All the Devils are Here

I recently read "All the Devils are Here" another book about the recent financial crisis by Bethany McLean and Joe Nocera. McLean was a coauthor (with Peter Elkind) of "The Smartest Guys in the Room" a book about the Enron debacle which I didn't particularly like . I thought this book was better. Although not as entertaining as the Michael Lewis book, "The Big Short", (which I read shortly before reading this book) it is wider in scope. And even more than the Lewis book it brought home to me just how bad the conduct of the rating agencies was. The rating agencies are often slow to react when a security they have rated starts to go bad sometimes waiting until a company is on the verge of bankruptcy to downgrade its securities. This is not good but is somewhat understandable as the agencies are being paid for the initial rating and keeping the ratings up to date for the life of the security is a lot more work. However the results of the agencies reluctance to revise their initial ratings downward were truly perverse when it came to rating synthetic mortgage securities whose components were already existing (and rated) mortgage securities. Wall Street found creating these synthetic securities profitable because the long side could be sold for more than the payment required to get speculators (like those in the Lewis book) to assume the short side. The long side was attractive to naive buyers because the rating agencies would give it a good rating. The short side was attractive to speculators to the extent that the ratings were obviously inflated. The ratings were obviously too high because it was the policy of the rating agencies not to revisit the ratings of existing mortgage securities even when they were included as components in newly created synthetic securities for which a new rating was being requested. So by including existing mortgage bonds which were obviously overrated (because the observed default rates on the underlying mortgages were much higher than the expected rates used to generate the original rating) but which the agencies had not downgraded one could create synthetic mortgage bonds which the agencies would rate highly but that a informed speculator could tell were very likely to quickly default and hence were actually worth little. So Wall Street firms like Goldman Sachs created such securities (sometimes with the assistance of shorts), obtained inflated ratings on them from the rating agencies, used these ratings to sell the long side to naive buyers and passed the proceeds (minus their cut) on to the speculators assuming the short side. The securities quickly went bad, the buyers lost most of their money and the shorts made a fortune. It is difficult to overstate the degree of willful stupidity on the part of the rating agencies that this required. And it is dismaying that they have suffered few ill effects from it.

The book has some faults, some subjects were treated more kindly than others in a way that left me wondering if this had more to do with how helpful they were to the authors than how culpable they were. And the book ends rather abruptly with the collapse of Lehman Brothers, some coverage of subsequent events would give a more complete picture of what happened.

In summary I think this is a better than average account of the roots of the financial crisis but I am hoping a more definite account will eventually be written after more of the dust has settled.

The Big Short

I recently read "The Big Short" by Michael Lewis. It tells the story of some of the people who were able to foresee the end of the housing bubble and made a lot of money shorting (or otherwise betting against) mortgage backed securities. I thought it was pretty good.

In part this is simply because I find Lewis an entertaining writer, I also quite liked two of his previous books, "Liar's Poker" and "Moneyball". And I find the idea of making a lot of money by seeing through a bunch of lies appealing. However I also thought the book was an instructive, albeit somewhat narrowly focused, account of the recent financial crisis. It left me feeling I understood aspects of what had happened a bit better.

One of these aspects was the effect of misratings by the bond rating agencies like Moody's. These agencies were giving inflated ratings to complicated mortgage securities which naive buyers foolishly trusted. It was if the agencies were declaring $5 bills to be worth $10 and this allowed them to be sold for $10. Obviously this allowed the Wall Street firms assembling such mortgage securities to profit, and the larger the discrepancy between the agency ratings and the true values the larger the profits. So this encouraged the creation of the most misvalued mortgage securities. So much so that there was a shortage of actual lousy mortgages to assemble into these overvalued mortgage securities. However Wall Street got around this by constructing synthetic mortgage securities using credit default swaps. A credit default swap is like insurance on a bond, in exchange for periodic premiums you are paid off if the bond defaults. So selling credit default swaps (or writing such insurance) is like owning the bond you get periodic payments but lose a lot of money if the bond defaults. So by selling credit default swaps on overvalued mortgage bonds to mortgage market bears (like the people portrayed in this book) the Wall Street firms were able to construct the equivalent of these overvalued bonds which the bond rating agencies would again bless and which could also be sold at inflated prices to naive buyers.

Another aspect was just how foolish these buyers were. Wall Street firms obtain their largest profits by taking advantage of their customers. Wall Street firms like complicated and illiquid securities because it is easier to sell them at inflated prices. So any naive buyer should never buy anything but the simplest, most liquid, most straightforward securities as otherwise they are almost certain to overpay.

There is a bit of a danger with an entertaining writer like Lewis that you will give undue credence to his point of view simply because he is such a good story teller. Lewis has been criticized along these lines but for the most part I think his books get the big picture (if not every detail) correct.

This book does portray its subjects sympathetically. One them was a hedge fund manager, Michael Burry. Many of Burry's clients were upset with him for using what they thought was to be a stock picking fund to make a massive bet against mortgage backed securities. Although this bet eventually turned out very well the clients were not actually being all that unreasonable in objecting.

In summary I liked this book quite a lot. However if you don't already know a bit about financial markets you may find it a little confusing in places and it is not a comprehensive account of the crisis.