Michael Lewis on Causes of Financial Crisis
posted by Lawrence Cunningham
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
November 12, 2008 at 8:07 pm
Posted in: Current Events
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Responses (7)
Carol Cross - November 12, 2008 at 10:52 pm
“The End” is a look into the culture of Wall Street that created the current crisis that is revealing, shocking, and brutally honest. Really good reading that gave me a stomach ache.
Is the dead bull and the great losses suffered by innocent investors the result of lies and negligence and greed of those who should have known better?
Let’s hope that The American People will get the honest and “extensive research and diagnosis” of the causes of this crisis from a government investigation that will be useful to the American people, who will suffer great pain and pay the bill for this crisis of capitalism.
The many factors that “conspired to create the disaster” should be shared with the public and not covered up to protect the special interests who created the crisis.
Hopefully, this crisis will not be further politicized and the two political parties will work together to bring the truth to the American people.
I think the law firms who made millions or billions of dollars, and who took part in creating some of these new products, like the
CDO’s, will have to step up and accept their share of the blame.
ragavendra - November 15, 2008 at 12:26 pm
His argument is completely correct, the main cause of this bankruptcy is due to the lack of planning by the investors bank.
A.J. Sutter - November 15, 2008 at 9:10 pm
The basic facts described by Lewis, if not his interpretation, are well-known by now. I think it’s simplistic to call this only a Wall Street problem. There was also a great deal of “moral hazard” involved at the mortgage-origination end of the chain and many intermediate steps (mortgage warehouses etc.). The risks involved in subprime loans were evident to retail bankers at the branch level, where these loans were originated. I know, because I’ve talked to some. More ethically scrupulous banks avoided these products altogether. (Union Bank of California is one example I’m personally acquainted with, but there are others as well, I hope.) Plenty of others didn’t care, since they made their money once the loans were packaged and sold up the chain. Another popular narrative, that Wall Street created the demand for the securities, which is why lenders made the loans, is a free market version of the “I was only following orders” defense. I’m not defending the Wall Street crowd, but many other people had to accept their ideas — and money — for this house of cards to get built. Lots of those folks were right in the homeowners’ neighborhoods, not in Manhattan.
Carol Cross - November 15, 2008 at 10:39 pm
A.J. Sutter points out that the sub-prime crisis was fed up the pyramid chain by many locals in the lending industry who took their “cut” and really didn’t care what happened, and this, of course, is true!
He points out also that there were ethical and good bankers/lenders who didn’t relax their due diligence and risk procedures, and who are standing somewhat securely in the economy today. In our city, we had some ethical banks/lenders who didn’t become involved in the search for “product” and who maintained the due diligence standards of good banks.
But, how can you not buy the fact that those who were getting the loans for which they shouldn’t have been approved in the first place were not purely hapless victims of the system that was fired by individual and institutional greed –of the builders, the appraisors, the real estate brokers, the lenders, and the Wall Street Investment Houses who produced the products that could be sold to institutional investors.
The system was being fed by the sheer volume of mortgages that could be sucuritised by the investment bankers — who would then receive high and inflated credit ratings on the special entity secrutities that made the insurance companies willing to insure them for a reasonable premium.
The Financial Services INDUSTRY had to have product on which to grow but in the sub-prime mortgage scandal, the BIG Money was being realized at the top of the pyramid based on the promises of those small people on the bottom of the pyramid.
This was “product” for all involved that did result in great profits for all involved until the economy cooled, the bubble started to leak, the defaults started to increase —and the BULL
appears to be mortally wounded.
Does the securitisation of future cash flows on hard assets make sense when there is always a boom and bust cycle? Securitisation is involved in many other areas of future cash flow; i.e., credit cards, franchise royalties, manufactured homes, etc.. .
Obviously, all of the so called experts were way off on their estimations of defaults but once “securitisation” of future cash flows on hard assets became part of the financial scene, they couldn’t close it down.
What do the different schools of Economics have to say about all of this? Why is this legal?
Apparently, we will hear a lot of “I was only following orders” and “it was legal” from all of the players.
brook - November 18, 2008 at 11:31 am
Michael Lewis is face the problem of financial crisis. it is due to down in economy all over the world.
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Brook
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Just a lawyer - November 18, 2008 at 7:20 pm
#5 and after are incorrect (although probably a fair summary of the Lewis article, which is unclear on this point, as best as I remember it from last week). CDOs are, generally, made up of securitized loans (mortgages and other types), not CDS contracts. I guess you could have a CDO made up of packaged CDS contracts, if the payments were a flow and not a one-time payment, but that is not the norm.
Carol - November 18, 2008 at 10:27 pm
I stand corrected. There is a good article “The Promise and Perils of Credit Derivatives” by David A. Skeel Jr., Univ. of Penn Law School and Frank Partnoy, University of San Diego –School of Law.
Hard for me to fully understand the interplay between the CDO and the CDS in terms of the losses that the investment banks have suffered —-because of the unexpected increase in defaults —and the short sales?
This is just betting on credit risk, isn’t it?
Just an onlooker who thinks we need new and better Treasury Law and regulation of the Big Casino.
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