The cult of smart money

Yves Smith, in her review of Michael Lewis’ The Big Short, provides us with an explanation of the mechanics of the financial crisis that is convoluted, counterintuitive, and ultimately utterly compelling. Her analysis manages to illuminate both why the boom went on so long and why the bust has been so brutal. It deserves broader exposure.

Let’s begin, as Smith does, with Michael Lewis’ new book. Lewis, a gifted author with a rollicking, readable style has been writing novelistic non-fiction for over 20 years. In The Big Short, he tells the story of the financial crisis through the prism of four maverick investors.

The book’s title refers to short-selling, where traders bet on falling share prices by borrowing the shares from a broker to sell immediately. When the share price falls he buys back the same quantity to return to the broker, taking the difference as profit. By 2005, Lewis’ traders had seen the precariousness of subprime lending and decided to bet big against it. This not only made each of them a fortune, it also brought down the entire rickety edifice. For Lewis, this makes them heroes: their plan fulfils the neoclassical ideal of smart money keeping the market in equilibrium.

So far, so normal. But Yves Smith, a veteran of decades on Wall Street, reminds us that immensely readable Big Short ignores three vital points:

1. The perpetual lowering of lending standards was a response to Wall Street’s insatiable need. The subprime mortgage boom was not driven by the desire of poor Americans to own their own houses, it was driven by the hunger of institutional investors for safe investments with higher yields.

2. By 2005, many more than Lewis’ handful of heroes realized we were in a bubble. By then, much of Wall Street realized the dubious nature of subprime debt. Every mortgage industry conference discussed it, every credit committee considered it. The bad debts were packaged up in collateralized debt obligations or CDOs—bundles of debt divided into tranches from very high-risk “equity” to safe-bet “AAA”. In such an environment, demand for subprime-backed CDOs should have fallen off a cliff and thus shut down the boom.

3. But it didn’t. Demand for subprime-backed debt packages continued to rise and their yields continued to fall. The bubble continued on Wall Street even as house prices stabilized and then began to fall.

How could that be? As more investors realised the precariousness of the bubble, demand for subprime debt should have disappeared, choking off the cash that enabled the boom. “Most mortgage industry participants assumed there was a degree of rationality that would constrain reckless behaviour,” writes Smith.

The difference this time was the availability of credit default swaps (insurance on bonds, carrying a premium payable to the insurer) and synthetic CDOs, which used CDSs to mimic the behaviour of underlying debt. These tools allowed short sellers a profitable if vicious vehicle with which to make their bets. In the old days, if market participants believed a bond was overpriced, their only option was to short it, which would tend to drive its price down and its yield up. Shorts could bet on falling prices but their very presence lowered the value of the asset they were shorting.

By informing a dealer of their interest in buying the equity (lowest rated) tranche in a CDO, the prescient shorts created demand for a slew of synthetic CDOs. They then would buy more CDSs on the higher rated “mezzanine” and AAA tranches that would pay off big should those tranches default. The shorts created more debt even as they were betting against it.

For the most part, the AAA tranches, slightly higher-yielding but stamped with the AAA symbol of quality were relatively easy to sell, to German Banks, Asian insurance companies, Australian fireman’s pension funds, what Smith calls “the international equivalent of widows and orphans . . . prototypical chumps”. The tough bits to sell, the part that would have clogged the pipeline and ended the boom, were the lower-rated equity and mezzanine tranches. Smith argues that without the shorts’ creation of these CDOs as a means to bet against the subprime market, and their purchasing the lower rated tranches in order to create the demand which enabled their strategy, the subprime fiasco would have ground to a halt years before.

Paul Volcker, the man who more than anyone else created our current financial world, says that the ATM machine, popularized in the 1970s, was the last truly beneficial financial innovation. Right now, as financiers struggle against populist regulations, Smith reminds us of the pernicious and devastating effect that synthetic CDOs and credit default swaps had on the real economy. Michael Lewis’ heroes made themselves a lot of money but don’t forget, not only did they skin their counterparties, they screwed the rest of us too.