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Wednesday, March 31, 2010

Preview of The Big Short by Michael Lewis

I remember a few years ago, before the economic bubble burst, when everybody became an expert on real-estate. People I knew quit their jobs as clerks & forklift drivers to become mortgage brokers, appraisers, and real-estate agents, eager to join an exploding industry. A couple of buddies of mine even started a business in "house-flipping," which is buying an undervalued house (usually at auction), quickly fixing it up, and putting it back on the market at an inflated price.

I also remember constantly hearing what became a truism for these people: "You always want to buy more house than you need." And the underlying assumption here -- that the real-estate market, like the stock market, was only ever going to rise -- was symptomatic of the bubble we were living in. Thankfully, this was advice I ignored (not through wisdom, I admit, but because I was no position to buy a house at all).

However, I know far too many people who bought more house than they could afford or who used the over-inflated market to turn what equity they had in their homes into ready cash. Now, some have lost those homes, doing damage to both their credit and their lifestyles. Others have refinanced to the point that they are now paying for mortgages that are substantially higher than the worth of their homes. As of this writing, the state of Nevada has the nation's highest rate of foreclosure, according to the Las Vegas Review-Journal.

In 2008, the bubble burst, leading to the worldwide recession we are currently mired in. The U.S. economy is still shedding jobs, and, even though Wall Street has received substantial help from the federal government, the rest of us remain financially depressed.

How did this happen?

Michael Lewis, a writer of great talent & insight, has written The Big Short: Inside the Doomsday Machine as a kind of explanation, telling the story of how a small group of people, as early as 2005, recognized the coming financial crisis and managed to get rich because of it.

As of now, I have not actually read Lewis's book, although I am a fan of his previous books, which include Liar's Poker and Moneyball and The Blind Side (which, yes, became the movie that got Sandra Bullock her Oscar). But I am writing about the book because, in the past week or so, I have seen & heard Michael Lewis appear on several shows, and what he has said on those shows has really gotten me thinking.

For instance, over the past several years, I have heard many explanations of how the world got into the financial mess it's currently in, but Mr. Lewis said it best when he was talking to The Motley Fool podcast on March 24:
"The nutshell answer is Wall Street created a credit-laundering machine without completely understanding what it was doing. So all these people in America needed to borrow money. Given the opportunity to borrow money, they welcomed it. They didn't think twice about it. And the lenders lent them money, and they were very risky loans, of course. And Wall Street went about disguising the risk of these loans, and, in the end, they disguised the risk even from themselves. It's a long and complicated tale how they did it, but that's the nutshell."
This explanation jibes with my own anecdotal experience. In about 2006, an acquaintance of mine got a mortgage on a house without supplying any proof of income or credit. He just signed a statement that, yes, he had a job and a bank account. Presto, he bought a house (or, to be more accurate, he took out a mortgage). He joked that it took more paperwork for him to donate blood.

Now, as we live in the shambles created by the bursting of the financial bubble, there is a completely naturally groundswell of anger at those who are perceived to have swindled us. I have been in conversations where prison terms were proposed for the "Wall Street crooks who got us into this mess!" Remember, these remarks come from people who have lost jobs and/or equity, but Michael Lewis has been quick to point out that the mistakes that caused the recession don't really rise to the level of criminality. This is what he said to the PBS Newshour:
"This is less a story about systematic criminality than it is a story of systematic misperception. You had these facts in the financial world, and you could arrange them into different kinds of pictures. And the financial system arranged them into a pretty picture, but it was a false picture. And the question is why it did that. And it did that because there were incentives not to see the world as it was. I mean, people were being paid a lot of money to ignore some pretty basic simple things that were right under their noses."
Mr. Lewis has hit upon a basic fact of human nature that most people acknowledge is true about everyone except themselves -- a truth about all of us that we would be best served to keep in mind whenever we open our mouths. It's a truth that explains every financial bubble from the Dutch Tulip Craze of 1620 to the Dot-Com Bubble that ended in 2000 to the current mess we're in. Again, I quote Michael Lewis, this time from the March 16, 2010, episode of Fresh Air:
"This is why I think this is a story about human perception as much as anything else: I think people see what they're incentivized to see."
So, we can blame Wall Street all we want for the current recession, but the fact is that almost none of us was complaining when easy credit made us all feel like financial moguls. We were "incentivized" to see that housing prices and the stock market were only ever going to rise. The Big Short tells the story of the few people who saw easy credit for the trap it was.

The scary thing is that, as of now, we have done almost nothing to prevent another, similar recession from happening not only again but soon. There are scattered rumblings in the news that the state of commercial real-estate is much worse than anything that has happened in residential properties, which makes me wonder if another TARP will be needed once the extent of the toxicity of those assets comes to light. After all, it took over a year for investigators to parse the misdealings that undid Lehman Brothers. (And now, according to the New York Times, the SEC is inquiring about similar practices at other firms. As Robert Reich says in a blog post entitled, "Fraud On The Street," "Where on earth has the SEC been?") 

Interestingly, in interviews with both Terry Gross of Fresh Air and Jon Stewart of The Daily Show, Michael Lewis has had to defend the moral stature of the people he writes about in The Big Short. Both Ms. Gross and Mr. Stewart seemed to imply that the practice of short-selling securities (and, specifically, the practice of buying credit default swaps) is inherently destructive, perhaps reacting to the common perception that such instruments "bet against" the success of the financial market.

Mr. Lewis countered those implications by asserting the instructional value of instruments like credit default swaps, as he said on The Daily Show:
 "The people in Wall Street firms actually forgot that they'd rigged the market. And the people who bet against these things are important because they create the only incentive in the system to bring bad news into the system."
"Bad news" is valuable, especially when good news proves to be just so much hot air. And the bearers of the bad news in The Big Short are such an interesting gallery of characters that I really cannot wait to dive into the book itself. As Mr. Lewis told the NPR show Wait Wait Don't Tell Me:
"There was this collection of oddballs and misfits who had bet on the collapse of the financial markets, and those are the main characters of this book. They had a view that was at variance with the entire financial system, and, if you want to have variant views, it helps to be variant."
Being one myself, I am a sucker for variant characters, especially ones whose outsider viewpoints made them millions of dollars while the rest of us stood around, wondering what the hell happened.

As soon as I finish The Big Short, I'll let you know how it is. I have high hopes.

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