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At the Heart of the Crash

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Natalie Behring/Reuters
Goldman Sachs CEO Lloyd Blankfein at a speech by President Barack Obama on financial regulation, New York City, April 22, 2010

Not the least striking revelation of Michael Lewis’s excellent book, The Big Short, is that this author of financial best-sellers has changed his mind. In a column for Bloomberg News in early 2007, he praised the rapidly expanding market for derivatives. Visiting the annual meeting of financiers and policymakers at the World Economic Forum in Davos, Switzerland, that year, he was exasperated by the fears of some of the participants. “None of them seemed to understand that when you create a derivative you don’t add to the sum total of risk in the financial world,” he wrote, sounding arguments very similar to those made by Alan Greenspan. “You merely create a means for redistributing that risk. They have no evidence that financial risk is being redistributed in ways we should all worry about.”

As we now know, derivatives were the instruments that enabled Wall Street to stretch capital dangerously far—and were at the center of the financial crisis that began that year. They are investment contracts between two parties based on other securities, which require little capital up-front, enabling buyers and sellers to take temporary large investment stakes inexpensively, including in mortgage securities. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Greenspan told Congress in 2003. Lewis wrote in 2007: “The most striking thing about the growing derivatives markets is the stability that has come with them.”

Soon after Lewis’s column, the housing market crashed. Then, in the fall of 2008, the financial markets collapsed as well, business lending worldwide came to a standstill, and Lewis apparently began to reconsider practically everything he had written on this subject. He heard that a hedge fund manager named John Paulson made $4 billion betting against mortgages by means of derivatives. “It was late 2008,” he writes in The Big Short. “By then there was a long and growing list of pundits who claimed they predicted the catastrophe, but a far shorter list of people who actually did.” Lewis, whose first book, Liar’s Poker (1989), was a revealing insider’s account of the beginnings of the new mortgage markets, decided to find out what the handful of people who did “stand apart from mass hysteria” understood that others didn’t.

Through these contrarians, he untangles in depth the sources of the crisis in ways that none of the recent literature on the subject has matched. Lewis shows that abstract principles govern the affairs of men much less than do plain, homely, and base human motives. The financial crisis, he concludes, was the work of people on Wall Street and mortgage brokers who acted in their self-interest without fear of either legal or economic reprisal. Whereas former treasury secretary Robert Rubin argued that “we all bear responsibility for not recognizing” the “possibility of a massive crisis,” Lewis shows that it was indeed possible to know what was going on—and more to the point, that the most dangerous activities in financial markets could have been stopped.

The recent Securities and Exchange Commission suit against Goldman Sachs, which alleges that John Paulson chose the risky mortgage bonds that Goldman bundled together and deliberately sold to others, will not surprise readers of this book. Paulson made a billion dollars by betting against derivatives based on those bonds, and Goldman’s investors lost a billion dollars. It was a small drop in a dark ocean.

Lewis relates in detail the stories of the shrewd leaders of three investment firms who were convinced by the early 2000s that the mortgage market was bound for a downturn if not outright collapse. These were not heroes. If they had a moral conviction that powerful forces on Wall Street were rigging the market, most were more interested in making money than in challenging a bad system. The exception was Steve Eisman, a “strident” Republican who voted for Ronald Reagan twice and had done research on mortgage lenders as an analyst for Oppenheimer & Co. in the early 1990s. He became incensed that these lenders made so many deceptive loans to home buyers who likely would not be able to repay them. Some blamed the homeowners. “‘I’m going to lie on my loan application?’ Yeah, people lied,” he said. “They lied because they were told to lie.” Working on Wall Street turned him into a political liberal.

Eisman was observing the first round of subprime mortgages—loans made by mortgage brokers, known formally as originators, to people with poor credit scores and generally poor prospects of repayment. He became furious at what he saw. A Harvard-trained lawyer from a well-off family, Eisman went on to bet against what he saw as financial injustice with, to his partners, sometimes uncontrollable intensity. In 2004, he started his own hedge fund, FrontPoint, later to be bought by Morgan Stanley, and his obsession with subprime mortgages only grew.

It was by now the second stage of the subprime boom, the first having ended in the late 1990s with one mortgage broker’s bankruptcy after another. Not merely tens but now hundreds of billions of dollars’ worth of subprime mortgages as well as hundreds of billions of dollars’ worth of more conventional mortgages were issued each year and they were repackaged into mortgage-backed securities and sold by Wall Street bankers to pension funds, insurance companies, and other investors in the US and around the world. This had become known as securitization. Eisman knew he could sell stocks short, i.e., by selling shares he did not own but borrowed and keeping a profit when their price fell. But he could not yet figure out how to sell short the mortgage market itself, in which hundreds of billions of dollars’ worth of securitized bonds were being issued and used as collateral for the bad loans he saw being written by unscrupulous brokers.

Meanwhile, Lewis writes, Dr. Michael Burry was also trying to figure out how to sell short the inflated mortgage bond market. Burry had been fascinated with the stock market since he was a boy. And Burry was obsessive, shutting out most of the rest of the world when he could. He attributed his antisocial behavior and single-minded intensity to having lost an eye to cancer as a child. Later, when his son was diagnosed with Asperger’s syndrome, he discovered that he had it also.

Burry became a doctor and served as a resident at Stanford Hospital, but gave it up to open an investment firm, Scion Capital. By 2004, he had a successful record as an investor in unpopular, undervalued stocks. But now, his analytical interest turned to the mortgage market. He started by observing the rising number of dubious mortgages being written. By doing more research, he came to believe that the huge numbers of mortgage bonds being packaged by Wall Street and sold to investors around the world were ultimately doomed. His own investors were dubious. Why would he turn from investing in undervalued stocks to selling bonds short? But Burry was persistent.

Charlie Ledley and Jamie Mai started Cornwall Capital Management in a shed behind a friend’s house in Berkeley, California, in 2003. A natural contrarian, Ledley believed, writes Lewis, 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.” But what made Ledley and Mai especially good at what they did was their tenacious research. It did not take them long to decide that they had to invest against the latest and, by sheer volume, the greatest rage of the age, Wall Street’s mortgage bonds. Securitization had gone much too far.

Lewis traces the thinking of these four men as they try to make sense of the new markets that seemed on the surface to make no sense at all. Trillions of dollars’ worth of new mortgages were written in the 2000s, and, once securitized, they became the primary source of income for many of Wall Street’s major firms, especially after the collapse of high-technology stocks in 2000. As the availability of mortgages increased, house prices rose at a faster pace than ever recorded, and by 2004 the proportion of adults owning homes rose to a record high of nearly 70 percent. Rising home values were also financing consumption, as new mortgages and home equity loans were taken out to buy appliances and cars and to send children to college. Interest on mortgages continued to be tax-deductible, while interest on credit cards and auto loans was not.

Wall Street began to securitize mortgages in the late 1970s and early 1980s, led by bankers at Salomon Brothers, where Lewis once worked, and at First Boston. The process involved turning mortgages into the equivalent of a straightforward bond, a financial piece of engineering that is harder to do than it may sound. Mortgages usually pay higher interest rates than corporate bonds, but they are often repaid early by homeowners, typically when interest rates fall and they can get a better deal, and, therefore, unlike with conventional bonds, investors cannot count on a guaranteed return. The potential for default on the outstanding interest on a package of thousands of mortgages is also often harder to assess than the riskiness of a bond issued by, say, a single company.

To make securitization work, the bankers bundled thousands of mortgages into a single package and sold different classes, or tranches, of bonds based on them. Of all the interest paid by the homeowners each year, a portion was first allocated to the highest tranche, usually comprising 80 percent of all bondholders. Thus, even if homeowners repaid early or defaults were higher than anticipated, this top 80 percent would typically get all the interest expected. After they were paid their interest, what was left went to the next tranche, and so forth down the line. The lowest tier, or mezzanine, got the remains and was most susceptible to loss (other than a small sliver at the very bottom of the line). The key to success was that the ratings agencies, led by Moody’s and Standard & Poor’s, agreed to rate the senior tranche, or 80 percent of the bonds, triple-A. The mezzanine got the lowest rating, triple-B.

Investors around the world poured money into mortgages by buying these seemingly safe and predictable bonds, and Wall Street earned enormous fees for creating and selling them. The triple-A bonds paid 1 to 3 percent more in interest than triple-A corporate bonds. The triple-B bonds were risky but paid considerably more than corporate bonds. Wall Street was able to raise so much money that the scarce commodity was no longer financing for buying bonds but finding home buyers who needed mortgages; originating more and more bad mortgages became inevitable.

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