Coming Up Short
What Michael Lewis' The Big Short gets right-and wrong-about the financial meltdown
Released two years after the historic failure of investment bank Bear Stearns, The Big Short: Inside the Doomsday Machine, the new book by financial journalist extraordinaire Michael Lewis, doesn't have a lot of new information to offer us. We already know well-educated idiots had too much control on Wall Street. We already know the ratings agencies offered less accurate analyses of the market than the best guesses of a fifth grade math class. And we already know the banks gamed the system by taking advantage of poorly conceived accounting rules. Still, Lewis' masterful tale of the known is a must read for all trying to understand why the economy fell apart.
Anyone frightened away by the mere mention of a credit default swap will certainly appreciate Lewis' ability to translate the confusing jumble of pundit-developed theories on the crisis into a readable story for the economically illiterate. And when the reader is done, there will be no doubt as to the folly that captivated Wall Street firms, the ratings agencies, and investors.
However, this lucidity winds up as a debilitating weakness if readers see The Big Short as a comprehensive guide to the crisis. Lewis' book should not be read in a vacuum, since it illuminates only a few pieces of a much bigger puzzle.
The Big Short is, above all else, a story of people. Lewis creates rich and gripping characters from a world that is often covered by stale journalists and boring economists more focused on the numbers than the narrative. Perhaps the most compelling of the lot is a one-eyed doctor-turned hedge fund manager with Asperger syndrome named Michael Burry. This reclusive cyclops was able to see what Wall Street missed by simply sitting in his California office and reading through every detail of the fine print on subprime mortgage-backed securities.
Also entertaining is Steve Eisman, a "former Republican turned socialist" whose skepticism about subprime lending and the ability to invest wisely more than outweighed his complete lack of manners or respect for any other human. Lewis tells his tale largely from the perspective of Eisman and a comparable cast of characters including Charlie Ledley and Jamie Mai, who run a "garage hedge fund" called Cornwall Capital, and a visionary trader at Deutche Bank named Gregg Lippmann. What they, and Burry, had in common was an understanding that there was too much dependence on the ratings agencies and credit scores.
To illustrate just how out of control the trust in ratings had become, Lewis tells the infamous story of a $724,000 mortgage given to a strawberry picker earning $14,000 per year. The agricultural worker technically had a good credit score—since he hadn't defaulted on a loan—yet this was due to having virtually no credit history. Nevertheless, he was given a cheap, subprime loan worth more than he was likely to earn in a lifetime. This loan with a "good credit score" was packaged with other thinly-documented loans and deemed AAA by a ratings agency. Investors who lacked the risk aversion of Mike Burry took this rating at face value and toxic debt subsequently spread like wildfire in the marketplace.
Similarly, investors lost sight of basic market principals as the housing bubble grew and Wall Street's success surged forward. Simple lessons like "don't invest in something you don't understand" were left behind. In hindsight, Lewis argues, it seems unconscionable that well-educated men like Wing Chau, a "CDO manager" who created demand for the riskiest stuff out there, would make such a dumb bet. But the herd mentality was dominant. And as Lewis points out, it wasn't all malicious, blood-sucking vampire squids operating in the market. Guys like Greg Lippmann received roughly half of their pay in restricted stock that required long-term ties between trader and institution. That's a lesson the former staffs of Bear Stearns and Lehman Brothers learned all too well.
Lewis also accurately points out how banks were able to game the system through clever accounting tricks that got around capital requirements. Banks could buy securities rated AAA and decrease the amount of capital they would have to hold in reserve relative to their risk. Never mind that the security was packed full of loans like our strawberry picker's mortgage. If the security came with a guarantee from a AAA rated institution, like Fannie Mae or Freddie Mac, banks would be allowed to hold even less capital. Never mind that those institutions were heavily invested in toxic debt themselves and edging towards insolvency.
As a result banks had more capital available to lend—making more loans that could be securitized and rated highly despite the low lending standards. The gimmicks got so creative that banks forgot there was actual risk to be considered. The idea that housing prices could slump or drop everywhere at once was apparently never even seriously considered. As Lewis takes the reader through this story, it becomes clear that most of Wall Street lacked the foresight to look beyond the moment to see that financial exuberance combined with unbridled risk cannot be a path to economic stability.
But to say, as Lewis does, that no one outside of his merry cast of investment sages knew what was going on is hyperbole for the sake of literature. There were more than a few academics who commented that housing prices would eventually come down and plenty of seminars on mortgage risks at industry conferences. Unfortunately, most financial professionals—even some who were warning of future problems—didn't take the concerns to heart. And few of those who did identify problems in the system really understood what was coming. But it would be a mistake to ignore prescience simply because it wasn't always accompanied by investment chutzpah.
Where Lewis really goes awry is not in his narrative but his analysis, confusing symptoms for causes. The Big Short builds an argument that complex products only served to help Wall Street "fuck the poor" and deceive dimwitted investors. While confusing financial products were certainly a problem, they were not the cause of the problem, merely a symptom of a larger error: misaligned incentives.
Highly complex financial products, like collateralized debt obligations, can serve the useful dual purpose of spreading out risk and offering an investment opportunity, provided the investor understands the product and the risk is appropriately balanced. Instead, risk was mislabeled and investors were too trusting. The question is how that happened.
The implicit "too big to fail" guarantees enjoyed by A.I.G., Bear Stearns, Lehman Brothers (or so they thought), and the rest of Wall Street, combined with perverse compensation systems, meant risk management was rarely a top priority. The government's promotion of homeownership, and its fueling of housing prices through Fannie Mae and Freddie Mac, created demand for housing products that the free market would never have developed. The complex products would not have been so bad if they hadn't been filled with toxic debt—after all, a super complex collateralized debt obligation squared that was made up entirely of AAA mortgages with 20 percent down that were issued to well-established borrowers wouldn't be such a bad investment.
Lewis falsely assumes that the perfect storm of failures at mortgage brokers, rating agencies, Wall Street firms, and regulators is the outcome of free market "hypercapitalism." But in fact those problems are all symptoms of a government-manipulated market that didn't allow for failure and had government subsides favoring housing investments over other sectors of the economy. One of The Big Short's biggest shortfalls is failing to examine how federal policy drove investors to get things wrong while Lippman, Eisman, Burry, and the Cornwall Capital boys managed to get it right.
Still, it could be easily argued that this isn't the purpose of Lewis' book. His great accomplishment is in taking this story from the stratosphere of ideas and making it accessible to the intellectual layman. The job for the rest of us is to provide the complete picture of how and why the whole market went to hell.
Anthony Randazzo is director of economic research at the Reason Foundation.