Thursday, April 08, 2010

The Big Short

By Mike Dorf

Michael Lewis--author of Liar's Poker, Moneyball, and The Blind Side--is back with a new book, The Big Short: Inside the Doomsday Machine.  It tells the story of the financial crisis from the perspective of the small number of people who saw it coming and figured out how to profit from it.  As suggested by the title, they "shorted" mortgage-backed securities.  Because such securities were not traded on exchanges (part of the problem with them, of course), they could not be shorted in the same way that a normal stock is shorted (by making a contract to sell it in the future at some price lower than it is now trading, and then, when that future date comes, buying the stock at its still lower market price and turning around and selling it for a profit at the contract price).  Instead, the protagonists of The Big Short mostly bought credit-default insurance on derivatives of mortgages they didn't own.  In that way, they not only profited from, but also exacerbated, the crisis: By increasing the demand for credit default swaps from AIG and others, they created a bigger hole for those companies when the day of reckoning came.  However, the contribution to the crisis by the main actors in the story was quite small.

The book is characteristically terrific.  Here I want to focus on one aspect of the story it tells: the role of compensation.  During much of the last 20 months or so, pundits have offered a variety of theories about what went wrong.  Yesterday Alan Greenspan was peddling one popular view before the Angelides Commission.  Greenspan blamed everyone but himself for the housing bubble, but he especially blamed Fannie Mae and Freddie Mac for buying subprime debt.  This theory--popular on the right for some time now--has it that under liberal influence, Fannie and Freddie were encouraging home ownership beyond the means of the working poor to afford homes.  And that's true, but it doesn't explain why the private sector investors were willing to take the same terrible risks that these government-backed entities were.  Perhaps it could be said that by supporting subprime borrowing, Fannie and Freddie were providing liquidity, which in turn kept housing prices up, and that the private investors counted on that, but such a story is almost totally at odds with how things unfolded.  Moreover, even if true, a prudent investor would have realized that Fannie and Freddie could only help inflate the bubble; they couldn't stop it from eventually bursting.

Lewis (rightly in my view) spends very little time on Fannie and Freddie, and almost no time on Greenspan, who is dismissed as a fool by the book's shrewdest protagonists.  Instead, the story Lewis tells leads to a private sector explanation: The gross mismatch between the incentives of Wall Street actors and the public good.

At the heart of the crisis were the rating agencies--mainly S&P and Moody's--that gave AAA ratings to what have come to be called toxic assets.  Lewis shows pretty clearly that these assets were always toxic, and that anyone who really dug into them would have known that.  To oversimplify a familiar story, the bonds at issue consisted of the right to receive portions of payments on various mortgages.  The underlying mortgages had high default risks, but so long as the housing market was rising, they appeared not to: People who couldn't afford to make their payments simply flipped their houses for a profit and paid off the mortgages.  Of course, once the housing market started to fall, defaults started occurring.  But before that happened (and amazingly, even after the housing market started to fall), the ratings agencies permitted the investment banks that created the bonds to persuade them that the combined risks were low because they were uncorrelated: Just as a diversified portfolio of stocks has lower risk than the average individual stock in the portfolio, so the agencies thought that a bond made up of the right to receive payments from mortgages around the country was much less risky than a collection of mortgages in a single housing market.  Thus, they gave AAA ratings to bonds made up of BBB tranches of other bonds.  The ratings agencies were persuaded that there was no single national housing market that could go belly up all at once.  But of course there was, and the spending-driven economic growth of the housing bubble period was caused by it and in turn helped fuel it (as did Greenspan's easy money policy, despite what he now says).  When the bubble burst it burst just about everywhere, thus rendering the bonds worthless.

So why didn't the ratings agencies see that coming?  The answer given by Lewis is basically two-fold: 1) Rating agencies are, perversely, paid by the firms whose bonds they rate; and 2) the people who worked at the I banks that dreamed up the new securities are paid so much more than the people who work at the ratings agencies, that the latter could not attract and retain people with sufficient skills to see that they were being bamboozled by the former.

Meanwhile, back on Wall Street, we encounter a different puzzle.  At first, the I banks realized that they were creating garbage and had the good sense to sell it off to suckers who believed the AAA ratings.  (Some of these purchasers were duped by both the banks and by their own highly overpaid functionaries who blew the money of institutional investors.  Lewis recounts one amazing scene in Las Vegas involving one such functionary.)  Over time, however, Wall Street began to believe its own hype and started buying its own worthless assets.  Why?  Lewis doesn't have a full answer but a giant piece of it has to be the same principal-agent story: The bankers received gigantic rewards for short-term profits.  Selling credit default insurance to a guy who's shorting the whole housing market looks like a good deal for the several years that it produces tens of millions in insurance premiums and by the time it explodes into billions of dollars in liability, the banker who decided to sell the insurance has pocketed his money.

For Lewis, the takeaway point is that the Wall Street culture he observed at Salomon Bros. in the 1980s planted the seed for what became the Wall Street culture of the housing bubble.  But I wonder whether he places too much emphasis on culture and insufficient emphasis on the rules.  Lewis begins the book by noting that he wrote Liar's Poker as a cautionary tale but, to his amazement, young people took it as a kind of advice manual about how to succeed on Wall Street.  That should have told him that there are always going to be lots of people out there who are motivated by the opportunity to make enormous sums of money, and so the society as a whole needs to find some way to ensure that that motivation does not work to the detriment of all of the rest of us.  Whether the financial regulatory reform package that eventually emerges from Congress is up to the task remains to be seen.  Ignoring the self-serving and selective recollection of Alan Greenspan would be a good way to start.