THE BIG SHORT - Inside the Doomsday Machine

THE BIG SHORT

Inside the Doomsday Machine

MICHAEL LEWIS

Penguin (

Allen Lane

) 2010

Pp 266    Rs.599

“… an undisciplined economy will collapse by its own rules …” a dire prediction of 1985 attributed to Cardinal Joseph Ratzinger (now Pope Benedict XVI) by Italian Finance Minister Giulio Tremonti. It matters little whether anyone said it so far back in time. No one was listening. Meredith Whitney, of Oppenheimer & Co., predicted in 2007 (when the world was yet traipsing on the edges of financial disaster) that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. No one listened – but two weeks later Citigroup slashed its dividend – after its CEO resigned … and since data on the extent of the mismanagement within Citigroup or elsewhere was clouded in intentional opacity, Meredith was largely guessing. But by now everyone was up and listening.

Then Bear Stearns fell and then Fannie Mae and Freddie Mac fell. The Lehman Brothers debacle followed… and then all hell broke loose with AIG and Washington Mutual and umpteen others and the vulgar-size bailout. US Treasury Secretary Henry Paulson persuaded the US Congress to release the S700 billion to buy subprime mortgage assets from banks; once he got the money, ‘Paulson ... [gave] away billions of dollars to Citigroup, Morgan Stanley, and Goldman Sachs, and a few other unnaturally selected for survival.

We have gone too far ahead in time.

Michael Lewis has, in his all too candid and chatty manner, traced the origins of the meltdown (American euphemism for rape of the financial world) through all the myriad frauds and countless acts of subterfuge.

Several seemingly unconnected events occurred in the 1980s. Saloman Brothers converted itself from a private partnership to Wall Street’s first public corporation. They encouraged small markets in bonds funded by all sorts of strange stuff: credit card receivables, aircraft leases, auto loans, health club dues – and the most obvious untapped asset in America was still the home. The creation of the mortgage bond market extended Wall Street into the debts of ordinary Americans. At first the new bond market addressed itself to solvent half of the American population – later, it addressed the other half. The intention was to give the loans to less and less creditworthy persons – not to buy a house but to cash in on the equity on the house they already owned. The method was simple: keep making loans to people who can’t repay; don’t keep them on your books; sell them to fixed income departments of big Wall Street investment banks who will package them into bonds. Initiated by Long Beach Savings, and followed by “B&C” (whose mortgage was bought by Lehman Brothers). By 2005, Bear Stearns, Merrill Lynch, Goldman Sachs and Morgan Stanley were in. At this time, a new tool was found for betting against subprime mortgage lending: credit default swaps. The author of this device was Dr. Michael Burry, medico turned financial analyst. The supporting factor in all this was the while the stock market was heavily regulated, the bond market was not.

Such bonds were claims on the cash flows from a pool of thousands of individual home mortgages. But the borrowers had the right to pay off any time they please – which made bond investors reluctant to invest in such loans. To limit this uncertainty, they took giant pools of home loans and carved up the payments made by borrowers into ‘tranches’. The buyers of the first tranch got hit with the first wave of mortgage prepayments – for which they received the highest rate of interest; the buyers of the last tranch got the lowest rate of interest in exchange for the assurance that his investment wouldn’t end before he wanted it to.

Then another innovation arrived: interest rate swaps – one party ‘swapped’ a floating rate of interest for another party’s fixed rate. The condition here was that it should be a large non-banking corporation “willing to bury exotic risks in its balance sheet”. AIG Financial Products came to be the largest owner of subprime mortgage bonds. Goldman Sachs’ Gregg Lippmann transferred to AIG FP all its future losses from $20 billion in Triple-B rated bonds.

Then came CDOs (collateralised debt obligation) – originally intended to redistribute the risk of defaults in corporate and government bond “now jiggered to disguise the risk of subprime mortgage bonds”. Surprisingly, the rating agencies (paid fat fees by Goldman Sachs) pronounced 80% of these as Triple-A. The innovative spirit turned the purpose of redistribution of risks associated with home loans to hiding the risks by complicating it.

When the defaults came cascading, there was financial genocide – and yet the problem remains: no one knows the amount, in dollars, of credit default swaps bought and/or sold by various banks.

The book wasn’t meant to be a chronological account, one presumes – it has been written more to display the author’s familiarity with the inner workings of the sinister financial machine (though not quite the I-told-you-so variety). At the end of it all one does get a rather murky  idea of the murkier deals that brought the house crashing down.