Debunking “The Big Short”: How Michael Lewis Turned the Real Villains of the Crisis into Heroes

I hate to give any attention to Michael Lewis’ The Big Short, since the wildly popular book told a fundamentally misleading story of the crisis which sadly has become conventional wisdom. And it wasn’t just harmlessly inaccurate; it directed public and even lawmaker attention away from the real drivers of this debacle.

Absent the actions of the subprime shorts that Lewis lionized, the US would have suffered a S&L-level housing criss (which at the time was seen as a serious blow to the banking system and the economy), not a global financial crisis that came perilously close to taking down systemically important capital markets firms around the world. And let us not forget that the way in which the financial system was rescued represented the greatest looting of the public purse in history.

But the fact that the movie based on the book is now out and getting a lot of attention in the media and even among people I know, it seems necessary to remind readers how the book has done a great disservice by deceiving the public. And that includes influential members of the public; Politico reported that “‘The Big Short’ has been mentioned at least 15 times on the Senate floor and in press conferences and committee hearings.”

In fairness, Lewis did a good job of explaining in laypeople’s language how out of control the subprime market was and how CDOs worked. But he was hardly alone on either account; Gillian Tett’s Fools Gold has a terrific primer on CDOs, and there were plenty of other fine accounts of the lunacy in the subprime market (but some of better long-form treatments, like All the Devils are Here, by Bethany McLean and Joe Nocera, were published after The Big Short, and thus lost the “first/early mover” advantage). Greg Zuckerman’s The Greatest Trade Ever is a much more comprehensive overview of the subprime short, and was released a good four months before The Big Short, but lacked its novelistic style, in particular, the reliable Lewis formula of “oddball outsiders take on the Establishment and win big”.

This post was first published on March 25, 2010, as Debunking Michael Lewis’ Subprime Short Hagiography

The current number one non-fiction best seller, Michael Lewis’ The Big Short: Inside the Doomsday Machine, addresses the question “Who got it right? Who saw the real estate market for the black hole it would become, and eventually made billions from that perception?” It is hailed as meeting the usual Lewis high standards of engaging story-telling and character depiction in combination with making a complex arena accessible to lay readers.

Lewis’ tale is neat, plausible to a mass market audience fed a steady diet of subprime markets stupidity and greed, and incomplete in critical ways that render his account fundamentally misleading. It’s almost too bad the book’s so readable, because a lot of people will mistake readability for accuracy, and it’s a pity that Lewis, being a brand name author, has been given a free pass by big-name media like 60 Minutes (old people) and The Daily Show (young people) to sell to an audience of tens of millions a version of the financial crisis that just won’t stand up – not if we’re really trying to get to the heart of the matter, rather than simply wishing to be entertained by breezy well-told stories that provide a bit of easy-to-digest instruction without challenging conventional wisdom.

The shortcomings of Lewis’ superficially pleasing work bear out the concerns of traditional reporters who were discomforted by the success of Truman Capote’s In Cold Blood: that turning a news report into a work of literature ran the risk of fitting facts to the Procrustean bed of a tidy, satisfying narrative.

The Big Short focuses on four clusters of subprime short sellers, all early to figure out this “greatest trade ever” and thus supposedly deserving of star treatment, bypassing the best known figure in this arena, John Paulson. The anchor is Steve Eisman, a blunt, unintentionally abrasive curmudgeon and money manager, who in his former life as an analyst put sell ratings on all the Gen One subprime lenders of the 1990s. Not only does most of the description of market chicanery and cluelessness come through him, but Eisman also serves as the main vehicle for depicting the shorts as noble opponents to a feckless industry.

Eisman’s realization that the industry he once covered, consumer finance, was out to “fuck the poor”, led a boyhood Republican to become, per Lewis, “Wall Street’s first socialist.” Eisman, plus his fellow colorful shorts, evoke comforting cultural cliches: Horatio Alger, Robin Hood, David v. Goliath (or as Eisman, would prefer to see it, Spiderman v. Carnage), Polonius’ “To thine own self be true” in modern garb, and of course, the classic Campbellian hero’s journey: a quest in the wilderness producing superior insight.

To make Lewis’ Manichean perspective stick, he has to omit vital facts that would lead to a more accurate, but complicated, less crowd-pleasing tale. Lewis repeatedly and incorrectly charges that no one on Wall Street, save his merry band of shorts, understood what was happening, because everyone blindly relied on ratings and failed to make their own assessment. By implication, the entire mortgage industry ignored the housing bubble and the frothiness of the subprime market. This is simply false (although with Bernanke and the persistently cheerleading US business media largely missing this story at the time, the “whocouldanode” defense is treated more seriously than it should be). Many people in the credit markets were aware that the risks were increasing in the subprime and residential real estate markets. Every mortgage industry conference during this period had panels on this topic, every credit committee considered it throughout 2005-07.

Lewis completely ignores the most vital player, the one who was on the other side of the subprime short bets. The notion that “it’s a CDO” is daunting enough to stop the non-financial reader in his tracks. The author is remarkably uncurious about who the end investors were for CDOs.

Listen up. Who really was on the other side of the shorts’ trades is the important question. And the section in which Lewis finally gets around to that (more than halfway thought the book, reader sympathies to his key actors now firmly established) hides the fundamental flaw in his narrative in plain sight:

…whenever Eisman sets out to explain the origins of the subprime crisis, he’d start with his dinner with Wing Chau [a CDO manager]. Only now did he fully appreciate the central importance of the so-called mezzanine CDO – the CDO composed mainly of BBB rated subprime mortgage bonds – and its synthetic component, the CDO composed entirely of credit default swaps on triple-B rated subprime mortgage bonds. “You have to understand this,” he says. “This was the engine of doom.”…

All by himself, Chau generated vast demand for the riskiest slices of subprime mortgage bonds. This demand had led inevitably to the supply of new home loans, as material for the bonds.

Yves here. It wasn’t all by himself, as we will see soon:

….the sorts of investors who handed money to Wing Chau, and thus bought the triple A rated traches of CDOs – German banks, Taiwanese insurance companies, Japanese farmer’s unions, European pension funds, and in general, entities more or less required to invest in AAA rated bonds -did precisely so because they were supposed to be foolproof, impervious to losses, and unnecessary to monitor of think about very much.

Yves again. Note that these are the international equivalent of widows and orphans, but because they are exotic, presumably elicit less sympathy. But as we will discuss soon, by this point in the tale, January 2007, that list of prototypical chumps was out of date, which has further implications for the real significance of this trade.

Starting in mid-2005, when the creation of a standardized credit default swap on mortgages made it feasible to take large subprime short positions, a system quickly developed that overrode the normal checks and balances of the market and allowed the unscrupulous to 1. Profit from making bad loans, and 2. Force the creation of more bad loans, which would both increase their profits and make it more likely that their bet would be successful.

Most mortgage industry participants assumed there was a degree of rationality that would constrain reckless behavior. And this belief was not as naïve as it seems now. Past lending excesses, such as the late 1980s LBO craze, even the savings and loan crisis, had died under their own weight. The 1990s subprime boom ended precisely because investors started to shun the risky slices of CDOs, which made selling subprime bonds unattractive (CDOs had been a necessary outlet for selling less desired tranches of subprime bonds), which choked off demand for subprime loans.

A critical element of how this new system operated was by sending false signals to market participants. Imagine you are a doctor. You have a well established patient with a known heart problem and high cholesterol. He comes to his regular checkup looking simply wretched, with bad color, low energy, and complains of not feeling well. You immediately run all of your regular (thorough) tests, plus some additional ones related to his new symptoms. Yet all the results come back within normal bounds, save his known problems, and there you see no meaningful change from his previous history. You ask him to come in quarterly, rather than annually. He continues to look even worse, yet his test results continue to show nothing more amiss than before he started to look so awful. He drops dead of massive coronary blockage.

Now in our little fable, what happened was that someone saw the patient on the street and recognized he was a prime candidate for heart failure. He takes out ten life insurance policies on the patient and finds a way to alter the test results so everything looked normal. The doctor, conditioned to trust the tests, believes them rather than his lyin’ eyes, and fails to take action.

Tom Adams, who has spent his career in the mortgage business, and was an executive at one of the major monoline insurers during the subprime mania, explains:

Starting in 2005, following the introduction of credit defaults swaps on mortgages, the spread for lending to risky borrowers fell. Normally, when risk becomes mispriced like this, the right approach is to step back and wait for sanity to return. And many cash investors did just that.

The problem this time was the market didn’t correct.

By 2006, many companies in the risk business received pressure, in one form or another (investors, rating agencies, etc.), about how they were missing out on revenue opportunities. The market was booming, yet they were on the sidelines. No one I encountered wanted to take subprime mortgage risk (or Alt A mortgage) risk directly because the risks were considered too high and the premiums were way too low.

In a normal environment, this should have led to the mortgage market grinding to a halt – since no one wanted the BBB portions of any subprime or Alt A deal. Hundreds of people at conferences, in meetings and over the phone lines argued that the market for subprime was acting irrationally. Refusing to participate in the market at all would, in retrospect, have been the only solution, but this is easier said than done. A lot of people were told: “You’re the expert in this area, find a way to make money in it – everyone else is.”

How did this happen? By 2005, “cash” or traditional investors, were leery of subprime risk. Yet the interaction of increasingly synthetic CDO issuance, credit default swap spreads, and the resulting artificially low yields on BBB subprime bonds sent a powerful signal that the subprime patient was somehow still healthy. Presumably, a lot of someones were highly confident they could find gold within what looked to most like certain subprime dreck.

Back to Lewis:

The whole point of the CDO was to launder a lot of subprime mortgage market risk that the firms had been unable to place straightforwardly…..

“He ‘managed’ the CDOs,” said Eisman, “but he managed what? …. I thought, ‘You prick, you don’t give a fuck about the investors in this thing.

“Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ ”

Say that again.

“He says to me, ‘The more excited that you get that you are right, the more trades you’ll do, and the more trades you do, the more product for me.”…

That is when Steve Eisman finally understood the madness of the machine… There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets to synthesize more of them… “They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than the just the subprime loans. That’s when I realized they needed us to keep the machine running.”

Yves again. So what does Eisman do, our hero, vocal advocate of the poor and exploited, who now (along with Lewis) indisputably knows that he is an integral part of the problem?

“Whatever that guy is buying, I want to short it.” Lippman took it as a joke, but Eisman was completely serious. “Greg, I want to short his paper. Sight unseen.”

Eisman recognizes that the subprime market is a disaster waiting to happen, a monstrous fire hazard that, once lit, will engulf the housing market and financial firms. Yet he continues to throw Molotov cocktails at it. Eisman is no noble outsider. He is a willing, knowing co-conspirator. Even worse, he and the other shorts Lewis lionizes didn’t simply set off the global debt conflagration, they made the severity of the crisis vastly worse.

So it wasn’t just that these speculators were harmful, and Lewis gave them a free pass. He failed to clue in his readers that the actions of his chosen heroes drove the demand for the worst sort of mortgages and turned what would otherwise have been a “contained” problem into a systemic crisis.

The subprime market would have died a much earlier, much less costly death absent the actions of the men Lewis celebrates. They didn’t simply keep the market going well past its sell-by date, they were the moving force behind otherwise inexplicable, superheated demand for the very worst sort of mortgages. His “heroes” were aggressively trying to find toxic waste to wager against. But unlike short positions in heavily-regulated equity markets, these wagers, the credit default swaps, had real economy effects. The use of CDOs masked the nature of their wagers and brought unwitting BBB protection sellers to the table, which lowered CDS spreads (and as in corporate bond markets, CDS dictate, via arbitrage, interest rates for bond issues) and pushed down the interest rates on the cash bonds backed by those same loans, which in turn made it perversely attractive for lenders to generate mortgages with the worst characteristics. And it isn’t surprising that weak-credit borrowers were enticed by this once in a lifetime “opportunity”.

Lewis misses an even more stunning part of this picture. His colorful band, although engaged in damaging conduct, were comparatively small fry, beneficiaries of the strategies of even more clever and lethal actors. Chapter 9 of ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism discusses how a single hedge fund, Magnetar, which has heretofore been missed in every major account of the subprime crisis, was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006. Apparently unbeknowst to Lewis, his shorts were riding the slipstream of Magnetar’s trade, with a significant percentage of their credit default swaps coming from its and its imitators’ CDOs.

And who stepped in on the other side of these short bets? Who were the investors in the CDOs? For the riskier slices of the CDO, it was a bizarre combination: chumps, almost entirely foreign, and supposedly sophisticated correlation traders, (Lewis discusses one at length, Howie Hubler of Morgan Stanley). Across the board, they suffered spectacular losses.

But as Lewis stresses, the ruse at the heart of this great trade was that the shorts were betting against BBB subprime trash, which when packaged into CDOs, had roughly 80% rated AAA. So who were the fools taking toxic BBB risk for mere AAA returns?

For the most part, the dealers themselves. Without going into mind-numbing detail, the apparent risklessness of an AAA instrument hedged by an AAA counterparty (in this case, a monoline) substantially reduced the capital a dealer needed to support a position. As a result, holding AAA CDOs hedged by AAA guarantors was treated, on a profit and loss basis on the relevant dealing desks, as vastly more attractive than finding investors to take the other side of the trade. In other words, this was massive gaming of the banks’ own bonus systems.

So what was the dealers’ big mistake? When the subprime market started hemorrhaging losses, the Magnetars and the smaller subprime shorts wanted to be paid on their successful bets. For the AAA investors, that meant ponying up cash. They went to the monolines, only to be rebuffed. Even though the insurers would likely have to pay out on their subprime guarantees, the provisions of their contracts assured would be a VERY long time, often decades, before their check would be in the mail. So the dealers themselves, due to their own poor incentives and inattention, were faced with unexpected losses and caught in a liquidity crisis. They suddenly had to cough up lots of money to Lewis’ supposed heroes. Wall Street took multiple hits: writedowns, downgrades, and a cash drain when funding was increasingly scarce.

So who was ultimately on the other side of these lionized trades? When Wall Street could no longer pay the Magnetars, the biggest chump of all, taxpayers in the US and abroad stepped into the breach. We are the ones bearing the enormous cost of state sponsored bailouts and real economy damage, the wreckage this “greatest trade ever” hath wrought.

Lewis’ need to anchor his tale in personalities results in a skewed misreading of the subprime crisis and why and how it got as bad as it did. The group of short sellers he celebrates were minor-leaguers compared to the likes of Goldman Sachs, Deutsche Bank and John Paulson. But no one on the short side of these trades, large or small, should be seen as any kind of a stalwart hero and defender of capitalism. Circumstances converged to create a perfect storm of folly on the buy side, beginning with essentially fraudulent mortgage originations at ground level, which the short-sellers – whether trading at the multimillion or multibillion dollars level – took advantage of. That they walked away with large profits may be enviable, but there was nothing valiant about it. In the end, Main Street, having been desolated by a mortgage-driven housing bust, now found itself the buyer of last resort of Wall Street’s garbage.

Lewis’ desire to satisfy his fan base’s craving for good guys led him to miss the most important story of our age: how a small number of operators used a nexus of astonishing leverage and camouflaged risk to bring the world financial system to its knees and miraculously walked away with their winnings. These players are not the ugly ducklings of Lewis’ fairy tale; they are merely ugly. Whether for his own profit or by accident, Lewis has denied the public the truth.

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  1. Mike Stenson

    Ms Smith

    I’m a long time reader and admirer of your work on NC as well as a fellow grad of those aparachnik factories Harvard College and HBS.

    I must disagree with your critique of Lewis’s The Big Short re educating the public in the financial crisis. Along with Flash Boys and to a lesser extent Liars Poker, Lewis has made an invaluable contribution to providing the general public with some currency in fundamental truths about the system that controls all our lives. The publications and experts you cite have the benefit of more technical heft but the weakness of remaining largely unread, even by the financial press and particularly lawmakers.

    Lewis takes some dramatic liberty to tell a good story, but let’s face the facts. If you don’t entice the public with an enticing Campbellian yawn involving finance, they’ll just get it in Star Wars 7 and the NFL instead. Ben Franklin would approve.

    The thrust of Lewis’s narratives is true, though he may shade where credit is concerned. Let’s not make the perfect the enemy of the good.

    1. Yves Smith Post author

      It appears you did not read the post, or at least not to the end.

      The thrust of his narrative is fundamentally untrue by misleading readers as to what drove the crisis.

      And the damage of telling people a false story was compounded by virtue of how popular his book proved to be.

      1. Thomas

        Having seen Adam McKay’s film this weekend, I can assuage you that in no way are Lewis’ lionized shorters depicted as heroes or clever or anything other than ruthless financiers, capitalizing on american misfortunate and exploiting the generosity of the federal reserve when faced with economic calamity.

        I never read the book, particularly because of the types of mischaracterizations you Lewis is chronically accused of, but I did find the film to offer no celebration in their “successes” and instead convey a melancholic and depressed mood amongst the characters when their eventual billion dollar pay days arrive. McKay, imho, does an effective job of emphasizing the scale of real economic consequences from wall street chicanery.

        1. Yves Smith Post author

          You need to get familiar with how Lewis’ books are marketed. And as a book author of much less prominence than Lewis, I approved every blurb, and I guarantee Lewis approved it and may have even written part of it.

          AMichael Lewis creates a fresh, character-driven narrative brimming with indignation and dark humor, a fitting sequel to his #1 bestseller Liar’s Poker. Out of a handful of unlikely–really unlikely–heroes, Lewis fashions a story as compelling and unusual as any of his earlier bestsellers, proving yet again that he is the finest and funniest chronicler of our time.

          Thus contrary to your assertion, calling Lewis’ shorts “heros” is not my projection but Lewis’ intent.

          So the real issue is that you as a reader like to view yourself as too sophisticated to be manipulated by Lewis. Fine, but that does not at all make the depiction of his short sellers in the Big Short as “heros” any less accurate.

          1. C.

            Yves, Thomas did not talk about Lewis’ book but about Adam McKay’s film.

            As i have seen the movie as well and not read the book, I will reiterate what Thomas said : Adam McCkay who cowrote the movie and directed it did not paint those people in the same light. Not only that but none of the names are the same. I have no idea who the people you talk about, the “heroes” in Lewis” books are. They’re not in the movie.

            They were portrayed as jerks, fully aware that they made a buck and profited against the entire world. The character played by Carrell debated whether to lose or not the money and finally entered the system and had a huge payout.

            The two traders (one is played by Finn Wittrock) explicitely said that they only got excited when they traded shit. They’d gamble on the side of the apocalypse if that made them a quick buck.

            So Lewis’ book might have glorified these people and not put the focus on the right people, the investors, the movie also doesn’t which i was wondering about as well, but the movie seems to rectify whatever lewis wrote. Somehow, they just used the canvas of the book.

            In the movie, they’re not heroes. They are portrayed as jerks who put famiies on the streets.

            Go see the movie. Then you can compare the two, but you can’t “debunk” the movie based on the book. Because these two are not the same thing.

            1. Yves Smith Post author

              Even if the movie was more critical of the short sellers (and mind you, I have no problem with equity short sellers), you seem to be missing the points I am making. All these popular accounts served to steer attention away from the damage the shorts did. I guarantee the movie did not cover that. Making them out to be louts still exculpates them of their role in pouring a huge amount of gas on the housing crisis fire. They are instead depicted more like people who cheered the fire and found ways to make money from it, not the key actors that turned what would have been a mere S&L level crisis (damaging and costly) into a global financial crisis that set the stage for the greatest looting of the public purse in history.

              Moreover, your idea that depicting them as greedy guys is not much of a ding these days. Lewis himself claims (I’m not sure I believe him) that he intended Liars’ Poker to turn people off from Wall Street. Instead, it would up operating like a recruitment ad. In plutocratic America, showing that the subprime shorts got rich will excuse them of all their other failings in the eyes of many, and potentially most, viewers.

              1. richardDave

                The people shorting the CDO market almost bankrupted the criminals on Wall Street. Humanity will never get another shot at putting the criminals at Goldman Sachs and JP Morgan out of business.

                The damage the shorts did was only accomplished because of the moral corruption of our banking system. From the Federal Reserve, to the SEC to the Wall Street crime syndicates, to the corrupt politicans owned by these criminals – every one of the people who work for these “institutions” should be hung for crimes against humanity.

                1. Craig Stef

                  I agree with this post. You can blame the shorts all you want but someone had to issue them. It was the greed of Wall Street that took the bets and allowed for the ensuing crisis. .

                  1. Yves Smith Post author

                    First, it was Paulson who dreamed up the idea of using CDOs to hide subprime short bets, and Magnetar who improved on it. It was not Wall Street that devised this strategy. And as we outlined in ECONNED, the toxic CDOs depended on a “sponsor” to take the equity tranche and much of the short side of the deal. That was again the subprime shorts, not Wall Street.

                    Wall Street did sell this to generally clueless parties and misled them. They told them that the heavily synthetic (made largely from CDS) were jus the same as ones composed of loans, when these CDOs had been cherry picked to be composed of crap exposures designed to fail.

                    The big banks that wound up stuck with them were either Euorbanks, where traders under Basel II gamed their banks’ own risk management systems (more detail on that in ECONNED) or banks like Merrill that decided to become a leader in subprime CDOs at the worst time and got stuck with inventory. Citi was also stuck with inventory.

              2. C.

                i’m not sure if i understood something.

                Are you saying that I said that being portrayed as greedy guys is not a ding these days or that being greedy is not a problem today.

                Because i certainly did not say that them being greedy was not despicable. It’s already done, unfortunately.

                I just dissociated the book from the movie and you’re criticizing something that on december 26 you still hadn’t seen, right ?

                I am sure your criticism of the book is legitimate and correct. But it is not, cannot be a legitimate criticism of the movie since you didn’t see it and don’t know what changes they made.

                But i understand that your main concern is that it doesn’t explain properly what the shorts did and to what extent. But at least it is something, no ?

                However i am not going to fault people who gamble against something, because that i believe has always existed.

                And i am more concerned about the fact that CDOS are being reintroduced under a new name.. So that means some people who already know what will happen will repeat the same scenario unless the SEC, the ratings companies like Moodys do their job properly and we all know that is not going to happen. Our only hope is that Obama uses his veto power to regulate the market to the high heavens…

      2. Salamander

        I read both the post and the book. I too disagree. There is a lot of highly subjective criticism in this post, for example your framing that Lewis “finally gets around to… readers sympathy firmly established…” what is so obviously the climax of his narrative that I remember the exact passage even as you cite it.

        He’s the author. He could have obscured or excluded the point if he so wished… I really don’t think he did.

        Rather, I think that there is little daylight between you and Lewis on the systemic problem which led to collapse. And really… If it hadn’t been Eisman, it would have been somebody else. What’s the point of blaming him, rather than the legislators and regulators who create the environment in which his gain is everybody’s loss? Our system is all about masked and misaligned incentives. And once you’ve created the synthetic derivative Frankenstein, and freed it of the bonds of capital reserves, it will take its vengeance…

        I find your criticism of Lewis hard to grok. I’ve learned more about finance from the both of you than I did in graduate school.

      3. Craig Burley

        Hey Yves. Quick note. You say ” the actions of his chosen heroes drove the demand for the worst sort of mortgages and turned what would otherwise have been a “contained” problem into a systemic crisis” but this actually gets it backwards.

        The credit default swaps that Eisman (and those like him) wrote actually reduced net demand for the liar-loan mortgages that were so harmful to borrowers (and the economy). Before those players entered the market aggressively looking for short opportunities, liar-loan mortgages were in huge demand from CDO issuers, and could therefore be sold at top dollar. Once the shorters entered the market asking to buy bust-side credit default swaps on these tranches, the issuers could move from creating cash CDOs to synthetic CDOs (or, at least, vastly increase the synthetic elements in the portfolios). This reduced the demand for lian-loan mortgages, because there was now price competition in the lower tiers of that market.

        As a result–and the National Commission on Causes agrees (see p.195 of the Report)–the worst loans stopped getting originated because the originators would have carried more risk. This shrank the bubble.

        1. Yves Smith Post author

          That is untrue and you need to read Chapter 9 of ECONNED, where I lay out the structure and the math of the CDOs in detail.

          First, you are wrong in that the explosion of demand for the worst mortgages correlates almost exactly with the ISDA’s creation of a standard protocol for credit default swaps on asset backed securities, allowing for a lag to gin up deals. No market participant agrees with your depiction of the decay of the market. The toxic phase may 3Q 2005 to when the subprime market shut down, July 2007. That did include other types of drecky loans, not just liar’s loans.

          Second, you are wrong about synthetics. The market for pure synthetics had only a very small market.

          Third, you appear unaware of the Magnetar trade, which was a hybrid, and I document in ECONNED how it drove 30% of demand in the toxic phase. I the math to prove it.

          Forth, the element that did NOT go into ECONNED, and I can kick myself, because it explains the difference between the 30% I could prove and the 50-60% of demand that everyone said Magnetar was creating, was (as I do clearly say), Magnetar was not using all the CDS its CDOs created. 25% of the CDS it created was used by hedgers, mosst often by providers of warehouse lines to originators like New Century. The use of the CDO, by successfully convincing buyers that BBB- risk was AAA (the top tranche IIRC was over 70% of the par value), kept prices for CDS low, which made insuring this risk artificially cheap. That kept the subprime party going much longer that it woudl have otherwise.

          The proof is that in 2004, Countrywide predicted subprime originations would fall in 2005 as a result of Fed tightening. Originations actually rose and got worse in quality even as prime mortgage originations fell. That is the reverse of what you’d expect to see in a tightening cycle. Demand for risky credit is what falls off first.

          I have the goods in ECONNED. I suggest you read it.

          1. Craig Burley

            I’ll be happy to read it. I was led to this piece from elsewhere, and wasn’t aware of ECONNED. I’ll get hold of it–this stuff is very interesting to me as I was following the securitization markets closely during the relevant periods as part of my work.

  2. Steve H.

    I wonder what posts from this year NC will be re-posting in 2020?

    It could be a new measure of veracity, the Toldjaso Index.

  3. griffen

    Nicely summarized. In addition to the treatment that your commentary heaps on the “protagonists” within Lewis’ writing, the most curious outcome of the situation was the paragraph below. Beforehand, it was difficult to comprehend, absent the regulatory capital feature, that Wall Street would deal in their own sausage machinery. After the fact of course it all comes together.

    “But as Lewis stresses, the ruse at the heart of this great trade was that the shorts were betting against BBB subprime trash, which when packaged into CDOs, had roughly 80% rated AAA. So who were the fools taking toxic BBB risk for mere AAA returns?

    For the most part, the dealers themselves. Without going into mind-numbing detail, the apparent risklessness of an AAA instrument hedged by an AAA counterparty (in this case, a monoline) substantially reduced the capital a dealer needed to support a position. As a result, holding AAA CDOs hedged by AAA guarantors was treated, on a profit and loss basis on the relevant dealing desks, as vastly more attractive… “

    1. digi_owl

      And trying to make head or tail of all that makes my head hurt.

      I am tempted to say that all of finance, from the trading floor all the way to the economists, are out to willfully obfuscate the topic.

      Most of their use of language is so twisted and ass backwards that you would think them aliens trying to speak a language they do not have the first clue about.

  4. Keith

    The biggest question should be:

    “Why didn’t others see what was going wrong?”

    This is what puzzled me after 2008

    Why didn’t the economists see the problems building?

    The people that did see the crashes of 1999 and 2008 coming can be found on the internet and they see the next crash coming very soon.

    The people that didn’t see 2008 coming are the ones the main stream media still rely on.

    A strange phenomenon has taken place where the knowledge required to see what is going wrong has been removed from the system.

    Global trade in raw materials is going downhill fast as can be seen from the Baltic Dry Index (the cost of shipping raw materials around the world). ZeroHedge

    Our leaders are fiddling while Rome burns.

    This time “Rome” is the global economy and all the nations within it.

    It became obvious in 2008, that current thinking was totally wrong and the bankers, economists and main stream commentators have no idea what they are doing.

    We were re-assured by their complex mathematical models that ensured the global economy was being run successfully.

    2008 was of such magnitude (nearly bringing down the Western financial system) it showed the lack of understanding lay in the very assumptions that we have built these layers of complexity on top of.

    Drilling down, I and many others, have found we don’t actually understand the very nature of money and how it can be created and destroyed on bank balance sheets.

    This was known in the 1930s and has been forgotten.

    The most basic and important fact in any financial system, the nature of the money used, is no longer understood.

    Modern economists treat banks as intermediaries where money flows from one party to another, in doing this they have left themselves blind to events like 2008, where wholesale money destruction takes place on bank balance sheets.

    Once you have come to this conclusion you can drill down elsewhere to find the same complexity built on bad assumptions.

    Today’s trickledown, supply side economics – Michael Hudson in “Killing the Host” calls it “junk” economics and I agree.

    We have forgotten the distinction between earned and unearned wealth that was well understood by classical economists including Adam Smith.

    We are now blind to the dangers of a parasitic financial, rentier economy bleeding the life out of the real economy.

    We are fiddling while Rome burns, thinking in ways that are based on very bad assumptions and taking no notice when the warning signs flash red.

    1998 – Long Term Capital Management collapses, a very small firm specialising in certain types of derivatives nearly takes down the US financial system. It was ignored and the decision to not regulate derivatives was made in 1999.

    1999/2000 – The bubble burst showing modern financial markets are no more sophisticated than the Tulip Markets of 1600s Holland. It was ignored and we carried on placing our faith in markets.

    2008 – Financial Armageddon – Never mind, no need to change too much, just carry on as before.

    Soon reality is going to catch up with us.

    1. Jim in SC

      Great post, Keith. Two of your points I’d like to follow up on:

      First, ‘why didn’t others see what was going wrong?’ I just finished reading ‘House of Cards,’ a 2010 book about the collapse of Bear Stearns. It is evident that the principals at Bear, which presumably had more knowledge about the sub-prime mortgage markets than any other firm, didn’t know a collapse was coming right up until the firm dissolved. The credit markets gradually pushed them from longer term commitments to the repo market. If anybody foresaw the collapse, it was collectively, as displayed by the change in Bear’s day to day funding. In other words, its possible no one consciously knew, but unconsciously the funders decided there were better places to lock up their money.

      Secondly, ‘a strange phenomenon has taken place where the knowledge required to see what is going wrong has been removed from the system.’ This is something we see in other fields as well. The break point seems to be the Second World War. Psychological trauma, stress was well understood before and after the First World War; after the Second, it was forgotten until the early ’80s. (See Bessel Van Der Kolk, ‘The Body Keeps the Score’.) The dangers of cocaine addiction were well understood by the 1920s, but forgotten until the ’80s. In the seventies, it was considered non-addictive. It is not so surprising, then, that important economic truths have been forgotten. The question is: how does this happen? What is the process? Collective dipping in the river Lethe?

      I do have one criticism, however: Don’t knock being a rentier unless you’ve tried it. It is a lot harder than one thinks. If you don’t want to work for the man, you have two choices: own a business, or be a rentier. Ensuring the flow of money from the renter’s pocket to yours is not easy. Everyone always has a reason not to pay you. The most common type of rentierhood, owning single family rental housing, is a type of business, and it is very difficult to turn a profit except in the major cities. You are providing a commodity, living space, very much like a business. I think landlords should be honored, not reviled.

      1. afreeman

        I wish Michael Hudson would come up with a word that everyone could grasp immediately, as opposed to “rentier.”

        I too, a small time landlord, had trouble with that term even though Hudson elaborately explains what the term has meant through the ages (plenty), all exclusive of small time landlords, or even the virtues of renting vs owning. The other problem I have with it is the one Keith just had—it kills the ah-soing.

        Ditto “neoliberal.” Hudson’s new book is a must read and I am most grateful even though it is a wade.
        If the public is to get it any time soon, Hudson and all of those who think they do will darn soon have to come up with at least a handful of ah-so phrases far better than what I and fellow community activists had done so far: Hudson’s financial capitalism, aka credit capitalism? Duany’s new urbanism vs. free market (free-for-all) urbanism? Hudson’s FIRE sector, aka real estate industry? I could go on.

        Is everyday language something NC could advance? Gail T. over at Our Finite World just acknowledged having read Killing the Host— shared learners there could sure do with some ah-so words too.

      2. John

        Jim, Not knocking your overall comment, but just want to point out that Matt Tannin at Bear Stearns saw it coming. He warned his bosses at Bear Stearns Asset Mgmt that the market was, in his words, “toast”. And they b*tch slapped him into silence because they were worried that investors in their funds would bail out.

    2. Zelenograd

      I had a friend that worked for New Century when they went bankrupt in Q1 2007.

      He had zero success in finding another job at a mortgage company. At that point it became obvious to him all the companies were in bad bad shape and left the industry. He was making $100k+ with only a high school education.

    3. digi_owl

      The basic issue is that mainstream economic teaching has so convinced themselves that debt can be ignored (as long as it is private) because they think it just moves money around within the economy.

      And whenever something “weird” shows up, they try to add another letter to their formulas, or another line of their intersecting graphs, to account for that weirdness.

      They so want to see themselves as closer to physics than sociology, yet they ignore most of the tools and changes in the very field they want to be compared with.

    4. steelhead23

      During the first decade of this century, I watched as median house prices zoomed and median wages stagnated and recognized there was a debt kiting parade underway as each leg down in interest rates spawned higher home prices and folks were refi-ing and cashing out like mad. I believe that what happened then was magical thinking on the part of the inhabitants of the financial industry’s C suites – the Fed – and Treasury. It was “the magic of the market”, or the “amazing power of dark finance” (as if it were a superhero of sorts). My simple rationale that most debts were paid with wages and since wages were stagnant as debt soared, risk was growing – wildly. And, as Yves suggests, I believe the C suites believed that while they might manage corporate business in a manner that maximized their personal gain (you simply must read Econned), they apparently failed to notice that their minions and counter-partiers were all drinking from the same punchbowl. Truly Yves, the aspect of the origins of this mess I most struggle with is the wages v. debt measure of financial security seems to have no meaning to MBAs or even PhDs. They seem to be “true believers” in stuff that just ain’t so.

      Someone just has to put the exclamation point on all of this. The financial crisis was caused by a touch of the aforementioned magical thinking, but in large measure it was caused by fraud. Mostly, I would argue that fraud was executed on the monolines and retail investors, but because the monolines and other financial counterparties would be bankrupted by this fraud, in effect the wealth of global citizenry was vacuumed up by big shorts to keep the system from flatlining. The cure is NOT more regulation, although it could help. The cure is aggressive prosecution of fraud. It was Obama’s decision not to prosecute this fraud that has prevented recovery of the global financial system and paved the way to the next crisis. I’d like to read Gretchen’s take on that decision. Made early in his presidency (likely even before inauguration), it created the financial weakness we continue to live with. Why do I think this decision so momentous? Because counsel to the C suites read court decisions – and advise their clients based on this reading. These guys and gals may revel in financial risk-taking, but going to jail is a risk too far.

  5. Keith

    Let’s face it, the fact that things were going wrong should have been obvious to anyone.

    NINA (no income no asset) sub-prime mortgages, how were these ever supposed to work?

    But no one did anything about them.

    We knew about them in the UK, but they didn’t cause sufficient concern in the US to do a thing about them.

    The US mortgage market had descended into a farce and the powers that be just looked on.

    If Michael Lewis’s book makes most of the financial establishment look like fools it has done a good job.

    He has now highlighted the front running, insider trading of high frequency trading (“Flash Boys”) but the music plays on and the financial establishment do nothing.

  6. abynormal

    i still remember there precise moment i backed into this:

    The damage was foreseeable and, in fact, foreseen. In 1998, before Li had even invented his copula function, Paul Wilmott wrote that “the correlations between financial quantities are notoriously unstable.” Wilmott, a quantitative-finance consultant and lecturer, argued that no theory should be built on such unpredictable parameters. And he wasn’t alone. During the boom years, everybody could reel off reasons why the Gaussian copula function wasn’t perfect. Li’s approach made no allowance for unpredictability: It assumed that correlation was a constant rather than something mercurial. Investment banks would regularly phone Stanford’s Duffie and ask him to come in and talk to them about exactly what Li’s copula was. Every time, he would warn them that it was not suitable for use in risk management or valuation.

    In hindsight, ignoring those warnings looks foolhardy. But at the time, it was easy. Banks dismissed them, partly because the managers empowered to apply the brakes didn’t understand the arguments between various arms of the quant universe. Besides, they were making too much money to stop.

    1. craazyman

      funny. I was just thinking of that and had, within the hour, just re-looked-up on the internet the Forbes piece from ’09 called “The Formula from Hell”

      This post is a tour de force of exposition and analysis, and nobody even match’s Yves mastery of detail and precision.

      The only quibble I’d have (and it’s less a quibble than simply a philosophical observation) is this: I don’t think even the individuals lionized by Mr. Lewis could have foreseen the social trauma that resulted from what they fomented. Seeing that would have required a clairvoyance about the impact on the financial institutions themselves, on market reaction, on political reaction, on acts of Congress, on Fed moves — in short (no pun intended) a whole sequence of events that lay, still, in the future. And that ocurred through acts of free will on the part of individuals, not on some physical process that obeys mathematical laws deducible in advance and active for all eternity.

      At best they’re the sort of immature “heros” somewhat unique to our time, or at least since the Greed Is Good 80s, who profit cleverly from someone else’s loss. That to some degree is finance — as an entire phenomenon. Not to a complete degree, since capital can assemble and support socially beneficial ventures. But certainly on the short selling side and even on the “sell at the top” side of things — winners are made by somebody else holding the bag of losses. This is considered a necessary evil that supports the greater good and most buy into that, and with largely good reason in my view. The Big Short “heros” took this to an extreme, although I don’t think even they could have seen just how extreme, at the time of their actions. Painting them as heros is a bit odious, but painting them as evildoers is a bit of an exaggeration, in my view. They’re just embodiments of our society, the way it is and as it is.

      1. TheCatSaid

        Your last sentence reminds me of Chomsky’s explanation of “framing”: that if you construct a wooden frame and then pour marbles into it, it will always create a pyramid. The shape created by the marbles is an inevitable consequence to the physical frame that was constructed.

        As with the PE GP series, if a series of incentives is created, it is inevitable that choices and actions will occur in response to that structure. Same with tax loopholes.

        Sometimes we are talked into participating into something for reasons that seem to make sense (e.g., the people that want “more security”), unaware that our participation by approval or lack of disapproval is creating part of a frame that will lead inevitably to consequences not foreseen by us.

        If I don’t have a great deal experience in a given area, it’s likely that I don’t yet have the perspective to understand the implicit consequences of my choices. That’s one reason I read NC–I start to see and understand some things more clearly.

      2. tegnost

        right, and if you define society by the rules we make then even more so. On the other side of the evil/not evil divide sits pharma bro, but had we crafted a different healthcare law he couldn’t have done what he’s done and all the reprobation heaped upon him is questionable in that light. Indeed it’s an excellent handy rebuttal to any ACA supporter because they have to define what level of rapacious profiteering the dude was supposed to stop at? Why not take it to the limit? We should recognize (since it’s sunday) that if we put lines on either side of the field and at the ends that every square inch of field within that area is in bounds.

    2. Yves Smith Post author

      Felix was wrong about the role of cupola function. It was used for the modeling of collateralized loan obligations, which are a type of CDO. But it was NOT used in the modeling of so-called “asset backed CDOs” which were the type used for subprime debt.

      There was a subprime CDO market before 1998, much smaller, for the much smaller subprime mortgage loan of its day. It was also a Ponzi and started imploding in 1999. The 2000s CDOs had a “better” structure, supposedly, but with less diversification of asset type (as in they were 80%, often 100%, residential mortgage debt).

      1. craazyman

        to be sure, this is minor detail and at most a ttrivia point for those so inciined and if it wasn”t the Gausian copula it would have been something else. Also, there’s a few types of copulas, the “gausian” version is the one that assumes multivariate normal distributions while others assume some more linked forms of multivariate correlation which would have been more appropriate for the modeling task at hand, so the ideas of “copula” and ‘gausian” are themselves independent ideas. Annhway there folks who read and comment here who know far more math than me, so this is just what I’ve picked up from my own observatons. It may be off a bit, or not, i’m not sure.

        buy anyway here’s a FT article from 2009 that does seem to link the Gausian copula to the mortgage melt down

        “CDOs built solely out of subprime mortgage debt became the rage. And using the magic of the Gaussian copula correlation model, and some clever off-balance-sheet architecture, high-risk mortgages were re-packaged into triple-A-rated investor gold. The CDO market exploded. In 2000, the total number of CDOs issued were worth somewhere in the tens of billions of dollars. By 2007, two trillion dollars of CDO bonds had been issued. And with so many investors looking to put their money in debt, that debt became incredibly cheap, fuelling a massive boom in house prices and turbo-charging the world’s economies. ”

        The formula that felled Wall St
        By Sam Jones
        FT Apr 24, 2009

        1. Yves Smith Post author

          Jones is relying on Felix. This is just propagating Felix’s misconstruction (and I have to confess I didn’t know better until I was deeper into my research on CDOs, I too thought Felix was right initially). The Felix Wired article was in February 2009 and the Sam Jones remark is derivative (no pun intended).

  7. Keith

    All big booms and busts need a new paradigm enabling you to ignore fundamentals.

    By looking at the US housing market after the 1930s, they came to the conclusion that US house prices would never go down across the nation.

    With this new paradigm in mind they dismissed fundamentals such as house price affordability based on disposable income.

    The new paradigm of the boom was a complete disaster, but we are not the sort of people that learn from mistakes.

    They then made two changes to ensure the historical data was meaningless:

    1) They started using UK style mortgages with initial low rates, before moving onto a variable rate. The historical data was based on fixed rates for the full term of the mortgage. This meant that mortgages were a lot more interest rate sensitive.

    2) Central Banks decided they would control the economy with interest rates.

    After the bust the FED lowered interest rates and stoked a housing boom.

    When the economy started over-heating they raised interest rates and burst the housing bubble.

    1. Keith

      We are not the sort of people that learn from mistakes ………

      The timeline for the collapsing global economy.

      Japanese banks had been on a maniacal lending spree into real estate and the bubble popped in 1989. Rather than own up to losses and admit their bankers were fools, they covered up the problems with loose monetary policy.

      Japan then had the rest of the world to trade with that was still doing well but it never really recovered.

      US banks went on a maniacal lending spree into real estate and the bubble popped in 2008. Rather than own up to losses and admit their bankers were fools, they covered up the problems with loose monetary policy.

      US banks used complex financial instruments to spread this problem throughout the West.

      Rather than own up to losses and admit their bankers were fools, the UK and Euro-zone covered up the problems with loose monetary policy.

      Japan, the UK, the US and the Euro-zone had the BRICS nations to trade with that were still doing well but they never really recovered.

      The BRICS nations are now heading for recession.

      Doesn’t look good does it.

      1. craazyboy

        Chinese banks went on a maniacal lending spree into real estate and the bubble popped in 2015. Rather than own up to losses and admit their bankers were fools, they covered up the problems with loose monetary policy…………..

  8. Boatwright

    One can always find reason to criticize authors of popular accounts of complex events. They are prone to simplify and dramatize to sell books.

    Your criticism of Eiseman and friends, however, seems like being disgusted at a vulture for being disgusting. The carcass in a three piece suit that they feasted on was the willing creation of numerous fools who must bear the moral result of the original folly, not Eiseman. Disgusting he may be, but it is in the nature of vultures to follow the smell and tear at the already rotten flesh.

    I do not believe that vast bubble could have been deflated slowly, that minus Eiseman it wouldn’t have grown even more distended and putrid, and that there never would have been an eventual stampede for a non-existent exit?

    1. johnnygl

      Looking at the analogy you made, i think you might be misunderstanding what the shorts did. They weren’t vultures. Unless vultures were to start setting grasslands on fire and driving massives herds over a cliff. These guy were much more than opprtunistic vultures.

  9. bkrasting

    Has the ‘full’ story of the Big Short ever come out? I don’t think so.

    Everything described above happened, CDOs, Magenta, etc. were a part of the Big Short. But that is not the full story.

    What did a number of Wall Street players (think Goldie) do when faced with a huge inventory of junk mortgages and rapidly declining values? They looked for ‘shorts’ that would profit as sub-prime melted. They looked at the traditional ways (CDOs), but they also looked at derivatives.

    A beautiful, liquid hedge
    was available. All one needed to do was to short the common stocks of those entities that had the portfolios of junk. That information was public, but guys like Goldie had the real details as the holders were all ‘shopping’ what they had for sale.

    So it was no a big leap to come up with a small list of common stocks that were gonna tank if sub prime went further south.

    The names on the ‘short list’? Think: IndyMac, Washington Mutual, Wachovia and Countrywide. The stocks of these dogs went to zero and the shorts had a winning hedge.

    But it went farther. Two other names on the list: Fannie and Freddie – those stocks went from the 50’s to zero. They were big caps with a big float, so easy to short.

    I’ve often wondered if the short/hedging attack on the DC Agencies were the root cause of the meltdown. If so, then Wall Street saved itself and ate itself at the same time.

    Oh – and Lehman was on the short list. The frenzy of selling caused by the hedging short interests did put that outfit in the tank. After that event, it was all written in stone.

    1. Yves Smith Post author

      Bruce, you’ve got the timeline all wrong.

      And those commons stocks were way too small in terms of market cap to make for any kind of a hedge. The value of subprime CDS was 4-6 the actual value of subprime debt.

      Fannie had a market cap of $58 billion at the end of 2006. And we both know you can’t hedge the full value of issued stock.

      The subprime market was $1.1 to $1.3 trillion. It took losses of about 40%.

      You couldn’t begin to hedge the actual cash losses on subprime, let alone that plus the vastly greater losses on CDS.

      Plus if you were in any real trading firm, you’d find it pretty much impossible to use stocks to hedge a credit market risk. The basis risk would be huge and there would be plenty of day when you’d lose on the hedge and the underlying. Most firms with any sort of decent risk management system wouldn’t let that sort of trade be put on in the first place.

  10. Carolinian

    Thanks for the look back at this post. Even this very non-financial reader could follow. Seems that simple morality tales have been used to defend other forms of financial chicanery, i.e. the vulture funds that have plagued Argentina and others. In truth we live in the age of PR.

  11. David Finnerty

    “In the end, Main Street, having been desolated by a mortgage-driven housing bust, now found itself the buyer of last resort of Wall Street’s garbage.”

    I would add that Main Street was COERCED into being the “buyer of last resort”… And thus the gorge by the plutocracy continued(s) apace…

    1. participant-observer-observed

      Coerced in the manner the employees and tax payers of the state of CA are now being COERCED by CALPers board & exec to play exactly the same crapification focused Wall St game?

  12. Raquel

    Doesn’t show Clinton signing the Commodities Futures Modernization Act in the last days of his presidency.

  13. Deloss Brown

    This is a terrific piece. I will, later on today, take ECONNED off the bookshelf and re-read it.

    But I have to agree with Boatwright, above. Your quarrel seems to with capitalism itself. Expecting its practitioners to have any kind of comprehensive intelligence or moral principles ignores the nature of capitalism, the only objective of which that I can recognize is to maximize profit.

    I can readily understand and sympathize with your disgust that the perpetrators in the book and movie are held up as heroes. I got fired from Citibank in 2008. In fact they fired every single contractor they had. Ours was a minor but real contribution to the general misery.

  14. Andrew Foland

    Your honor, the defense would like to stipulate to everything presented. But in defense… 

    To the general public, there were two books written about the crisis: The Big Short, and Sorkin’s TBTF. And whatever the details, the takeaway messages of these two are very different.

    The underlying message of TBTF is not in the details of how Dick Fuld sucks.  It’s that, “Sometimes, things go so wrong in your economy, even powerful men working around the clock can’t save it.”

    The underlying message of TBS is not in the details of how great Steven Eisman is.  It’s that, “This is what happens when your economy is run by the corrupt, greedy, and callous.”

    So I can agree that anyone who attends to finance or economics professionally should view the shortcomings of TBS as real, and unconscionable to ignore.  But which book’s message do you think gives the public better insight into what happened? 

    On that count, I’ll take The Big Short any day of the week.

  15. Ivy

    Greenspan, Bernanke et al suffered from tragic myopia. There remain stories to tell regarding their unwitting roles.

    Following Wikipedia, in tragedy, hamartia is commonly understood to refer to the protagonist’s error or flaw that leads to a chain of plot actions culminating in a reversal from their good fortune to bad.

  16. Jack Heape

    I have not read The Big Short yet, though I have read several other of his books. I had planned to read it after learning of the movie coming out, and I am glad I read this article first before I do so. From what I have read in other places about the mortgage crisis it seems that while you can blame the actors all you want, it really is a failure of the regulators to enforce the law that allowed this to happen. And the regulators failed to do so because the politicians have been bought and paid for by the elite wealthy, Wall Street in particular.

  17. Keynes D. Von Elsner

    I have immense respect & admiration for you, but your comments re Lewis are off base. You’re assuming that but for the actions of Eisman & others the sub-prime crisis would have been alot milder, but I believe it far more likely that the banks & manipulators just would have continued compounding their crimes and when the s hit the fan it would have been far worse.

    1. Yves Smith Post author

      It’s pretty clear you have not read my book. I lay out how CDOs worked, how the Magnetar trade worked, and go through the mathematics of its impact on the subprime market. I have the goods and show that I have them.

      Eisman and his ilk were essential to the Magnetar trade because Magnetar bought only ~20% of the CDS they created in that trade. They needed other buyers like Eisman and Paulson. The fact that Eisman was smaller does not make him any less morally culpable, particularly since, as I lay out in the post, he did at a certain point understand who the real “buyers” were.

      Moreover, as I also demonstrate in ECONNED, the toxic phase of the subprime criss was the direct result of CDS. There was an about 18 month period, starting in the Sept 2005, when the origination of astonishingly drecky subprime exploded. This came IMMEDIATELY on the heels of the creation of a standardized template for subprimee CDS. Before that, it was very hard to “write” as in create them, because each seller was creating customized documentation and negotiating it. And as Greg Zuckerman’s book makes clear, Goldman and Deutsche were motivated to push ISDA to create this template due to demands from the shorts.

  18. omg the stupid i just can't anymore

    Boom, drop the mic, Sister Yves. You naileth it. Damn such excellent writing and analysis.

    To me it seems people don’t want the truth – rather they crave good-sounding and above all comforting stories. This sadly fundamental desire seems to drive our world from top to bottom, including of course the actions of these Wall Street delusionalists as they continue to go about their daily ruinous ruining.

    (Or the MIC delusionalists, or .. etc etc, list as long as my arm)

  19. Ishmael

    Some time in 2000 or so I received a call where the caller’s first words were “Well you certainly nailed Enron.” I was kind of like “Huhh, I never even looked at Enron, ” but their response was “No, but you said accounting was so out of whack that there was going to be a big accounting explosion some place and it was going to take down one of the Big 5 and that is exactly what happened.” The caller was right and I did say that. In fact looking at Enron I saw that I knew several of the higher ups and some of them (ex-partners from Big 5 firms) were pretty smart. I also nailed Boston Chicken less than 12 months before that one happened. Now why is that and why did 2008 happen. I can summarize it in one phrase that I heard early in my year and never forgot. Companies go bankrupt not from lack of assets but lack of cash! Now they might think they have cash but bank lines can be cancelled pretty quickly!

    People in this country and around the world have read to much Harry Potter and watched too much Disney. They believe in unreality. Recently I said something to some one that a picture had Mario Draghi in it and his response is whether that was the Dorthraki leader (he meant Drogo). The average person is so buried in tv, movies and sports they have no idea what is the real world any more.

    In fact it ended up I knew some of the high-level personnel at Enron and I wondered how they got fooled by it. All I can come up with is they were always involved in high level companies who did not worry about money. They did not understand that cash is all that matters. They pay attention to “Adjusted EBITDA.”

    The average American can not deal with bad news. It is not politically correct to say someone is a fool or incompetent (especially if they are not a white male). Well history has a way of dealing with such nations and it is not well!

  20. johnnygl

    Yves, lots has been written about the financial crisis. Some of it is flat out lies like blaming the Community Reinvestment Act. Most of it is useless stuff that says something like ‘oh how crazy human nature is’ or ‘markets are wonderful but they get screwy sometimes and we just have to deal with it’. Only a few people have dug into what really happened. Some have pointed out the fraud on the front end of the mortgage complex at the retail level. Absolutely NO ONE ELSE has pointed the massive fraud on the back end in the capital markets. Thanks again for telling the truth!

  21. trinity river

    Yves, it is good you are posting this again. Last week I was invited to a preview of The Big Short, which will open here in theaters on Dec 23rd. I started reading your website in 2012 after I retired so unfortunately did not get your insights until then. I am not sure that most people will understand CDOs as a result of the movie. About all it communicates is that there was a big scam that was brought down by the people who bet against the big guys on wall street. There is so much more to know. People will assume that the whole problem is over. The movie conveys that the short sellers solved our problems. It is the old saw that the market will right itself, w/o government interference. And we are left to assume that the victims of this nonsense were the perpetrators. The real victims are missing.

  22. eclecticmn

    I read The Big Short but never got the impression that the protagonists were ‘heroes.’

    I knew that Paulson was left out and that a simple narrative, likely too simple, was being created. The story focused on a few characters. I have read other books/articles on the subject.

    I did not slog my way through the entire above column. It is very poor writing IMO. Verbal quicksand. Can someone who CAN write summarize the point she is trying to make?

    Here is my summary of The Big Short
    1. X discovers some interesting patterns in the data.
    2. X draws conclusion.
    3. X thinks he must be wrong if not crazy.
    4. X goes to ‘experts’ to explain why X is wrong.
    5. X discovers the ‘experts’ do not have a clue, including Greenspan.
    6. X is amazed and bewildered.
    7. X decides to bet on the collapse of the US financial system.

    Thanks for the Bethany McLean cite. I will read that if I can find it. SHE can write.

    1. eclecticmn

      The tone of my first post is harsher than the writer deserves. I got exasperated trying to find the point of the column.

      A couple plugs:
      1. Margin Call movie. The financial crash condensed into 24 hours. Very well done. Great cast.
      2. The Great Deformation (Stockman). A polemic but provides opinions/details into why the big firms should have been allowed to fail and be purged from the system.
      3. Bailout (Neil Barofsky). How the Treasury dept acts to protect Wall St. from the US citizens.


    2. Yves Smith Post author

      Please see this comment:

      The official blurb which I assure you was approved by Lewis, calls them “heroes”. That means it was his intent.

      Moreover, the Michael Lewis formula, and it is widely described as such, is to find outsiders, best if they are oddballs too, who go up against The System in some fashion and win. It sells well because it’s a variant of the Joseph Campbell hero’s journey.

    3. trinity river

      The book is less simplistic, but the movie is clear. The protagonists were brilliant even if they were social misfits. At the end of the day, they stopped the wall street bankers who were selling fraudulent securities. It’s a classic good vs evil tale. This is a fast moving drama that doesn’t slow down to be understood.

  23. david

    So Lewis should have made the book “more complicated”. For what purpose – readability? – given the complications of the subject matter to begin with

    The book is very easy read and now with the movie in place the public, who rarely reads anything, have a full frontal view of the fact that the industry no matter what the product, is completely corrupt to include the rating agencies, the regulators and congress.

    In an election year where the establishment is on trial that is worth more than the minor details which don’t change the underlying story of the source of the corruption.

    1. Yves Smith Post author

      I take it you did not read beyond the headline. The point is that Lewis got the story line as to who was a good guy v. a bad guy fundamentally wrong, and that resulted in serious policymakers ignoring what drove the crisis, and not coming up with adequate remedies (radically shrinking the credit default swap market, for starters).

      This is not about simplifying. It’s about misleading. Stunning that you can’t understand the difference.

  24. alex morfesis

    Nina, american aparteid, rejection of the eu constitution, basel 2 and pay 2 play…it was not an accident nor human nature…pass the tin foil please…

    most profits with least capital and most leverage…why work hard when you can game the system and make up rocket science nonsense to hide bribes and collusion so that the average juror can be hoodwinked into acquittal…

    if you margin stock you can borrow x…if you margin bonds…you can lever more…if you can pay someone to use a zero note argument to flaten out the risk scenario by showing real estate over a 10-15 year horizon tends to keep up with inflation risk, then you can take the excess cash flow of american real estate apartheid of the mythical sub prime homeowner by the illegal refusal of the big players to offer oecd mortgage rates to stupid americans who dont complain about it and create new vehicles instead of reducing interest rates for homeowners…

    News flash…herr Volker lied…he made interest rates go up to allow the big money center banks to end up with national footprints…and created this illusion that you should be allowing your “savings” to earn you 6, 9 or 12% depending on which year it is…and now we have interest rate addicts who squawk they were “promised” a certain interest rate and they want the lie they were sold…

    I did say great post before i went loopy on this response…oh…ok…great post by the way

    Full moon on Christmas eve this year…enjoy life…create peace…and learn to laugh at the boogeyman

    1. griffen

      Ummm, volcker didn’t lie and inflation was rampant in late 70’s to early 80’s. I don’t believe that 8 to 12% annualised inflation was doing anyone a favor at the time.

      Bank deregulation happened in 1994, also…at the least it opened the door to what we observe today.

      1. alex morfesis

        Capital is allocated by banks via loans…no loans or capital to “buy” things to then sell…no inflation…

        Just like with wars…no capital allocation, no wars…no gas for the vehicles to get the troops to the killing zone…the french central bank and treasury could have shut down the 100 daze in Rwanda…someone thought otherwise and must have gotten a woody from the pink splatter…

        and if you took the time to read the fine print… despite glass/steigl banking “could” cross state lines if approved by herr volker to “rescue” a financial institution… thus phony inflation destroys value of “fixed” rate loans and get your handy dandy ratings agency or nyssa stooge to say the sky is falling for any local in state bank but magically the money center bank is “safe and sound” and poof…the only “viable” purchaser is that wall street guy…

        Derivatives are a form of “profit” allocation…smoke and mirrors from the smoking section of the club…in theory they might have begun as risk diffusion strategy…but if you read up on the little war between buffet/munger gen re vs aig in Connecticut just before the crash(2005)…you might notice some confusing math…and if you followed along on the bk of general motors parts company spinoff you might have also seen fuzzy math with all the “derivatives” and mystery bond sales of non existant paper…

        but herr volker is a hero to many…so all hail ming…pass the bratwurst

          1. alex morfesis

            No…its herr volker…the after thought from the 15 year thrill kill of the us heartland was the item you mention in 94. After the damage was done…after the s&l crisis finished opening up the country to nationwide banking…sorry that you cant or wont follow along…

            Money is not from deposits…deposits are from capital allocations…loans…where does the “money” from prime brokerage operations come from ???

            Capital requirements were tied to the needs of basel 2…no capital…no eastern european or second world expansion…aaa rate something and someone can buy it to grow their banking enterprise…trade it and you can sustain the argument it has a “market value”…nothing has any value unless someone is willing to pay you for it today here and now…gold is worthless to a hungry eagle…water has more value in the desert…

            2 lips on my mind…

  25. gizzardboy

    Two quotes and my comments:
    “Now in our little fable, what happened was that someone saw the patient on the street and recognized he was a prime candidate for heart failure. He takes out ten life insurance policies on the patient and finds a way to alter the test results so everything looked normal.”

    The heroes of Lewis’s book didn’t “find a way to alter the test results”. They just bought the insurance policies. The rating agencies and those who incentivized them were the ones who rigged the tests.

    “When Wall Street could no longer pay the Magnetars, the biggest chump of all, taxpayers in the US and abroad stepped into the breach. We are the ones bearing the enormous cost of state sponsored bailouts and real economy damage, the wreckage this “greatest trade ever” hath wrought.”

    The heroes of Lewis’ book had nothing to do with the political decision to make AIG and the big banks whole at everybody else’s expense. The “no haircuts” decisions came from our corrupt politicians.

    I take your point that Magnitar and Jim Paulson hold a great deal of responsibility (though less than the banks and the credit rating agencies). But is was a good story and a good read. And don’t you kick yourself, Eves, just a bit for knowing what was coming and not making a little something from that knowledge?

    1. Yves Smith Post author

      No, you appear not to have read the post carefully. The buying of CDS drove demand to the worst mortgages. It was not a neutral activity. It compressed spreads for supprime mortgages even as spreads were widening for prime mortgages, which is unheard of in a Fed tightening cycle! Demand for risky credit is alway hit faster and harder than for better risks.

      Using a CDO as the vehicle for masquerading short bets, and selling BBB- risk at largely AAA prices, which were for the very worst subprime mortgages, drover demand to those very mortgages. I lay out the mechanisms and math in much more detail in ECONNED. The Magnetar trade drove 50 to 60% of subprime demand in the toxic phase of the crisis. There was a discrete point in time when the origination of subprime mortgages exploded, and you can trace it virtually exactly in time to when ISDA created a standardized protocol for subprime CDS. Before each had be negotiated on a customized basis which restricted the creation of subprime CDS to very low levels.

      And I’m not wired the way you suggest. I did see what was coming well enough to be short the stock market in 2007 and 2008 and to short oil right before its peak in 2008. But I had a sense that CDOs were critical based on what Gillian Tett was writing about them in early 2007, particularly that they were so massively levered. That much gearing always leads to very bad outcomes.

      But there were only about 75 to 100 people on dealer desks who packaged CDOs,and maybe another 300 in the world who really understood them in addition to the packagers. It took over two years of chipping away at this for three people, one of them one of those 75 to 100 packagers, helped me understand what Magnetar was up to and why it was so central to the crisis, which each of them independently confirmed.

      I never would have shorted subprime understanding its impact on the residential mortgage market. If I were that type of person, I’d still be at Goldman. I could have done very well with a lot less bad karma doing I would probably have been doing there.

      1. Shawnna

        Thank YOU Yves! You give me so much hope for humanity!

        I won’t offer an opinion on any of this as I only understand it at a very macro level. That being said, I never underestimate the depth of corruption and greed in the financial markets. When I’ve done that, I’ve been burned immensely.

        If I had known any of this in 2006, I would never have refinanced my house. But alas, I knew nothing other than my 20+ year old house needed a new roof and a new kitchen so I refinanced. When the shit hit the fan in 2008 and I found my house was underwater by about $50K in 2010, I thought I’d never be able to get out from underneath it. I’m scared now as it appears my house has about $40K worth of equity (if I believe the valuation I got from the realtor who sold me the house in 1994).

        What’s an average person like me supposed to do now? Sell it and do what? Rent? Really?

        Anyway – thanks for your thoughtful reporting and commentary Yves. I rely on NC for the truth – it’s my only source now.

  26. DeadlyClear

    I read the book, actually first in my library, and it was his writing style that kept me interested. As we all well know the subject glazes over the eyes of the majority of Americans an especially judges. How do you write about such an intense scheme without focusing on personalities? He stressed the delusional aspect of Wall Street.

    Michael Lewis used entertainment to write the message. I use pictures to help visualize and cut up the boring factual text (hopefully to keep the reader interested)… It’s just a style. The book is based in truth and personal experience – some writers are just better storytellers than others, which is the difference between a novelist and a journalist…and remember he was reaching for a mass audience to educate and entertain.

    1. RalphR

      It’s not “journalism” when the author tells a story that is 180 degrees wrong, as Yves explained.

      It’s fiction or propaganda.

      And you are a mark for believing Lewis as being accurate.

  27. DeadlyClear

    I have to admit that his idea that only a handful of hedge fund guys knew what was going on was a bit naive… I mean c’mon, on Wall Street money and scandal are like sex and there are no secrets.

  28. participant-observer-observed

    Taiwanese insurance company investors, at least one i know, had the misfortune of branding their business after the American, with AIG right there on their business card. For them, the implosion was magnified!

  29. James Housel

    I just finished TBS a couple of weeks ago and I take slight exception to the notion that the central characters are “heroes”. What gives you that impression? They struck me as geeks, opportunists, and greedy. So? You expected heroes? On Wall Street? What IS remarkable about them was their persistence in holding a contrarian view, one of the most difficult things an investor can do. It seems obvious (and Lewis mentions it) that Paulson and Goldman would not talk to him. Did Lewis’ characters make things worse w/their bets…marginally? The damage was done (as you point out) at Goldman and Magnetar.

    To take TBS as the WHOLE story is, indeed, misleading, but ML never claims that was his purpose, only to make clearer how this disaster occurred and to blow a big hole in the notion that this could not have been foreseen or prevented. I think it is a very useful (and entertaining) part of the puzzle.

    1. Yves Smith Post author

      This is the from the official blurb at Amazon. As an author who has been through the marketing process, I guarantee Lewis approved this language. He may have even written parts of it:

      Michael Lewis creates a fresh, character-driven narrative brimming with indignation and dark humor, a fitting sequel to his #1 bestseller Liar’s Poker. Out of a handful of unlikely–really unlikely–heroes, Lewis fashions a story as compelling and unusual as any of his earlier bestsellers, proving yet again that he is the finest and funniest chronicler of our time.

      1. Sluggeaux

        When I read TBS 5 years ago, I thought that all the persons portrayed were a bunch of a-holes. I thought that was the whole point.

        It was the marketing machines such as ScAmazon (and now Hollywood) that painted these clowns as “heroes.” I thought that Lewis was simply a perfectly self-aware cynic getting rich off of the same scam, only further downstream. His whole plot seemed to be that even a-holes like his protagonists could figure-out how to bet against such a transparent Ponzi.

        What do I know? All my money’s in CalPERS and California coastal real estate. What could go wrong?

        1. Yves Smith Post author

          You live in California, where everyone is nice, or at least feels compelled to pretend to be a lot of the time.

          In NYC, most people are assholes, or at best brusque. We are allowed to be, and we rationalize that we are required to be, as a result of the population density.

          Wall Street takes that NYC culture further by virtue of the competitiveness over money.

          In this culture, the people who can buy the best toys ARE heroes.

          1. jonboinAR

            Well, not quite the same subject regarding New Yorkers, but, in the brief time I was there, I was there I found them to be extremely fast, in a rush, but compassionate. I’d be on the street with my map, fumbling, and a local would come up, start pointing at my map and speaking very quickly. They’d look in my eyes to see if I understood. I always faked it because I could see they were very busy to get where they were going. Then they’d smile, tell me to enjoy myself and rush off. Like Jeremiah the bullfrog’s friend, I never understood a thing they said. I found them to be perfectly kind, though.

          2. Sluggeaux

            Californians are just pretending to be nice. It’s why we are suckers for con-artists like Charles Keating, Angelo Mozillo, and Ronald Reagan. Calling a crook a crook is considered “bad manners” and so they walk all over us…

            1. robb rogers

              It is not just Californians who are easy marks for PR/propaganda. 50 million people voted for Bush –twice!

              Huge question for professional educators is, “Why are we so easily propagandized?”
              My sense is that it’s not so much for lack of knowledge, but the subconscious influences in our analysis of what we know.

              We know, we just don’t understand. We fail to see connections. We fail to look behind the curtain.

  30. Fool

    Generally, I agree with this review in terms of Lewis’ historical revisionism. But it seems unfair to blame Eisman et al., or consider them villains for that matter?

    That Lewis’ shorts we small-fry compared to Magnetar, Goldman, Paulson, etc. isn’t the only thing that separates them. As you’ve pointed out many times on these pages, it was these bigger fish who were selling protection on the truly garbage tranches and shorting the also garbage but seemingly safe (or safely rated) tranches, essentially creating (or augmenting to) the market for which they could short.

    ‘There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets to synthesize more of them…’

    Now that’s bad! But Lewis’ heroes weren’t doing that? Eisman, after all, had a fiduciary duty to his investors, and the purpose of shorts is to signal a discrepancy in the market and correct it (and profit accordingly). What should he have told his investors, that he didn’t feel comfortable shorting the market, but not to worry he sent a letter to the Feds?

    1. Yves Smith Post author

      Lordie. A fiduciary duty means you take care to avoid risks. The legal standard is that you put your principal’s interest ahead of your own. It has nothing to do with profit maximization.

      The CDS created to satisfy the demand of the shorts was somewhere between 4-6X the actually amount of residential mortgages. That is why the damage to the financial system was so disproportionate. You only had about $400 to $500 billion of losses on subprime. Given the size of the economy, this is proportional to the roughly $150 billion in losses in the S&L crisis.

      Magnetar took down only about 20% of the CDS it created in its CDOs. Another 25% went to hedgers, people like Bear Stearns who were hedging warehouse lines of credit to parties like New Century who were making subprime loans. The rest of the CDS created by the CDOs were bought by other people….like Eisman and Lewis’ other heros as well as Paulson (Paulson set up only a few CDOS, early on. Even Bear Stearns thought having him set up CDOs to fail and buying all of the short side was too unseemly). So Magnetar would not have been able to put on its trade in the absence of other shorts.

      And you do seem insistent on missing the real point, that the action of the shorts drove demand to the very worst mortgages and was the driver of the blow-up of the financial system. The resulting bailouts were so bank-favorable that Simon Johnson called them “The Quiet Coup”. We’ve pointed out, and we are hardly alone, that this was the greatest looting of the public purse ever. You are one of the losers, yet you defend this?

      1. Fool

        I wasn’t one of the losers, but because I do agree that “this was the greatest looting of the public purse ever,” perhaps I should humbly walk back my position…

        I do share your criticism of Lewis’ flippant moral treatment of the actors in his book (namely w regards to Lippman), especially by exclusion (Magnetar, Paulson, etc.). That said it seems unfair to point out that “the action of the shorts drove demand” since, in theory, all market behavior becomes priced into the market (i.e. recalibrates estimations of supply/demand). There really wasn’t much Eisman et al could have done short of writing a letter to their local representative or regulator (which, I may be mistaken, Eisman does at some point?). But generally, that doesn’t seem like a realistic expectation to have of money managers. Today at least…

        I think Lewis’ book — despite its exemplary ability to explain what a CDO is — has serious moral and intellectual shortcomings for the reasons you name (by inclusion or exclusion), but, I dunno, in the long list of people/institutions responsible for the financial crisis, the small time managers who were smart enough to short the market, individually, seem very low on that list. That those individuals collectively augmented this market of dogsht — for that I would blame the Lippmans/Goldmans whose job it is to structure the vehicles, bring investors together, match up the Chaus with the Eismans, etc. Banks invest in markets; if the market is a hazardous pile of dogsht…the blame for its collapse would seem to fall on the banks far more than it does on the market’s congenitally self-interested participants (the investors).

        That said, if you’re disagreeing with me I assume I’m on the wrong side of the issue…

  31. Russell Scott Day/Founder of Transcendia

    Trapped here in the US by age and circumstance, painting in broad strokes, I am recommending to youths that they get far from tanks and prevailing winds.
    Painting in broad strokes there was the 29 crash from margin calls and suicide jumpers, then WWII.
    Beatniks knew the atom bomb changed everything and became junkies with a leading junkie who murdered his wife for the stash. Enlightened hedonism followed and beaten hippies co-opted camp in Redway.
    Cuba sent the excess population on the Island to Miami. Now there are a lot of draft dodgers from Syria, where the Iron age started, in Germany.
    The 100 years oil war is coming to its climax. Poland get tanks from Germany.
    The advice I would give to youth with 60 more years to live is, move to Uruguay.
    This morning the only lyrics I had to sing were curse words.
    “Ice Melts,” “Time Runs out.” -Curses.

  32. nat scientist

    Do you expect Hollywood to stop paying whores, when it can lie to the Fools who will always believe that something comes from nothing, anatomically-impossible acts notwithstanding, through the magic of Teledivision?
    Agency religions have been doing quite well since Constantine worked it out in the 4th Century. Absolute silence is the response when the competitor gets it. Rome and Persia, then and now. Colonization and tribalism are the road to hell for the believers in such shortcuts to the fantasy of their choice. Climate change comes from the culture that demands it. Blood money buys no redemption, just more tickets to the next show.

  33. Anders

    I’m just curious. How many were the synthetic CDOs compared to ‘real’ CDOs? Does anybody know? Is it possible to make an educated guess? This number has to give some sort of indication of what importance the synthetic CDOs had on the crisis.

    1. Yves Smith Post author

      ECONNED lays this all out in detail, including the structure of a typical Magnetar CDO and the process by which it was created.

      The Magnatar CDOs were not pure synthetics (meaning the assets were only CDS and and a cash reserve). There weren’t that many institutions that would “face” as in be the credit protection writer (equivalent of buyer) of a pure synthetic. From what I can tell, the biggest synthetic program was Goldman’s Abacus CDOs, which were about 26 in total. The early ones were arguably not as pernicious since they were using them to hedge their own book (and the subprime market was not as rancid then). Deutsche had a smaller program called Start.

      The Magnetar deals had about 20% actual subprime bond tranches as assets, the rest was CDS. The buyer universe for that type of CDO was vastly larger. They were called “hybrids”.

  34. perpetualWAR

    The uninformed public will lap up this movie and think they are ‘enlightened.’

    Keep in mind, the movie depicting the housing industry as the evil it truly was, ’99 Homes,’ got literally one week big screen viewing in my city. By the time I could go, the movie was out of the theaters. So, it appears that even Hollywood has been coerced by Wall Street to pull the truth-teller’s tales from the big screen.

  35. Katya

    I’m surprised that Yves seems to be the only fin. blogger out there who points out the obvious. Where’s @felixsalmon, @noahpinion, @ritholtz, @thestalwart, etc?
    Here’s the deal. When you’re short and market goes down the last thing on your mind is who’s on the other side of the trade. THAT would be an honest portrayal. You don’t sit at your trading desk ruminating on poor shmucks. You’re exhilarated, even gleeful. That’s why it’s hard for me to take those gratuitous displays of remorse seriously.

    Second, we are led to believe that only that little ragtag team of oddball outsiders that saw what was coming. That’s a far stretch. Are you telling me that all those thousands of analysts crunching numbers and lenders tapes all night long didn’t see those low FICOs and NINJA docs and high LTVs?

    Furthermore, if we are to believe, as the author and the director would like us to, that those guys are the good guys, then after they made all those riches they would leave the industry in disgust, right? Did they? No. They went to run their hedge funds.

    I understand the moviemakers desire to humanize those guys. They wanted the viewer to care for them, otherwise we would not sit till the end of the movie. But they don’t see how implicitly they condone what those guys did. In the end, the public gets a distorted view of who’s to blame and it will be cemented in history.

    This whitewash of a movie really does a disservice to the public.

    1. Yves Smith Post author

      I hate to tell you, but the only people who saw the loan tapes were the monolines (who had better rights to data access) and a few third party reviewers like Clayton who started calling out problems only conveniently very late in the game. People I know in the MBS business also say that Clayton discredited themselves by calling out anomalies that weren’t credit problems. So they cynically think Clayton was in CYA mode, sending warnings in ways that were certain to be ignored (if people stopped lending to subprime, their business would contract radically), it a way they could say they warned people (as they maintained in Congressional hearings and to the FCIC) but in a manner designed to be ignored at the time.

      Also I know people in the business who kept investing in subprime. They tried sitting out the market in 2005. Their bosses told them, “Other people are doing this business. They are finding acceptable risks. If you can’t find a way to keep underwriting/investing in subprime, we’ll replace you with someone who can.” The compressed spreads, which was one of the results of the Magnetar trade, sent the signal that there was a lot of demand for subprime, which kept the party going.

      1. Katya

        I crunched hundreds of those tapes while I was an analyst at one of the subsequently defunct shops. There were hundreds of analysts like me on the street doing this unglamorous but illuminating task. Granted, I didn’t understand where all the risk goes, but back then no one gave it much thought. We got the tapes, “crunched” them and passed them on to structurers. The point is many people saw what went into the sausage. So to think that Michael Burry was one of the few guys who happened to look what’s inside is, like I said, a stretch. Later, when I was on a prop desk, it came in handy. We started going short as early as late 2006.

        1. Yves Smith Post author

          What type of player were your working for? The structures were usually originators (Countrywide, New Century, Indymac). If so, the people seeing your work were the higher-ups….whose incentives were just to find someone to buy the deal.

          Now is is crystal clear that deals were being originated late in cycle with high percentages of loans with crap FICO scores. WaMu in particular has some God-awful late deals. We reported on that based on the work of other analysts. And we were saying pretty much as soon as we started blogging that this was going to end badly (remember when Merrill bought First Franklin in early 2007? We called that catching a falling safe).

          But even by early 2007, the party was on its last wheeze. There was a meltdown in Feb, as you may recall, a rally in March which lasted through about May, in which the smarter folks cleared out as much inventory as they could and the dumbnicks treated as buying on a dip. The market started cratering again in June and was done by July.

          1. Katya

            Well, if you must ask it was Bear. And true, the timing was as you describe it. At the ASF in Vegas in early 2007 there were clear signs it’s all going down. By that time I was at a prop desk at diff shop. We were short through ABX, not CDOs. Not proud of it and I’m not saying it in jest.

            1. Yves Smith Post author

              My impression was Bear was an oddball case, in a bad way. I believe they hit the point they realized that if they put the ugly-looking loans back to the originators, as they were permitted to do, they’d bankrupt them, and they’d be stuck with unrecoverable losses on their warehouse lines. And Bear was too small and too mortgage-heavy to do that (note that I’m not saying they would necessarily have failed then, I don’t know either way, but big losses and low bonuses makes an institution ripe for death by poaching).

              So Bear as an institution thought their only solution was to keep selling the dreck.

              But you think it would have occurred to them that they needed to wind down their subprime activity, as in tail down the originations from the New Centurys et al, and thus cut their warehouse loans so they would not lose much or lose anything, And maybe that did occur to them, but too late to execute on it.

              1. Katya

                Well, my point was about the ease with which one could learn about loan level info. What they chose to do with it is a different matter. Their bonuses depended on not knowing. Mine depended on knowing.

                1. Yves Smith Post author

                  Oh, you had good incentives but then the big bosses could choose to ignore you! That actually is how a lot of traders look at research…they decide to take the risk anyhow but they want to be informed. Here, the risk was being caught as a fraudster not the usual trading risk.

                  Now I’ll have to find out how unusual it was to have a structurer review the tapes when the structurer was an independent organization.

                  1. griffen

                    Earlier in 2015, there was a court ruling in a case brought by FHFA against Nomura. That’s probably a reference worth searching into, perhaps.

                    *I do not recall if the resulting court fine & ruling was covered here.

  36. Katya

    Also, blaming the banks without blaming the shorts is like blaming prostitues but not the clients. The shorts went out looking for a facilitator and whaddaya know, they found him!

    1. Fool

      Hmm…I would think the bank is the pimp: investing in the market, matching up buyers and sellers; whether longs/shorts correspond to johns or prostitutes depends on your vantage point. That may change how one analogizes the blame.

  37. Tom

    Credit where it is due. Magnetar was reported as a key bad actor by This American Life in a superb episode.

    1. Yves Smith Post author

      We broke the story a full five weeks before ProPublica reported on it, in a BOOK which meant we had the story into the publisher a full six months before that. ECONNED was published March 2, 2010. The American Life show was a derivative of the ProPublica story. I was very nervous that Greg Zuckerman would beat us, since his book The Greatest Trade Ever was published at the end of October 2009, but he didn’t mention Magnetar.

      And it was deeply frustrating to see ProPublica also miss how Magnetar was not just a particularly clever bad actor, but that its strategy was a major, and according to sources who sought me out (and had no reason to have personal animosity towards Magnetar) was the biggest driver of why what would have been S&L level crisis into a global financial crisis.

      With the benefit of hindsight, we got bad guidance from our publisher. We probably should have pushed the Magnetar story even earlier, say six weeks before the book was out.

      1. Tom

        Thanks for the clarification. I did not mean
        To imply TAL was first on the story. They have a mass following: until your post today I’d only heard about magnetar through them.

  38. SomeCallMeTim

    Thanks Yves, for your clearly writing. I’m at least 90% of the way to understanding / buying your description of the role ML’s ‘heroes’ had in exacerbating (metastasizing) the bubble.

    1. Yves Smith Post author

      Thanks for the kind words. Unfortunately some of this material is technical, and even a 3000 ish word blog post isn’t enough space to unpack it fully. So I appreciate your patience and interest.

  39. mannfm11

    What is a credit default swap, but one party paying the perceived risk premium on an instrument for the other party to take the risk. It appears to me those taking the risk were doing so, not out of prudent analysis, but because they didn’t have to put any money up to earn a return. They found out different at a later point, when it came time to pay the fiddler. This is a deeper subject than merely the surface players. Tell someone they can earn X on nothing, they might be enticed to do so. Widows and orphans and taxpayers might have been affected, but these players weren’t that stupid.

  40. Brewster Jamieson

    Great post. But your logic stops just short (pun intended) of the biggest outrage: without the US government bailouts, the Big Shorters would have been Big Losers. Taxpayer money, and taxpayer money alone, made them wealthy. The counterparties with whom they placed their bets (AIG chief among them) could not have paid these contracts off. It took a bailout by the taxpayers to make these bets good.

    So, these guys are not heroes. They simultaneously created (or at least worsened) and profited from the crisis, and only because we bailed them out. Had we let the Morgans and the AIGs twist in the wind, these guys would have gotten cents on the dollar or nothing. The true crime was the failure of the Treasury and Fed to make sure that these bettors were not paid off 100% with our money. A simple call to the Shorters telling them “you get nothing or you can take 25%” would have saved billions, yet nobody even had the presence of mind to do that!

    What good came from making the Big Shorters wealthy at taxpayer expense? What economic principal was preserved? How was America’s interest protected? What did the taxpayers get for these billions? I would like someone to ask them (and Bernanke and Geitner) these questions under oath. It might embarrass and shame them, but that’s the least they should pay!

  41. pat b


    With all due respect if the dealers had been forced into 363 bankruptcy and even if recapitalized by
    the treasury buying all the new stock options, these banks could have been sold off.

    The criminal folly of TARP and the Fed was separate from the nature of the entities shorting Wall Street CDS/CDO…

    I was all in favor of Citicorp and Goldman being put through the same process as GM. Wipe out the existing stock, force haircuts on debentures, place new equity and sell off in chunks soon enough.

  42. Brandon

    With all due Respect Mr. Smith and i admit i had to read your synopsis way too fast. First as a trader myself what i see even as we speak the crime of proportions 1k times greater than the 2008, Manufactured Crisis which is or was the planned orchestrated destruction of price discovery of any asset. This is typical look at left hand when the right is committing the true. crime. No. Tarp baiouts werent the grand crime. Its the 4.5 trillion dollar balance sheet of the fed, ZIRP etc for the next 7 years which was the REAL crime of the century. Ive read the book way too many times. and yes Lewis described well but when he went in with the con 2 years ago., showed up on That criminal channel CNBS touting how the FBI, etc were all gonna clean up HFTs everyone missed it. .Lewis is part of the tribe when he showed up as a willing “actor” to which i have zero respect for him. As of today Wall street with their 100 % fake “markets” just print themselves billions at will with the move a mouse. (need any evidence see last 15 minutes of trade 12/21.) or 10am ET 10/2.. You see 2001 2008 were all and still are part of a grand plan.. 2001 A coupe de ta if you will of the military and people of the US and 2008 the same of the financial system .. And who are these people?? .. Pretty simple connect the dots Once again everyone is focusing on wrong enemy and remember for many things Hollywood is used as a mechanism for steering the public the direction TPTB want. Evidence … See JFK . Enjoyed your crituqe Mr smith

  43. Kinder

    This was an interesting post. Well thought out. I really don’t agree for the most part though. At any point, there were numerous parties that could have brought some common sense to the solution, and it would have stopped even with demand from the short sellers. After reading your post, I came away thinking you are blaming the drug dealers for the high drug usage. If the end users stopped, the dealers go away.

    You pointed to people who “saw it coming” and didn’t stop the activity because “it was easier said than done.” These are the people that created the collapse. If you give me 70 points and Michigan State against Alabama, I am taking that bet all day and levering it if possible. If you keep increasing the bet with me, then it is your fault, not mine. In the housing market, there were numerous parties letting the MSU/Alabama bet go on. If they did see the ridiculousness of the bet and kept making it, they are at fault.

    Having read Lewis’ book, I never came away seeing these guys as heroes or champions for America. Lewis lays out how silly the system was and how these guys made money betting against it. Maybe they added liquidity and leverage to the subprime market, but it was the investment banks, rating agencies, mortgage companies, and real estate companies that allowed it to happen.

    1. Yves Smith Post author

      If you didn’t wind up sympathizing much with Lewis’s “heroes,” you are more skeptical than most readers. If you have time, read the first 1/3 to 1/2 of the Big Short again, and think of Lewis as a novelist rather than a journalist. Look at all the devices he uses to create sympathy for Steve Eisman. Trust me, there are a lot.

  44. james

    I’m a very simple man in many ways but I do understand dishonesty and I can follow an effect to it’s origin and causing factors. Economics only becomes confusing when we play slight of hand. Debt is debt no mater how you package it and bad investment is bad investment no mater how you package it. There are two sides to the crime. One, the side that conceives the crime and recruits others into it and two, those that are willing to become apart of the crime. Wall Street and banks and the housing industry conceived the crime but it is the American people that were recruited into it. If you note in the movie how the American people lied to achieve a loan they could not afford and they also deceived themselves to believe that the future was secure when history shows that the economy always fluctuates in unforeseen ways.
    The investors, wall street and the housing industry know this reality better than anyone, because economics is the world they live in and greed is something they understand how to manipulate. Sure banks and the housing industry and investors never want to see the fall out that happened in 2008 but the fact is it has been a running business to give loans that have a high % rate of failure when the economy fluctuates because the investment is never really lost in the gentle decline of the economy. The property is the hard asset and while the economy tanks and they take loss on default loan its also a tax write off and still they have the property which in the end can be sold. As we see in part of the movie when the real-estate lady is driving around pointing to houses she sold and how people either were ready to sell or had defaulted and the bank sold the property for even more money. Here another shell game is going on because no matter what the asset is still a sellable commodity that can be turned for profit and it is the American people that in the end pay for it. The more concerning reality is that the government sponsored the enterprise of Freddie Mac and Fannie Mae and that the banks were bailed out by our government at our expense. Of course I don’t think there was much of an option there because to avert total collapse we had to save our greedy banks and they knew it.
    The important question is not in whether the heros of the story were really heros, they weren’t they were opportunist. The real question is whether everyone involved learned a lesson and has come to see the harm their actions caused us? Will the American institutions and American people learn to love this country and its people and the generations to come more than money? The truth is if we don’t find a way to see clearly and honestly we will become a very broken county that looks like the middle east where everyone is divided and all the countries are always on the brink of civil war. I have to say I’m betting against the American bond because greed doesn’t encourage the whole it encourages the individual and the kind of divisions that we see today in our country from top to bottom can be seen in history before every revolution and civil war.
    I realize I am poorly educated, please forgive my horrible grammar and my simple view of things.

  45. Matt

    How much better would you say the crisis would have been had the “heroes” not shorted the market? Or in other words, how much did the shorters exacerbate the crisis?

    1. Yves Smith Post author

      The value of credit default swaps on risky subprime (the BBB/BBB- tranches) was 4-6X the value of the TOTAL subprime market. And subprime was not a total loss (the loss on the bonds was about 40%) while the losses on the CDS were close to 100%.

      So they increased the losses by about a factor of 10x.

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