March 31, 2010

The Big Short

I finished Michael Lewis's latest last night, one of those books I was sorry to see end. Lewis is a great storyteller, maybe the best around. It isn't easy to be entertaining when you're writing about something as intrinsically dull as mortgage-backed securities, but he managed. As with his other books, Lewis concentrates on personalities and weaves the technical stuff into an emotional matrix. He described the often harrowing journey of those gutsy investors who saw the craziness of the subprime market and found a way to short it, particularly a small group of three one-time dilettantes operating out of Berkeley who parlayed about $110,000 in a Schwab account into $80 million; a hedge fund manager in Cupertino with one eye and Asperger's syndrome (and at one time a neurology resident at Stanford Hospital); and a group in New York centered around the iconoclastic and acerbic Steve Eisman, who delighted in telling all the big bankers on Wall Street who bet on the enduring quality of a rising housing market that they were completely full of shit.

They all did it essentally the same way, by buying credit default swaps (CDS) which would pay off if the mortgage-backed bonds ("tranched" into Collateralized Debt Obligations by the securitizers) tanked. What they discovered (since they were all "quants" in one way or another) was that a slight disturbance in the integrity of the mortgages making up the bond (on the order of 6-7%) would make the entire tranche of which they were a part essentially worthless. And since a great many of the mortgages were of the interest-only, adjustable, pick-a-payment, no down subprime variety which a Vegas pole dancer could acquire if she could fog a mirror (or the pole she just slid down), the treasure hunt consisted of finding the CDOs which were chock-full of shitty mortgages of this kind and then going down big against them. Which the treasure hunters did.

The funniest part in the book is Lewis's masterful re-creation of his heroes' constant sense of wonder: the money was just too easy. They kept thinking they must have made a fundamental, paradigm-quality error. The Wall Street banks could not all be this incredibly stupid. They roamed the country attending conferences and seminars on CDO investment trying to find people who could convince them they were wrong, that their fundamental approach was just misconceived. But no one ever did. In fact, as they found out, everyone on the long side of the CDO market was in the thrall of the same mass delusion: the housing market would always go up. Thus, since although it was inevitable that more than 6-7% of the subprime mortgages would fail, it would make no difference. Foreclosure would simply pay off everybody participating on the long side. It never occurred to anyone that the entire housing market operated in a 100% correlation once you scaled up the mortgage business to the levels possible with securitization of the whole industry. That is, the production of rows and rows of empty, abandoned houses worth considerably less than the paper written on them meant that all other houses in the market would also suffer loss (including the Alt-A and the prime market); and although Ben Bernanke, in a phrase which will forever haunt him, assured Congress that the "subprime contagion will be contained," it was not contained. It spread everywhere, and brought America to its knees economically.

So Paulson & Bush asked Congress for $700 billion (Troubled Asset Relief Program, TARP) to bail out the banks which held CDOs in mass quantities, then used none of it for that purpose. That was okay with Congress; I mean they held a few hearings about it, but nothing happened. Then the Federal Reserve Bank, under the same Bernanke who had promised that a coordinated, broad-scale decline in the American housing market was unprecedented in American history and would never happen now, began a program whereby the Fed (quite illegally under its charter of 1913) took mortgage-backed securities off the hands of the reeling banks (it "completes" the program today, $1.25 trillion later - we'll see if it can really keep its hands off the market when mortgage rates start inching up again). So that's about $2 trillion worth of damage right there, all transferred from the miscreants who created this colossal fiasco to the U.S. taxpayer and the national debt. And while a few investment banks failed, none was nationalized. There was no program for cleaning house, firing all the executives, cutting off their bonuses, investigating them for criminal fraud prosecution. Obama made a few noises about the bonuses paid after the collapse as being, I don't know, in bad taste or something, but that's about it.

So all the idiots on Wall Street also became rich, just like the intrepid mavericks who bet against them, even though they had been 100% wrong. They became rich in three ways, by selling all this trash to unsuspecting investors; by buying credit default swaps themselves against the very assets they were promoting and selling; and by being bailed out by the federal government for the large CDO positions they somewhat mystifyingly kept on their books. So you could be brilliant or stupid, and either way you got rich simply by being in this strange business.

It's grist for another day, but this subject of mass delusions is fascinating. I think we're in the grip of one right now, again, already, in "waiting" for the economy to turn around. The federal government decided to go all in on the bailouts and stimulus based simply on the theory that time itself will turn the economy around, because that's what always happens in recession cycles. And if it doesn't, what happens to us as a result of all this debt we piled up in the expectation that the market would "reflate" and prosperity would return? What if the economy remains crappy with the only difference being that we're now being crushed by unsustainable debt?

Propaganda can only take you so far. What rude beast slouches toward the District of Columbia to be born this time?

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