Tuesday, January 27, 2015

Exposing the wizards of Wall Street

The Big Short, Inside the Doomsday Machine
By Michael Lewis
Published by W.W. Norton & Company, 2010

In The Big Short, Michael Lewis (Moneyball, Liar's Poker) takes readers behind the scenes at America's major banks and brokerage houses to explain the litany of events that triggered the global financial crisis of 2008. It's not a pretty picture.

In as much as this book is about high-risk mortgages and complex financial products, and the obliteration of trillions (with a 'T') in market capital, it also explores an interesting David versus Goliath tale where a few clever Davids manage to outsmart the most influential (and wealthiest) Goliaths in the U.S. financial industry with savvy insights and shrewd investing.

In a nutshell, here's what happened: In 2005, U.S. banks made it easy for people with poor credit to secure mortgages that they couldn't afford. Many of these mortgages were sold with teaser interest rates, which would automatically double or more within two years, which put them at a higher risk than traditional mortgages. These high-risk mortgages were packaged and sold as bonds to investors for quick profits with the belief that housing prices would continue to rise forever, and the rating agencies blessed these bonds with Triple-A rating status (Triple-A status made them appear as sound investments).

Few in the financial/investment community saw the potential for large-scale default on these high-risk mortgages. One of the investors who did was Michael Burry, who managed a hedge fund called Scion Capital. He tried to warn the investment community, regulators and the public that a large percentage of these high-risk mortgages would default, based on his reading of the prospectuses. But nobody listened. So, through his hedge fund, Burry bet against the subprime mortgage market by buying millions' worth of subprime mortgage credit default swaps (insurance contracts).  These mortgage default swaps eventually netted Burry and his investors over $700 million.

In the film Wizard of Oz, there is a scene near the end of the movie when Dorothy and her friends finally get to see the elusive Wizard, and they realize that he's no wizard at all, just an ordinary man pretending to be a Wizard. That scene kept popping into my head as I read The Big Short. The presidents of big banks, brokerage houses and regulatory agencies (the so-called wizards of Wall Street) were supposed to be wise and all-knowing arbiters of finance. They were supposed to be attuned to market trends and know all about evaluating risk. They should have known that the subprime mortgage business model was unsustainable and that their businesses were seriously at risk. But they were just as short-sighted and fallible as anybody else.

What Lewis details in The Big Short is events surrounding the financial collapse, including the buyers and sellers of these convoluted financial products who foresaw the potential for damage and who and bet against the subprime mortgage bonds. Throughout the story, readers are rooting for the underdogs (small hedge funds / managers who nobody took seriously), if only because of their clarity of vision and their willingness to stick to their convictions.

The Big Short adopts exactly the right darkly comic tone for the telling of this sad chapter in America's history. Lewis populates this story with several key figures in the mortgage crisis and sets the stage for the eventual collapse of many large banks and resulting government bailouts. For me, The Big Short was an extremely entertaining read, inasmuch as bonds, derivatives and credit default swaps can be made entertaining. The book should be on the syllabus at any college or university that teaches courses on business and finance. 

The beauty of hindsight is that it provides answers that are all too obvious after the fact, and if this book allows for even a smidgeon of common sense to prevail on Wall Street, it will more than have served its purpose.