July 2010

Lewis, Michael. The Big Short. New York: W. W. Norton, 2010. ISBN 978-0-393-07223-5.
After concluding his brief career on Wall Street in the 1980s, the author wrote Liar's Poker, a memoir of a period of financial euphoria and insanity which he assumed would come crashing down shortly after his timely escape. Who could have imagined that the game would keep on going for two decades more, in the process raising the stakes from mere billions to trillions of dollars, extending its tendrils into financial institutions around the globe, and fuelling real estate and consumption bubbles in which individuals were motivated to lie to obtain money they couldn't pay back to lenders who were defrauded as to the risk they were taking?

Most descriptions of the financial crisis which erupted in 2007 and continues to play out at this writing gloss over the details, referring to “arcanely complex transactions that nobody could understand” or some such. But, in the hands of a master explainer like the author, what happened isn't at all difficult to comprehend. Irresponsible lenders (in some cases motivated by government policy) made mortgage loans to individuals which they could not afford, with an initial “teaser” rate of interest. The only way the borrower could avoid default when the interest rate “reset” to market rates was to refinance the property, paying off the original loan. But since housing prices were rising rapidly, and everybody knew that real estate prices never fall, by that time the house would have appreciated in value, giving the “homeowner” equity in the house which would justify a higher grade mortgage the borrower could afford to pay. Naturally, this flood of money into the housing market accelerated the bubble in housing prices, and encouraged lenders to create ever more innovative loans in the interest of “affordable housing for all”, including interest-only loans, those with variable payments where the borrower could actually increase the principal amount by underpaying, no-money-down loans, and “liar loans” which simply accepted the borrower's claims of income and net worth without verification.

But what financial institution would be crazy enough to undertake the risk of carrying these junk loans on its books? Well, that's where the genius of Wall Street comes in. The originators of these loans, immediately after collecting the loan fee, bundled them up into “mortgage-backed securities” and sold them to other investors. The idea was that by aggregating a large number of loans into a pool, the risk of default, estimated from historical rates of foreclosure, would be spread just as insurance spreads the risk of fire and other damages. Further, the mortgage-backed securities were divided into “tranches”: slices which bore the risk of default in serial order. If you assumed, say, a 5% rate of default on the loans making up the security, the top-level tranche would have little or no risk of default, and the rating agencies concurred, giving it the same AAA rating as U.S. Treasury Bonds. Buyers of the lower-rated tranches, all the way down to the lowest investment grade of BBB, were compensated for the risk they were assuming by higher interest rates on the bonds. In a typical deal, if 15% of the mortgages defaulted, the BBB tranche would be completely wiped out.

Now, you may ask, who would be crazy enough to buy the BBB bottom-tier tranches? This indeed posed a problem to Wall Street bond salesmen (who are universally regarded as the sharpest-toothed sharks in the tank). So, they had the back-office “quants” invent a new kind of financial derivative, the “collateralised debt obligation” (CDO), which bundled up a whole bunch of these BBB tranche bonds into a pool, divided it into tranches, et voilà, the rating agencies would rate the lowest risk tranches of the pool of junk as triple A. How to get rid of the riskiest tranches of the CDO? Lather; rinse; repeat.

Investors worried about the risk of default in these securities could insure against them by purchasing a “credit default swap”, which is simply an insurance contract which pays off if the bond it insures is not repaid in full at maturity. Insurance giant AIG sold tens of billions of these swaps, with premiums ranging from a fraction of a percent on the AAA tranches to on the order of two percent on BBB tranches. As long as the bonds did not default, these premiums were a pure revenue stream for AIG, which went right to the bottom line.

As long as the housing bubble continued to inflate, this created an unlimited supply of AAA rated securities, rated as essentially without risk (historical rates of default on AAA bonds are about one in 100,000), ginned up on Wall Street from the flakiest and shakiest of mortgages. Naturally, this caused a huge flow of funds into the housing market, which kept the bubble expanding ever faster.

Until it popped.

Testifying before a hearing by the U.S. House of Representatives on October 22nd, 2008, Deven Sharma, president of Standard & Poor's, said, “Virtually no one—be they homeowners, financial institutions, rating agencies, regulators, or investors—anticipated what is occurring.” Notwithstanding the claim of culpable clueless clown Sharma, there were a small cadre of insightful investors who saw it all coming, had the audacity to take a position against the consensus of the entire financial establishment—in truth a bet against the Western world's financial system, and the courage to hang in there, against gnawing self-doubt (“Can I really be right and everybody else wrong?”) and skittish investors, to finally cash out on the trade of the century. This book is their story. Now, lots of people knew well in advance that the derivatives-fuelled housing bubble was not going to end well: I have been making jokes about “highly-leveraged financial derivatives” since at least 1996. But it's one thing to see an inevitable train wreck coming and entirely another to figure out approximately when it's going to happen, discover (or invent) the financial instruments with which to speculate upon it, put your own capital and reputation on the line making the bet, persist in the face of an overwhelming consensus that you're not only wrong but crazy, and finally cash out in a chaotic environment where there's a risk your bets won't be paid off due to bankruptcy on the other side (counterparty risk) or government intervention.

As the insightful investors profiled here dug into the details of the fairy castle of mortgage-backed securities, they discovered that it wouldn't even take a decline in housing prices to cause defaults sufficient to wipe out the AAA rated derivatives: a mere stagnation in real estate prices would suffice to render them worthless. And yet even after prices in the markets most affected by the bubble had already levelled off, the rating agencies continued to deem the securities based on their mortgages riskless, and insurance against their default could be bought at nominal cost. And those who bought it made vast fortunes as every other market around the world plummeted.

People who make bets like that tend to be way out on the tail of the human bell curve, and their stories, recounted here, are correspondingly fascinating. This book reads like one of Paul Erdman's financial thrillers, with the difference that the events described are simultaneously much less probable and absolutely factual. If this were a novel and not reportage, I doubt many readers would find the characters plausible.

There are many lessons to be learnt here. The first is that the human animal, and therefore the financial markets in which they interact, frequently mis-estimates and incorrectly prices the risk of outcomes with low probability: Black Swan (January 2009) events, and that investors who foresee them and can structure highly leveraged, long-term bets on them can do very well indeed. Second, Wall Street is just as predatory and ruthless as you've heard it to be: Goldman Sachs was simultaneously peddling mortgage-backed securities to its customers while its own proprietary traders were betting on them becoming worthless, and this is just one of a multitude of examples. Third, never assume that “experts”, however intelligent, highly credentialed, or richly compensated, actually have any idea what they're doing: the rating agencies grading these swampgas securities AAA had never even looked at the bonds from which they were composed, no less estimated the probability that an entire collection of mortgages made at the same time, to borrowers in similar circumstances, in the same bubble markets might all default at the same time.

We're still in the early phases of the Great Deleveraging, in which towers of debt which cannot possibly be repaid are liquidated through default, restructuring, and/or inflation of the currencies in which they are denominated. This book is a masterful and exquisitely entertaining exposition of the first chapter of this drama, and reading it is an excellent preparation for those wishing to ride out, and perhaps even profit from the ongoing tragedy. I have just two words to say to you: sovereign debt.


Flynn, Vince. Extreme Measures. New York: Pocket Books, 2008. ISBN 978-1-4165-0504-4.
This is the ninth novel in the Mitch Rapp (warning—the article at this link contains minor spoilers) series and is perhaps the most politically charged of the saga so far. When a high-ranking Taliban commander and liaison to al-Qaeda is captured in Afghanistan, CIA agent Mike Nash begins an interrogation with the aim of uncovering a sleeper cell planning terrorist attacks in the United States, but is constrained in his methods by a grandstanding senator who insists that the protections of the Geneva Convention be applied to this non-state murderer. Frustrated, Nash calls in Mitch Rapp for a covert and intense debrief of the prisoner, but things go horribly wrong and Rapp ends up in the lock-up of Bagram Air Base charged with violence not only against the prisoner but also a U.S. Air Force colonel (who is one of the great twits of all time—one wonders even with a service academy ring how such a jackass could attain that rank).

Rapp finds himself summoned before the Senate Judiciary Committee to answer the charges and endure the venting of pompous gasbags which constitutes the bulk of such proceedings. This time, however, Rapp isn't having any. He challenges the senators directly, starkly forcing them to choose between legalistic niceties and defeating rogue killers who do not play by the rules. Meanwhile, the sleeper cell is activated and puts into motion its plot to wreak terror on the political class in Washington. Deprived of information from the Taliban captive, the attack takes place, forcing politicians to realise that verbal virtuosity and grandstanding in front of cameras is no way to fight a war. Or, at least, for a moment until they forget once again, and as long as it is they who are personally threatened, not their constituents.

As Mitch Rapp becomes a senior figure and something of a Washington celebrity, Mike Nash is emerging as the conflicted CIA cowboy that Rapp was in the early books of the series. I suspect we'll see more and more of Nash in the future as Rapp recedes into the background.


Sowell, Thomas. Intellectuals and Society. New York: Basic Books, 2009. ISBN 978-0-465-01948-9.
What does it mean to be an intellectual in today's society? Well, certainly one expects intellectuals to engage in work which is mentally demanding, which many do, particularly within their own narrow specialities. But many other people perform work which is just as cognitively demanding: chess grandmasters, musical prodigies, physicists, engineers, and entrepreneurs, yet we rarely consider them “intellectuals” (unless they become “public intellectuals”, discussed below), and indeed “real” intellectuals often disdain their concern with the grubby details of reality.

In this book, the author identifies intellectuals as the class of people whose output consists exclusively of ideas, and whose work is evaluated solely upon the esteem in which it is held by other intellectuals. A chess player who loses consistently, a composer whose works summon vegetables from the audience, an engineer whose aircraft designs fall out of the sky are distinguished from intellectuals in that they produce objective results which succeed or fail on their own merits, and it is this reality check which determines the reputation of their creators.

Intellectuals, on the other hand, are evaluated and, in many cases, hired, funded, and promoted solely upon the basis of peer review, whether formal as in selection for publication, grant applications, or awarding of tenure, or informal: the estimation of colleagues and their citing of an individual's work. To anybody with the slightest sense of incentives, this seems a prescription for groupthink, and it is no surprise that the results confirm that supposition. If intellectuals were simply high-performance independent thinkers, you'd expect their opinions to vary all over the landscape (as is often the case among members of other mentally demanding professions). But in the case of intellectuals, as defined here, there is an overwhelming acceptance of the nostrums of the political left which appears to be unshakable regardless of how many times and how definitively they have been falsified and discredited by real world experience. But why should it be otherwise? Intellectuals themselves are not evaluated by the real world outcomes of their ideas, so it's only natural they're inclined to ignore the demonstrated pernicious consequences of the policies they advocate and bask instead in the admiration of their like-thinking peers. You don't find chemists still working with the phlogiston theory or astronomers fine-tuning geocentric models of the solar system, yet intellectuals elaborating Marxist theories are everywhere in the humanities and social sciences.

With the emergence of mass media in the 20th century, the “public intellectual” came into increasing prominence. These are people with distinguished credentials in a specialised field who proceed to pronounce upon a broad variety of topics in which their professional expertise provides them no competence or authority whatsoever. The accomplishments of Bertrand Russell in mathematics and philosophy, of Noam Chomsky in linguistics, or of Paul Erlich in entomology are beyond dispute. But when they walk onto the public stage and begin to expound upon disarmament, colonialism, and human population and resources, almost nobody in the media or political communities stops to ask just why their opinion should be weighed more highly than that of anybody else without specific expertise in the topic under discussion. And further, few go back and verify their past predictions against what actually happened. As long as the message is congenial to the audience, it seems like public intellectuals can get a career-long pass from checking their predictions against outcomes, even when the discrepancies are so great they would have caused a physical scientist to be laughed out of the field or an investor to have gone bankrupt. As biographer Roy Harrod wrote of eminent economist and public intellectual John Maynard Keynes:

He held forth on a great range of topics, on some of which he was thoroughly expert, but on others of which he may have derived his views from the few pages of a book at which he happened to glance. The air of authority was the same in both cases.
As was, of course, the attention paid by his audience.

Intellectuals, even when pronouncing within their area of specialisation, encounter the same “knowledge problem” Hayek identified in conjunction with central planning of economies. While the expert, or the central planning bureau, may know more about the problem domain than 99% of individual participants in the area, in many cases that expertise constitutes less than 1% of the total information distributed among all participants and expressed in their individual preferences and choices. A free market economy can be thought of as a massively parallel cloud computer for setting prices and allocating scarce resources. Its information is in the totality of the system, not in any particular place or transaction, and any attempt to extract that information by aggregating data and working on bulk measurements is doomed to failure both because of the inherent loss of information in making the aggregations and also because any such measure will be out of date long before it is computed and delivered to the would-be planner. Intellectuals have the same conceit: because they believe they know far more about a topic than the average person involved with it (and in this they may be right), they conclude that they know much more about the topic than everybody put together, and that if people would only heed their sage counsel much better policies would be put in place. In this, as with central planning, they are almost always wrong, and the sorry history of expert-guided policy should be adequate testament to its folly.

But it never is, of course. The modern administrative state and the intelligentsia are joined at the hip. Both seek to concentrate power, sucking it out from individuals acting at their own discretion in their own perceived interest, and centralising it in order to implement the enlightened policies of the “experts”. That this always ends badly doesn't deter them, because it's power they're ultimately interested in, not good outcomes. In a section titled “The Propagation of the Vision”, Sowell presents a bill of particulars as damning as that against King George III in the Declaration of Independence, and argues that modern-day intellectuals, burrowed within the institutions of academia, government, and media, are a corrosive force etching away the underpinnings of a free society. He concludes:

Just as a physical body can continue to live, despite containing a certain amount of microorganisms whose prevalence would destroy it, so a society can survive a certain amount of forces of disintegration within it. But that is very different from saying that there is no limit to the amount, audacity and ferocity of those disintegrative forces which a society can survive, without at least the will to resist.
In the past century, it has mostly been authoritarian tyrannies which have “cleaned out the universities” and sent their effete intellectual classes off to seek gainful employment in the productive sector, for example doing some of those “jobs Americans won't do”. Will free societies, whose citizens fund the intellectual class through their taxes, muster the backbone to do the same before intellectuals deliver them to poverty and tyranny? Until that day, you might want to install my “Monkeying with the Mainstream Media”, whose Red Meat edition translates “expert” to “idiot”, “analyst” to “moron”, and “specialist” to “nitwit” in Web pages you read.

An extended video interview with the author about the issues discussed in this book is available, along with a complete transcript.


Thor, Brad. Foreign Influence. New York: Atria Books, 2010. ISBN 978-1-4165-8659-3.
Thanks to the inexorable working of Jerry Pournelle's Iron Law of Bureaucracy, government agencies, even those most central to the legitimate functions of government and essential to its survival and the safety of the citizenry, will inevitably become sclerotic and ineffective, serving their employees at the expense of the taxpayers. The only way to get things done is for government to outsource traditionally governmental functions to private sector contractors, and recent years have seen even military operations farmed out to private security companies.

With the intelligence community having become so dysfunctional and hamstrung by feel-good constraints upon their actions and fear of political retribution against operatives, it is only natural that intelligence work—both collection and covert operations—will move to the private sector, and in this novel, Scot Harvath has left government service to join the shadowy Carlton Group, providing innovative services to the Department of Defense. Freed of bureaucratic constraints, Harvath's inner klootzak (read the book) is fully unleashed. Less than halfway into the novel, here's Harvath reporting to his boss, Reed Carlton:

“So let me get this straight,” said the Old Man. “You trunked two Basque separatists, Tasered a madam and a bodyguard—after she kicked your tail—then bagged and dragged her to some French farmhouse where you threatened to disfigure her, then iceboarded a concierge, shot three hotel security guards, kidnapped the wife of one of Russia's wealthiest mobsters, are now sitting in a hotel in Marseille waiting for a callback from the man I sent you over there to apprehend. Is that about right?”
Never a dull moment with the Carlton Group on the job!

Aggressive action is called for, because Harvath finds himself on the trail of a time-sensitive plot to unleash terror attacks in Europe and the U.S., launched by an opaque conspiracy where nothing is as it appears to be. Is this a jihadist plot, or the first volley in an asymmetric warfare conflict launched by an adversary, or a terror network hijacked by another mysterious non-state actor with its own obscure agenda? As Harvath follows the threads, two wisecracking Chicago cops moonlighting to investigate a hit and run accident stumble upon a domestic sleeper cell about to be activated by the terror network. And as the action becomes intense, we make the acquaintance of an Athena Team, an all-babe special forces outfit which is expected to figure prominently in the next novel in the saga and will doubtless improve the prospects of these books being picked up by Hollywood. With the clock ticking, these diverse forces (and at least one you'll never see coming) unite to avert a disastrous attack on American soil. The story is nicely wrapped up at the end, but the larger mystery remains to be pursued in subsequent books.

I find Brad Thor's novels substantially more “edgy” than those of Vince Flynn or Tom Clancy—like Ian Fleming, he's willing to entertain the reader with eccentric characters and situations even if they strain the sense of authenticity. If you enjoy this kind of thing—and I do, very much—you'll find this an entertaining thriller, perfect “airplane book”, and look forward to the next in the series. A podcast interview with the author is available.