Wednesday, June 1, 2011

Michael Lewis: The Big Short + Obama’s Mistake

The Big Short: Inside the Doomsday Machine, by Michael Lewis, W.W. Norton & Co., 2010.

Since I spend a lot of time driving around the country, I listen to a lot of audio books. This past month, I checked four out of the library, but ended up listening to just one book - three times: Michael Lewis's history of how the subprime mortgage market transmogrified into a highly leveraged monster of collateralized debt obligations (CDO) and credit default swaps (CDS), which eventually blew up beginning in 2006-2007, leading to the financial collapse of 2008.
Yves Smith of Naked Capitalism, argues that Lewis commits a grievous error by holding up as heroes the people who shorted subprimes using CDOs and CDSs. According to her, the financial collapse would not have been as bad, and possibly even avoided, if the shorts had not been able to place their bets using credit default swaps. Hence, concludes Smith, the shorts are not the heroes, but the villains in this story.

Smith is correct in a strictly technical sense only. Missing from Smith’s critique is her usual outrage over the larger moral issues presented by the financial collapse. I was truly surprised by this, because I deeply admire her for being one of the very few people to have been fully immersed in Wall Street’s financial machinations, and emerge with her soul and moral sense intact. There must have been something about Lewis’s book that provoked an outburst, but I can’t put my finger on it.

In point of fact, Lewis quotes one of the shorts, Steve Eisman, discussing when he realized that the Wall Street subprime monster depended entirely on the demand by the shorts for CDOs and CDS. And in fairness to Eisman, it should be noted that his first reaction on realizing the extent of the fraud in the sub-prime mortgage market was to alert state and federal officials in an attempt to spur criminal investigations.

With his light-hearted humor, and a keen eye for anecdotal details, Lewis performs the inestimable public service of making the hideously complicated world of Wall Street finance understandable and accessible to all the rest of us.

Moreover, Lewis correctly identifies the real problem, though he does not explicitly point to its importance, or dwell on it in such manner as to drive home the point. On page 9, he writes, regarding the beginnings of the subprime securitization market in the last half of the 1990s:

Subprime mortgage lending was still a trivial fraction of the U.S. credit markets—a few tens of billions in loans each year—but its existence made sense, even to Steve Eisman. “I thought it was partly a response to growing income inequality,” he said. “The distribution of income in this country was skewed and becoming more skewed, and the result was that you have more subprime customers.” (Emphasis mine.)
What began to happen on Wall Street in the early 2000s, is called securitization. For example, a bank with 1,000 home mortgages, each with a combined principal and interest payment of $1,000 a month, would have an expected cash flow of $1,000,000 a month from those 1,000 home mortgages. Rather than wait an entire 30 years for all those mortgages to be paid off, the bank could instead sell that expected cash flow as a package in a securitized mortgage bond. Assume the bank sold off the cash flow of those mortgages for one entire year, or an expected cash flow of $12 million. However, the bank would not get the entire $12 million for selling the bond. Assume it sold the bond for only $11.5 million. The $500,000 missing from the price of the bond would be the “profit” to the bond buyer. This “profit” of course, could be decreased by some homeowners defaulting on their house payments. If 500 homeowners missed their monthly mortgage payment once, the entire “profit” of the bond buyer would be wiped out. It was for assuming this risk that the bond buyer was given the $500,000 off the “price” of the $12 million bond.

This is a misleadingly simple example, and the numbers and ratios involved are far outside what became the norm in the securitization markets. We will quickly note a number of considerations here. First, is that almost any expected cash flow – car loans, college loans, credit card balances, aircraft leases, etc. – can be securitized.

Second, the cash flows can be “sliced and diced” in different ways to create different securitized bonds. In our example of 1,000 home mortgages, assume all had a monthly interest payment of $600 and a principal payment of $400. The mortgage lender could sell only the interest payments of $600,000 a month as one bond; and sell only the principal payments of $400,000 a month as another bond. Or not sell them and keep the principal payments for itself. Or, the mortgage lender could divide its pool of 1,000 home mortgages in a number of different way. As an example, say the bank sorts the 1,000 home mortgages into one pool of 500 mortgages that the lender thinks has a less than one percent chance of the home buyer defaulting. The cash flow from this pool is sold off as one bond. The remaining 500 mortgages thus have a higher than one percent chance of being defaulted on, and is sold off as a second bond. Clearly, there is more risk involved for the buyer of the second bond, so that buyer would expect a larger amount of “profit” for buying that second bond.

Third, think of the accounting complexities that begin to arise with securitization. How does the mortgage lender account for the selling of the 1,000 home mortgage cash flows on its books? How does the bond buyer account for the bond it has purchased? What if the mortgages in the bond have variable rates of interest? What material interest remains for the mortgage lender to make sure that the home buyers it is lending to will actually be able to pay off their mortgages each month, if the mortgage lender securitizes its mortgages and sells them off right away? Who actually has the lien on the houses themselves? (A question we now see is particularly important, given the documentation problems in the home foreclosure documentation crisis, which threatens to debase the entire national locally-based system of property records). The mortgage lender? What if the mortgages were sliced and diced? Does the buyer of securitized interest payments hold the liens? Or the buyer of securitized principal payments?

Back to Lewis. A few pages later, Lewis quotes Vincent Daniel, Eisman’s market analyst, who was struggling to understand the subprime market in 1997:

What first caught Vinny’s eye were the high prepayments coming in from a sector called “manufactured housing.” (“It sounds better than ‘mobile homes.’”) Mobile homes were different from the wheel-less kind: Their value dropped, like cars’, the moment they left the store. The mobile home buyer, unlike the ordinary home buyer, couldn’t expect to refinance in two years and take money out. Why were they prepaying so fast? Vinny asked himself. “It made no sense to me. Then I saw that the reason the prepayments were so high is that they were involuntary.” “Involuntary prepayment” sounds better than “default.” Mobile home buyers were defaulting on their loans, their mobile homes were being repossessed, and the people who had lent them money were receiving fractions of the original loans. “Eventually I saw that all the subprime sectors were either being prepaid or going bad at an incredible rate,” said Vinny. “I was just seeing stunningly high delinquency rates in these pools.” The interest rate on the loans wasn’t high enough to justify the risk of lending to this particular slice of the American population. It was as if the ordinary rules of finance had been suspended in response to a social problem. A thought crossed his mind: How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans. (Emphasis mine.
So, in the final analysis, what the entire game comes down to is the rapidly growing debt burden Americans assumed through the 1990s and 2000s -- and their diminishing ability to service that debt burden as incomes for all but the rich stagnated, and for many, declined. As Jacob Hacker and other researchers have found, the probability of an average American suffering a 50 percent decline in income more than doubled from the 1970s to the 2000s.
Most people believe the financial collapse began in 2008. In fact, the collapse began in 2005. As Lewis writes on page 54 “In the second quarter of 2005, credit card delinquencies hit an all-time high – even though house prices had boomed. That is, even with this asset to borrow against, Americans were struggling to meet their obligations.” There were very, very few people on Wall Street like Eisman and Daniels, who were willing to accept the evidence that discredited the myth -- which had assumed the position of unassailable truth by the mid-2000s -- that Wall Street’s securitization schemes were some fabulously cornucopian machine for generating wealth by trading ever increasing amounts of paper. For these skeptics, the very fact that the amounts of paper being traded was increasing so rapidly, while Americans’ wages and earnings were declining, was a flashing danger sign. Eisman and Daniels and others were carefully watching certain economic and financial indicators, and saw the catastrophe coming years before it occurred. For others, such as myself, it was merely enough to know a bit about the 1920s, and recognize the historic parallels: increasingly wild financial speculation at the same time wages and earnings were being squeezed. In early December 2007, a full four months before the collapse of Bear Stearns, I wrote Not Good – We’ve Been Here Before in which I used a quote from the memoirs of Marriner Eccles, Federal Reserve chairman under Franklin Roosevelt, discussing how the financial collapse of the First Great Depression had been caused by the income and wealth gaps that had grown dangerously wide in the 1920s “boom.”

Let us note here, that conservative wrong-wingers today vehemently defend disparities in wealth and income as the “natural” result of people who “work hard” being more richly rewarded than people who are “lazy.” As Lewis paraphrases or quotes one person: conservatives just have a hard time accepting that some people get rich by cheating other people. And what we have with Wall Street’s securitization, was a process that could not have been better designed to cheat and defraud people. The financial paper created by securitization is sold in the bond market, and as Lewis explains, there are huge differences between the bond markets, and the equity, or stock, markets most people are familiar with.

An investor who went from the stock market to the bond market, was like a small, furry creature raised on an island without predators removed to a pit full of pythons. . . The stock market was not only transparent, but heavily policed. . . The presence of millions of small investors had politicized the stock market. It had been legislated and regulated to at least seem fair.
The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they'd be reported to some authority. Bond traders could exploit inside information 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 bigger, more liquid end of the bond market - the market for U.S. Treasury bonds, for example - traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn't know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.
What is interesting, in a clinical sort of way, is how the amorality and even immorality of the bond markets seeped into other financial markets. Lewis, of course, is focused on the home mortgage market, and he provides anecdotes of this corrupting process, without fully exploring it. Eisman actually identified for Lewis the events that drove Eisman to realize how fundamentally corrupt was not just the financial system, but the political and judicial systems as well: the mortgage rate fraud perpetrated on homebuyers in the late 1990s by Household Finance Corporation, at the time, the largest provider of subprime mortgages in the country.

Whatever Eisman was meant to be doing got pushed to one side. His job became a single-minded crusade against the Household Finance Corporation. He alerted newspaper reporters, he called up magazine writers, he became friendly with the Association of Community Organizations for Reform Now (ACORN), which must be the first time a guy from a Wall Street hedge fund exhibited such interest in an organization devoted to guarding the interests of the poor. He repeatedly pestered the office of the attorney general of the state of Washington. He was incredulous to learn that the attorney general had investigated Household and then been prevented, by a state judge, from releasing the results of his investigation. Eisman obtained a copy; its contents confirmed his worst suspicions. “I would say to the guy in the attorney general’s office, ‘Why aren’t you arresting people?’ He’d say, ‘They’re a powerful company. If they’re gone, who would make subprime loans in the state of Washington?’

. . . . Really, it was a federal issue. Household was peddling these deceptive mortgages all over the country. Yet the federal government failed to act. Instead, at the end of 2002, Household settled a class action suit out of court and agreed to pay a $484 million fine distributed to twelve states. The following year it sold itself, and its giant portfolio of subprime loans, for $15.5 billion to the British financial conglomerate the HSBC Group.

Eisman was genuinely shocked. “It never entered my mind that this could possibly happen,” he said. “This wasn’t just another company—this was the biggest company by far making subprime loans. And it was engaged in just blatant fraud. They should have taken the CEO out and hung him up by his fucking testicles. Instead they sold the company and the CEO made a hundred million dollars. And I thought, Whoa! That one didn’t end the way it should have.” His pessimism toward high finance was becoming tinged with political ideas. “That’s when I started to see the social implications,” he said. “If you are going to start a regulatory regime from scratch, you’d design it to protect middle- and lower-middle-income people, because the opportunity for them to get ripped off was so high. Instead what we had was a regime where those were the people who were protected the least.”

. . . . Obsessing over Household, he attended a lunch organized by a big Wall Street firm. The guest speaker was Herb Sandler, the CEO of a giant savings and loan called Golden West Financial Corporation. “Someone asked him if he believed in the free checking model,” recalls Eisman. “And he said, ‘Turn off your tape recorders.’ Everyone turned off their tape recorders. And he explained that they avoided free checking because it was really a tax on poor people—in the form of fines for overdrawing their checking accounts. And that banks that used it were really just banking on being able to rip off poor people even more than they could if they charged them for their checks.”

Eisman asked, “Are any regulators interested in this?”

“No,” said Sandler.

“That’s when I decided the system was really, ‘Fuck the poor.’”
And that’s what the U.S. financial system had become under the deregulatory impulses of the neo-liberal economics launched by Milton Friedman and the Chicago School in the 1970s: Examine and study the rapidly growing pool of Americans whose incomes were not matching their needs, and devise ever more clever ways to defraud them. In a nutshell, “Fuck the poor.”

By 2005 the FBI was reporting that mortgage fraud had increased five-fold since 2000, and was warning that the extent of the fraud could cause another financial crisis on the level of the 1980s savings and loan crisis. As Lewis writes: The original goal of financial innovation as applied to home mortgages was to make home loans cheaper for home buyers by making the financial markets “more efficient.”

Now, somehow, the same innovative spirit was being put to the opposite purpose: to hide the risk by complicating it. The market was paying Goldman Sachs bond traders to make the market less efficient.
In a footnote on page 77, Lewis quotes someone who helped unravel the credit default mess, and who was very familiar with people at Goldman Sachs: “If a team of forensic accountants went over Goldman’s books, they’d be shocked at just how good Goldman is at hiding things.” And in fact, Eisman and his team, once they realized that there would be no political and judicial obstacles to what was occurring in the mortgage bond market, proceeded to pick the securities they would short by explicitly asking “Which mortgage originators were the most corrupt? Which Wall Street firms were creating the most dishonest mortgage bonds?”
Lewis ably describes how the big Wall Street firms skillfully and efficiently manipulated the credit rating agencies - Standard & Poor’s, Moody’s, and Fitch - to use mathematical models to price and evaluate mortgage bonds, without fully exploring or understanding the assumptions embedded in those models – assumptions that proved to be erroneous and dangerously divorced from reality.

“The more egregious the rating agencies’ mistakes, the bigger the opportunity for the Wall Street trading desks. . . . the bonds that had been most ineptly rated were the bonds That Wall Street firms had tricked the rating agencies into rating most ineptly. “I cannot fucking believe that this is allowed, said Eisman. “I must have said that a thousand times.”
Charlie Ledley, one of the three principals in Cornwall Investments, one of the other shorts Lewis focuses on, summarized their reaction to their struggle to study and understand collateralized debt obligations (CDOs) this way:
It took us weeks to really grasp because it was so weird. . . But the more we looked at what a CDO was, the more we were like, Holy shit, that’s just fucking crazy. That’s fraud. Maybe you can’t prove it in a court of law. But that’s fraud.
On page 205, Lewis has a notable footnote that summarizes Eisman’s and Daniels’ view of the big Wall Street firms. It is particularly noteworthy because it directly addresses the brutal dishonesty that characterizes Wall Street’s relationship with its customers and clients:
Wall Street firms like to say they build Chinese walls to keep information about customer trading from leaking to their own proprietary trading. Vincent Daniel of FrontPoint Partners offered the most succinct response to this pretense: “When I hear ‘Chinese wall,’ I think, ‘You’re a fucking liar.’”
In her critique of Lewis’s book, Yves Smith points out that Lewis ignores entirely the largest shorts that caused the financial collapse. She writes that multiple sources informed her that an astonishingly high 50% to 75% of subprime bond demand in 2006-2007 came from a single hedge fund based in the Chicago suburbs, Magnetar. I do not think focusing on much smaller short players than Magnetar compromises or lessens Lewis’s book in any way. The important story of the financial collapse ignited by sub-prime mortgage bonds, CDOs, and CDSs is not that a few people caused the crisis by using instruments devised to bet against the rising insanity of subprime mortgage lending, but that there was a crisis at all. Even if there had not been any subprime mortgages at all to repackage and then repackage again into hopelessly complicated financial instruments, Wall Street and the bond market would have remained as corrupt and predatory as it was in 2005, as well as today.
Eisman and his team had a from-the-ground-up understanding of both the U.S. housing market and Wall Street. They knew most of the subprime lenders—the guys on the ground making the loans. Many were the very same characters who had created the late 1990s debacle. Eisman was predisposed to suspect the worst of whatever Goldman Sachs might be doing with the debts of lower-middle-class Americans. “You have to understand,” he says. “I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn’t give a shit what it sold.”
I will go even further. In my opinion, Steve Eisman would be one of the few people capable of carrying out the task of dismantling the Wall Street monster that I would trust. His first reaction, once he understood the breathtaking scope and depth of the fraud and corruption in the mortgage markets, as epitomized by Household Finance, was an attempt to spur the proper government authorities to begin a criminal investigation. Once it became clear to Eisman that the American political system had been hopelessly debased by the corrupting influence of banking and high finance, he became almost a zealot in the satisfaction he took from directly confronting the top executives and managers of the monster. Time and again Eisman humiliated and enraged top Wall Street executives by calling them on their bullshit. Personally, I admire Eisman for having the brains and fortitude to figure out a way to extract millions of dollars out of the monster for himself and his associates. If you can’t beat them, exploit them.
In an interview at the end of the book, Lewis explains that Obama is now paying the political price for being a friend of Wall Street. The administration's view was that it was impossible to take on the political power of Wall Street, so decided instead to expend their political capital on health care reform. This was a tragic miscalculation. Lewis argues - and I entirely agree that if Obama had made destroying Wall Street his first priority, he would have gained political capital because it would have been so wildly popular. In fact, I made a similar argument through all of 2009: that the failure to annihilate Wall Street would lead to the wrong-wing getting the momentum of populist outrage by default.

And in one diary in May 2009, I asked Will Obama forfeit a second term because of Wall Street? I think Obama's major weakness going into re-election is the economy, specifically, the "jobless recovery." And that weakness is a direct result of not taking on Wall Street. We have to force Americans to face this: we have conducted a two-year, multi-trillion dollar experiment to test the premise that saving Wall Street is vital to the rest of the economy. What are the test results? Wall Street has been saved, but the rest of the economy is in a depression. There's no getting around the evidence on the ground, the anecdotal evidence, and even the statistics. For example:
Wal-Mart: Our shoppers are 'running out of money'

Gallup Poll Shows that More Americans Believe the U.S. is in a Depression than is Growing … Are They Right?
The Housing Bubble Broke The Middle Class
So, we have conclusively proven in the past two years that NO, we do NOT need Wall Street in order to keep the rest of the economy functioning. This has been my crusade for the past 30 years: I've been trying to warn that the speculation and economic rent of the financial system is increasingly a BURDEN on the rest of the economy, not a help. The fact we must face is that Wall Street's usurpation of the credit mechanism of the economy, is endangering a very survival. Why? Because we are faced with peak oil, and global climate change, and we cannot as a society afford to have a bunch of financial predators mis-allocating trillions of dollars of capital every damn day.

Here is a transcript I typed of just part of the longer interview included at the back of the audio book. This is Michael Lewis, the author of The Big Short speaking:
Two big questions about the bailout as it happened. The first is the simple economic question: are we all better off now with the government having done what it did, then if we let nature take its course? Nature taking its course, all these firms would be out of business, and there would have been a great catastrophe. It’s true, we would be living in a depression right now.
The problem is the way they frame the question. It was either, or. It was let nature take its course, or this full-on, prop-up, not just the system, but also all these people who caused the problem in the first place. The people in the Treasury never pursued aggressively the power to force one of these firms into receivership and wind them down in a less chaotic way. I think that would have been a more equitable solution.

That brings me to the second question, and that is the political side of all this. We’re now living in a perverse world, where the Obama administration is essentially paying the price for being a friend of Wall Street. That’s insane. But they brought this on themselves. They took the decision, I think, that it was politically unacceptable to force all these firms into receivership, to essentially dramatically restructure the financial system. That if they did that, they would be spending all their political capital on the Wall Street problem, leaving them none for everything else they wanted to do. So they, in effect, shoved the Wall Street problem on to a back burner, so they could get health care reform and other things they wanted.

In retrospect, I think that was a terrible mistake. At the time, I thought it was a mistake. But I didn’t know. Now, it’s looking more and more like it was a mistake. I think they did have the political capital to be very aggressive with Wall Street firms. They have infuriated an awful lot of people, but it would have been politically very popular. And it would have empowered them to do other things.

… The politics boxed them in. Once they decided that they couldn’t put these firms out of business in an orderly way, they were left with basically no other choice but to gift them money until they got back on their feet. And that’s what we’re doing now: our government is gifting huge sums of money to Wall Street firms, much of which is being paid out in huge bonuses to Wall Street people who created the problem we’re in, because they fear the consequences of not doing that. And there’s an insanity to that no. But a lot of people see that. So, there’s some second act that’s about to happen.

No comments:

Post a Comment