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Friday, July 2, 2010

Reading List: The Big Short

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.

Posted at July 2, 2010 21:08