Michael Lewis writes a very interesting account of the bond business in his best-seller, The Big Short. I had a chance to read most of it over the weekend, and I come away from the book with a much better understanding of how subprime mortgages were securitized, packaged, sliced and sold in the bond market.
It is amazing to read about the advent of the credit default swap. It is amazing to think companies such as AIG could sell these things with no capital to back them. Lewis tells a story of an entire industry that was completely blinded by its own success.
Lewis describes bond salesmen as the lowest form of human life. Unlike equity salesmen, bond salesmen deal almost exclusively in a institutional environment with little transparency and little regulation. I would invite you to think back to 2002, 2003, 2004, in that time frame. Who were the bond salesmen you were dealing with? Were they selling CMOs? When they started to call them CDOs did they explain the difference? Could they explain what they were selling in a way you could understand?
The other group of people who really get skewered in this book at the rating agencies. Lewis explains that these folks were completely asleep at the wheel. Even when they were awake, they must have been blind because when people attempted to show them how bad the assets were behind some of these mortgage-backed securities, the agencies refused to take notice.
The Big Short is a natural companion book to Panic, the book I recommended earlier by Andrew Redleaf and Richard Vigilante. In fact, Whitebox, the investment fund run by Redleaf, is mentioned favorably in Lewis’s book.
I am finding it very instructive to think about what happened to our financial system in 2008-2009. Next week, a book called “Panic: The betrayal of capitalism by Wall Street and Washington” will be released. Written by a friend of mine, Richard Vigilante and his colleague Andrew Redleaf, this book really puts the events of the last two years into perspective.
The authors write about securitization, noting that one of the significant features of a pool of mortgages is that it free investors from having to consider the individual merits and demerits of particular mortgages. “The investor in a mortgage-backed security, in theory, does not need to know anything about Bill’s mortgage or Bob’s mortgage or whether Bill drinks or Bob is about to lose his job. Mixed into a pool, Bill’s and Bob’s mortgages simply become part of an ‘asset class.’ The creation of a class of investments that will behave in statistically predictable ways excludes the need for judgment of particular cases.”
The authors go on to explain how such thinking led to big problems. Even more importantly from my perspective, is the way in which this kind of securitization attempts to minimize the need for human judgment. In my opinion, the very essence of successful American capitalism is the careful judgment exercised by great entrepreneurs since the advent of the Industrial Age.
I was further intrigued recently reading Henry Paulson’s new book, “One the Brink: Inside the race to stop the collapse of the global financial system.” Paulson, the former U.S. Treasury Secretary, shares his account of the events of 2008 in an interesting book released Feb. 1. Here is what he writes on pages 68-69:
Lacking the ability of traditional lenders to examine the credit quality of the loans underlying these securities, investors relied on rating agencies — which employed statistical analyses rather than detailed studies of individual borrowers — to rate the structured products…
The drive to make as many loans as possible, combined with the severing of the traditional prudential relationship between borrower and lender, would prove lethal.
The lesson? No matter how you package a loan, you still have to assess the quality of the borrower. Ability to repay is important no matter how many times you slice and dice, sell and resale the loan.