- 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.