The Great Read-cession, Part II

Too Big To FailIt’s Part II of John’s attempt to read every single book on the financial crisis of 2008. Check out Part I here if you missed yesterday’s introduction. Today we talk about the two most famous books the crisis produced.

Too Big To Fail: The Inside Story of How Wall Street and Washington Fought to Save The Financial System—And Themselves*

by Andrew Ross Sorkin, 2009


*See? I warned you about those subtitles…

The first book I read was probably the most famous book on the subject of the financial disaster. Sorkin’s book was an award-winning best seller, and it was adapted into an HBO film. It also has the most iconic name.

It’s easy to understand why TBTF was such a hit: The book is essentially a thriller, depicting the days and months of greatest turmoil. It’s not so much about the causes of the crisis as it is about the disastrous results.

Sorkin embraces the thriller-quality of his narrative, and he does it very well. The book is excellent at setting scenes and introducing a myriad of characters. His scenes are short—rarely more than two pages long—and colorful, with lots of detail and dialogue. Although there are over 150 people introduced (there is a helpful eight-page Cast List in the front of the book), Sorkin does an excellent job of making them all seem unique—a difficult task, since almost all are rich, middle-aged white guys. He includes just enough backstory to provide context and make them seem like real people, without weighing down his narrative.

The narrative begins in March 2008, with the bailout of Bear Stearns. Sorkin doesn’t spend much time on the specifics of that deal—in which the Fed guaranteed $30 billion of assets in exchange for JP Morgan buying the firm for $2 a share*—but instead focuses on the ripple effect of the deal. There is some irony, of course, in this ripple effect: The main reason the Fed intervened in the Bear Stearns failure was to prevent the failure from infecting other firms. Instead, all the Fed did was replace one ripple effect with another.

*Those numbers would both be revised in later weeks: In exchange for bumping the price up to $10 per share, JP Morgan agreed to accept the first billion dollars of losses.

The first half of TBTF deals primarily with the chain linking the fall of Bear Stearns to the fall of Lehman Brothers. After Bear failed, the market immediately started to look for the next investment bank to fail; Lehman, often referred to as “a bigger Bear” was an obvious choice. Dick Fuld, Lehman’s CEO, thought of this as a witch-hunt; in scene after scene, he is blaming short sellers for his stock’s poor performance, or refusing to reevaluate the firm’s suspect real estate assets, or denying any problems at all with his company’s suspect accounting practices. Although Hank Paulson warned him repeatedly to raise capital, Fuld refused terms for investments from Warren Buffett and the Korea Development Bank.

Meanwhile, the firm’s stock continued to plummet, and the bank’s liquidity got lower and lower.* Most of the summer was spent trying to sell the bank, with Fuld again refusing the terms from any potential buyer. Fuld became such an obstacle to Lehman that, by the firm’s final weeks, his employees were not telling him about possible deals and not inviting him to negotiations. He was nothing but a feckless figurehead, kept around only because firing him would scare off investors.

*This crisis of liquidity—companies simply not having enough cash—would be a major contributor to pretty much every financial institution failure in 2008.

Sorkin subtly underscores the dark humor of situations like this without intruding too directly. There are lots of sources of humor, which helps make the story bearable as it gets scarier: The second half of the book describes how the failure of Lehman rippled through the entire financial system. There are scenes that perfectly illustrate how little those involved knew how to deal with the situation. In one, Tim Geithner, who was then the head of the New York Federal Reserve, wakes up early on the Saturday after Lehman’s bankruptcy, concerned that Morgan Stanley and Goldman Sachs may not be able to fund their businesses on Monday morning. His ad hoc solution is to merge them, but he doesn’t know with whom yet:

“On a pad that morning, Geithner started writing out various merger permutations: Morgan Stanley and Citigroup. Morgan Stanley and JP Morgan Chase. Morgan Stanley and Mitsubishi. Morgan Stanley and CIC. Morgan Stanley and Outside Investor. Goldman Sachs and Citigroup. Goldman Sachs and Wachovia. Goldman Sachs and Outside Investor. Fortress Goldman. Fortress Morgan Stanley… It was the ultimate Wall Street chessboard.”

I don’t think Sorkin is actually trying to be ironic with that last sentence—I think he wants us to view this as a cunning act of a crafty financier—but it is hilarious. The idea of someone trying to avert a national banking disaster by writing out random pairs in a notebook like some high school girl trying out prom dates is scary. The idea that this somehow makes him Bobby Fischer is laughable: Wachovia, one of the banks Geithner writes down as a possible savior for Goldman Sachs, would be seized and sold by the FDIC eight days later. Nevermind that Geithner was not an actual employee or adviser to any of the banks he was trying to sell off…

In general, Sorkin does a great job of letting small details like this one say a lot. Of course, he can get a little bit indulgent. At one point, in describing a meeting between all the Wall Street CEOs, he invokes the Battle of Salamis:

“On this day the bankers assembled at the Fed had their own historic battle to wage, with stakes that were in some ways just as high. They were trying to save themselves from their own worst excesses, and in the process, save Western capitalism from financial catastrophe.”

Yes, the meeting in which the Fed decided to not bail out Lehman Brothers truly was just like when vastly outnumbered Greek forces repelled Persian invasion and preserved Athenian independence.

In fairness, most of Sorkin’s hyperbole is not nearly that egregious, but there is a disturbing sense that Sorkin finds every detail not just colorful, but really important. And why? Because these guys are really rich. Sorkin includes scores of lavish displays of wealth, from Joe Gregory’s morning helicopter ride to work to John Thain’s infamous bathroom expenditures. Often these details are included to highlight the absurd levels of compensation on Wall Street, but there are also times when it reads like a kind of wealth porn. The glamour provides vicarious excitement and serves to inflate the importance of what’s transpiring. If these people live like kings, then they must be as historically important as world leaders. Or so the thinking goes.

The scenes at the New York Fed are certainly the most iconic in the book, though the comparison that came to my mind was less the Battle of Salamis and more the meeting of the heads of the Five Families in The Godfather. On two separate occasions, the heads of the biggest banks in the world were summoned to meet with Hank Paulson and Ben Bernanke; like the scene in The Godfather, there was a lot of talk about “the common good” and the “fair thing to do,” while everyone was looking out for the interests of his own institution.

The first meeting at the Fed was called to help save Lehman Brothers. The decision to let Lehman go bankrupt—as opposed to bailing it out, as the government had done for Bear—is possibly the most controversial one of the entire crisis. Lehman’s bankruptcy is seen as the moment when the crisis went from a recession of above-average severity to a worldwide disaster. The event serves as shorthand for the moment when the shit hit the fan—President Obama even used the recent five-year anniversary for a speech on the economy—and many prominent figures blame the government for exacerbating the crisis by letting the bank fail.

Since the fall of 2008, the official position of Bernanke, Paulson, Geithner, and everyone involved in the decision has been that the government simply had no choice but to let Lehman fail. Unlike the situation with Bear Stearns, there was no buyer for the government to assist, and unlike the situation with AIG, Lehman had no assets for the Fed to lend against. As a result, there was simply no legal method for saving Lehman.

TBTF makes it very hard to accept this logic. For one, the idea that the law presented any real impediment to the government during the crisis is kind of silly. Treasury and the Fed were constantly operating in legal gray areas, stretching the meaning of phrases like “exigent circumstances” and “banking institution.” When they weren’t authorized to do something they felt they needed to, they simply went to Congress and demanded the authority (which it inevitably gave).

Also, the logic the government used was never consistent. In the immediate aftermath of the bankruptcy, Paulson stressed the importance of avoiding moral hazard, insisting that repeated bailouts would encourage excessive risk. In other words, it wasn’t that the Treasury couldn’t bail out Lehman, it was that doing so would have been bad policy. It was only later, when public opinion turned on the decision, that the reasoning was retroactively changed.*

*The retroactive changing of the decision’s justification is just one of many similarities between this crisis and the invasion of Iraq.

Finally, the idea that there was no buyer for Lehman is extremely misleading. It was technically true at the moment Lehman failed, but various institutions, including Bank of America and Barclays, had been willing to buy the bank—with government support—before that. On the Thursday before the bankruptcy, Ken Lewis of BofA called Paulson to tell him that he could only buy Lehman with government assistance: “But Paulson still wasn’t prepared to resort to drawing on federal money…. It was politically unpalatable, especially with the Fannie and Freddie bailouts still making headlines.” In other words, it was the bad publicity, not the law, that prevented a deal from being made. As Paulson himself put it, he didn’t want to be “Mr. Bailout.”

In a final blow of ineptitude, the Wall Street heads who had been summoned to save Lehman nearly came up with a private consortium to fund a non-governmental bailout. The consortium would purchase Lehman’s bad assets while the rest of the firm would get sold to Barclays. Unfortunately, nobody ever checked with the British bank’s regulator, so the deal fell through at the last minute.

The Wall Street CEOs would be summoned to the Treasury building in Washington, D.C. six weeks later. This time it would be to discuss the recently passed TARP bill.* Although the bailout was originally designed to buy toxic assets (hence the name), Treasury quickly realized that would take too long. Instead, they decided to just give the banks cash.

*Sorkin has a nice scene in which Treasury officials calculate how big the TARP bill should be:

“What about $1 trillion?”

“We’ll get killed.”

“Okay… How about $700 billion?”

“I don’t know. That’s better than $1 trillion.”

The greatest financial minds on the planet…

The CEOs were furious that the government was going to hand them billions of dollars with no strings attached. Seriously. Most of them didn’t want to take it, fearing that doing so would stigmatize their banks. John Thain, CEO of Merril Lynch, asked the first question: “What kind of protections can you give us on changes in compensation policy?” Eventually, all the banks gave in, after essentially being ordered by the government to accept billions of dollars.

The conclusion of Sorkin’s narrative, then, is appropriately absurd, and morbidly funny. Although the book does not really go into the causes of the crisis, it is a great, thorough recap of the chain of events in 2008. Perhaps just as importantly, it provides a broad psychological profile of the way Wall Street works. It’s only when you’re acquainted with the perverse logic of the financial industry that the rest of the story makes sense.

The Big ShortThe Big Short: Inside the Doomsday Machine

by Michael Lewis, 2010


If any financial crisis book is more famous than Sorkin’s, it’s The Big Short. Author Michael Lewis is a literary celebrity whose books get made into Oscar-nominated movies, so it’s no surprise that The Big Short was a bestseller. But he’s also one of the best living writers, and Wall Street is the subject that gave him his start, so he turns out to be a good storyteller for this complicated but intriguing topic.

I don’t foresee The Big Short getting made into a film, but the story certainly has heroes. This is noteworthy on its own, since most books in this genre tend to be about failure and ineptitude. Unlike most financial-crisis books (including Too Big To Fail), which detail how firms and CEOs made disastrous decisions that led to economic ruin, Lewis’ book tells the story of the people who foresaw the disaster and bet against it.

Lewis covers a lot of people who bet against the housing bubble, but the two figures he is most interested in are Steve Eisman and Michael Burry. Eisman and Burry are both, to various degrees, Wall Street outsiders. In a sea of stories about a bunch of successful, middle-aged, white, male bankers from New York, these two stand out. Some of that is because they are both truly compelling figures, and some of it is obviously because of how Lewis brings them to life.

In a Wall Street world characterized by charm and cunning, Eisman is a slob with meager social skills and a streak of righteous indignation. Typically an investor in stocks, Eisman started doing research into companies specializing in subprime loans. Eisman couldn’t figure out how these companies kept granting more and more loans to customers with shakier and shakier credit—actions that made no sense when interest rates were rising. Eventually, he started to recognize that these companies were just selling their loans to banks, where they were packaged into CDOs.

This led Eisman and his team down the nefarious rabbit hole of fixed income trading.* As they learned more—about how poorly the rating agencies were at evaluating the bonds, about how little investment firms knew about the contents of various CDOs and other instruments, about how manipulative a lot of the mortgages really were—Eisman became convinced that this bubble would crash.

*TIMEOUT: To a layman, the difference between a stock and a bond is negligible. They’re both things rich people invest in. But in the world of investment, they are super different. I was not aware of just how monumentally different these worlds are until I read Liar’s Poker, and this endeavor only amplified it.

For one, stocks (a/k/a “equity”) and bonds (a/k/a “fixed income”) are traded by totally different people, and asking experts in one to be experts in another is like asking Albert Pujols to pitch. So for Eisman, an equity investor, to start learning about the fixed income world is only slightly more natural than, say, Miley Cyrus trying to study bonds.

Also, the world of bonds is much bigger and much more secretive than the world of stocks. Everybody, of course, is vaguely aware of the stock market. We know when the Dow has a bad day, or if Facebook is going public, etc. It’s also very easy to own stock. You can buy many stocks for less than a dollar, and many people own only “a little” stock. Bonds don’t work this way. You can’t really buy bonds—which, for the most part, are not traded on exchanges—unless you are investing huge sums of money.

As a result, the vast majority of profits at big banks come from bonds. The lack of transparency in the bond market makes big banks essential to it. It also helps explain why virtually all of the problems leading to the crash stemmed from the bond market.

Beyond that, though, he became convinced of the moral turpitude of Wall Street. Unlike most investors, Eisman kept wondering how all of these instruments benefited actual homeowners, and he could never figure it out; he became convinced that they were really just ways for banks to squeeze profits out of unsuspecting buyers. He went to conferences and meetings to try to convince people that he was right and the rest of the industry was wrong. As Lewis puts it,  “it was more than an argument…. It was a moral crusade.”

In one vibrant scene, Eisman meets Wing Chau, a CDO manager, at a banquet. “I had no idea there was such a thing as a CDO manager,” Eisman explains to Lewis. “I didn’t know there was anything to manage.” As Chau told him what a CDO manager manages, it became clear to Eisman that Chau’s only real job was to buy slices of bonds that banks didn’t want on behalf of institutional investors who didn’t know any better. Chau even admitted that he didn’t care about the quality of loans, since he got paid based on the size of the CDO and not its quality. By the end of the meeting, Eisman told his banker he wanted to short* whatever loans Chau was buying, sight unseen.

*TIMEOUT: It’s not always clear what it means to “short” something, but since it’s in Lewis’ title, now seems like a good time to review: Generally, it refers to any investment where you expect the value of an asset to decline, but the way it’s done can vary. For a stock, it’s usually pretty simple: You borrow the stock from a dealer, and sell it at the current price, with the expectation that you’ll replace the stock later on. If the price falls, then you’ve profited the difference.

For a bond, though, it’s trickier. This essentially is where the credit default swaps (CDS) come in. A credit default swap is what it sounds like: a swap on the risk of a default. Suppose you lend your friend $100, and you expect him to pay you back in a month. But then he loses his job, and you start to worry whether you’ll see that money again. A second friend comes in and says, “Don’t worry: Give me $10 right now and, if he doesn’t pay you back at the end of the month, I’ll give you $100.” That’s a credit default swap: You and the second friend have swapped the risk of default.

From a practical perspective, this type of agreement makes sense: No matter what, you’ll get $100 at the end of the month. And if the original borrower pays up, then your second friend has made an easy $10. Of course, the swap also serves as a way to bet against someone’s ability to repay debt. In the example, you have essentially bet $10 on the fact that your friend won’t pay up.

Now suppose you could make the same deal, but WITHOUT lending anybody any money in the first place. In that case, you’d be on the short side of a bond, which is exactly what Eisman did.

Scenes like this, coupled with Eisman’s personal investment in the issue of subprime loans, sometimes make Eisman seem like an arrogant jerk. As Lewis puts it, “His bets against subprime mortgage bonds were to him more than just bets; he intended them almost as insults.” Still, Eisman was right, and his concern for the true victims of the crisis—the homeowners—never comes off as phony. By the end of the crisis, Eisman’s vindication had become so complete that he seemed to regret some of his belligerence towards those who had disagreed with him. After insulting the CFO of Merrill Lynch, for example, Eisman said, “I felt bad about it…. He was a lovely guy. He was just wrong.”

Compared to the story of Steve Eisman, Lewis’s parallel story of Michael Burry is less triumphant, and (not coincidentally) even more interesting. Burry, like Eisman, came from the world of equity, but Burry was even more out of step with the rest of Wall Street: He got started in investing by posting on an online thread during his spare time as a neurology resident at Stanford Hospital. Eventually his advice led to a $1 million dollar investment from Joel Greenblatt, and Burry started his own hedge fund.

Like Eisman, Burry suffered from poor social skills, but while Lewis portrays Eisman as harmlessly quirky or charmingly aloof, Burry comes off as a kind of lone-suffering genius. He was misdiagnosed as bipolar as a kid; his first wife left him; he says at one point that “he thought of himself as the sort of person who didn’t have friends.” In the course of the book, Burry’s son gets diagnosed with Asperger’s, at which point Burry realizes he exhibits all the same symptoms.

Of course, Burry’s behavior had its benefits, one of which is his ability to immerse himself in a subject—like, say, subprime mortgage bonds. Burry started reading the ~130-page prospectuses that came with every bond, even though he was “certain he was the only one apart from the lawyers who drafted them to do so.” As a result, he could see through the shorthand details most investors used to evaluate the bonds: the average FICO scores, the loan-to-value ratios, etc. Unlike most investors, Burry could see that the types of loans themselves were changing: interest-only adjustable-rate loans, or negative amortization loans, were making up a larger and larger percentage of the bonds.

He was convinced that the loans would go bad, so he did what Eisman did: He bought credit default swaps on mortgage bonds. Tellingly, the banks that sold him these swaps didn’t care which bonds he bet against: “From their point of view… all subprime bonds were the same.” Burry, then, could cherry-pick the bonds with the most bad loans.

Unfortunately, this tailoring made Burry reliant on the firms who sold him the swaps. Since there was no real “market” for the swaps he invented, he had to accept whatever price the banks gave him. So even as the evidence in favor of Burry’s position piled up—subprime lenders going bankrupt, CDOs experiencing higher rates of default, etc.—the banks insisted that Burry’s bets were losing money.

Meanwhile, his investors got restless. Burry, an equity investor, was pouring more and more money into an investment that wasn’t his area of expertise, that nobody on Wall Street agreed with, and that kept losing money. When investors threatened to pull money from the fund, Burry side-pocketed the investment—a loophole which allowed him to keep the money while a market was temporarily malfunctioning. Of course, this only made his investors angrier, and some threatened to sue, including Joel Greenblatt.

Though Burry’s certainty never wavered, he grew increasingly alienated from his investors and the world around him. He felt depressed and sick, and he’d lock himself in his office and listen to heavy metal music. Even the ultimate validation of his position—in 2007, his fund made a profit of over $720 million on a portfolio of less than $550 million—didn’t make him happy: “Even when it was clear it was a big year and I was proven right, there was no triumph in it…. Making money was nothing like I thought it would be.” None of his investors apologized, or even thanked him; most withdrew their investments after Burry lifted his side-pocket. Eventually, Burry shut down his fund and now manages money only for himself.

Ultimately, then, Lewis’s story is a strange one: a triumphant tragedy. Though his subjects are vindicated in the end, Lewis is clear that there is no real happy ending. That Eisman, Burry, et al., were so right only highlights how wrong everyone else was; for every Cassandra, there’s a Trojan War. And the difficulty they faced only demonstrates how inefficiently investors did the one thing they were supposed to do: find value. The figures Lewis highlights are certainly exceptional, but we’d all be better off if they were the rule.

One response to this post.

  1. […] « The Great Read-cession, Part II […]


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