Day after day, bankers have been paraded before Congressional committees regarding their role in the financial crisis, which brought the financial system to the edge of the abyss on September 18,2008. Every one has claimed that they were not responsible in any way for the disaster. They blame once in a lifetime circumstances that no one could have anticipated. It was a perfect storm and they had no way of knowing. These Harvard MBA Wall Street geniuses, who collected compensation in excess of $100 million each before the collapse, had no idea what was going on within their own firms. Ignorance and stupidity is no excuse for losing a trillion dollars. The truth is that the CEO's of all the Wall Street banks encouraged a casino culture of greed and gambling. The generation of fees became the sole driving incentive for every firm. It started with collateralizing subprime mortgages into packages of mortgage backed securities. Then they created Credit Default Swaps as insurance on these mortgages. When they ran out of chumps to put into houses, they created side bets with Credit Default Obligations that didn't require an actual homeowner.
The fees generated by creating this crap were incomprehensible. The Masters of the Universe were taking home pay packages of $25 million and weren't satisfied. They only made one small mistake. They deluded themselves into thinking the crap they were selling to suckers wasn't actually crap. They ended up buying their own toxic paper. Even though they knew that the ratings agencies were basically whoring out AAA ratings for fees, they believed that AAA rated securities they were buyingand insuring weren't actually worthless. They didn't understand that they had created Frankenderivatives. Author Michael Lewis has done a fantastic job making this sordid tale of greed understandable to the common person.
You are probably thinking that the title of this article is strange, but you will understand in a few minutes. Michael Lewis wrote the classic Wall Street book about the greed of the 1980's Liar's Poker, published in 1989. He detailed the absurdity and greed of Wall Street from his firsthand experiences working at Salomon Brothers fresh out of college. He captured the destructive culture of Wall Street in a very funny 290 page classic. He immortalized the term Big Swinging Dickregarding Salomon("If he could make millions of dollars come out of those phones, he became that most revered of all species: a Big Swinging Dick."). He also described the act of Blowing up a customer -Successfully convincing a customer to purchase an investment product which ends up declining rapidly in value, forcing the client to withdraw from the market.
He described an old mortgage bond trader named Donnie Green who once stopped a young callow salesman on his way out the door to catch a flight from New York to Chicago. Green tossed the salesman a ten dollar bill. "Hey, take out some crash insurance for yourself in my name", he said. "Why?" asked the salesman. "I feel lucky," said Green. Some other memorable snippets included:
- The larger the number of people involved, the easier it was for them to delude themselves that what they were doing must be smart. The first thing you learn on the trading floor is that when large numbers of people are after the same commodity, be it a stock, a bond, or a job, the commodity quickly becomes overvalued.
- In any market, as in any poker game, there is a fool. The astute investor Warren Buffet is fond of saying that any player unaware of the fool in the market probably is the fool in the market.
- The firm's management created a training programme, filled it to the brim, then walked away. In the ensuing anarchy the bad drove out the good, the big drove out the small, and the brawn drove out the brains.
- Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience.
- The only thing that history teaches us, a wise man once said, is that history doesn't teach us anything.
- That was how a Salomon bond trader thought: he forgot whatever it was that he wanted to do for a minute and put his finger on the pulse of the market. If the market felt fidgety, if people were scared or desperate, he herded them like sheep into a corner, then made them pay for their uncertainty. He sat on the market until it puked gold coins. Then he worried about what he wanted to do.
- Stupid customers (the fools in the market) were a wonderful asset, but at some level of ignorance they became a liability they went broke.
Michael expected that his book would convince many smart college students to pass on Wall Street and pursue worthwhile careers. Instead he was bombarded with fan mail thanking him for making Wall Street seem so appealing. The unquenchable desire for millions in compensation and unfettered greed on Wall Street only grew during the two decades since his book.
He has now book-ended two decades of greed with his latest masterpiece The Big Short: Inside the Doomsday Machine. He was able to link the two books by interviewing John Gutfreund,his former bossat Salomon Brothers, at the end of his new book. Lewis is able toexplain the most recent financial crisis caused by Wall Street through the eyes of a few oddball skeptics. It is a truly enlightening book and reveals the true nature of the Wall Street mega-banks. Lewis summarizes the big picture in the following sequence:
By early 2005, the sub-prime mortgage machine was up and running again. If the first act of sub-prime lending had been freaky, this second act was terrifying. $30bn was a big year for sub-prime lending in the mid-1990s. In 2005 there would be $625bn in sub-prime mortgage loans, $507bn of which found its way into mortgage bonds. Even more shocking was that the terms of the loans were changing in ways that increased the likelihood they would go bad. Back in 1996, 65% of sub-prime loans had been fixed-rate. By 2005, 75% were some form of floating rate, usually fixed for the first two years.
By the time Greg Lippmann, the head sub-prime guy at Deutsche Bank, turned up in the FrontPoint conference room, in February 2006, Steve Eisman knew enough about the bond market to be wary. Lippmann's aim was to sell Eisman on what he claimed was his own original brilliant idea for betting against or short selling the sub-prime mortgage bond market.
Eisman didn't understand. Lippmann wasn't even a bond salesman; he was a bond trader: "In my entire life, I never saw a sell-side guy come in and say, "Short my market.'" But Lippmann made his case with a long and involved presentation: over the last three years, housing prices had risen far more rapidly than they had over the previous 30; they had not yet fallen but they had ceased to rise; even so, the loans against them were now going sour in their first year at amazing rates.
He showed Eisman this little chart that illustrated an astonishing fact: since 2000, people whose homes had risen in value between 1% and 5% were nearly four times more likely to default on their home loans than people whose homes had risen in value more than 10%. Millions of Americans had no ability to repay their mortgages unless their houses rose dramatically in value, which enabled them to borrow even more. That was the pitch in a nutshell: home prices didn't even need to fall; they merely needed to stop rising at the unprecedented rates they had been for vast numbers of Americans to default on their home loans.
Lippmann's presentation was just a fancy way to describe the idea of betting against US home loans: buying credit default swaps on the crappiest sub-prime mortgage bonds. The beauty of the credit default swap, or CDS, was that it solved the timing problem. Eisman no longer needed to guess exactly when the sub-prime mortgage market would crash. It also allowed him to make the bet without laying down cash up front, and put him in a position to win many times the sums he could possibly lose. Worst case: insolvent Americans somehow paid off their sub-prime mortgage loans, and you were stuck paying an insurance premium of roughly 2% a year for as long as six years the longest expected life span of the putatively 30-year loans.
Eisman could imagine very little that would give him so much pleasure as going to bed each night, possibly for the next six years, knowing he was shorting a financial market he'd come to know and despise, and was certain would one day explode.
In the summer of 2006, house prices peaked and began to fall. For the entire year they would fall, nationally, by 2%. By that autumn, Lippmann had made his case to hundreds more investors. Yet only 100 or so dabbled in the new market for credit default swaps on sub-prime mortgage bonds. A smaller number of people still more than 10, fewer than 20 made a straightforward bet against the entire multi-trillion-dollar sub-prime mortgage market and, by extension, the global financial system. The catastrophe was foreseeable, yet only a handful noticed.
Eisman was odd in his conviction that the leveraging of middle-class America was a corrupt and corrupting event. At the annual sub-prime conference that year, Eisman walked around the Venetian hotel in Las Vegas with its penny slots and cash machines that spat out $100 bills and felt depressed. It was overrun by thousands of white men now earning their living, one way or another, off sub-prime mortgages.
Later, whenever Eisman set out to explain to others the origins of the financial crisis, he would start with what he learned in Las Vegas. He'd draw a picture of several towers of debt. The first tower was the original sub-prime loans that had been piled together. At the top of this tower was the safest triple-A rated tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche the bonds Eisman had bet against. The Wall Street firms had taken these triple-B tranches the worst of the worst to build yet another tower of bonds: a collateralised debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults, and was now being rejigged to disguise the risk of sub-prime mortgage loans.
It was in Vegas that Eisman finally understood the madness of the machine. He'd been making these side bets with major investment banks on the fate of the triple-B tranche of sub-prime mortgage-backed bonds without fully understanding why those firms were so eager to accept them. Now he got it: the credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. There weren't enough Americans with sh*tty credit taking out loans to satisfy investors' appetite for the end product. Wall Street needed his bets in order to synthesise more of them. "They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford," Eisman says. "They were creating them out of whole cloth. One hundred times over! That's why the losses in the financial system are so much greater than just the sub-prime loans. That's when I realised they needed us to keep the machine running. I was like, This is allowed?"