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Tuesday, 4 May 2010

Review: The Big Short, Michael Lewis (2010)

About 18 months ago I was driving my car in suburban Sydney listening to the radio when they started talking about the exposure of municipal councils to the mortgage bonds that had, by losing value so spectacularly, sparked the global financial crisis. The bonds, said one municipal employee, were triple-A rated. The council was therefore not responsible for the massive deterioration of its financial health.

This moment stays with me because I remember thinking, at the time, "If the bonds were so safe, how could they have fallen? Sure," I thought, "it's not the council's fault they lost so much money if they were rated as a safe bet."

The GFC was unprecedented because of the amount of money governments poured into financial firms and the larger economy. In 2009, I received - along with anyone else who had completed a tax return that year - a $900 cheque in the mail. I bought an ink drawing with it. I remember telling the guy who sold it to me, "This is my stimulus cheque." He laughed. The self-portrait was done in Paris during a sojourn he made there. It shows the artist after a late night of partying.

Subtitled, 'Inside the Doomsday Machine', Lewis' book is an anatomy of pending disaster, a portrait of a whole industry drunk on sneeky profits.

Lewis overcame the problem of how to write the book so soon after the crisis by pinning down the guys who won, not the ones who lost big-time. Winners are much more likely to talk, at length, to a nosey journalist than losers, many of whom face the prospect, nowadays, of serious legal trouble.

Think Goldman Sachs. The brokerage firm had generated a large number of mortgage bonds in 2005 and 2006 based on so-called "sub-prime" mortgages. By doing so, they ensured that the supply of such mortgages continued to flow. Lending companies picked people with little chance of repayment. They set a "teaser" interest rate of six per cent, say, and allowed people to only pay off the interest (no capital repayment necessary!).

Once the two-year "teaser" rate period ended, however, the interest rate suddenly doubled and the borrowers had no chance of keeping up with their payments. They defaulted. The bank moved in to repossess. When enough people defaulted, the supply of housing pushed down the value of real estate so that the collateral held by the bank was worth less than the amount of money they were owed.

Why did they keep lending? For one, they bet that house prices would continue to rise. Secondly, the finance companies higher-up in the food chain were collecting these sub-prime mortgages together and creating financial instruments that were sold to greedy organisations. These organisations saw two things that attracted them: a triple-A rating and a high yield. They didn't blink before buying.

This demand pushed mortgage lenders to keep making sub-prime loans.

The ratings agencies, Moody's and Standard & Poors, kept rating these poor bonds triple-A because they didn't look at the detail, the nature of the loans underpinning the bonds. And also they were paid per rating. That means that if they didn't rate, they wouldn't get paid. If one of them downgraded the rating, they were afraid, the customer would just go to the competition to get the rating they wanted.

In 2007, as all those loans came due and the value of property started to crash, there was a mad scramble to exit the scheme by a lot of people.

A few smart men - the men Lewis talks to at most length - 'shorted' the bonds, and profited handsomely long-term. This means they bought insurance to the effect that they believed the bonds would lose value. The cost of the insurance was much lower than the potential gain, so this was a good deal for them. Nevertheless, without hindsight, these guys took a risk at a time when everyone else in the industry was going 'long' on the bonds (ie betting they would retain value).

Anyone who wants to understand the causes of the GFC should read this book. It's a cracker.

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