Michael Lewis on the financial crisis

If you haven't read it yet, this Michael Lewis piece on the financial meltdown is a storytelling classic matched only by the This American Life episode on the crisis.

Comments

[Rob]

Thanks for the link. Lewis does a good job in explaining much of the debacle, including noting the importance of Salomon Brothers' going public in the mid-80's, soon followed by other Wall Street investment banks.

As a private partnership, Salomon Brothers' managing directors (which is what they called the partners) were permitted to take home approximately $200,000 a year after taxes. Everything else they earned was invested in the partnership, reflected in each M.D.'s partnership share. Thus they had enough disposable income to live decently, but their real accumulation of wealth was all tied up in the firm. Even though the M.D.'s were very much risk-takers (the annual outing featured card games with absurdly high betting), they were sufficiently prudent not to bet all their accumulated wealth on foolish investments.

Compare that to the publicly-held investment banks in recent years, which were, as Lewis points out, leveraged approximately 35 to 1 and therefore insanely risky. (Lewis doesn't mention that not only were the investment banks heavily leveraged, they were also leveraged largely with short-term debt, making them particularly vulnerable to disruptions of the debt market such as happened in September and October.) The investment banks, as structured in recent years, were a disaster waiting to happen.

Another thing Lewis doesn't note is that when his protagonist Steve Eisman was shorting BBB bonds by entering into credit default swaps with the likes of Deutsche Bank and Goldman Sachs, he was in a sense guilty of the same thing he faulted the rating agencies and issuers of the bonds for doing. He expected the bonds to fail, but he didn't look very carefully at the balance sheet of the issuers of the credit default swaps--the Deutsche Banks and Goldman Sachses and AIG's. If he had, he'd have seen how highly leveraged they were and how little able they might be to stand behind the credit default swaps they were making. It's only because the Government stepped in to bail out these characters that Eisman is able to profit from his shorts. As Kurt Vonnegut wrote, so it goes.

[David]

Thanks for the link, Brendan and thanks for your insightful comments, Rob. Here's a question for Rob or any other financial experts:

By bailing out AIG and others, the government in effect was backing the viability of the credit default swaps these companies had issued or had invested in. As I understand Michael Lewis's analogy to fantasy football, these CDO swaps were based on real economic factors, but were not a part of the real economy.

It would seem to follow that there was no need to protect these CDO swaps by bailing out AIG, et. al. If the CDO swaps defaulted, that wouldn't impact the actual mortgages.

I'd hate to believe that the government had wrongly committed trillions of dollars by unnecessarily guaranteeing firms and deals. Can anyone explain if this is the case, and, if so, why.

[Rob]

I'm no expert, but my understanding is that some of the CDO's were entered into for the originally intended purpose, to hedge against the possibility that a company whose short-term obligations someone had bought would default on those obligations. Most, however, were not hedges but simple bets, akin to what used to be referred to as naked options, in which you promise to deliver a block of stock at a certain price without actually owning the stock. The CDO market was a large and essentially unregulated casino in which traders played with Other People's Money. Some prudent souls no doubt forwent the fun, but they weren't the guys taking home the eight-figure bonuses at the end of the year.

Further confusing the CDO situation, when someone wanted to take his profits or losses on a CDO, he didn't sell it but rather issued his own CDO, secured by the CDO he was holding. That's why the so-called notional value of the CDO market became a whopping $62 trillion. Much of that total consists of trades back and forth among a limited number of players.

Would the sky have fallen if the CDO issuers were allowed to collapse? Probably not, though the process of unwinding and sorting out the transactions would have taken time, and many of the holders of the CDO's would have been rendered insolvent either by the ultimate result or the delay. The ripple effect on the economy would have been severe. How severe, I'm not qualified to say.

[Rob]

Sorry, when I referred to CDO's in the previous comment, I meant credit default swaps. The CDO's are a different animal.