Ledley, Ben Hockett and Jamie Mai (of Cornwall Capital); and Greg Lippmann (of Deutsche Bank), and a handful of others.
Amazingly, none of these contrarian investors were experts in the housing market. They saw disaster coming while the "smart money" was betting that house prices would continue to rise and that subprime mortgages would pay off. It took this unlikely group of outsiders to see what was about to happen and undertake "the big short."
So what was the Doomsday Machine and how did it work? As Lewis points out, it was spawned by a toxic mix of the US housing bubble, sub-prime mortgage lending, investor greed, and the insatiable demand for leverage by Wall Street Banks. Aiding and abetting these factors were unwitting credit agencies populated by Wall Street rejects and wannabes.
Investors around the world wanted access to the ever-inflating American mortgage market. This gave lenders ever stronger incentive to push new loans out the door. Interest rates went down and credit standards for borrowers were relaxed again and again with demand filled by writing increasing numbers of sub-prime mortgages. Mortgage-backed security (MBS) sales were driven through the roof.
Many mortgage lenders practiced an "originate and sell" strategy - taking their profits by bundling the loans up as mortgage-backed securities and selling them to third parties, mainly investment banks, (thereby passing along the risk associated with the sub-prime mortgages they were writing). The investment banks then repackaged these mortgages in various ways and sold the mortgage debt of the US household sector to global investors. Among the exotic financial instruments used for this purpose were Collateralized Debt Obligations (CDOs).
CDOs were actually pyramids consisting of tranches representing various levels of risk and related interest payments. The riskiest level ("the mezzanine") got the highest rate of interest, but were the first to be wiped out as defaults rose. The least risky level at the top of the pyramid ("the penthouse") received the lowest rate of interest and were last to fall as defaults rose. Many of these portfolio slices received generous ratings of triple-B and even triple-A from the big rating agencies, creating a false sense of security among potential investors
This process was highly profitable for the financial sector and, as long as home prices were rising and producing good returns for investors. But, when the market turned, things got really ugly. It was a house of cards. Lewis notes that for the whole system to collapse, the housing market didn't need to fail in absolute terms. It didn't even need to fall. It just had to stop growing as fast as it had during the boom years. Of course, as fate would have it, that's precisely what happened.
In the ultimate irony, firms like Goldman, who created and sold CDOs, bet against their own investors by buying Credit Default Swaps (CDSs) which insured the mortgage-backed securities they were selling against default. (For a few cents on the dollar a CDS commits the seller to pay the full value of the contract if a mortgage-backed bond defaults, or becomes worthless.)
What this meant was that, to mitigate its own exposure, Goldman was betting against its own customers. And, by aggressively taking the other side of this risk by selling CDSs for a small return, firms like Morgan Stanley put billions of dollars of their proprietary capital at risk. Not smart!
Just how bad were the mortgages underpinning the subprime mortgage market? Lewis provides an example of "a Mexican strawberry picker in Bakersfield California with an income of $14,000 and no English who was given every penny he needed to buy a house for $724,000." This was cited as an example of the type of "no-doc mortgages"(no evidence of income or employment) that helped fuel the market collapse.
In short, the Doomsday Machine was a massive Ponzi scheme that, save for a massive government bailout, could have collapsed the entire global financial system.
If you're keeping score, Lewis points out that Morgan Stanley's $9 billion trading loss was "the single biggest trading loss in the history of Wall Street." But this pales to insignificance when you consider that the losses include five million jobs in the United States alone and some 40 percent of the world's wealth. In addition to the billions in taxpayer and investor losses, the human tragedy toll included evaporated pensions, ruined careers and, in many cases, lost homes.
In retrospect, the questions posed by this book are: "Has anything really changed on Wall Street?"; "Has financial regulation improved?"; and, most importantly, "Could something like this happen again?"