Pack of Fools

By James Kwak

“I thought that I was writing a period piece about the 1980s in America, when a great nation lost its financial mind. I expected readers of the future would be appalled that, back in 1986, the CEO of Salomon Brothers, John Gutfreund, was paid $3.1 million as he ran the business into the ground. . . . I expected them to be shocked that, once upon a time on Wall Street, the CEOs had only the vaguest idea of the complicated risks their bond traders were running.

“And that’s pretty much how I imagined it; what I never imagined is that the future reader might look back on any of this, or on my own peculiar experience, and say, ‘How quaint.'”

That’s Michael Lewis in The Big Short (p. xiv), looking back on Liar’s Poker.

“Looking back, however, Salomon seems so . . . small. When the Business Week story was written, it had $68 billion in assets and $2.8 billion in shareholders’ equity. It expected to earn $1.1 billion in operating profits for all of 1985. The next year, Gutfreund earned $3.2 million. At the time, those numbers seemed extravagant. Today? Not so much.”

That’s the third paragraph of Chapter 3 of 13 Bankers. (This was a complete coincidence; I didn’t see The Big Short until it came out, and I have no reason to think that Lewis saw a draft of our book.)

I actually did not rush out to buy The Big Short, even though Michael Lewis is a great storyteller. I figured I knew the story already; Gregory Zuckerman’s The Greatest Trade Ever covered some of the same ground and some of the same characters, and I already knew plenty about CDOs, credit default swaps, and synthetic CDOs. But I’m very glad I read it, and not just because it’s a fun read.

Lewis’s central theme is the question of why some people were able to see a financial disaster that, in retrospect, seems so obvious, while almost everyone else — including even the people who concocted the machine that broke down so spectacularly — were so blind. This is the point of his epigraph, by Tolstoy:

“The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him.”

But I enjoyed it most for its portrait of what was going on behind the scenes on Wall Street. The picture is not pretty.

Lewis’s book focuses on a group of people (mainly at hedge funds) who figured out that subprime-backed CDOs were going to collapse and set out to make money from that collapse. To do so, they bought credit default swaps on bonds issued by those CDOs. They had to buy these credit default swaps from their brokers — the big investment banks. These swaps had collateral requirements: as the price of the swap fell (or the price of the underlying bonds rose), they had to give collateral (cash or Treasuries) to the banks; as the price of the swap rose, the banks had to give collateral to them.

The problem was that the banks, as the swap dealers, got to decide what the swaps were worth. So, for example, Charlie Ledley bought an illiquid CDS on a particular CDO from Morgan Stanley. Five days later, in February 2007, the banks started trading an index of CDOs that promptly lost half its value. But, as Lewis writes, “With one hand the Wall Street firms were selling low interest rate-bearing double-A-rated CDOs at par, or 100; with the other they were trading this index composed of those very same bonds for 49 cents on the dollar” (p. 162).* That is, the market price of the already-issued CDOs didn’t affect the sale price of new CDOs. And what’s more, Ledley’s broker insisted that the price of his CDS (which should have soared as the index of CDOs fell) had not changed. Here you see the banks simultaneously ignoring a market price in two separate ways: once so they can continue selling new assets that are extremely similar — worse, if anything — to assets that they are trading as garbage; and again so they can avoid sending collateral to their hedge fund client.

In June 2007, the subprime-backed CDO market began to collapse for good. And, again, the banks suddenly couldn’t figure out how much their clients’ CDS were worth, so they could avoid sending them collateral. “Goldman was newly unable, or unwilling, to determine the value of those positions, and so could not say how much collateral should be shifted back and forth” (p. 195). Between June 15 and June 20, Michael Burry could not get ahold of his Goldman Sachs salesperson, who finally claimed that Goldman had had a “systems failure” — which was what Morgan Stanley and Bank of America also claimed. According to Burry, the only reason why the banks finally started marking his positions accurately was that they were getting in on the same trade.

This also happened between the dealers. At one point Greg Lippmann at Deutsche Bank, who had shorted the market, said to his counterpart at Morgan Stanley, who insisted that subprime CDOs were still worth 95 cents on the dollar: “I’ll make you a market. They are 70-77. You have three choices. You can sell them back to me at 70. You can buy some more at 77. Or you can give me my f—ing $1.2 billion” (the collateral owed) (p. 213). But even though Morgan Stanley claimed the securities were worth 95, they refused to buy more at 77 — even though that would have represented instant profits according to their “model.”

What’s the point here? It’s the same as yesterday. Free financial markets are supposed to create efficient prices. Every argument about the benefits of financial markets (optimal allocation of capital, liquidity, etc.) depends on this one point. But the prices in this market were being set based on the dealers’ own interests. Think about that.

Then there is the story of Howie Hubler (Chapter 9). Hubler was smart enough to buy credit default swaps on $2 billion of BBB-rated CDOs. But to pay the premiums on those CDS, he then went and sold credit default swaps on $16 billion of AAA-rated CDOs. In other words, he was betting that the housing collapse would wipe out the BBB tranches of the CDOs, but not the AAA tranches. At the time, CDS prices reflected a belief that the AAA tranches were only one-tenth as likely to default as the BBB tranches. So to be more precise about it, he was actually betting that the AAA tranches were less than one-tenth as likely to default as the BBB tranches.

So some trader misjudges the correlation between mortgage-backed securities (which determines the correlation of the AAA and BBB tranches) and makes a trade that turns out badly. So what? The problem is what we learn about the system.

First, we learn this: “The $16 billion in subprime risk Hubler had taken on showed up in Morgan Stanley’s risk reports inside a bucket marked ‘triple A’ — which is to say, they might as well have been U.S. Treasury bonds” (p. 207). (The VaR calculation for this position also showed virtually no risk, since it was based on historical volatility data.) So Morgan Stanley had no idea what it was holding onto.

This is incompetence. But is it innocent incompetence or willful ignorance? I doubt that anyone on the management team said, “Let’s design a stupid way of categorizing our positions so that our traders can make risky bets, hide them from us, and blow up the bank.” But think about this: this type of error only goes one way. Steve Randy Waldman has already made this point about capital:  “For large complex financials, capital cannot be measured precisely enough to distinguish conservatively solvent from insolvent banks, and capital positions are always optimistically padded.” The same is true about risk, which will always be underestimated. If a bank has a system that overestimates risk, the traders who understand the positions will (correctly) argue that real risk levels are lower; if the system underestimates risk, they will keep their mouths shut. Higher risk measures mean more capital means lower returns; all the internal pressures are to underestimate risk. The incentives of the system breed incompetence, and everyone benefits in the short term.

Eventually, Morgan Stanley lost $9 billion on the trade. In December 2007, CEO John Mack tried to explain the loss on an investor call. “The hedges didn’t perform adequately in extraordinary market condition of late October and November,” he said (p. 217). This wasn’t a hedge; it was a long-short bet. But on Wall Street, it’s second nature to call everything a hedge. When pressed by an analyst (from Goldman), Mack punted (“I am very happy to get back to you on that when we have been out of this, because I can’t answer that at the moment”). As Lewis said, “The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley’s bond trading business. What the words actually revealed was that the CEO himself didn’t really understand the situation.”

This is a classic example of something that goes far beyond Wall Street: the CEO who has no idea what is going on inside his business. And, as Lewis says, Mack was generally considered one of the more competent ones. CEOs of large corporations exist on such a high level of abstraction relative to what actually happens that all they know is what their subordinates tell them, and their subordinates barely know what is going on as well. (I believe there is now a reality show based on this gap.) Mack probably really thought that Howie Hubler was putting on a hedge, because that’s probably what someone told him before he went on the call. And when CEOs show up before the Financial Crisis Inquiry Commission and say something like “we put the interests of our clients first in everything we do,” they may actually believe it — because they don’t know any better. (Which is very convenient, because ignorance allows you to say things that are not true without actually lying.)

So what kind of picture of Wall Street does The Big Short paint? Banks manipulating the prices of custom derivatives. Traders making stupid bets and taking home eight-figure bonuses. Painfully inadequate risk management systems. Management teams that have no idea what is going on. A toxic combination of cutthroat greed on the part of individual bankers and broken incentive systems on the part of banks.

This is not a finely-tuned machine for allocating capital and fueling the real economy. It’s a system whose rules have been twisted to allow the few smart people to get rich by screwing their customers or their employers. “That Wall Street has gone down because of this is justice,” says Steve Eisman at the end of the book (p. 251). But as we now know, it didn’t go down.

* I believe they were not the “very same bonds,” since the newly issued bonds were 2007 vintage and the ones in the index were earlier vintages; but if anything, that meant that the 2007 bonds, which were sold at par, were even worse.

Update: I forgot to mention that I bought my copy of The Big Short. Actually, I bought mine and then I traded it for Christopher Lydon’s copy, because Lydon got Michael Lewis to autograph his copy for me. But net, I paid for it.

39 responses to “Pack of Fools

  1. A glance at a graph like the latest one posted by CR should have made things obvious to just about anyone. It is indeed incredible that markets were so stupid. I shorted the DOW in late 2006, as a hedge against what seemed to me a clear danger that assets were overvalued (based mostly on what was happening to the ratio of debt to GDP), and was very surprised at how long it took to happen.
    But I beleive that the global savings glut was an important cause of this phenomenon, and that Asian currency policies (which amount to government policies of forced savings) were important contributors to the savings glut. These are creating debt levels that, I’m very afraid, will reach crisis proportions before they are properly addressed.

  2. Yep, cutting taxes, starting two wars and increasing spending along with insanely low interest rates had nothing to do with it. It’s all the Chinese peoples fault.

    Don’t look now but the US was the sucker at the table.

  3. Yep, starting two wars, cutting taxes and increasing spending had nothing to do with excessive debts. Along with insanely low interest rates and regulators that believed all regulations were bad (read Greenspan’s book). Yep it’s all the Chinese’s fault.

    Don’t look now but you are the sucker at the table.

  4. A few thoughts, some of which were also prompted by your book:

    1. I think something missing in the story of how banker compensation got so out of whack is the influence of the tech bubble. Mythical guys who started businesses in their garage started getting mega-rich off of valueless (in retrospect) IPOs, leading CEO everywhere, and in particular bankers on Wall Street working on the IPOs, to believe that they were worth that kind of money too. If the secretary at Initech can make a million bucks in (perhaps backdated) stock options, than surely Mr. Big Time Ibanker deserves at least that much.

    2. As I am sure you are aware, there is economic literature about rational behavior in the midst of a bubble. I wish I was more familiar with that work, but I think an issue here is that while people may well have been aware (or suspected) that they were in the midst of a bubble, they had little choice but to continue to try to ride it. Trying to pull out only put your company at a disadvantage if you timed it incorrectly and others continued to rake in money, which is why you need an outside force to help correct things (hello, federal reserve).

    3. Lewis’s book is next on my list, but the This American Life on Magnetar had me thinking that another of the unfortunate consequences that the short side here was in the form of CDSs is that there wasn’t necessarily a strong relationship between the short side bets and downward price pressure. Or at least not one that I am close enough to the process to see. Enough momentum shorting a stock will cause its price to fall, thus providing useful feedback on the stock’s value. I don’t see how that happens with CDSs and CDOs.

    3. I believe it has been in the press that the antitrust division at DOJ is investigation the banks’ access to information about CDO pricing. Perhaps that is a topic that would interest you (and maybe it is covered in Lewis’s book).

    4. There is no way a CEO of a modern business can really know everything that is going on inside it. That said, when we are talking about Mr. Mack, we should also keep in mind the alternative explanation of obfuscation.

    5. Finally, as an unfair swipe, in Chapter 12 of 13 Bankers you say the each of the crisis combinations of big banks required “waiver by DOJ of guidelines intended to prevent the accumulation of monopoly power” (paraphrase). This isn’t right. There aren’t any binding guidelines, and there is no waiver by DOJ. Presumably you have generally in mind the joint DOJ/FTC Horizontal Merger Guidelines, and specifically the concentration “presumptions” within them. First, the Guidelines are only guidelines in the sense that they describe the analysis the agencies used when they were published (last updated in ’97 if memory serves). There has been significant evolution since then, and there is a current exercise to update them. The presumptions in particular are widely recognized to have fallen out of use. Deals that significantly exceed the presumptions are routinely cleared without even an in depth investigation. But regardless, by declining to investigate during the HSR (pre-merger notification) process, DOJ isn’t granting a waiver. Legally (although perhaps not politically), it reserves the right to investigate and challenge a transaction at any time.

  5. Like Don, I figured that the money coming from overseas must have played a major role in the Great Mess. Brad Setser, before he stopped blogging, posted some good stuff on how much Fannie & Freddie paper the Chinese were holding along with Treasuries. Sovereign reserve demand for USD AAA paper, along with the Basel II rules which allowed European banks to hold very little capital against AAA paper, certainly were part of the landscape as risk was discounted generally in the early to mid Naughties.

    I still believe that, as the Great Moderation ramped into the Great Enthusiasm (and at its climax the Great Insanity, a brief but crucially important period), demand for AAA paper outstripped the major conventional sources of supply such as Treasuries and RMBS composed of conforming mortgages, so lending standards were relaxed and CDOs built on dodgy mortgage loans were used to generate USD AAA paper to meet market demand.

    It’s important to remember that all sorts of credit risk was being priced very low: cov-lite corporates, emerging market sovereigns, etc. There was a broad underpricing of risk. As part of this, big players in finance were moving toward very short-term funding in repo markets.

    But as the Great Insanity took hold (late 2006, 2007, into 2008), when Bear Stearns was funding itself to the tune of $75 billion in overnight repos, and CDO squared and cubed were magicked into the world, and enormous bonuses were tucked away on Ponzi finance, I’m with Yves Smith and others who believe it was the Magentar trade that created very, very large amounts of worthless AAA paper as a function of shorting the market and thanks to CDS.

    I guess my point is that I’m trying to build a narrative of the lead-up to the Mess that takes account of lots of moving parts and how their relative importance changed over time.

    Cheers Mr. Kwak for a solid post. I very much believe that this Mess cannot be fathomed without attention to corporate governance. It seems the discipline of economics has a convenient slot for this (the agency problem), but to a garden variety idiot like me it looks more like a crisis of the “Anglo-Saxon” model of capitalism which has been the bulwark of US soft power for many years.

  6. The Banana Peel Theory in modern economics: We never saw the giant banana peel. It was an accident. Honest !

  7. I can understand why they wouldn’t buy at 77 even though their model said it was worth 95. MS must have had (and probably still has) a lot of this junk on their books, and by the summer of 2007 risk management may have awakened from their long naps.

    What I do find amazing from stories like this is the pro-CDS argument often comes down to the usual hand-waving like “liquidity”, “price discovery”, etc. It sounds like that’s not the case in the real world, not even close. CDSs were and are there so people can make bets.

  8. I am all tapped out on the story line so perhaps I will quit reading different versions of the same drama. Thanks for the excerpt pointing out that the CDS index was selling at 50 cents on the dollar when the new issues were par. That is a gem and proof that there was no Adam Smith free market at play here but rather a game of Old Maid except the deck seems to be filled with all Old Maids. It calls for a Federal VAT tax on all the CDO, CDS, derivative trades to pay for enforcement of new regulations. Everything must be cleared through an exchange with instant pricing and trading data like NYSE and NASDAQ.
    Of course then they would have to create a new bunch of shadow banks to hide it all because this stuff can only make money when it can be done in secret. Better yet let them move the business to Dubai, Singapore and Bermuda and
    our courts will refuse their jurisdiction,

  9. Ech, enough with the hair splitting and propaganda. The big simple model that explains everything nicely is:

    The entire world was given enough rope to hang itself. Why? When people are suffering and on their knees, they look to strong leaders to help them. Start asking who these strong leaders are/will be and who is guiding them. The pattern is: create massive crisis, generate massive socialist programs, consolidate power, go to war. With any luck they’re going to skip the war part this time.

    Ask yourself this question: Are there people smart, twisted, and machiavellian enough to do the above? If so, why wouldn’t they?

    Your asylum is being run by lunatics.

  10. I think by now we’re becoming pointlessly entangled in the actual mechanisms of how the gangsters function.

    Does anyone still think it’s actually possible that a particular de jure crime (if any still exist according to their rigged laws, rigged to legalize all the worst crimes) will end up leading to indictments, prosecutions, convictions? It seems to me that would be an example of doing the same thing over and over and expecting the same result.

    That’s why I’d focus not on trying to build legal briefs against these perps (since no matter how manifest the criminality of e.g. Geithner or Blankfein becomes, it remains incredible that they’ll ever be brought to justice under this system) but on building the political case against the general tyranny of organized crime including its hijacked “government”.

    So I’d look at every aspect or the argument, the presentation of every detail, from that perspective.

    Con jobs, consumer fraud, regular accounting fraud, control fraud, outright theft, bribery, extortion, racketeering – those just for starters are what really happened and is happening here. To talk about any aspect of it in any other terms is pointless. I would never tell anyone, “the technically legal and illegal parts comprise a tangled skein..”, and “figuring out direct criminal intent vs. willful negligence vs. innocent ignorance is hard to do.” That’s because these are both false.

    Organized crime is organized crime, and its technically legal elements are merely for the laundering of the criminal operations. A gang leader is always a criminal in everything he does, since it’s all for the sake of the syndicate, no matter what the nominal legality of this or that. So it’s impossible for him to perform any action or have any thought which is not culpable.

    These are especially true where the gangs are powerful enough to hijack the legislative and legal systems in themselves.

  11. The ghost of William Black.

    Your examples are just americans though. This sucker is global. And there is a very good chance that the “bad guys” were being used by people that look now, or will look like, the good guys.

    Also, see: The Phenix City Story

  12. I think Yves Slith is very upset that Michael Lewis didn’t write the same book she did. Too bad Lewis didn’t check with her as he was writing it.

  13. i always like asking the stupid question: why does anyone deal with these bankers if they are so obviously so venal?
    Simple monopoly power?

  14. Oh, I forgot. OUTSTANDING post.
    I agree with those who note that it certainly seems to demolish the arguement that CDS perform a price discovery function.

  15. We are, indeed, becoming engaged not only in an endless debate on how gangsters function, but in how many financial-angels can dance on the head of a pin.

    To continue the metaphor-thread, the first thing to do is shoot the alligators — then, we drain (read: ‘reregulate’) the swamp.

    We need not know the particulars of the behavior of gangsters, or alligators, to put both under firm control.

  16. Uncle Billy Cunctator wrote:

    “Your asylum is being run by lunatics.”

    Rich lunatics

  17. Really? You write: “So what kind of picture of Wall Street does The Big Short paint? Banks manipulating the prices of custom derivatives. Traders making stupid bets and taking home eight-figure bonuses. Painfully inadequate risk management systems. Management teams that have no idea what is going on. A toxic combination of cutthroat greed on the part of individual bankers and broken incentive systems on the part of banks.”
    This all sounds like a, you can’t blame management because they really didn’t understand what was going on, cop-out. I’m sorry, I don’t buy this.
    I was going to buy that book the other day, I’m glad I didn’t. I’m not willing to exculpate any of the CEO’s, COO’s or CFO’s or their Board of Directors and their accounting firms. They are all, each and every one, frauds, charlatans and thieves of the worse kind.
    Where is the outrage? Where are the Indictments? Where are the firing squads? These people just stole our country’s future, and are getting away with it!

  18. If I get the gist of this, I understand why there is such an uproar against creating an exchange for these financial instruments. Begging the pardon of Oliver Wendell Holmes, Jr.: it is not only the lawyers (or maybe these guys are lawyers) “who are spending a great deal of their time shoveling smoke.”

    The creators of these instruments claim that exchange trading would expose the proprietary structure of their instruments and eat into their profits because of some sort of potential “copyright” infringement…sounds to me like they are shoveling something more dense than smoke here. This kind of intellectual property we can do without.

  19. I am reminded of one of my favorite Mark Twain quotes: It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.

  20. It has been my experience that management takes the “what you don’t know, won’t hurt you” approach to traders who are raking in the dough. As I recall, no one at Drexel Burnham, other than Michael Milken, was indicted for securities fraud. Drexel execs knew Milken was being investigated or, at least scrutinized, by the SEC for 10 years before he was arrested. No one fired him. I bet they did nothing for fear of vexing the golden goose.

  21. Love Twain too. I don’t know if you have this one: A banker is a fellow who lends you his umbrella when the sun is shining, but wants it back the minute it begins to rain. Mark Twain

  22. I should have said “no INDIVIDUAL other than Michael Milken…The company pleaded nolo contendere to felony charges of stock parking and stock manipulation.

  23. winstongator

    It seems like some of the problems arise from double dipping – acting both sides of a trade. If you’re underwriting bond issues, you shouldn’t be able to play the down side.

    Can a company issue stock at $20/share, but do share buybacks at $10/share? If they were, wouldn’t you really want to know? Could a company short their own stock?

    I guess there is a lot of risk buying a security instrument from a broker with absolutely no interest in the real value of the security, but shouldn’t there be mechanisms whereby brokers are obliged to care about quality?

  24. Are we mad at Yves now?

  25. the people we are seeing in the news are just puppets to the real people in the background pulling the strings.

  26. “This is a classic example of something that goes far beyond Wall Street: the CEO who has no idea what is going on inside his business.”

    Bush and Obama are examples of this.

  27. “…ignorance allows you to say things that are not true without actually lying.”

    They learned this trick from Ronald Reagan.

  28. The Western World is facing a moral crisis of Biblical proportions.. What were the Ten Commandments if not moral regulations for the people that had lost all sense of human dignity? The sad truth about Humans is that free riding is a deeply set behaviour.. We, for the most part, have a hard time turning away from temptation, taking the easy way to riches and power, especially when the chances of getting caught seem to most casual participants in any given scheme as being remote.

    I find it quite ironic that the very behaviour that well-healed interests fear from having a “socialist” or “welfare” state – where the lazy and the opportunitic feed on the bounty created by the educated, cultured and powerful – has been flipped on its head. The welfare bums are in fact those who like to think of themselves the natural leaders of the free world. They took the easy way to power and fortune on the backs of the common man fuelled by the conviction that their beliefs about the Nature of Man were not only Just, but for some participants, God given.

    Of the commentators on this blog, how many could have resisted? Perhaps we can differentiate between folks who sort of fell into banking and finance not expecting to become fiat money millionaires from those who have been chasing the bucks from the get go… sitting up late at night fantasizing of mansions, fast cars, and faster women, while putting in their time at MBA boot camp. But the point that seems lost on anti-regulatory zealots is that humans are by nature free riders.. there’s tons of literature on the subject…try starting with the Bible. Simply put, humanity has been struggling with this kind of self-destructive behaviour since the dawn of civilaztion. We suffer from huge collective action problems that only solid, well understood and easy to apply rules can help mitigate.

    America’s history of championing rugged individualism is at odds with this. But as the events of the past three years have shown, left to their own devices people cheat – plain and simple. Without regulation you get a race to the bottom, where “everybody does it” becomes the name of the game. America used to be a Nation that prided itself in its respect for the rule of law and Justice. But the law in the U.S. has been so perverted by the tendrils of Mamon that Justice is no longer being served.

    So while there might be a lot of “innocent” people who just went along with it due to their lack of moral fortitude, this is no excuse to shield them from the consequences of their actions. For a country that worships God as much as it does and that pays so much lip service to moral rectitude I find it disturbing the extent to which morality (or ethics if you prefer) is so rarely discussed. It’s always about the letter of the law. What ever happend to the Spirit? Moreover, it is clear to my layman’s eyes that much of the deceitful behaviour on Wall Street is out and out fraud which IS punishable by law.

    Is it that the cost of prosecuting the guilty and the collateral damage it may cause to many of the firms involved and thus the economy as a whole deemed too risky? Is the systemtic risk of throwing a good part of Wall Street in jail greater than the cost of what could happen if business is allowed to proceed as usual?

    I will wager (without resorting to a CDS) that only civil disobediance on a massive scale will bring the necessary changes to put America and by extension the Western World back on a path to some kind of sustainable Future… Figuring out how to mitigate climate change and retool American industry – nay, society! – to be competitive with the rising behemoths of the East will require a newly defined contract with America that trumps fairness over bald faced greed! I don’t see how it can be any other way.

  29. AJ: “Enough momentum shorting a stock will cause its price to fall, thus providing useful feedback on the stock’s value. I don’t see how that happens with CDSs and CDOs.”

    There are a few interesting topics here. One is that the supply of stock is very large, but limited by the issuer; whereas the supply of CDOs is small but theoretically unlimited, since a financial company can theoretically always build more. To short a stock, you need to borrow some first (at least, since the “naked short” rule was put in place), but to short a CDO you just need to buy CDS, and a financial company can always originate more contracts (subject to capital restraints).

    Furthermore, there was a market for the “long” side of CDS contracts — they were used to build synthetic CDOs. The equivalent in a stock short situation would be if the i-bank you borrowed the stock from were to bundle up all of its stock IOUs and sell them as some sort of “synthetic mutual fund”, saying that its performance would track that of the underlying portfolio. That would amount essentially to selling the same shares twice (once by you in the short transaction, and once in the synthetic fund), effectively increasing the supply of the stock. The salesman who tried to sell you this synthesized monstrosity might even try to convince you that it was “less risky” than owning the individual stock because of some “capital structure” that segregated all the risk into an “equity tranche”. This activity would dilute the effect of the actions of the short sellers on the prices of the underlying securities. In particular, it would give the bank the incentive to go out and buy lots more shares so they can lend them to the short sellers and make even more fee income with additional synthetic funds.

  30. Scot Griffin

    “This is incompetence. But is it innocent incompetence or willful ignorance?”

    Actually, the best phrase to describe happened is “innocent fraud,” coined by John Kenneth Galbraith in his “The Economics of Innocent Fraud.”

  31. Lewis’s book has had us in tears of both laughter and intense dismay.

    Reading today of JP Morgan’s staggering 1Q 2010 earnings, we wonder why no one seems to be asking where it’s all coming from. What sort of bonds are they buying and selling?

    Another way to say this is: Noriel Roubini, Steve Eisman, Michael Burry, and Jamie and Charlie, and all their friends, where are you now that we need you AGAIN? What’s going on? What are the banks up to this time? How long until they all topple over?

  32. Yep. And that’s also exactly why Spain, Ireland,, Iceland, Portugal, the U.K., Greece, Italy, among others, experienced problems with debt. Do you recall Greenspan’s ‘conundrum’ on why long-term rates refused to rise when he raised the short-term rates?

  33. Also Lee Iacocaa with regard to the Pinto “scandal” where human beings were actually incinerated by design which is a whole helluva lot worse than any financial loss or even the whole Iran-Contra scandal (which is what i think you are implying or at least I am inferring.)

  34. P.G. Waddilove wrote:

    “What’s going on? What are the banks up to this time? How long until they all topple over?”

    We are experiencing a Wile E. Coyote moment.

  35. I didn’t read Michael’s first book, but I did read it’s fictional counterpart Bondfire of the Vanities by Tom Wolfe. The Big Short is a better story the Bondfire. I read it in two sittings. I was rooting, all through it, for the short sellers who got rich. Why? Because, although they are greedy gamers akin to their Wall Street big shot banksters, it was, for me, like wanting the unseeded player to win a golf or tennis tournament. I love underdogs. Now, I want to find a way to bring down the greedy banksters once and for all. Do I care how much money they make? Not in the least. What I care about is that they make their millions the Smith Barney old fashioned way: They earn it!! How could they earn it? By making useful contributions to both the national and international way of life in a transparent, albeit conventional way: by using the power of financial institutions to support productivity and innovation in the other markets beyond the financial world.

  36. Lucy Honeychurch

    Bravo! Nice post James. You sum it up perfectly.

  37. Lucy Honeychurch

    Innocent my ass. Willful ignorance is fraud. Try telling your local cop you didn’t stop at that light because you didn’t know a red light meant stop.

  38. Greenback – sorry you are absolutely dead wrong on CDS, there are plenty of perfectly legitimate hedging reasons to utilise them, and they DO increase liquidity not reduce it. For example consider the issue of a bank with too much exposure to Greece as a region. Do they sell down Greek assets and renege on loans to Greek corporations, creating a run on the country? At the moment instead of doing that they can buy CDS protection until their market risk guys are content again. People are focusing on completely the wrong issues. “Naked” CDS are not a problem, they are a complete red herring.

  39. After Long Term Capital Management went under and Greenspan – knew enough to bail them out, as we found out Greenspan knew nothing. In 2000 Bill Clinton knew nothing, now it seem all of the CEOs of the 13 Big Banks know nothing???
    I guess the Dumbing Down of America is complete.

    Do you honestly think these guys did not know give me a break, what they knew/know is that they are Greedy, they know that. They know they do not give a damn about their Clients, only their Client’s money.”Remember Buyer Beware”

    Are Americans so Stupid that they believe these College/MBA Grads, Life Long Wall Street guys did not know, of course the knew and they know that if it all falls down, they get Golden Parachutes, they know that for years preceding the fall, they have made 10s 100s of Million, for some Billions, so if it all falls down – guess what.

    They have their Real Estate broker run around and buy up foreclosed property with the Money they have in Switzerland.

    These guys never lose because they will never be held to account. If you think Obama or the Republicans will go after the guys at the Top your the Fool. (Oh the Democrats – they’re still looking for the Light Switch).