The problem with the libertarian persuasion of thought is that most people aren’t familiar with the same. If, for example, I go off on a rant about the way the War on Some Drugs is being prosecuted, I’m generally immediately labeled a dirty bastard hippy with no regard for public order and simultaneously assumed to be a jackbooted Marxist thug. (None of that is true. In particular, my parents were married when I was conceived.) Similarly, if — as I’ve done — I go off on a rant about how ridiculously poorly the government has managed the economy over the past few (dozen) decades, I’m often brushed off as a smarmily self-righteous apologist for the corporatist status quo.
For the most part, I can’t be bothered to give even half of a shit. Every once in a while, however, someone whose opinion I value gets wind of my polemics and, being primarily exposed to the usual one-dimensional model of politics, gets the wrong idea. So in an effort to persuade the undecided reader that I haven’t simply been text-messaging a particularly lengthy blowjob to the world’s investment banks over the past three months, I present the following:
- The End (Michael Lewis at Portfolio.com)
Now, most of you likely understand that government simply cannot understand the market well enough to reason about it. Many of you who’ve been keeping track of my vitriolic scribblings will also recall that government simply cannot understand government well enough to reason about it. By symmetry, therefore, it should be no surprise that — as Mr. Lewis’s article demonstrates — players in the market cannot understand the market well enough to reason about it.
Lewis describes the recondite world of investment banking. Well, maybe “recondite” isn’t quite the word I had in mind.
To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.
I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.
(Now, as I see it, the “essential function of Wall Street” is to make money for Wall Street. If it does so by at least glancingly efficient allocation of capital, so much the better for the rest of us… but let’s not idealize things, here. We’ll leave that to the enthusiastic idealizers in Venezuela and Zimbabwe.)
Nonetheless, we find — if we believe Mr. Lewis, and I for one have no particular reason not to — that Wall Street’s investment banks (and pretty much all other investment banks) compartmentalized themselves into rather specific groups. (This would seem to substantiate my hypothesis that the market is too big for anyone to understand.) Those groups, armed with models of What Ought To Happen, went off and did things that seemed reasonable under the specific constraints and assumptions of their specialized roles.
Reality, as usual, had different plans.
In particular, we consider the case of investment bankers working with securities backed by subprime mortgages. These bankers had the problem that the investments backing their securities were fundamentally unsound (hence the “subprime” bit, as explained here). No-one, it would at first seem, really wants to buy a fundamentally unsound security — but by dividing this bullshit into tranches and invoking a significant amount of investment-banking mumble wango those bankers convinced a few ratings agents that said bullshit was really powerful fertilizer; that which promotes growth.
Now, that’s bad enough for most leftists. There’s some magic by which eee-ville awful investment bankers* can turn bad loans into good investments, and if you scratch at it a bit with a stick you find something like this:
“I didn’t understand how they were turning all this garbage into gold,” [Steve Eisman] says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.
But that’s pretty much what I’ve already ranted about, and I’m bored with it. I have a different rant now, and it goes a bit like this:
[T]he scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.
There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans.”
I’ve read the Michael Lewis article a dozen or so times, and I have a feeling that I still haven’t fully come to appreciate all the stupid contained in those two paragraphs. That said, let me try to summarize the idiocy by analogy.
Suppose you go to a casino in the company of a dozen professional gamblers**. You decide to put your money on roulette, and they tell you, essentially, “good luck with that” and snicker as they wander off. You then place a large bet on a single number (this represents a subprime loan stack, with a small chance of payoff but plenty of interest).
Another player at the table wanders over and asks you just what the fuck you think you’re doing, and you reply confidently that you’re making a profitable investment (after all, the book odds are pretty good not completely shitty in terms of expected payoffs, and you have lots of time to wager). You get to talking with this guy, and you become so convinced that your bet is a sensible one that you offer a side bet: you lend him a certain percentage of the money you’ve wagered, and he will in turn repay you (in percentage) after the spin. (This represents other people shorting your investments.)
This is where the analogy breaks down, because in the investment-market game, the bankers (“you”) were able to resell the short-selling contracts as investments in their own rights (as far as I can tell; remember, I’m just a glib dilettante here). They were so secure in their “real estate never goes down” models that they never stopped to question why other people would bet against their shitty mortgages. That led to a glut of investments backed by the same abysmally bad mortgages, which ended up doing pretty much what you’d expect: failing. (That is, you don’t hit your number. Gosh, that’s a shocking development.)
I have yet to come across a plausible explanation for what the fuck these people were thinking.
Well, that won’t be a problem for long, I suppose. After all, what with the federal bailout of the financial sector, we’ve shown the investment banks that they can keep pulling these fucking stupids as much as they want — and if they run into trouble, someone else’ll magically fix it for them. We’ll be able to collect enough data to understand the thought processes behind it… provided that we don’t destroy ourselves beforehand.
* The kind at which good leftists sneer whilst in line at Starbucks
** That strikes me as oxymoronic, so they’re probably poker players