Maybe Wall Street is just stupid Hrush Nov 25, 2008

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Yesterday, I read what I consider to be the most lucid and well-written article about the current financial crisis — entitled, The End of Wall Street’s Boom, by Michael Lewis, author of Liar’s Poker.

We’ve recommended Michael Lewis’ excellent prose before and, with this article, the man demonstrates what makes him one of the best writers around today–sharp, witty and unforgiving. Lewis takes a narrative scalpel to the current financial crisis and peels back the onion to lay bare the fact: Maybe the denizens of Wall Street are just plain stupid. And greedy.

Bad combination, as it turned out…

To be fair, Lewis has never been a fan of Wall Street and he discloses this upfront with panache:

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. I�d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous.

It’s a longish article, but it’s well worth the time to understand the roots of the current financial implosion. And the writing is phenomenal:

I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility.

There’s a few more choice picks after the jump, but unless you’re really pressed for time, you should read the entire article.

The beginning of the end:

Then came Meredith Whitney with news. Whitney was an obscure analyst of financial firms for Oppenheimer Securities who, on October 31, 2007, ceased to be obscure. On that day, she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. It�s never entirely clear on any given day what causes what in the stock market, but it was pretty obvious that on October 31, Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of had shaved $369 billion off the value of financial firms in the market. Four days later, Citigroup�s C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.

The summary judgement:

Now, obviously, Meredith Whitney didnâ��t sink Wall Street… If mere scandal could have destroyed the big Wall Street investment banks, they’d have vanished long ago. This woman wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.

Running away from the herd:

There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria–to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded–without actually being insane. A handful of people had been inside the black box, understood how it worked, and bet on it blowing up.

The greatest line ever written by an analyst:

“The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “â��’The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after heâ��d delivered that line in his report, Lomas Financial returned to bankruptcy.

The mechanism of doom:

But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

The model that didn’t accept negative numbers:

But he couldnâ��t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And Iâ��d always get the same reaction. It was a smirk.” He called Standard & Poorâ��s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

Short Merrill:

“We just shorted Merrill Lynch,” Eisman told him.

“Why?” asked Hintz.

“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logicâ��the logic of Wall Streetâ��s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things.

The heart of the matter:

There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldnâ��t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! Thatâ��s why the losses are so much greater than the loans.”

Extinction:

This was what they had been waiting for: total collapse. “The investment-banking industry is fucked,” Eisman had told me a few weeks earlier. “These guys are only beginning to understand how fucked they are. It’s like being a Scholastic, prior to Newton. Newton comes along, and one morning you wake up: ‘Holy shit, Iâ��m wrong!’â��” Now Lehman Brothers had vanished, Merrill had surrendered, and Goldman Sachs and Morgan Stanley were just a week away from ceasing to be investment banks. The investment banks were not just fucked; they were extinct.