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David's Macro Blog

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Tag: financial crisis 2008

When did Wall Street become the dumb money?

Why did traders who lost on their bets still earn millions (sometimes tens of millions) in income?

Author Micheal Lewis (Liars Poker, Moneyball, The Blind Side) explains the answers to both of these questions in his best-selling book, The Big Short. He writes so that even his mother could understand the intricacies of the financial system that the wrecked the global economy for the next decade.

The most remarkable thing to me is that individual traders on BOTH sides of the bet (for or against subprime mortgages) got rich while their firms collapsed and taxpayers got the bill.

Watch the C-SPAN interview with Michael Lewis below:

My Favorite Quotes

That the Wall Street firms had become the dumb money at the poker table. Somehow these firms, which used to be the smart money… When I left Soloman Brothers, the last thing you wanted to do if you were an investor, was be on the other side of one of Soloman Brothers trades. There was some zero-sum bet to be made with Soloman Brothers, you did not make it because you were sure to lose money. And what had happened was somehow the firms had become, had turned stupid as institutions, they’d become the dumb money. That made me curious. Something big had changed. The natural question was, who was the smart money? That led me to my characters because they were the smart money.

They didn’t know their own balance sheets. He doesn’t persuasively know his own business.

The whole financial system is organized around a bet.

The minute that the Wall Street firms were in the business of harvesting middle class and lower middle class Americans for their home equity value (via sub-prime loans) and making loans to them against it, there was a natural risk of abuse because just generally in financial transactions people are bewildered.

There were lots of cases where the nature of the loan was sort of disguised from the person who was borrowing the money. Teaser rates should be criminal. You essentially talk someone into taking a loan out that has an artificially low rate for the first couple of years so it looks very tempting. Then it skyrockets after two years.

There were 3 trillion dollars of loans there were dubious [referring to sub prime and alt-A]

But then seeing this explosion of lending again in this beast he (Steven Eisman) thought he slayed back in the 90’s, the sub-prime mortgage lending business and he says this is all going to blow up again, this is going to end badly because I know how this business is done. It’s a sinister business.

Interviewer: “So the $180 billion taxpayers dollars that went to AIG then went to Goldman Sachs (and other Wall Street firms) to pay off bets?”

ML: “Yes, yes, yes – for bets”

Interviewer: “Why did Hank Paulson and Ben Bernanke want to pay off the gambling debts of AIG?”

ML: “Because all the other Wall Street firms were on the other side of (AIG’s) bets and if AIG didn’t pay off then those firms would have experienced losses. For example Goldman Sachs lost on its bet to Michael Burry, but they thought they were just brokering the bet between Michael Burry and AIG so they paid off Michael Burry and they are out of pocket. They want to get paid by AIG, or they have a $13 billion loss. Paulson and Bernanke are thinking, if we don’t make the Wall Street firms whole, they will collapse, the market is not going to believe they’ll survive. And they would have all collapsed.”

Interviewer: “Who got hurt?”

ML: “Not the Wall Street firms. The rest of the country got hurt by what the Wall Street firms had been doing the last five years, generating this frenzy of finance where finance shouldn’t have happened.”

This was to me, my revelation. First, that the financial system had organized itself around this bet. And second, no matter which side of this bet you were on, you STILL got rich personally. Your institution might have lost huge sums of money, but you yourself got rich.

The only social purpose I had in writing the book was, I thought if I could explain this to people, they’d be outraged. And they need to know.

Derivatives are meant to redistribute the risk in an intelligent way.

None of those people in Davos made a lot of money betting against the subprime mortgage market. If they really understood it, that’s what they would have done.

Michael Lewis on his personal profession of book writing:

The interesting thing that I do is learn about something and communicating it in words.

Notes

Credit Default Swaps is the mechanism created in 2005 to bet against the subprime mortgage market. CDS is like an insurance policy and costs a couple percent per year.

CDS quickly became a way to bet against mortgages, instead of just an insurance policy against your own bonds defaulting.

Subprime mortgage bonds are pools of loans. Most were betting the bonds would pay off, just a few were betting against it – they were the smart money who ran the numbers, not just looking for commissions and transaction fees.

The unit selling most of the CDS was AIG FP (AIG financial products group). They used AIG’s AAA rating to sell insurance but reserved no capital against losses.

During the height of the 2008 credit crunch, Lehman Brothers, led by CEO Dick Fuld, was not bailed out by the government. Instead, it was allowed to fail and become the largest bankruptcy in history.

How did this 150-year old firm that survived the Civil War and the Great Depression fail?

The short answer is, the firm was obsessed with growth so it chased returns with little regard for prudent risk management.

Their business model during the 2000’s economic growth period relied upon:

  • Excessive leverage (40 to 1): a couple percent drop in asset prices renders the firm’s balance sheet without equity.
  • Being the largest securitizer of sub-prime real estate mortgages.
  • The overnight repo market to fund daily operations.
  • Accounting gimmicks such as Repo 105 to make the balance sheet look good for quarterly reporting.
  • Unrealistic modeling with faulty assumptions such as real estate prices only go up and the overnight repo market is always liquid.
  • Believing “this time is different” and not preparing for the inevitable market cycle to reverse course.
  • Retaining ownership in some securities they created to increase their profits.
  • Incorrectly believing they would get a bailout from the government like Bear Sterns (after rejecting a bailout from Warren Buffett before late 2008).

What lesson can individual investors learn from this?

Be wary of investments requiring excessive leverage and market conditions remaining the same in perpetuity.

Source:
Barry Ritholtz – Dick Fuld’s Fantastic Revisionism!

It is always interesting to go back and read what I wrote last year because often I’ve forgotten! Plus it is humbling to realize how imperfectly we see the future, which looked so clear at the time.

My favorite quote for 2010 is:

“Prediction is very hard, especially about the future.” – Yogi Berra

Let’s take a look at the past year and what happened. My next post will contain my 2011 predictions.

Notable Events During 2010

Economic

  • The unemployment rate is just below 10%, which is about where it was at the end of 2009. Most of the decrease came from a decline in the Labor Force Participation Rate and Employment Population Ratio. Some new jobs were created but far below the number needed to decrease unemployment down to a reasonable 6% range.
  • Consumer spending recovered remarkably well despite no real improvement in unemployment.
  • Credit was tight for those at the lower ends of the financial spectrum but was certainly extremely loose for large financial institutions and businesses.
  • The stock market continued its climb back up from the 2008 Financial Crisis lows, yet suffered the May-6 Flash Crash. There was plenty of volatility in the trading ranges.
  • The S&P 500 rose about 12% to 1257.
  • Commodity and precious metal prices rose during the year. Gold and silver are at new highs and oil is back to $90 per barrel.

Real Estate

  • Real estate prices continued to stabilize across most markets.
    • The residential market is of course driven by location. Most lower priced homes already fell dramatically because subprime loans were the first to fail. Now higher priced homes are showing weakness.
    • In the commercial market, there was a bifurcation of assets. The best assets actually saw increased prices and rents because investors were chasing yields higher than bonds. The lower-end assets fell because they don’t produce much stabilized income.
  • U.S. home mortgage rates fell to multi-generational lows in the mid-4% range. This wasn’t expected originally because it was projected to rise when the Fed ceased buying additional mortgage debt.

Political

  • Reappointment of Ben Bernanke as Fed chairman in closest vote ever.
  • The Federal government still has a $1 trillion budget deficit. We’ll see if the new, more conservative Congress reins in spending (not too likely). At some point the Federal debt problem will have to be addressed as in Greece.
  • States, counties, and cities did not go bankrupt en-mass yet. However some politicians are speaking out on their budget crisis finally. We may see radical change in 2011.
  • The Federal government passed sweeping national health care reform. The effects are just starting to be known.
  • The Federal government also passed financial reform legislation. The effects aren’t clear yet, but does anyone think radical reform will improve abusive behavior?
  • The power of the financial industry over the American economy and the government became more evident.
  • The Fed kept the money flowing with Quantitative Easing 2 (QE2). When QE2 ends, will QE3 be required?
  • Economies in Europe and even the Euro currency experienced major challenges. There were bailouts in Greece and Ireland, with more on the way for Portugal, Spain, and maybe Italy. Curiously Iceland opted out of the bailout scheme and is recovering faster than expected.

Now let’s review some of my 2010 predictions and grade them.

Most Accurate Predictions from Last Year (2010)

Perhaps unemployment might fall below 10%, but it should remain at or near double digit territory.

Pretty accurate, unemployment for December 2010 came in at 9.7%.

[Interest rates] are at zero and should remain there for 2010. Remember, Japan had zero interest rates for 10+ years. It can happen.

There wasn’t any hint that short term rates would move up from the 0% -0.25% range they’ve been in for awhile now. Honestly this wasn’t difficult to predict so it hardly qualifies as a “most accurate prediction.”

If forced to make a firm prediction, I’d say the best chance of a currency crisis is in the EU, not Asia or North America.

The European Union did have a very large currency crisis in the form of bailouts. The EFSF was formed to backstop unmanagable debt in countries like Ireland, Greece, and eventually Spain and Portugal.

Least Accurate Predictions from Last Year (2010)

The market indices should fall in 2010 and stay within their prior 2 year trading range with a 1/3 chance of retesting the prior lows of March 2009.

The stock market finished up about 12% (S&P 500). There were some swing trades up and down but in general the stock market continued its recovery.

If the economy doesn’t suffer a major meltdown and doesn’t recover either, then gold prices will probably flatten and possible show downward bias.

Gold (and silver) prices didn’t fall in 2010 – they increased instead as investors and hot money flowed into alternatives to risky paper money.

Oil prices remained in the $60 to $80 range for most of the year [2009]. I expect more of the same and a downward bias too.

Oil prices finished year 2010 at $90/barrel as the global economy strengthened and GDP grew. I expected slower growth, which would have likely kept oil prices lower.

The Daily Show With Jon Stewart Mon – Thurs 11p / 10c
A Nightmare on Wall Street
www.thedailyshow.com
Daily Show Full Episodes Political Humor Tea Party

Related Posts

Jon Stewart Explains the May 6th Flash Crash

Jon Stewart Interviews Jim Cramer on the Daily Show

Are you an expert if you make mistakes? 

Are you an expert if you make BIG mistakes?

Are you still an expert if you miss the biggest financial bubble in world history?

Let’s consider these questions while reviewing some quotes from the so-called “experts” just prior to the 2008 financial collapse and the start of the Great Recession.

“I believe that the general growth in large [financial] institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically — I should say, fully — hedged.”

— Alan Greenspan, 2000

“Even though some down payments are borrowed, it would take a large, and historically most unusual, fall in home prices to wipe out a significant part of home equity. Many of those who purchased their residence more than a year ago have equity buffers in their homes adequate to withstand any price decline other than a very deep one.”

— Alan Greenspan, October 2004

Financial innovation means “shocks may be less likely to result in the type of trend amplifying, self-reinforcing dynamic for sustained periods of time that can threaten the stability of the financial system… but it is unlikely to have brought an end to the periodic tendency of markets to experience waves of mania and panic.”

“Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.”

— Alan Greenspan, October 2004

“The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions …. Derivatives have permitted the unbundling of financial risks.”

— Alan Greenspan, May 2005

“We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.”

— Ben Bernanke, July 2005

“In the financial system we have today, with less risk concentrated in banks, the probability of systemic financial crises may be lower than in traditional bank-centered financial systems.”

“The Federal Reserve is not currently forecasting a recession.”

— Fed chairman, Ben Bernanke, January, 2007

“At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

— Fed chairman, Ben Bernanke, Congressional Testimony, March, 2007

Final Questions:

  • Should an expert still be considered an expert AND be in a position of power and influence to repair the economy/financial systems after they didn’t even see it coming?
  • Why do professionals with significant academic training, industry experience, and extensive access to real-time data mis-interpret the fundamentals and say things that look foolish in retrospect?

Perhaps the best quote to summarize the situation:

“The economy depends about as much on economists as the weather does on weather forecasters.”

What do you think? Do you have a favorite expert quote not shown above? Comment below and let me know.