We looked at the early part of the subprime mortgage crisis last week in This Time is Different. Now we get the full catastrophe, from the point of view of the few on Wall Street who could/were willing to see it coming, and put real money into countering it. The Bikini Graph above shows how Wall Street, the Fed, and W allowed the situation to get completely out of hand, and then how President Obama and his team dealt with it, against screaming Republican opposition at every step.
I can’t do justice to it all. Michael Lewis didn’t do justice to it all, in either his book The Big Short: Inside the Doomsday Machine, or the Hollywoodized version in the movie. Nobody knows the full scope of the disaster, because bits of it are kept officially secret by corporations and various parts of the Federal government. But the book and movie are enough to make the main points, points which we have been seeing throughout this series of economics book posts.
Money, taxes, subsidies, stocks, bonds, banking, and the utterly incomprehensible derivatives that Wall Street has been pushing ever harder and harder have been recipes for inconceivable moral hazard, and hence for economy-destroying, sometimes nation-destroying catastrophe.
So what can we do to prevent another one? How about we throw away Wall Street, re-regulate banks so they can’t do that again, and put in, oh, a Guaranteed Basic Income and an Unbalanced Budget Amendment? For starters.
I know, politically we can’t even talk about that yet. But let’s suppose that Democrats win full control in November, and we can ignore Wrong-Wing objections to Truth, Justice, the real Public Interest, and Sanity starting in January.
Elizabeth Warren, among others, has some plans for all of that, which we will not get to yet. History first.
Our book begins thus:
The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.
Leo Tolstoy
I am just going to let Lewis tell the outline of the story here. He has expressed enough outrage for all of us. His tale began in Liar’s Poker, about his own time on Wall Street.
I expected readers of the future would be appalled that, back in 1986, the CEO of Salomon Brothers, John Gutfreund, was paid $3.1 million as he ran the business into the ground. I expected them to gape in wonder at the story of Howie Rubin, the Salomon mortgage bond trader, who had moved to Merrill Lynch and promptly lost $250 million. I expected them to be shocked that, once upon a time on Wall Street, the CEOs had only the vaguest idea of the complicated risks their bond traders were running.
And that's pretty much how I imagined it; what I never imagined is that the future reader might look back on any of this, or on my own peculiar experience, and say, "How quaint." How innocent.
Not for a moment did I suspect that a single bond trader might be paid $47 million a year and feel cheated. That the mortgage bond market invented on the Salomon Brothers trading floor, which seemed like such a good idea at the time, would lead to the most purely financial economic disaster in history.
That exactly twenty years after Howie Rubin became a scandalous household name for losing $250 million, another mortgage bond trader named Howie, inside Morgan Stanley, would lose $9 billion on a single mortgage trade, and remain essentially unknown, without anyone beyond a small circle inside Morgan Stanley ever hearing about what he'd done, or why.
Then came Meredith Whitney, with news. Whitney was an obscure analyst of financial firms for an obscure financial firm, Oppenheimer and Co., who, on October 31, 2007, ceased to be obscure. On that day she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. It's never entirely clear on any given day what causes what inside the stock market, but it was pretty clear that, on October 31, Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of, and who could have been dismissed as a nobody, had shaved 8 percent off the shares of Citigroup and $390 billion off the value of the U.S. stock market.
Four days later, Citigroup CEO Chuck Prince resigned. Two weeks later, Citigroup slashed its dividend.
But then I read the news that a little-known New York hedge fund manager named John Paulson had made $20 billion or so for his investors and nearly $4 billion for himself. This was more money than anyone had ever made so quickly on Wall Street. Moreover, he had done it by betting against the very subprime mortgage bonds now sinking Citigroup and every other big Wall Street investment bank.
The casino had misjudged, badly, the odds of its own game, and at least one person had noticed. I called Whitney again to ask her, as I was asking others, if she knew anyone who had anticipated the subprime mortgage cataclysm, thus setting himself up in advance to make a fortune from it. Who else had noticed, before the casino caught on, that the roulette wheel had become predictable? Who else inside the black box of modern finance had grasped the flaws of its machinery?
It was then late 2008. By then there was a long and growing list of pundits who claimed they predicted the catastrophe, but a far shorter list of people who actually did. Of those, even fewer had the nerve to bet on their vision. It's not easy to stand apart from mass hysteria--to believe that most of what's in the financial news is wrong, to believe that most important financial people are either lying or deluded—without being insane. Whitney rattled off a list with a half-dozen names on it, mainly investors she had personally advised. In the middle was John Paulson. At the top was Steve Eisman.
We get a lot about Eisman and his colleagues at Scion Capital in this book, and about those who took Eisman’s insights and went off on their own with them. I omit nearly all of this fascinating detail, plus a lot of gyrations of various markets, and take up the story again at the critical moment. But first,
Finance
I also omit the mind-numbing technical explanations of financial instruments, which all come down to Eisman’s fundamental insight.
By early 2005 Eisman's little group shared a sense that a great many people working on Wall Street couldn't possibly understand what they were doing.
For example,
The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment.
Later on, his partners told him,
However corrupt you think this industry is, it's worse.
So I’ll give you the minimal for 2¢ plain version.
A mortgage bond wasn't a single giant loan for an explicit fixed term. A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages. These cash flows were always problematic, as the borrowers had the right to pay off any time they pleased.
Next,
interest-only negative-amortizing adjustable-rate subprime mortgage
with a low introductory rate: a way to screw the poor, which turned out to be a way for the poor to screw the financial typhoons without them noticing, as long as housing prices kept rising. Pay interest for two years, then sell at a higher price and take out a new mortgage.
Anyway, Wall Street invented insurance on mortgage bonds, under the name Credit Default Swaps. This bright idea turned out to be the petard on which all of Wall Street was to be hoist, because it became the way to short the subprime mortgage market.
You might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing. It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million.
This turned into a trillion-dollar business, enhanced with the
pay-as-you-go credit default swap. The buyer of the swap—the buyer of insurance—would be paid off not all at once, if and when the entire pool of mortgages went bust, but incrementally, as individual homeowners went into default.
Wall Street’s next line of defense was the Collateralized Debt Obligation.
Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans.
This painted an even bigger target on Wall Street’s back. Their trick was to take a hundred CDS segments of triple-B-rated bonds and stack them into a tower, and then get 80% of the whole tower triple-A rated. Then you take the worst of the worst 20% slices and combine them into new towers, and get them triple-A rated. The leading rating agencies, Moody’s and Standard & Poor’s, had less than no idea what this was about, and obligingly went along with the charade. They thus, for a fat fee, turned lead into what could be sold as gold.
So the leading short sellers bought as much mortgage “insurance” as they could. Later, when defaults actually started to loom, they shorted everyone in sight who had anything to do with subprime loans—banks, bond issuers, insurers, the rating agencies, CDO management companies, the biggest and baddest Wall Street firms.
Cue the Disaster
In the summer of 2006, the Case-Shiller index of house prices peaked, and house prices across the country began to fall. For the entire year they would fall, nationally, by 2 percent.
But the prices of the insurance swaps didn’t move. Was everybody really that clueless?
Yes, it turned out. The biggest Wall Street crooks were artificially supporting the market so that their own holdings wouldn’t be wiped out. That is, until the dam broke—at first in a trickle, but eventually completely.
This video is a more obvious illustration of what happens when things start to break, and you don’t have any idea what is happening, and your original engineering analysis was completely wrong.
What Really Happened at the Oroville Dam Spillway?
It took two years for the market to unwind completely, up to the point where Lehmann Brothers was allowed to go bust, to cease to exist. Until then nobody outside of Wall Street really paid any attention. None of these goings-on made the news. Then panic set in among everyone but the short sellers—most visibly John McCain, on national TV.
Letterman Blasts McCain's Bail-Out
David Letterman let loose on John McCain after he suspended his campaign -- and pulled out of a scheduled appearance on "The Late Show!"
The comic riffed about the cancellation, saying, "John McCain had to cancel an appearance on the show because he is suspending his campaign because the economy is exploding." He also took a light jab, saying, "You know John McCain, the running mate of Sarah Palin?"
Then, Dave got miffed after hearing McCain bailed on him to sit down with CBS anchor Katie Couric.
READERS & BOOK LOVERS SERIES SCHEDULE
If you’re not already following Readers and Book Lovers, please go to our homepage (link), find the top button in the left margin, and click it to FOLLOW GROUP. Thank You and Welcome, to the most followed group on Daily Kos. Now you’ll get all our R&BLers diaries in your stream.