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Free Minds & Free Markets

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.

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  • ||

    Two key components of the entire mess are missing here:

    1 - The enormous amount of cash available globally in the mid 2000's (Saudis and Chinese) that the investment banks direly wanted to get their hands on.

    2 - The Fed's insistence on an arbitrarily low long term rate that made holding bonds unattractive and created a demand for investments that were perceived to be "secure" like collateralized mortgages.

    Otherwise should be an interesting read about the day to day insanity of Wall Street.

  • ||

    You have to love reason, even huge market failures are the government's fault. Never once does the commenter mention the subprime MBS market was not dominated by Fannie and Freddie or any other GSE, particularly at the height of the bubble. When all you have is a hammer, everything looks like a nail. Sometimes markets fail. Sometimes fraud occurs. Sometimes it's not the government's fault.

  • ||

    Never once does the commenter mention the subprime MBS market was not dominated by Fannie and Freddie or any other GSE, particularly at the height of the bubble.

    60 percent isn't dominated? 37% at the height isn't "dominated?"

    Fannie and Freddie didn't originate all the loans, sure, they just repurchased them. More importantly, Fannie and Freddie worsened their own standards to try to keep up their market share and dominance, and even more importantly, taxpayers were always going to be on the hook for Fannie and Freddie.

  • ||

    Granted that the Fannie and Freddie share of the MBS market got even higher after the crash, up to 80%, but that's because Fannie and Freddie were willing to keep buying even after everyone else was running to the exits.

    And yet you act like that's a good thing.

    There were mistakes everywhere, sure. But surely the first thing we can ask is that government stop adding fuel to the fire.

  • Sean W. Malone||

    I'd also appreciate it if they quit supplying the matches.

  • ||

    Or at the very least, stop calling the fuel and matches firefighting tools.

  • ||

    Mises is unreliable, Thacker.

    "Federal Reserve Board data show that:

    * More than 84 percent of the subprime mortgages in 2006 were issued by private lending institutions.

    * Private firms made nearly 83 percent of the subprime loans to low- and moderate-income borrowers that year.

    * Only one of the top 25 subprime lenders in 2006 was directly subject to the housing law that's being lambasted by conservative critics.

    The "turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for U.S. subprime mortgages, beginning in late 2004 and extending into 2007,"

    Read more: http://www.mcclatchydc.com/200.....z0mGFvLgWg

    FNM and FRE took only conforming loans - those of $330,000 or less.

    LEH, BS, and ML fell on their own sword. They don't complain about FNM and FRE - only info-deprived Market fundies do.

  • ||

    shrike|4.26.10 @ 9:54PM|#
    "...FNM and FRE took only conforming loans - those of $330,000 or less..."

    Sniff... Smells like MNG strawmen!
    Yes, they were "conforming". So?

  • ||

    Sure. And none of these firms would exist anymore except by the Grace of Bernanke.

    The market rewards stupidity with free food out of a dumpster. It isn't happening because of the very intelligent bureaucrats in Washington.

    Derek

  • ||

    i don't think you understand, shrike.

    markets work perfectly until there is some distortion by the government. this is, and will always be true; and is indisputable. therefore, we need to start from that perfect truth and continue to dig up more information and data until we figure out exactly how government caused this mess.

    with regard to unregulated shadow markets the solution is to deregulate. reducing capital gains taxes wouldn't hurt either.

  • Sean W. Malone||

    Sometimes, longterm "record low" interest rates, massive subsidies & various other incentives into the housing sector, a vast increase in the supply of money and a thousand other centrally controlled facets of the economy encourage rampant misallocation of resources which in turn results in a Boom and then resultant Bust.

    It's not even about whether or not the market was "dominated" by Fannie & Freddie - but whether or not the implicit guarantees were in fact the moral hazard many of the better economists out there had been saying they were.

    Since as early as 2002, most of the Austrian school and the more hard-core strains of free market analysis pointed towards a Federal Reserve/Government created boom. By 2004-2005, that group had expanded to even the weaker free market folks.

    You know who failed miserably to produce accurate analysis? Keynesians and all the "mainstream" economists working for the government - guys who are STILL working for the government like Ben Bernanke.

    Try again, Apple.

  • ||

    most of the Austrian school and the more hard-core strains of free market analysis pointed towards a Federal Reserve/Government

    Proof of their stupidity.

    The Fed did not diminish underwriting standards.

    WaMu died a deserved death for NINJA loans while Wells Fargo (20% down) never faltered.

    It was a market decision by both. The Fed/Gov never entered the picture.

    Just more Market Fundie claptrap.

  • ||

    shrike|4.26.10 @ 10:02PM|#
    "most of the Austrian school and the more hard-core strains of free market analysis pointed towards a Federal Reserve/Government
    Proof of their stupidity.
    The Fed did not diminish underwriting standards."

    Proof or your stupidity.
    Fannie and Freddie did that, while the Fed kept interest rate below market.

  • Sean W. Malone||

    The Federal Reserve kept interest rates at literally historic lows while rapidly expanding the money supply.

    Government policy promoting home ownership, guaranteeing/underwriting & encouraging lower lending standards and giving special privileges to the big 5 investment banks (like 30:1 leveraging allowances) did everything any sane person might have expected to direct that fabricated (fake) capital into the housing & financials markets...

    From there it was just a matter of time before those misallocated resources imploded when it became apparent that there was no sustainable market demand to back it up.

    The governments hands are ALL over housing & financials and always were... This should be obvious to a first grader.

    You failed pretty hard there Shrike. Well done.

  • ||

    I happen to have a Wells Fargo loan for which I put 0 money down--of course i haven't defaulted either.

    I don't have a point. I mostly just wanted to contradict you.

  • ||

    +1

  • ||

    Apple is right, people. If the government had any fault in this mess, officials would be the first to admit mistakes. You haven't seen any of the bureaucrats suggesting any blame on their behalf, therefore government cannot be at fault. You Reasonoids are so uninformed.

  • ||

    Apple|4.26.10 @ 5:16PM|#
    "Never once does the commenter mention the subprime MBS market was not dominated by Fannie and Freddie or any other GSE,..."

    "The government only distorted the market by, oh, half or so! Why didn't the market correct that?!"
    Next, I'm sure that since Obamapork hasn't totally socialized healthcare, you'll blame the failure on 'the market', right?

  • ||

    "Sometimes it's not the government's fault." It is always the governments fault.

  • ||

    Fraud occurs. It takes the wonder of government to defraud a whole nation though.

    Ponzi scheme to fleece a few billionaires and you go to jail for the rest of your life.

    Ponzi scheme to fleece the entire nation for generations and we call it social security.

  • ||

    How many of those mortgages would have been made if the originator knew Fannie or Freddie wasn't going to buy them? If the originator knew they were going to hold the crappy mortgages and risk their own money they would never have been made.

    FNMA and FMAC were greasing the pole for the originators to slide down.

  • ||

    Apphole = FAIL

  • ||

    "after all, a super complex collateralized debt obligation squared that was made up entirely of [real] AAA mortgages with 20 percent down that were issued to well-established borrowers wouldn’t be such a bad investment"

    And this is the money quote of the article.

    Apple, you dip, read the above. Those standards (good credit, 20% down, payments not more than 37% of income, job stability, etc.) are what real bankers, investing their 'own' money [and fully exposed to the loss], without a government backing, without government coercion used to do so, would do. Subprime is largely an invention of the feds with their bullshit on red lining, every body must own a home no matter how innumerate they are, Barney Frank and company, etc.

  • ||

    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.

    A lot of people, with no formal training in economics or financed, were looking at the frenzy of home-building in the greater Indianapolis metropolitan area five or six years ago, and asking, "Who the fuck is buying these houses? How can they afford them?"

    It's not that hard.

  • ||

    So true. That's funny, I use to say the same thing about cars: who in the fuck is buying all of these cars?

    Of course, now the Chinese are - with cash.

  • Sean W. Malone||

    I started to more seriously ask these questions early in around 2004-2005 when my folks had just sold a house they'd bought only 2 years before for something like $150,000 more than they bought it for in an area that wasn't even fully developed yet.

    Then when they were looking for new house in a different part of the country, and they were pre-approved for $800,000 loans and virtually all houses were above a half a million dollars in a suburb everything on that score started to just feel like nonsense.

    I think a lot of people could see that - but it was only through obtaining a better understanding of economics and paying closer attention to the activities of the Federal Reserve & Congress (and HUD, FNMA, FDMC, FDIC, etc.) that it all made perfect sense.

  • ||

    Ahh, but it wasn't simply that people missed the obvious.

    The market was built on high risk. You could not sell credit default swaps to non bond holders if the bond was good quality. You could not manufacture synthetic collateralized debt obligations if there weren't a very large pool of CDS contracts generating cash flow. The mortgage to that poor schmuck was what this whole thing was built upon.

    I for the life of me can't understand why these fools got the better part of $12 trillion to be kept alive.

    Derek

  • Sean W. Malone||

    d, I would say that for a lot of people - simply due to their misguided beliefs on how economies work - didn't actually see any of this stuff as "obvious" to begin with.

    I mean, you really have to look at the differences between the means of analysis that someone like Peter Schiff or Mark Thornton (who accurately predicted the crisis years in advance, and who went on public record stating the problems with the economy) versus someone like Ben Bernanke who completely biffed the analysis and said that everything was fine.

    There's a reason some people found it to be "obvious" and some were caught with their metaphorical pants down.

  • Sean W. Malone||

    (Shrike is one of those people without proper attire, by the way)

  • ||

    financed

  • ||

    What's oft forgotten when thinking through the Fed's role in this crisis is how the Fed works. People think of the Fed as passing a law saying "interest rates shall be thus", when in fact, the Fed uses its tremendous power to manipulate the markets until interest rates arrive at a pre-assigned target. Hence, if the Fed wants 0% interest, but the market wants 15%, the Fed will use the tools at its disposal to increase the money supply until that 15% drops to 0%. If interest rates are held low over a period of time, money growth becomes an exponential curve (as we have seen and are seeing happen). The Fed floods the market, pushing the interest rate below equilibrium, investors respond with more and riskier borrowing, the market wants an even higher interest rate in response to that borrowing, so the Fed puts even more money in to compensate.

    If you dump a whole jar of fish food in the goldfish bowl, your fish will eat it and die. Those who are blaming Wall Street are blaming the goldfish. While I'd like to think we're all smarter than a fish, I'd also like the blame where it belongs -- on the person who dumped in all the food.

  • Sean W. Malone||

    +1

  • ||

    So Wall St bankers have as much brains as goldfish?

  • Zenmaster||

    as logic would dictate

  • ||

    +5

  • ||

    Decent analogy with the fishbowl. I may borrow it when a more detailed explanation is failing.

  • ||

    Summary: depending on ideology it's all Wall Street's fault or all government's fault :o)

    I am on the side of Lewis whose main point is that it was opacity's fault. In other words, Congress and the WH are culpable of caving to the pressures of finance regarding accounting laws and derivatives regulation.

  • ||

    Greed itself cannot bring down an economy. But greed and political power lust are a deadly combination.

  • ||

    Have folks here read the book? Lewis was mostly channeling Eisman when talking about the failures of capitalism - it was Eisman's dreary outlook, not Lewis's own.

    Lewis put most of the blame (rightly) on the credit rating agencies. The larger issue seemed to be that very few people understood how the derivatives worked or how much risk was involved. That's a point Lewis makes repeatedly.

  • ||

    "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."

    I would argue that these types of financial products by their very nature will ALWAYS hvae bad incentives. When the person making the loan isn't planning on keeping the loan, their incentives will be misplaced.

    Far better to go back to boring old regular mortgages where the bank actually keeps your loan. I know not much excitment there, but IMO finance isn't the place for excitment.

  • ||

    1 star amazon rating bomb imo.

  • Rimfax||

    On a marginalrevolution.com thread, a back of the envelope calculation showed that even if you saw the bust coming it was still a winning play to ride the wave until it started to crash. Investing with intent to capitalize on the bust led to a noticeably lower return in the long run as compared to capitalizing on the bubble and liquidating as soon as the bust started to happen.

    The problem lied in predicting when the bust would occur. Back in 1999, it seemed clear even to me that Freddie Mac was on an unsustainable course, but I never expected it to crash within the decade, much less predict the year.

    The regulatory deck is stacked so much against betting on contraction or collapse that it is very hard to make money doing so. One consequence is that even those who know that foolishness is driving up a price realize that there is more money to be made by being a fool than by being wise.

  • ||

    Yes, from an investment standpoint that's where trend following comes in. Maybe a combination of Donchian channels, and trendlines.

  • ||

    "...Donchian channels".

    The things I learn on this site. Amazing!

  • ||

    If egregious crimes
    were committed, one
    would think that the
    investor community
    would be lined up in
    droves to litigate...

    I'm hearing nothing of
    this...?

  • ||

    Don't be so sure about the intents of Michael Lewis as being salutory story-telling. Read Lewis' books and you will find it impossible to conclude that his political ideology is anything save leftist. And, think about the uncritical manner in which Lewis recounts Eisman's conversion from republican to socialist--supposedly. One thing's for sure: A smart guy like Eisman could not possibly have failed to see that the origin of the collapse was government owned enterprises blundering through the market like bulls in a china shop...in other words, the very definition of socialism. If Eisman's conversion is true, then ascribing high intelligence to him is questionable at the very least.

    God help us.

    ciao.

  • ปลวก||

    There were mistakes everywhere, sure. But surely the first thing we can ask is that government stop adding fuel to the fire.

  • RAN||

    They don't complain about FNM and FRE - only info-deprived Market fundies do. | ran แรน |

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  • Travel Thailand||

    I would argue that these types of financial products by their very nature will ALWAYS hvae bad incentives.

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  • real-bid||

    There's a reason some people found it to be "obvious" and some were caught with their metaphorical pants down.

  • ahmed kamel||

    There's a reason some people found it to be "obvious" and some were caught with their metaphorical pants down.

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