Sunday, April 10, 2011

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.

1 comment:

  1. It really makes you wonder who you can trust....

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