Here’s an exceedingly sobering article by Michael Lewis on the roots of the financial crisis, and a few of the prognosticators who saw it coming. These people had a couple of characteristics in common: a finely-honed BS detector; a willingness to face unpleasant truths, ask unwelcome questions, and make depressing predictions; and an immunity to the desire to move with the pack.
In retrospect, the truths in the article seem self-evident. But at the time they were being formulated they most certainly were not. There’s apparently a very powerful desire to believe in a pleasant fable in which home prices continue to rise forever, and where heads of huge companies and the people they employ actually know—and care—what they are doing, and what the larger consequences of their actions might be.
A while back I called the subprime mortgage market and its derivatives and tranchings an attempt at alchemy, that futile quest to turn base metals into gold. Unlike actual alchemy, this effort seemed to work—for a while. But now it’s turned to dross.
I was surprised to see something akin to my alchemy metaphor appear in the Lewis article in the following quote from a man named Steve Eisman, the abrasive yet prescient Wall Street analyst featured in the piece, “I didn’t understand how they were turning all this garbage into gold.” Some years ago, Eisman set about to find out, researching the situation by observing and talking to those in the subprime debt business.
What he discovered makes chilling reading. At the end of this long but edifying article, you may find yourself very angry, if you weren’t already.
Here’s a sample; Eisman is explaining to the author how the “creative” instruments called collateralized debt obligations (C.D.O.s) operated:
“You have to understand this,” [Eisman] says. “This was the engine of doom.” Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche—the bonds Eisman had shorted. But Wall Street had used these BBB tranches—the worst of the worst—to build yet another tower of bonds: a “particularly egregious” C.D.O. The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors—pension funds, insurance companies—who were allowed to invest only in highly rated securities. “I cannot fucking believe this is allowed—I must have said that a thousand times in the past two years,” Eisman says.
His dinner companion in Las Vegas ran a fund of about $15 billion and managed C.D.O.’s backed by the BBB tranche of a mortgage bond, or as Eisman puts it, “the equivalent of three levels of dog shit lower than the original bonds.”
FrontPoint had spent a lot of time digging around in the dog shit and knew that the default rates were already sufficient to wipe out this guy’s entire portfolio. “God, you must be having a hard time,” Eisman told his dinner companion.
“No,” the guy said, “I’ve sold everything out.”
After taking a fee, he passed them on to other investors. His job was to be the C.D.O. “expert,” but he actually didn’t spend any time at all thinking about what was in the C.D.O.’s. “He managed the C.D.O.’s,” says Eisman, “but managed what? I was just appalled. People would pay up to have someone manage their C.D.O.’s—as if this moron was helping you. I thought, You prick, you don’t give a fuck about the investors in this thing.”
Whatever rising anger Eisman felt was offset by the man’s genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. “Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ ”
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”
Yes, we can blame Barney Frank and the Democrats and Fannie and Freddie for their part in the subprime mortgage debacle. But they only acted as a starter engine, and failed (along with so many) to see where the runaway bus was heading. The point is that few people did see; it took someone with the clearsighted cynicism (I don’t think that’s an oxymoron) and the drive of Eisman to put it all together and try to sound the (largely unheeded) warning.
I agree with those who criticized John McCain for failing to point out the Democrats’ large role in pushing subprime mortgages at the start, and failing to check them later on. However, he was also excoriated by many people for blaming the crisis on “Wall Street greed” instead. There’s no “either-or,” of course. But if anyone has any doubt at this point how right McCain was about the greed part, all they have to do is read this article.
I know I’ve already quoted the piece at some length, but here’s just a bit more. It describes the beginning of the end, when a man named John Gutfreund, the ex-CEO of Salomon Brothers, turned it from a private partnership into Wall Street’s first public corporation in the 80s:
From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished….No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit…
“When things go wrong, it’s their problem,” [Gutfreund] said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.
Actually, Gutfreund got out of the game quite some time ago, forced to resign in disgrace from Salomon in 1991. Later, he advised students to do something better with their lives than follow in his footsteps. But he knows more than most what went down and how it worked—and how it is that we are all now forced to assume risks we would never have thought of taking.
[NOTE: Hat tip on the article, commenter "logern."]