Commentary: 'The Big Short' tells a long story
This article first appeared in the St. Louis Beacon, May 13, 2010 - British philosopher Albert North Whitehead wrote of the “fallacy of misplaced concreteness” — or the tendency of the intellect to confuse abstraction with tangible reality. Before you dismiss Whitehead’s notion as esoteric academia with no practical correlation to ordinary living, I suggest that you read Michael Lewis’ seminal new bestseller, “The Big Short.”
Lewis’ book recounts the story of a handful of investors who figured out that the emperor had no clothes in the subprime mortgage market long before the bottom fell out in September of 2008. There’s enough misplaced concrete in this tale to rebuild the Twin Towers.
When most people hear the words, “Wall Street,” they usually think of the stock market. When an investor buys stock in a publicly traded firm, he literally owns shares of that enterprise and becomes eligible to share in its profits by way of dividends. He also acquires a theoretical voice in how the firm is managed through his ability to “vote his shares” at stockholders’ meetings.
In the bond market, however, the investor buys debt. The bond is an IOU from the entity that issues it and has value only to the extent that the issuer has the wherewithal to redeem it when it matures. The gold standard of the bond market is the Treasury bill (T-Bill) precisely because the U.S. government has never defaulted on its debt (it helps to be able to print money).
The riskier the bond, the higher the interest it pays. Bonds are rated by private agencies — preferably Standard & Poor’s or Moody’s — and the interest a given bond pays above the T-Bill rate is called the bond’s “spread.”
Here, then, is how the subprime market operated prior to the Great Collapse of ’08:
Step #1: A retail bank lends a marginal borrower money to buy a house he can’t afford. Typically, the instrument is an adjustable rate mortgage (ARM) with a favorable fixed interest rate for two years, after which the rate resets to float a given percentage above the prime.
Because housing values had been rising about 4 percent a year — and were presumed to do so in perpetuity — the borrower could “grow into his mortgage” and refinance later with all the new equity he’d earned by living indoors.
Step #2: The retail bank sells the shaky mortgage to an investment bank. The originating bank makes its money off the closing fees paid by the borrower and whatever profit it has negotiated from the investment bank.
Step #3: The investment bank spreads the risk by bundling the mortgage with a bunch of similar loans and fabricates a bond, which is submitted to a rating agency.
Step #4: Perhaps fearful of losing the big bank’s business to a competitor, the rating agency gives the instrument a favorable rating, after which it is sold to investors by the investment bank.
Step #5: Credit default swaps (CDS) are offered for sale on the bonds. If the swaps are bought by the bond holder, they function as a kind of insurance because they limit his losses in the event of default. In reality, they are chits on bets made against the bond — a way of shorting the market. The swap buyer pays between one-half and 2 percent of the bond’s face value annually to the firm he bought the swaps from. You don’t have to own the bond to bet against it.
Step#6: Unsold bonds (often the worst-rated) and related swaps are bundled together into a new financial instrument called a “collateralized debt obligation” (CDO). The CDOs are rated by the same agencies and then sold to investors as derivatives. Swaps are also issued against the CDOs.
Step #7: With all these swaps floating around, it’s only a matter of time before somebody figures out how to bundle them into something new. Thus is born the “synthetic collateralized debt obligation” — a financial derivative that consists solely of betting slips on other bonds and CDOs.
Steve Eisman was one of the maverick investors who made a fortune buying swaps against the subprime market. Lewis writes, “Now he got it: the credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. … Wall Street needed his bets to synthesize more of them. ‘They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,’ said Eisman. ‘They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the subprime loans. That’s when I realized they needed us to keep the machine running. I was like, This is allowed?’” (emphasis in original)
A veteran commodities trader explained it to me like this: “The private investor reads a prospectus or two and studies market trends, preparing to play financial chess. What the insider knows, that he doesn’t, is that the game being played is actually Whack-a-Mole.”
Lost in a maze of abstraction, even the major players couldn’t comprehend the enormous size of the looming disaster. Like Balzac’s “clowns capering on the edge of a precipice,” financial wizards got so caught up in the short-term profit of the scheme that they failed to notice the yawning abyss below.
Thus did an envelope full of unpaid betting slips come to be mistaken for genuine wealth and thus did a cast of bond traders — most of whom had never heard of A.N. Whitehead — unwittingly stage a production of the exact intellectual folly that he’d warned against.
Last week, the stock market suddenly dropped nearly 1,000 points in 60 seconds. Computerized trading programs are blamed for the mishap. One minute, Accenture was trading at $42 a share, the next it had plunged to a penny before rebounding to $41. Obviously, innocent investors could have been wiped out while wily schemers could have stolen a fortune.
None of this happened, however, because stocks trade in a regulated market. The SEC simply disqualified the bogus trades and, in effect, put all the players back on the board about where they were before calamity struck.
For decades, free market advocates have argued in favor of deregulation. The market, we were told, is self-regulating and burdensome governmental strictures on banking merely served to hamper financial innovation that could otherwise spread prosperity and generally improve the standard of living.
What these crusaders failed to mention was that these pesky regulations came into being in response to our last experiment with free market finance that resulted in the Great Depression. They were intended to keep market grounded in something resembling reality.
Just as the Roaring Twenties laid the foundation for the global misery to follow, so did the progressive financial deregulation begun in the ‘80s set the table for the current Great Recession.
Somewhere, Whitehead must be chuckling…
M.W. Guzy is a retired St. Louis cop who currently works for the city Sheriff's Department. His column appears weekly in the Beacon.