Tuesday, April 27, 2010

"The Big Short"



I've taken advantage of my local library to do a fair bit of reading on the cheap lately. I'm interested in the details of how our most recent financial debacle happened. Any book that sheds light on the subject is on my list.

"The Big Short" by Michael Lewis fits the bill perfectly. It's the true story of a cadre of individuals who saw what was going on, well before anyone else did, when the conventional wisdom said they were fools. They put their money where their mouths were, too. They bet millions on shorting the mortgage market, knowing that the rate of default didn't have to reach historic proportions for the bet to pay off. It took great courage, because they were either betting with their own money or that of investors. They were certain that the crash would come, but they couldn't predict when. They didn't know if their funds or courage would run out before the payoff would arrive.

Michael Lewis knows something about the terrain. He worked for an investment bank back in the 80s. He wasn't a great success as a financial adviser, but it did start him on the writer's path with "Liar's Poker". How fortunate for the rest of us!

It's a great read, very entertaining. I recommend it highly.

There was a lot of negative discussion about short selling when the market came down and Lehman Brothers failed. CEOs hate short sellers. They complain about their company being hurt by rumors and whispers, implying that the short sellers are merely manipulating the market for their own benefit.

There might be some truth to this, especially for naked short sellers who don't have to risk their own money. But people who put up their own money and take a real risk are providing an alternative information source to the market. If short action is lively, perhaps there's something to it. It's the sobering other side to the happy talk pumped out by CEOs and the sellers of their stock.

With congressional testimony going on, it's especially timely to answer a few questions about how this happened to us:

1. Was this a "perfect storm" of circumstances that no one could have foreseen?
2. Were the financial instruments so inherently complex that they couldn't be understood by anyone?
3. What did CEOs know, and when did they know it?
4. Was it merely the latest example of an Enron-style theft?

All four contributed, but I think the fourth option is one that will win the day.

The news from the New York Times today says that Goldman Sachs was offsetting losses in the mortgage market with their own short action. They can't claim perfect storm or too complex or not knowing what was going on.

There are lots of great sources for reading about what happened. "The Black Swan" by Nassim Nicholas Taleb spells out the dangers of over-reliance on lovely mathematical models and normal distributions. (Note to self: There's a second edition available.) Mark Chu-Carroll's "Good Math, Bad Math" blog has a fine entry on the matter.

What will we do about this? There's legislation being crafted right now that claims to reform our banking system. This will be Chris Dodd's last hurrah, but I fear that it won't be at all effective. There will be too many amendments to water it down. Lobbyists from the banking industry will lend their "expertise" to craft the laws. Senators and representatives on both sides of the aisle have taken too much money from banks and financial services firms to be objective anymore.

I've maintained all along that the biggest mistake was repealing Glass-Steagall and replacing it with Gramm-Leach-Bliley. That was done on Bill Clinton's watch, with Goldman Sachs principals Robert Rubin and Lawrence Summers running things. Goldman Sachs is embedded far too deeply into our government today. I know I'll be watching the hearings very closely.

In the meantime, I recommend that you go out and read "The Big Short".

1 comment:

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