As usual, Michael Lewis is a great and informative read, trying to unravel the whole subprime mortgage / CDS / CDO bundle somewhat for laymen. The article does not excerpt well, but I would summarize it in saying he identified four mistakes by the financial world. The first two I would describe as real problems but not really new mistakes -- something similar could have been said about S&L's in the 1980's. These are:
- A lot of subprime loans were issued to people with no freaking hope of repaying them, in an incredible general lowering of underwriting standards. (we all should remember, though, the government and the media was trumpeting this as good news -- increase in home ownership rates, blah blah blah).
- People who bought these securities grossly underestimated the default risks, particularly in the crappiest tranches (securitized packages of loans are resold in tiers, with a AAA tranche getting first call on any payouts, and the tail end BBB tier getting high interest rates but who takes the first principal losses if the loans default).
But Lewis highlights two mistakes that are in some sense brand new. These mistakes were effectively vast increases in leverage that acted as a multiplier for the subprime problem, while simultaneously spreading the problem into the hands of AAA investors who accepted the higher returns without paying too much attention to how they were obtained
- Someone started scooping up the BBB tranches from various securities packages, bundled these together, and somehow got a ratings agency to declare that the top 60% tranche of these repackaged dog turds were AAA.
- Credit default swaps, originally insurance policies on loan portfolios, turned into a sort of futures market on subprime mortgage packages. But, unlike futures markets, say in oil, where the futures trading volume are generally well under the total volumes of the underlying commodity flowing around the world, CDS values grew to as much as 100x the underlying commodity volume (in this case subprime mortgage securities). CDS's went from a risk-management tool to a naked side-bet.
This is interesting stuff, and it was really only reading this piece that I think I started to understand #4 above (though if readers think I am describing this wrong, let me know). All of this leads me to a few thoughts:
- Nothing about this convinces me any of these firms need to be saved or bailed out. Let them die. Maybe the guys who rebuild the industry in their place will be smarter and more careful. The country is going to face a recession whether Wall Street is bailed out or not -- too much (paper) value disappeared from consumer's net worths (or their perceptions of their net worth) for that not to be the case. I lived through Texas in the 1980s when the S&L industry went bust almost to the last institution. Nearly every one of the top 10 banks in the state went into FDIC recievership.
- I have seen people observe that this is an indictment of capitalism because so many people made such bad mistakes. Sure. No one said capitalism is a gaurantee against stupidity, or even fraud. The difference is that the consequences of said stupidity and fraud have to be less in a free market system than if the same people had the power of cersion via government. In a free market, these guys will fail and be wiped out and get washed away. The people who they drag down may consider themselves to be innocent, but they participated of their own free will -- if they did not understand what they were doing, that is their problem. In a statist system, you still have mistakes like this, but they are infinitely more catastrophic, as the stakes in play are often higher. And the people who made the mistakes are never punished financially, because they are in charge of the machinery of state (or friends of those in charge). They make damn sure the power of the state is used to make everyone else pay for their mistake, kind of like ... this $700 billion bailout.
- Lewis seems to have a hypothesis that the main system change that allowed all this to happen was the shift in ownership structure from partnerships to publicly-held corporations. And certainly you do get some added agency risks with this, though I find this explanation a bit shallow. I do think that folks with money are going to approach Wall Street "experts" and rating agencies with a lot more skepticism for a long time, and that can't be a bad thing.
- The opportunity really exists for someone smart to start a brand new rating agency from scratch. The only reason the current ones won't get wept away is simply that there are not many alternatives right now. Warren Buffett should partner with someone well-connected with the new administration (Maybe Larry Summers, since there is no way he will survive a confirmation hearing with his men-are-from-large-standard-deviations-women-are-from-narrow-distributions baggage.)
- Lewis is unfair in depicting all the mortgage lenders as predatory. I am sure some were cheats, but remember that as far as Congress, the Administration, the Federal Government, and the media were concerned, these lenders making subprime loans were doing God's work -- they were expanding home ownership and bringing the dream of owning a home to poor people historically redlined, blah blah blah. It is only with hindsight that we demonize them for doing the wrong thing -- at the time, absolutely everyone on in the country was pushing them to do exactly what they did. This is also why Democrats struggle to suggest a resposive regulatory package to this whole mess, as any real reform would have to address minimum underwriting standards, which in turn would have the direct effect of limiting lending to the poor, an outcome with which no Democrat wants to be associated.
Update: Just to be clear, as I have said before, this is about half of what happened. There are really two stories, and usually authors focus on one or the other. Story 1 is the steps taken by the Federal Government (Fannie, Freddie, Community Reinvestment Act, mortgage interest deduction, low interest rates) that fueled the housing bubble and the expansion of credit to questionable borrowers. It is described here, among other places. Story 2 is the one above, how private firms decided not only to purchase these questionable loans made on bubble-inflated assets, but to leverage these assets up to staggering levels.