Michael Lewis on Causes of Financial Crisis
Michael Lewis, author of the long-selling book, Liar’s Poker, offers a magazine-style account of some of the factors provoking the current financial crisis. It is a delightfully literary contribution that will likely appeal to those captivated by best-selling narrative (complete with protagonists and famous characters plus expletives and references to football, sex and gambling).
Mr. Lewis’s 9000-word piece does not purport to provide a full picture, of course, because many factors conspired to generate the disaster. Extensive research and diagnosis must be undertaken to form a useful understanding. But the piece is enjoying attention and may be of some interest.
In general, Mr. Lewis blames the crisis on a “Wall Street machine” incubated by stupid investment bankers who lacked training to understand the risks they were creating. He ties the current crisis back 20 years to his period on Wall Street, as a 20-something, know-nothing paid a huge salary and bonuses. It was in that period that devices like mortgage-backed derivative securities were invented—the devices that proliferated geometrically in the past five years and form the catalyst of crisis.
In particular, the “Wall Street machine” consists of two parts: (1) real pools of subprime mortgage loans packaged into bonds presenting meaningful default risk and (2) a synthetic market of side bets that those bonds would indeed default packaged into bonds backed by bettors’ wagers. Mr. Lewis reports a story based on interviews with several people who participated in this casino. Its substantive elements can be summarized as follows.
1. In 2004, a few Wall Street denizens considered the US housing market unhealthy. Firms were lending to people with weak credit. Housing prices had risen considerably. The average ratio of home prices to income, normally around 3:1, reached 4:1. In 2000, subprime mortgage loans totaled $130 billion with half resold as mortgage bonds; by 2005, such loans totaled $625 billion with more than 80% turned into mortgage bonds.
2. Mortgage bonds were created by pooling the individual homeowner loans into a trust that sold the bonds to investors. Each trust-pool is split into tranches of bonds, with premium bonds, rated AAA, to be paid first, and inferior bonds, rated BBB, only repaid if defaults on underlying homeowner loans were low enough to provide cash flows.
3. Firms invented credit default swaps they sold to people who believed that defaults on BBB bonds were likely. These people paid the firms cash in exchange for the chance to win a payoff if the bonds defaulted. The result was a separate market of side bets that defaults would occur, especially on BBB bonds.
4. Some BBB bonds were even more likely to default than the BBB rating suggested. Rating agencies who assign ratings had assumed that home prices would always rise. But if they fell, defaults on BBB bonds were so much more likely that they deserved a far lower rating.
5. Firms that sold credit default swaps tried to make more money by creating an additional product called collateralized debt obligations. They sold bonds backed by the cash flows that bettors were paying when wagering that defaults on BBB mortgage bonds would occur.
6. The result is best captured by picturing the two deals, the original trust pool and the separate market for bets on BBB defaults, as towers of debt. Tower 1 is the trust, divided into tranches AAA through BBB, and funded by interest payments on underlying subprime loans. Tower 2 is the BBB tranche of the trust, funded by payments for side bets made by people believing that defaults on BBB bonds would occur.
7. Bettors wagering on BBB default thus were functionally equivalent to borrowers of subprime mortgage loans, except, of course, there was neither a house nor a mortgage involved.
8. Mr. Lewis quotes one of the bettors: “The [firms] weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford. They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. . . . [T]hey needed us to keep the machine running.”
The piece’s tenor suggests sympathy, even admiration, for the side bettors, taken in by the “Wall Street machine.” Blamed is placed with investment bankers. But parsing the substantive content of the story, one wonders how innocent or admirable the side-bettors really were. And, of course, as noted, this deal-making process is but one factor contributing to the current crisis. There is plenty of blame to go around, perhaps in pari delicto, all over again.
Hat tip: Art Wilmarth