The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes. They were learning about this on the fly, shorting the bonds and then trying to figure out what they had done. [Steve] Eisman knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism. For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.
But he couldn’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 I’d always get the same reaction. It was a smirk.” He called Standard & Poor’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….
There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007. “The thing we couldn’t figure out is: It’s so obvious. Why hasn’t everyone else figured out that the machine is done?” Eisman had long subscribed to Grant’s Interest Rate Observer, a newsletter famous in Wall Street circles and obscure outside them. Jim Grant, its editor, had been prophesying doom ever since the great debt cycle began, in the mid-1980s. In late 2006, he decided to investigate these things called C.D.O.’s. Or rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an M.B.A., to see if he could understand them. Gertner went off with the documents that purported to explain C.D.O.’s to potential investors and for several days sweated and groaned and heaved and suffered. “Then he came back,” says Grant, “and said, ”˜I can’t figure this thing out.’ And I said, ”˜I think we have our story.’”‰”
Eisman read Grant’s piece as independent confirmation of what he knew in his bones about the C.D.O.’s he had shorted. “When I read it, I thought, Oh my God. This is like owning a gold mine….
Quite a piece from the author of Liar’s Poker. Read it carefully and read it all.
The essence of the problem is quite different than that proffered by Mr Lewis:
a) The US central bank, aka “The Fed,” held interest rates far too low, far too long. Easy, cheap money leads to clusters of stupid decisions and malinvestment.
b) Artificially low interest rates also drive a stampede for “yield” without regard to risk.
c) Nearly everyone assumed that “risk” in that world existed somewhere far out on the tail of a Gaussian (bell curve) distribution, and that potential blow-ups were expected only once every ten thousand years, or fifty thousand, or whatever.
d) Investors therefore clambered after yield they did not understand, and to boost that yield used significant leverage. In the case of the investment houses that cratered, such leverage was approaching 50 to 1. It works great, and you look like a genius as long as the trends run with you.
e) Unfortunately, “risk” in such situations (and basically [i]all[/i] living systems) tends to exist on what is known as a ‘power curve.’ Devastating deviations are vastly more common on power curves than on bell curves.
That’s how you get four or five “once in 50 thousand years” event coalescing in less than [i]five[/i] years. At which point all the leverage runs backwards, and sitting on two cents for every dollar of obligation somehow doesn’t look so smart anymore.