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Author Michael Lewis in his book The Big Short: Inside the Doomsday Machine (2011) narrates his experience as a Wall Street insider for a time period spanning over 20 years highlighting fallacies of newer financial products like subprime mortgages, collateralized bond obligations (CDOs), credit default swaps (CDS) introduced by financial houses starting from the 1980s and popularized vigorously during the 1990s and the first decade of this century in the run up to a terrible economic recession beginning 2008. More importantly, Lewis takes through the Wall Street culture of refusing to handle or admit a problem.
The author’s book ‘Liar’s Poker,’ published in the late 1980s, questions practices at some of the America’s biggest financial institutions like Goldman Sachs, Bear Stearns, and Merrill Lynch. Lewis writes in the introduction, “In the two decades after I left, I waited for the end of Wall Street as I had known it.”
Selling of something that seller does not own is called short selling. While short selling in the stock market may bring equilibrium in day-to-day stock movements, imprudent use of this in the long-term debt and bond market perhaps added a deep problem to the system. According to the author, such actions, if left open, can be used by financial operators to buy time, misrepresent facts. As Lewis puts it, CDS was a sort of monster dragging us into the sea.
Lewis mocks the claim that CDS solved the timing problem. It is evident that events such as selling something that does not exist have no real economic utility. Interestingly, Lewis finds that if this is what the job in a Wall Street should be, there should be no reason why young Americans who really want to offer something valuable to the society should choose. Author’s expectation after writing his first book was that ‘some bright kid at Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Goldman Sachs, and set out to sea.’
The book has many inside stories of Wall Street such as the creation of first mezzanine CDO at Drexel Burnham in 1987, first mortgage-backed CDO at Credit Suisse in 2000 by Andy Stone. CDO (Collateralized Debt Obligation) can be defined as an undertaking to remunerate lenders in a time series built on the method of cash flow from the group of bonds or other assets possessed.
CDO securities are divided into different risk categories or tranches whereby ‘high ranking’ tranches are deemed more reliable. Interest rates are determined such that junior tranches attract higher payments to make up for extra default risk.
If cash pulled together by a CDO is inadequate to reimburse all its financiers, those in the lower tranches bear losses to begin with. In the words of Lewis, “CDO created a tower of bonds, in which both risk and return diminished as you rose.” “They may not have known what a CDO was, but their minds were prepared for it,” highlights culture of greed with ignorance that dominated Wall Street during its long crazy years.
A CDS (Credit Default Swap) is a type of insurance that defends a lender in the event of loan default. When a lender buys CDS from an insurance company, the loan turns into an asset that can be swapped for cash in case the loan defaults. In contrast to a customary insurance policy, anyone can buy CDS, even someone who has no direct interest on the loan reimbursed.
According to Lewis, credit default swap was confusing mainly because it wasn’t really a swap at all. The book reveals how ‘subprime CDSs’ became a ‘new place’ to ‘stuff’ the ‘riskiest triple-B tranches’ of ‘subprime mortgage bonds’-‘though who these people were was not entirely clear for.’ Steve Eisman (a Wall Street investor) in an interview with the author states, “A bank with a market capitalization of one billion dollars might have one trillion dollars’ worth of credit default swaps outstanding.”
Wall Street was turned into a corporation instead of partnership mode. John Gutfreund (CEO of Salmon Brothers in 1986) acknowledges in an interview with Lewis that though there was a consensus among Wall Street firms that it was an impractical thing to do, yet when the ‘temptation’ arose, they all succumbed to it.
Initially, Wall Street was only about the stock market. However, Wall Street gradually started encroaching bond market during the 1980s, thriving by designing newer products with the debts of the Americans. The author recalls an event of 1986 when CEO of Salomon Brothers John Gutfreund was salaried $3.1 million as he ‘ran the business into the ground’. Despite hiccups like the ‘Internet bubble,’ the system kept growing. The government policy of bailing out banks on the plea of too big to fail, according to an interview conducted with Wall Street investor Steve Eisman, is, instead of a ‘solution,’ points to the ‘symptoms of still deeply dysfunctional financial system.’
According to the author, US financial culture is rigid to amend despite symptoms of looming problems since mid-2006. There was an umbilical cord running from the belly of the exploded beast back to the financial 1980s. The crisis of 2008 had its roots not just in the subprime loans made in 2005 but ideas hatched in 1985. Going forward, Lewis advocates approval of only those financial products that add value to the system instead of fictitious ones that led to the 2008 economic crisis or in the author’s word ‘The Big Short.’