Michael Lewis takes a look at the financial crisis by way of revisiting ground trod in his book Liar's Poker, a tale of his years as an investment banker in the 1980s. It's a pleasant exercise. As well as offering a decently understandable explanation of the complex financial instruments that led to the crisis -- it is interesting, I promise -- he also gets to the heart of the matter: No one really knew what the hell was going on:
But he couldn’t figure out exactly how the rating agencies justified turning BBB loans [the worst-rated] into AAA-rated bonds [considered same-as-cash]. “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 [investor protagonist Steve] 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.
One really interesting thing Lewis takes up toward the end is that investment banks became a much more pernicious actor when they started offering stock for sale to the public. As managment and employees owned less and less of a company, perverse incentives are created to take bigger risk -- without the steady profit of ownership, bonuses become the best way to get paid a good deal. Lewis again:
The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith. No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.
This, then, is what we talk about when we talk about re-regulation, coming in January 2009 to a Congress near you.
-- Tim Fernholz
