Short the Delusion
Ask the average guy on the street — Main or Wall — about what caused the meltdown on Wall Street in 2008, and you might get "greed," or "arrogance," or "too much leverage," or "too little regulation," or a blank stare. After all, the arcane world of mortgage securities was new. After the dot-com bust, Wall Street needed products to make money on. And with middle Americans figuring they could collectively get rich just by taking title to a home with no money down and watching the value climb to the heavens (extracting money to maintain their lifestyles along the way), well, that's what Wall Street's all about: something for nothing.
But understanding stocks and bonds, or even puts and calls, is one thing — but CDOs and CDSs? It's not like your E*Trade brochure spelled out what this new alphabet soup meant so that the average Joe and Jane could take the plunge. So now that the whole shootin' match has caved in, only to be pumped back up by the Bernanke Fed in order to keep the big banks alive to fight (and buy government debt) another day, it's time to find out just what happened. What was that strange mortgage goulash that Wall Street was serving?
"It's never paid to bet against America," according to Warren Buffett. But a quirky group of investors did just that and made millions, betting against what is more American than apple pie and baseball — the idea that housing prices always go up. And just as he shined a bright light on the shenanigans going on at the bond-trading house Solomon Brothers in his 1989 best seller Liar's Poker, Michael Lewis has come to rescue us from our ignorance with an engaging tale about the brave souls who put their (and their investors') money where their conviction was — and won — with his new book The Big Short: Inside The Doomsday Machine.
Sure, a few readers will say, "Gee, I knew this whole housing thing was going to blow up," and according to the SEC, the folks at Goldman Sachs did too. The government claims that Wall Street's highly connected firm was selling mortgage investments without telling the buyers that the securities were created with the help of a client who was at the same time making a bet that these same securities would fail.
That Goldman Sachs client was John Paulson, with whom, by the way, the SEC has no beef. Paulson made millions from his trade — and is a big name in investing circles — but gets only a minor mention in Lewis's story, which revolves around guys no one has heard of: Steve Eisman, Dr. Michael Burry, Charlie Ledley, Jamie Mai, Vincent Daniel, Danny Moses, Porter Collins, and Ben Hockett.
This group stood at the end of the housing-market craps table (but not necessarily together) loading up on "don't pass" and "don't come" bets while the rest of Wall Street had all its money on the "do" side because Moody's and S&P said the housing dice would never "seven out." It was a lonely place to be, and Lewis makes sure we understand that few were obsessed enough to stick it out for the big payday.
The most obsessive of the group, if that's possible, was the socially awkward one-eyed doctor with Asperger's Syndrome, Michael Burry. He and his wife are an Asperger's couple with an Asperger's son — not that he knew that when he began to notice that mortgages were being underwritten in increasingly dicey fashion, yet the ratings agencies were calling subprime AAA. So, he positioned his fund in 2005 for the mortgage market to fall apart when the teaser-rate period was over in 2007. After all, reading 130-page subprime-mortgage-bond prospectuses that are only normally read by the lawyers who write them (in a way that discourages anyone else from reading them) was a snap for Burry, while nobody at Moody's or Standard & Poors (S&P) was studying these things at all.
But the doctor's investors were breathing down his neck. They wanted their money back. He had lost them over 18 percent in 2006, while the S&P 500 index had been up over 10 percent. But he was resolute in his view that he was right. And right he was: over $800 million right for him and his investors. "It was a stroke of luck that his special interest was financial markets and not, say, collecting lawn-mower catalogues." But the investors for whom he made so much money said little; Burry's success only served to shut them up.
While telling the stories of the financial swashbucklers like Burry, Lewis is able to elegantly explain just how "a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation" is created. Honestly, it takes him less than a page. However, the thicket of financial products does get a bit more complicated from there.
As many gamey mortgages as there were to make side bets on, Lewis points out that
when Mike Burry bought a credit default swap based on a Long Beach Savings subprime-backed bond, he enabled Goldman Sachs to create another bond identical to the original in every respect but one: There were no actual home loans or home buyers. Only the gains and losses from the side bet on the bonds were real.
Oh, and by the way, a swap isn't really a swap but the equivalent of an insurance policy against the creditworthiness of a particular CDO. So when you buy a swap, you have to pay the premiums on the insurance that the CDO will tank, or if not completely tank, slip a little, and you have to keep paying them. So these guys weren't just taking a position and keeping their fingers crossed, they had to keep feeding their bets, even when the financial world (and their investors) thought they were nuts.
So if nobody could really figure these things out — and the underlying mortgages were made to people like the stripper in Vegas who bought five homes with subprime loans or the strawberry picker in Bakersfield who borrowed the entire $724,000 purchase price for his dream home, qualifying with only $14,000 in annual income — how on earth could the ratings agencies call these things triple-A?
Well, first of all, the folks working at Moody's and S&P were the ones not sharp enough to get work at the Wall Street firms. And, as one former Goldman Sachs trader told Lewis, the worst of the bunch working at the ratings agencies were those reviewing asset-backed products including subprime mortgage bonds, "who are basically like brain-dead."
Lewis goes on to describe how the ratings agencies would not ask for a list of all the credit scores of the borrowers in a particular bond, they only asked for an average. And to obtain a AAA rating, the only rating people wanted to see was an average FICO score of 615 (which, by the way, is not all that hot). But, by using that average, half the borrowers had FICOs of 550 and half at 680, and the bond gets its 615 average and triple-A rating. Never mind that the 550 FICO folks will default even in the best of times.
And when the pugnacious ex-lawyer turned fund manager Steve Eisman and his skeptical accounting guru, Vinny Daniel, took the train down to see a woman at S&P who was in charge of monitoring subprime bonds, thinking that she surely had information they didn't, they were stunned — because she didn't. "This was insane: The arbiter of the value of the bonds lacked access to relevant information about the bonds."
Lewis goes on to relate how Eisman tore into the woman from S&P for not having more information than he did — not unusual for a man who studied the Talmud as a young man in order to find mistakes, and when he became a rich man, donated to an organization called Footsteps, "devoted to helping Hasidic Jews flee their religion. He couldn't even give away his money without picking a fight," Lewis writes.
To be proved right in the end is never as sweet as one imagines. The recognition goes to those who curry favor with the media through publicists and charm while reconstructing history to suit their purposes. Government bailouts and the Federal Reserve's endless money printing keeps those who made the big mistakes from paying the price. If not for Michael Lewis, the names and the stories of the real entrepreneurs in this boom-and-bust tragedy would have been lost to history. That is his great gift.
Douglas French is president of the Mises Institute and author of Early Speculative Bubbles & Increases in the Money Supply. He received his Master's Degree in economics from the University of Nevada, Las Vegas, under Murray Rothbard, with Professor Hans-Hermann Hoppe serving on his thesis committee. See his tribute to Murray Rothbard. Send him mail. See Doug French's article archives.
Learn about Mr. Stolyarov's novel, Eden against the Colossus, here.