- 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.
July 2010 