Derivatives (complex financial instruments) are time bombs and “financial weapons of mass destruction” that could harm not only their buyers and sellers, but the whole economic system.
“Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years.”
After seeing Michael Lewis on both 60 Minutes and The Charlie Rose Show last week, I had to read The Big Short: Inside the Doomsday Machine, the just released book by Lewis about the subprime mortgage disaster. Lewis is a fabulous story teller, and I cannot recommend this book enough.
He tells how the subprime mortgage market was created, who benefited, who lost, the cons, the dupes and the dopes and “how some of Wall Street’s finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets” and created the worst financial crisis since the Great Depression.
Essentially billions of dollars were lent to people who had very little chance of ever paying it back. And Wall Street firms earned billions of dollars creating, packaging and betting on complex financial instruments whose raw material was the risky mortgage loans they created. And that was just the beginning.
Tremendous leverage (using borrowed money to magnify possible returns) increased the risk of wiping out entire firms.
Lewis follows a few very colorful individuals who gradually figured out just how corrupt the entire risky mortgage system was. These investors made billions by betting against the subprime market by selling short.
Note that “selling short” is an entirely legal transaction, but generally considered a high risk one that involves betting against something, i.e. a stock, bond, or currency, for example, which isn’t “actually” owned by the investor. Selling short requires astuteness, foresight, excellent timing and staying power. Being “right” too soon can be both nerve wracking and very costly, because until the market agrees with your assessment, you are at risk of losing a great deal of money. (Disclosure: I do not sell short.)
In reading Lewis’s gripping story, I alternated between nodding my head in recognition of the self-serving greed that categorized Wall Street to shaking my head in disbelief that Wall Street bankers could have been so deluded that they ended up believing their own lies, I mean “models.” As I read, I found myself laughing out loud more times than I can count – truly, Lewis has a way with words.
To give you some background info, in the “old” days, a bank lent money to a home buyer and they held the mortgage. The bank was very serious about getting repaid, so before they agreed to fund the loan, they did some rather basic things like verify the borrower’s creditworthiness, check his employment and salary history and retain an appraiser to assess the value of the property being bought. A good credit history, a stable job and a property value that would support the loan were enough incentive for banks, back in the “old” days, to grant a loan request.
But when banks started selling the mortgage to a Wall Street firm who repackaged the loan and then sold the package to investors, the incentives became very different. It was like the Wild West before the Marshall came to town to establish law and order.
The acronym IBGYBG came into being. The brokers who made more money than they ever imagined said, “I’ll be gone, you’ll be gone” so let’s not worry about the suckers who will probably lose their homes or the gullible institutions that bought the crappy investments in the purposely opaque financial instruments. And it was easy to rationalize the sleazy behavior, because, after all, it was possible that this will all work out, if home prices keep rising. That was a big IF.
It was really a mammoth legal Ponzi scheme, or as Lewis called it a “mass delusion.”
The individual character’s stories are fascinating, but I will not try to summarize them. Instead, here are some observations that emphasize the need for fundamental financial regulation of Wall Street firms.
- No one goes to Wall Street investment banks to make the world a better place. “Greed on Wall Street is assumed – almost an obligation. The problem was the system of incentives that channeled the greed.”
- People see what they are incentivized to see. Wall Street employees, managers and CEOs had an incentive (i.e. huge bonuses – surely, you’ve heard about them) not to see the truth.
- When Wall Street firms were partnerships and the principals had their own money at risk, they had a sane long-term approach to their business operations. When these same firms became publicly traded corporations, risk was transferred to the shareholders. But, of course, huge bonuses were paid to successful traders based on one year’s results. In the short term, traders had every incentive to take large risks. “Heads I win, tails someone else loses, perhaps some time in the future.”
- The fixed income (bonds) world dwarfs the equity (stocks) world in size. The stock market is transparent and heavily policed. On the other hand, “bond salesmen could say and do anything without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation – one reason why so many derivatives had been derived, one way or another, from bonds.”
- The world of mortgage-backed securities (pooled investments backed by mortgages) and derivatives (financial instruments created by Wall Street) were intentionally difficult to understand, so no one even bothered to try. The book describes the nature of asset-backed securities, tranches, collateralized debt obligations, credit default swaps, etc. You, dear reader, can safely skip those portions if you want to. The horse is already out of the barn.
- It’s difficult to appreciate the amount of backstabbing, mistrust and cynicism that is endemic on Wall Street firms. “Wall Street doesn’t care what it sells.” Investment banks exploited their institutional customers (pension funds, mutual funds, banks). The same firm that is advising them on what to invest in (the sell side) also has an in-house operation that is trading for its own account. Why is this blatant conflict of interest allowed?
- While there may have been some criminal behavior, in the end, group think, mass delusion and incompetence were more important factors. Wall Street firms did not understand the money-making machine they had created or the risks they had taken.
- When lenders ran out of customers who would qualify for a normal mortgage, they dreamt up new ways to lend to people who could not afford to pay the old fashioned way. Hence the introduction of “interest-only negative-amortizing adjustable-rate subprime mortgages.” Translation: you don’t have to pay any principal or any interest on your new mortgage; we’ll just keep adding that to the amount you owe.
- Amazingly enough, Wall Street firms convinced bond ratings agencies (Moody’s, S&P) to give such garbage a Triple A rating. That credit rating agencies are “educated” by and paid by the issuers of the bonds is quite a conflict of interest! And it still exists.
- Lewis asserts that today “nobody believes that Wall Street knows what it is doing.” He understands why Goldman Sachs and Morgan Stanley, for example, want a say in how they are regulated. He wonders why anyone would listen to them.
The greed and miscalculation of Wall Street firms caused the near collapse of the world economy. Governments around the world felt forced to commit trillions of dollars to resuscitate the banks.
Regulation of firms and people which have fundamentally the wrong incentives will not be easy. Regulatory reform of institutions that are too well connected to fail will not be easy. Change is never easy. But it is absolutely essential or we will all be at risk of a repeat performance of the last financial crisis. Without reform, the investment banking system can crash again, taking with it jobs, savings and U.S. tax payer dollars.