March 14, 2010
The global financial crisis of 2008, which economists estimate could result in several trillion dollars of losses and which has already cost American taxpayers billions of dollars in government bailouts, was triggered not by war or recession but by a crazy, man-made money machine, built on flawed mathematical models that most financial executives did not really understand themselves. Greedy and heedless, Wall Street firms had been turning subprime mortgages — loans made to people with low creditworthiness or little documentation — into exotic, toxic financial products that they made a fortune laundering and reselling, and they were enabled in doing so by the very ratings agencies that were supposed to police risk. The insanity of this growing and highly leveraged trade in mortgage derivativescontinued even as the quality of the underlying loans grew increasingly dubious, even as it became increasingly likely that the American housing bubble was going to pop.
The clear and present danger posed by this deranged edifice built on the unstable foundation of subprime mortgages was not foreseen by the chief executives of America’s premier banks. It was not foreseen by government regulators, by Treasury officials or by the Fed. It was foreseen, however, by a handful of investors, who were aghast at the madness they saw on the Street and who used their prescience to make a fortune off the financial system’s calamitous meltdown. Some of their stories are told by Michael Lewis in “The Big Short.”
No one writes with more narrative panache about money and finance than Mr. Lewis, the author of “Liar’s Poker,” that now classic portrait of 1980s Wall Street. His entertaining new book does not attempt a macro view of the financial crisis, but instead proposes to open a small window on the calamities by recounting the stories of some savvy renegades who cashed in on their conviction that the system was rotten. In doing so Mr. Lewis faces the same problem that the Wall Street Journal reporter Gregory Zuckerman faced in “The Greatest Trade Ever,” his recent book about John Paulson, a hedge fund manager who made $15 billion in 2007 by shorting the housing bubble — the problem, namely, that the reader is put in the position of rooting for people who, while smarter or more farsighted than those who helped bring about catastrophe in the first place, were nonetheless trying to make money (who saw a rare opportunity, as one put it) by betting against the health of our financial system.
Still, Mr. Lewis does a nimble job of using his subjects’ stories to explicate the greed, idiocies and hypocrisies of a system notably lacking in grown-up supervision, a system filled with firms that “disdained the need for government regulation in good times” but “insisted on being rescued by government in bad times.”
Mr. Lewis argues that the roots of the meltdown of 2008 can be found in the 1980s of “Liar’s Poker,” when complex financial products like mortgage derivatives were developed. He also suggests that these financial instruments (which had names like “the synthetic subprime mortgage bond-backed C.D.O., or collateralized debt obligation”) grew increasingly opaque and complex to help obscure the fact that they were built around increasingly suspect loans: “low-doc or no-doc loans” requiring little documentation, adjustable-rate mortgages that ballooned after two years, “interest-only negative-amortizing adjustable-rate subprime” mortgages, and mortgages given to migrant workers and poor immigrants with little or no English.
As Mr. Lewis describes it, Wall Street firms were able “to hide the risk by complicating it” and by getting the rating agencies — notably, Moody’s and Standard & Poor’s — to give triple-A ratings to bonds that were far lower in quality. Why, he asks, “were Moody’s and Standard & Poor’s willing to bless 80 percent of a pool of dicey mortgage loans with the same triple-A rating they bestowed on the debts of the U.S. Treasury?” Because, he suggests, Wall Street firms knew how to game the system; they knew how to get the rating agencies (which were eager to collect big fees for their services) to ineptly rate dangerous bonds. Most evaluation models, he observes, were based on rising house prices and used “the foreshortened, statistically meaningless past to predict the future”; this was how “the entire food chain of intermediaries in the subprime mortgage machine” was able to dupe itself.
Writing in faintly Tom Wolfe-ian prose, Mr. Lewis does a colorful job of introducing the lay reader to the Darwinian world of the bond market: “An investor who went from the stock market to the bond market,” he writes, “was like a small, furry creature raised on an island without predators removed to a pit full of pythons.” He draws equally lively portraits of the central characters in his story. All, he notes, were oddballs or outsiders — people impervious to groupthink and conventional wisdom, and each of them, he says, “told you something about the state of the financial system, in the same way that people who survive a plane crash told you something about the accident, and also about the nature of people who survive accidents.”
To begin with, there’s Steve Eisman, who had started out “a strident Republican” and was on his way “to becoming the financial market’s first socialist” as he grew increasingly convinced that “an entire industry, called consumer finance,” basically “existed to rip people off.” Mr. Eisman and his team “had a from-the-ground-up understanding of both the U.S. housing market and Wall Street,” Mr. Lewis writes, and by performing the sort of nitty-gritty credit analysis on mortgages (that should have been done before the loans were made in the first place), they realized that they could make a fortune by shorting the worst of the worst.
Then there is Michael Burry, a doctor with Asperger’s syndrome, who’d become obsessed with investing and started a fund with money from a small settlement his family received when his father died after a medical misdiagnosis. Dr. Burry immersed himself in studying the bond market in 2004 and became convinced that lending standards had declined so alarmingly that he could make money by shorting subprime mortgage bonds; by the end of 2007, Mr. Lewis reports, “he would have realized profits of more than $720 million” for his fund.
Finally, there is the “garage band hedge fund” started by Jamie Mai and Charlie Ledley in 2003 with a Schwab account containing $110,000 and housed in a shed in the back of a friend’s house in Berkeley, Calif. Mr. Ledley believed, Mr. Lewis writes, “that the best way to make money on Wall Street was to seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening.” In this case, his contrarian instincts told him, in Mr. Lewis’s words, that “the markets were predisposed to underestimating the likelihood of dramatic change.”
Four and a half years later the American economy was in trouble, and, Mr. Lewis says, the fund run by Mr. Ledley, Mr. Mai and their partner, Ben Hockett, would net more than $80 million.