The financial crash of 2008 surprised almost everybody—the investment banks, the government, and the Federal Reserve, not to mention millions of American homeowners. In The Big Short, Michael Lewis tells the story of a handful of investors who saw it coming, who read the tea leaves in the mortgage market, recognized that it was unsustainable, and decided to bet against the system. They earned hundreds of millions of dollars off one of the worst economic collapses in history.
Lewis dives into the underworld of mortgage backed securities (MBS), collateralized debt obligations (CDO), and credit default swaps (CDS), explaining them all in incredible detail. Despite the technical discussion, if you stick with it Lewis rewards you: he manages to weave a story so fascinating that it reads like a thriller novel. I devoured it in just a few days.
There were a lot of players involved in the system, some who knew what was going on (to a degree), and others who were just cogs in the machine with no understanding of its inherent fragility: the banks that realized they could originate crappy loans and sell them on the secondary mortgage market; the ratings agencies (S&P and Moody’s) who competed against each other to get paid by the investment banks to rate their products highly—and thus did so without appropriate understanding or incredulity; the investment bankers who packaged up sub-prime loans into securities and got them rated as AAA assets that were considered to be literally risk-free when they were actually ticking time bombs; the same bankers who sliced and diced those securities even further and managed to turn the very worst of the sub-prime turds into seemingly shiny gold; the very small group of traders and investors who scoured prospectuses and other esoteric financial documents to discover that the emperor had no clothes, and so decided to buy up the equivalent of insurance that would pay out if (when) the markets crashed.
One hedge fund manager, who had gained respect with his genius stock picks, stumbled onto the sub-prime problem and bet against the market. The problem was that he couldn’t get anybody to understand what he was doing, angering his clients who thought he was destroying their capital and almost giving him a nervous breakdown. When the chips fell and he ultimately won them billions, literally nobody called him to congratulate him or apologize for doubting. He almost had a nervous breakdown and shuttered his fund shortly thereafter.
Three guys with zero investment experience somehow stumbled into an understanding of the state of the market. The problem was, they were novices, and none of the “experts” grasped what these guys were seeing, so they kept second-guessing themselves. Ultimately, however, they bet big and won even bigger.
Reflecting on the financial crisis in the 1980s, to which he had a front-row seat, Lewis writes:
"The market might have learned a simple lesson: Don’t make loans to people who can’t repay them. Instead it learned a complicated one: You can keep on making these loans, just don’t keep them on your books. Make the loans, then sell them off to the fixed income departments of big Wall Street banks, which will in turn package them into bonds and sell them to investors." (23-24)
To be fair, some of the Wall Street folks operated the way they did because they simply hadn’t worked in an environment when real estate wasn’t increasing in value; they were short-sighted, to be sure, but not nefarious. But there were plenty of others looking to screw over poor Americans by giving them loans that could never be justified by their credit history or annual incomes, enticing them with “teaser” interest rates that would skyrocket in a couple years and force them to either default or refinance—the latter of which would bring in new profits from fees. As long as the market continued to go up, the house of cards stood. The system became so overleveraged that the whole thing could potentially crash not because of an actual drop in market value, but simply a decrease in the rate of growth!
Because the government bailed everybody out (except Lehman Brothers, that is)—even those who didn’t need it—Lewis points out that the distinguishing characteristic of this financial crisis is that none of the worst players were punished. CEOs who oversaw debilitating losses stayed employed or left with huge bonuses; one Morgan Stanley trader lost $9 billion all by himself, and walked away with millions.
Lewis doesn’t attempt to explain the fundamental reasons for the build-up and crash. The closest he gets is to disagree with his former boss (and a former investment bank CEO), John Gutfreund, who thought the cause of the financial crisis was “simple”:
'Greed on both sides—greed of investors and the greed of the bankers.' I thought it was more complicated. Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed.
He comes so close, but doesn’t seem to want to dig for “the incentives that channeled the greed.” The answer, as best I can figure, is this: Pressure by the federal government (beginning in the 90s) to drastically degrade lending standards in pursuit of reducing poverty and increasing home ownership among the poor, combined with cheap money from the Federal Reserve and an implicit guarantee of Fannie Mae, Freddie Mac and even the “too big to fail” corporations. The U.S. government was the root source of the moral hazard that enticed the financial markets to systematically pillage the American economy. This fiasco is a resounding affirmation of economist Henry Hazlitt’s warning about watching out for the unintended consequences of policies undertaken in good faith and benevolent intent.
So what is the best way to discourage [a company like] Goldman Sachs from taking foolish risks that will lead to its bankruptcy? Two main alternatives: (1) the federal government could write rules of incomprehensible detail and complexity to try to account for every possible eventuality and so prevent collapse at Goldman Sachs or rescue it before it collapses; or, (2) the government could clearly and consistently maintain the policy that the companies and executives that take risks in the hope of future benefit get to enjoy those benefits if they succeed, but must bear the weight of the consequences if they fail. The first option would almost certainly destroy the institution being regulated. The second option, however, would create market discipline, which is the greatest regulator, because it aligns incentives correctly. It strengthens and clarifies the key market signal. Any secondary regulations imposed by government should strengthen that key signal—namely, that you gain when your risks pan out, and you pay the consequences if they fail. At the very least, it should not interfere with it. Unfortunately, this commonsense market regulator has been mostly scrambled and subverted by a government preference for option number 1—our old friend, the moral hazard. (225)—
"Market discipline is the greatest regulator because it aligns incentives correctly."
Social welfare programs do not need to be eradicated, but they need to be reduced to the point that the benefits they bring are worth less than what could be earned by hard work. As long as the benefit scales are tipped toward accepting more and more government support, all the social and economic incentives will remain skewed. This is why we have more poverty, more food stamps, more children born to unmarried mothers, etc.
To connect this all to current events: you want to eradicate the conditions that brought about what’s happening in Ferguson, MO? Repeal liberalism.
And this is why history is so interesting; sometimes we invented something without having a clue as to why it worked. We just hit upon it by accident, by serendipity, by trial and error, or maybe by completely fallacious reasoning. The point is that the inventions are made when there is a minimum epistemic base—which can be zero, but sometimes not. You cannot build a nuclear reactor by accident. You’ve got to know something about nuclear science. But you can invent aspirin quite serendipitously, without having the faintest clue about how it works. (112)— Economist Joel Mokyr, interviewed in Invisible Wealth: The Hidden Story of How Markets Work
The conventional wisdom, whether liberal or conservative, free market or socialist, regards charity or generosity as essentially simple—just giving things away without calculation or continuing concern with their uses. The best giver is the anonymous donor of money or valuable things, while the investor is seen as the image of a Shylock, extorting usurious gains from lending money, or a Scrooge, exploiting workers to make sure profits. By this measure, a welfare system of direct money grants financed by anonymous taxpayers through the choices of their elected representatives can be the epitome of compassion and charity.— George Gilder, Wealth and Poverty
This vision captures and important truth. The effort to predetermine results by coercion or exploitation is inimical to the spirit of giving on which capitalist growth depends. The reciprocation must be voluntary to succeed. The grasping or hoarding rich man is the antithesis of capitalism, not its epitome, more a feudal figure than a bourgeois one.
The investor must give his money, offer his goods, freely, depending on the voluntary willingness of others to respond with creative efforts of their own. To the extend that the capitalist allies himself with the government or uses other modes of force in an effort to predetermine outcomes, he is just another kind of socialist, sometimes termed a fascist, rather than an investor who makes his contributions in the hopes that others will want them and willingly work to earn them. Similarly, a society without welfare of any kind—a system like China’s that forces people to work on pain of starvation—is as hostile to the spirit of giving as a society that forces them to work at the point of a gun. Sensible levels of benefits are indeed generous and capitalistic, since they relieve people of coercion and thus permit them freely to join the system of giving.
Nonetheless, welfare beyond a minimal level becomes deeply problematic. The fact is that it is extremely difficult to transfer value to people in a way that actually helps them. Excessive welfare hurts its recipients , demoralizing them or reducing them to an addictive dependency that can ruin their lives. The anonymous private donation may be a good thing in itself. As an example for others, it may foster an outgoing and generous spirit in the community. But as a role of society it is best of the givers are given unto, if the givers seek some form of voluntary reciprocation. Then the spirit of giving spreads, and wealth tends to gravitate toward those who are most likely to give it back, most capable of using it for the benefit of others, toward those whose gifts evoke the greatest returns. Even the most indigent families will do better under a system of free enterprise and investment than under an excessively “compassionate” dole that asks no return. The understanding of the Law of Reciprocity, that one must supply in order to demand, save in order to invest, consider others in order to serve oneself, is crucial to all life in society. (38-39)
Entrepreneurs must be allowed to retain wealth for the practical reason that only they, collectively, can possibly know where it should go, to whom it should be given. Successful capitalism confronts the potential investor, public or private, with millions of small companies (nearly 16 million in the U.S.), scores of thousands of them launched every year with growth rates between 20 and 40 percent and more, and suffering from crises of expansion and cash flow. It offers a vast Babel of business plans and projects presented by every form of fast-shuffling charlatan, stuttering genius, business school tyro, flimflam artists, sleek financier, babbling broker, mumbling non-entity, voluble flack, computer shark, shaggy boffin, statistical booster; every imaginable combination of managerial, marketing, engineering, and huckstering skills; all inscrutably mixed in a teeming marketplace of “investment opportunities”: over and under-the-counter shares, Denver “penny stocks,” Sub-Chapter-S corporations, limited partnerships, proprietorships, franchises, concessions, leveraged buyouts, leasebacks and carry-forwards, spreads and deals of every description. The investor must appraise a vast, traveling bazaar of new products, the overflow of a million garages and laboratories, hobby shops and machinery “skunkworks”; companies on the edge of “new breakthroughs”; takeoff trajectories; unique product niches in the “fast-moving, high-tech semioptical bioconductor floppy tacos field”; firms offering fame and fortune and tax shelter; business providing low-cost fuel, high margin fast food, automatic profits in mail-order marketing, forty-seven magazines the world needs now, the Photonic Chip!, the people’s airline, fourteen plausible cures for asthma, the perfect coffee cup, the new Elvis, all demanding huge infusions of instant capital, all continually bursting beyond the ken even of banks and experts, let alone government planners, regulators, and subsidizers, no matter if they bear such promising titles as Small Business Administration or National Enterprise Board. Governments are entirely and inevitably unable to master the baffling specificity and elusiveness of economic opportunity.— George Gilder, Wealth and Poverty
The flood of protean growth can be comprehended and sustained only by millions of individuals with access to disposable savings and deep involvement in the companies themselves—that is, by investors who have money of their own and who can share in and pass on the profits as they gain new knowledge and investment skills. Although the desire to consume is ubiquitous and plays a significant role in motivating all men, far more important in capitalism is the purposeful drive to understand the world and to create things: to generate wealth (value defined by others) and reinvest it in the continuing drama of human invention and progress. (36-37)
Are [capitalists] greedier than doctors or writers or professors of sociology or assistant secretaries of energy of commissars of wheat? Yes, their goals seem more mercenary. But this is only because money is their very means of production. Just as the sociologist requires books and free time and the bureaucrat needs arbitrary power, the capitalist needs capital. It is no more sensible to begrudge the entrepreneur his profits—of ascribe them to overweening avarice—than to begrudge the writer or professor his free time and access to libraries and research aides, or the scientist his laboratory and assistants, or the doctor his power to prescribe medicines and perform surgery. Capitalists need capital to fulfill their role in launching and financing enterprise. Are they self-interested? Presumably. But the crucial fact about them is their deep interest and engagement in the world beyond themselves, impelled by their imagination, optimism, and faith. (36)— George Gilder, Wealth and Poverty
No surprise that, with tuition debt reaching $1 trillion, one of the complaints of the younger Occupy Wall Street protestors was the student loan crisis. They have a point here too. The moral devastation of loose money extends beyond market truth telling. What kind of society sells a lifelong burden of indebtedness to people inexperienced with money who are at the beginning of their working lives? Loan sharks and drug dealers who create debt and dependence get put in prison. But government gets to call its enabling of debt “financial aid.”— Steve Forbes in Money: How the Destruction of the Dollar Threatens the Global Economy
When interest rates are kept arbitrarily low by government policy, the effect must be inflationary. In the first place, interest rates cannot be kept artificially low, except by inflation. The real or natural rate of interest is the rate that would be established if the supply and demand for real capital were in equilibrium. The actual money interest rate can only be kept below the natural rate by pumping new money into the economic system. This new money and new credit add to the apparent supply of new capital just as the judicious addition of water add to the apparent supply of real milk.— Henry Hazlitt
Quality. It’s so impressive how much genuine academic content they can coherently cram into this.
Peter Schiff - Bailing Out Banks Put Homeowners Underwater
We keep hearing about the Federal Reserve “tapering” its quantitative easing exercise in money creation. But a tweet from the St. Louis Fed says: “adjusted monetary base rises by more than $65 billion over the past two weeks to $3.963 trillion.” The sum of currency in circulation plus deposits held by banks at the Federal Reserve, this measure of money supply stood at less than $900 billion before the financial crisis. What will happen to prices in the economy once banks start lending this money out to customers?—
Did you get that? Our money supply increased from around $900 billion to almost $4 trillion in the last few years. This goes beyond tinkering—it has been and will continue to be hugely disruptive to our economy and standard of living.