Friday, April 30, 2010

History of the Financial Meltdown

Don’t comprehend the big financial meltdown of 2008 and all that stuff about sub-prime mortgages? Michael Lewis offers a pretty good orientation in The Big Short. Since he is truly a marvellous writer, it’s a very funny and entertaining read too.

This ain’t really a history of the financial crisis. Lewis is a magazine journalist, and the book is just a set of linked profiles of a handful of investors who concluded a big crash was inevitable and started betting on it big-time. As Lewis says, lots of people will tell you they saw the financial meltdown coming. A few were willing to risk their money on it ahead of time -- and also knew how to. They provide Lewis with a great story.

The Big Short does explain one little wrinkle I never saw sorted out in the business press. The billions of dollars of bonds that turned out to be worthless (and took down AIG Insurance, and Fanny Mae, and Lehmann Brothers, and Northern Rock Bank, and anyone else who did not get bailed out in time) were based on mortgages. As everyone has said, Wall Street somehow took millions of lousy, risky, unsecured, individual sub-prime mortgages, bundled them into big compilations of the very same mortgages – and somehow managed to reclassify and sell the collections as Triple-A secure.

Huh? you said every time you read that.

Lewis explains it. It was a sort of perversion of the principle of insurance. Sell insurance on one house, and there’s some risk it will burn down and you will be ruined. But sell insurance on 10,000 houses, and it’s unlikely they will all burn down. Some will, but the premiums on those that don’t will cover the cost of the few that do.

That was the principle on which sub-prime mortgages, packaged together, seemed less risky. They could not all collapse at the same time, any more than all the houses could burn down. Put enough of them together, and the ones that carried on would cover those that went bad.

Trouble was, they could go bust together. They did. The United States is basically one big housing market. When some subprime mortgages began to be defaulted on, they pretty much all did. When payments stopped being made on that riskily mortgaged house on that dusty hillside in California, payments were stopping on all its neighbours too, and on all the riskily mortgaged houses in Florida and Ohio and everywhere else. They all caught the same fire, you might say.

That’s the underlying explanation. You’re welcome.

Lewis profiles a few cranky, eccentric, not-part-of-the-Wall-Street-consensus, investors who figured that out and bet on the collapse. It’s a terrific story. But the misallocation of risk is not really the heart of his explanation of what happened, though he’s pointedly funny about the failures of the ratings agencies like Standard and Poors. At conventions, he observes, the investment bankers swagger about wearing shorts and Hawaiian shirts or, sometimes, really fabulous Italian designer suits. The ratings guys, salarymen all, wear suits and ties – but off-the-rack suits and cheap ties. A menswear salesman could tell at a glance who dominates who.

So Lewis's explanation is partly about stupidity: if his characters could read the situation, the Wall Street zillionaires should have been able to. But really he locates the cause in the failure of the investment markets, which is to say the corruption of the market. Back to his 1980s book Liar’s Poker, about his own days as a Wall Street investment banker, Lewis has always presented Wall Street as a rigged game, not a real marketplace but a rigged one, designed to enrich the traders who control the markets.

There was so much money for Wall Streeters to make, and so easily, and with all the risk being to other people’s money, that Wall Street did not really care, had no incentive to look more closely and discover the flawed principle (yes, they could all catch fire at once!) on which these bonds were based. They could afford to be ignorant enough to destroy the American financial system; indeed they were becoming fabulously rich doing precisely that. Working in an unrigged game would be much harder and not nearly so lucrative.

Gradually, however, Wall Street made so much money on subprime mortgage bonds that it came to believe in them. The investment banks put their own money, not just the customers’ money, into the subprime mortgage packages. Which is why the Wall Street investment banks were swept away along with customers like AIG and Fanny Mae. But even then, the actual managers mostly did fine – because they had long since made the investment banks into public companies and merged them with retail banks. It still was not their own money they were risking in pursuit of those seven- and eight-figure bonuses, it was the shareholders’ and depositers’ money.

Distilling the message of The Big Short, I’m making it sound like a finance treatise, when really it’s a fast and funny book-length piece of magazine journalism by a master of the craft. Read it for the entertainment. The lessons are optional.
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