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.