Wednesday, November 12, 2008

The End of Wall Street as we knew it

I have read just about everything Michael Lewis has written (Liar's Poker being the most famous), and he's very good. I would highly recommend his latest article. It's called The End and it's all about how the subprime mortgage crisis wiped out Wall Street investment banks. But certain things he exaggerates, and certain key things he leaves out.

You hear a lot of politicians and pundits talking about how the housing crisis is the result of greed and stupidity on Wall Street and the failings of the free market. But the entire world operates on the principle of greed: you can always expect the majority of the people to act in their own self-interest. So blaming the housing/subprime crisis on greed doesn't really shed any light on the issue, because disasters like this don't come along very often, and our unparalleled prosperity today is the result of the fantastic advances that free markets have made over the years. As for stupidity, yes, many stupid things happened. Many. At all levels of the banking and investment world as well as at the highest levels of government.

There's an important fact which Lewis left out in his article, and that is that subprime loans never would have been made in such volume were it not for the unique role of Freddie Mac and Fannie Mae. They were the kings of greed, if you will. They were owned by shareholders and managers, so they could reap all gains for themselves, but uniquely, any losses they suffered would be born by the taxpayers. Lewis makes fun of how investment banking firms found the ultimate way to screw people (by going public and passing all the risks from private owners to public shareholders). But Freddie and Fannie were by far the more obscene scam. And whom do we have to thank for that? Our friendly congressmen and senators who first created F&F and then worked diligently over the years to keep F&F insulated from any constraints on their ability to leverage up their portfolio at the taxpayer's expense. Politicians were the incredibly stupid ones, and they did it all in the name of making housing more affordable. They pointedly ignored dozens of warnings by serious people of an impending F&F disaster for well over a decade.

If F&F hadn't bought $1 trillion of the AAA tranches of subprime loans, responding to the urgings of Congress, I feel confident saying that the bulk of those loans would never have been made. And without all those loans we never would have found ourselves in this mess, even if housing prices collapsed as they have.

I remember learning about the AAA tranches of securities backed by subprime loans when I worked at Western Asset some years ago. They weren't all that attractive, which is why the firm invested only a paltry amount of clients' money in them, and then only after persuading Wall Street to make the securities doubly AAA by adding extra credit enhancements. In order for an investor to lose any of his principal in these loans, as I recall about 70% of the underlying loans would have to default, assuming a recovery rate (selling the house in foreclosure) of 50%. It seemed almost impossible that those loans could go bad, and we were fully aware at the time that housing prices could decline 25-30% (which they haven't yet done). Yet we invested only a tiny amount in AAA loans, just a few percent of assets. F&F invested $1 trillion, which was a huge portion of its total assets. Most of those loans are trading at a fraction of their par value, but not all of them have suffered actual principal loss; a good portion of the losses are so far only mark-to-market losses. A good portion of those securities could still pay off at or close to par, with only modest losses, if held to maturity. But given F&F's enormous taxpayer-backed leverage, even small losses were enough to turn them into a ward of the state.

Lewis also left out a more thorough description of credit default swaps. He wants the reader to believe that the key to the great unravelling and implosion of the mortgage mess was the ability of Wall Street to create synthetic mortgage CDOs—via credit default swaps—that magnified hugely the risks of a downturn in the mortgage market. Yet if you look closely at the huge notional amount of credit default swaps tied directly or indirectly to subprime loans, you will find that the net exposure is only a tiny fraction of the much-ballyhooed total. That is the case for all swaps, in fact. Derivatives such as credit default swaps don't magnify the total amount of risk in the system, they redistribute it. Granted, if the housing market collapses as it has, there will be hundreds of billions of losses, but the losses are ultimately traceable almost in their entirety to the equity that has been wiped out on the mortgages. And we know that those losses are finite, and can't be more than $1 trillion in the worst of cases. We've already seen the bulk of the losses, as I've mentioned before.

Lewis leaves out another important fact: as is the case for all derivatives, credit default swaps are a zero-sum game. For every loser there is a winner. So if a whole herd of investors were wiped out because they sold protection on subprime mortgages, then there's a herd of equal size that has been hugely enriched.

He writes a good story that grabs any reader. But just as he relates how an astute investor friend always asked the salesman how Wall Street was going to screw him if he bought what was being offered, I would advise the reader of any gripping true-life story to ask himself just what the author is leaving out that might ruin the brilliance of the story. In real life things are never as clear as they are when you're telling the story after the fact, and every storyteller has his own agenda.

One final note which illustrates where the true stupidity of all of this lies. You can bet a lot of money that subprime loans won't again see the light of day for a generation at least. And you can bet that the uninformed press, public and politicians will continue blaming the free market for this mess, rather than a series of grievous errors on the part of our politicians and bureaucrats. The free market doesn't make the same mistake twice, but the same logic does not apply to the government. Are not the same politicians that protected F&F now in charge of the bailout?

Moral of the subprime story: without the help of our political system this crisis would not have happened.


Tom Burger said...

Couldn't agree more. And it is the Republicans over the last eight years that bear a great responsibility for this mess.

I have voted Republican in every election except 2004, and will likely never vote again -- so I am not playing politics here. But it's time for Republicans to admit that their party is a disgrace to all rational governance and either try to do something about it or renounce this political sickness that has taken over the Republican party and defined its recent behavior.


Tom Burger

housam said...

I would definetly refer to myself as an independent.With that being said I find your notion that this mess was a republican one to be sad at most,and laughable at the least.Both parties contributed to this mess.Just check the people who sat on the boards of both fanie and freddie Including rahm emanuel of all people.The bottom line is this.Democrats pushed both agencies to make unaffordable loans to minorities whom could not afford them for the sake of equality,While republicans did not want to be seen as anti-minorities in a time when their possible vote was so eagerly needed.

Scott Grannis said...

housam, where did you get the idea I was blaming the republicans for this? If you read my previous posts going back a ways, you will see I am a conservative and a libertarian. I blame both parties for this mess, but I think the Dems deserve the greater share of the blame.

Scott Grannis said...

housam, in re-reading this I realize you are referring to Tom's reply. Sorry to imply that you were mistaken. But I do see merit in Tom's criticism of the Republicans, because they have really been miserable defenders of free markets and limited government.

I've always thought that the Libertarian party, as embodied and articulated so well by the Cato Institute, was the heart and soul of the Republican Party. Whenever Republicans stray from libertarian principals, they make a grievous mistake.

housam said...

I'm the one who should apologize.I should have specified who I was replying to.With that being said,I think that republicans do share a great deal of the blame in terms of not having a backbone to stand up for their core principles which I still believe in(low taxes,small government,state rights and above all fiscal responsibility).If you take those principals,then it would not be a stretch to label bush as the biggest liberal president this country has ever witnessed.One last question scott! I noticed you were optimistic about the fact that the dollar is rallying,however,I have read more than one article that states that what we are observing is nothing more than a short covering,and that the downward trend will resume once the full weight of the currently issued treasures(bailout money..etc) is you agree with such an assessment?

Unknown said...

Thanks for posting this. _Moneyball_ is among my favorite books, and Lewis among my favorite writers. What seems of note to me is how bipartisan this whole fiasco is and continues to be. The $500 (600? 700?) billion bailout plan, seems (quite obviously) counter-intuitive, and yet neither party has spoken out against it in any meaningful way. Why are we giving billions of dollars to the very same people who squandered our investments in the first place? Perhaps it is because our legislators are more concerned with calming their constituents than with actually doing the right thing - yet another argument against the 17th Amendment. If we had law makers that were not concerned with re-election, we might actually have law makers who cared about making good laws (or good bailout packages).

Mark Gerber said...

Thanks as always for your Blog entries. I sure wish the mainstream press would make it widely known that F&F bought $1Trillion of AAA subprime paper making them the biggest enabler/supporter of the whole fiasco. I hope the history books reflect this fact as well, but I doubt it.


Scott Grannis said...

housam: regarding the dollar, you have to first put it in context. The dollar is up 20% from its lows, but it is still undervalued relative to most major currencies. I worry about all the money the Fed is pumping into the system, but so far it has only been in response to increased money demand, so it has not hurt the dollar and has not been inflationary. That may change, but we'll have to wait and see.

A "carry trade" is just another name for a speculative play on something other than the dollar. You sell or borrow dollars and buy something else you think will do better. To the extent that the unwinding of carry trades is boosting the dollar, it is because speculation got way out of hand in a number of areas. Prices of homes, gold, commodities and other currencies went too high, and these prices are now coming back down to more reasonable levels. I think that is a good thing: less speculation, and more reasonable prices. So a stronger dollar reflects a healthier market in general.