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4.0 out of 5 stars Greed and Stupidity Overwhelm Wall Street, March 18, 2010
This review is from: The Big Short: Inside the Doomsday Machine (Hardcover)
A new book by Michael Lewis on the financial collapse of the American housing industry is going to make blood boil in the veins of many of the book's readers -- and with good reason. In his book, THE BIG SHORT: INSIDE THE DOOMSDAY MACHINE, Lewis has essentially written a literary indictment of the major institutions in America's financial system. From Goldman Sachs on down, Lewis depicts the financial industry that served up the sub prime mortgage crisis as a bunch of cheap, tawdry crooks.

A key question is whether Lewis's book is fact or fiction? In the absence of any reasonable defense, the average reader is going to treat this book as a factual report on what happened on Wall Street over the past three years. Alas, in cases like this, perception becomes reality.

And that's too bad, because the capital markets are a key, crucial, element of the American free enterprise system. Confidence in our system is absolutely vital to the success of the capitalistic system that has created immense value to the average U.S. citizen (as well as the rest of the world). So when the capital markets come under suspicion, it does not bode well for either the U.S. or global economy. Wall Street itself has very nearly destroyed the American economic system - and left future generations of Americans with trillions of dollars of debt.

So what to do? Do we discount Lewis and his incredible story? Or do we accept the problem, fix the system and move on with the business of America. We can only hope that Chris Dodd and Barney Frank in the U.S. Congress, on the verge of passing legislation to reform the financial system, know what they are doing.

But is a legislative fix the solution? After reading Lewis' book, one has to wonder whether the architects of the financial collapse need to be held accountable - that is to say, criminally liable.

After all, we watch the CEO's of America's financial institutions traipse down to Washington, kowtow to the Congressmen (and women) as they pander to the cameras, and then return to Wall Street and pay themselves even more money in bonuses for screwing up their business. That's a doomsday scenario that is further soured when you consider that all that bonus money is coming straight from the American taxpayer (money is fungible). At the end, while millions of Americans are losing their investment in their homes, Wall Street firms like Goldman Sachs got 100 cents on the dollar in federal funds to pay off the questionable insurance on their phony synthetic sub prime securities.

Where are attorneys general Eliot Spitzer (oops) or Eric Holder (guarding terrorist rights) when we need them? What is the Securities Exchange Commission doing about what may be clearly fraud on Wall Street? Where is the FBI? Someone, somewhere, ought to be launching a criminal investigation into the financial collapse of 2007-09 (Lewis reports that two Bear Stearns officials were charged and tried, but they were acquitted, because the prosecutors presented a weak case).

If one has any interest at all in the detailed background of the 2007-2010 financial collapse, Lewis' book is a fascinating read. Lewis demonstrates that the sub prime mortgage industry proved to be a giant Ponzi scheme, constructed, by our august financial institutions, including the aforementioned Goldman Sachs, as well as, Morgan Stanley, Merrill Lynch, Lehman Brothers and others.

"Even as it came to dwarf the stock market, the bond market eluded serious regulation," Lewis writes. "The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn't know. If the Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers."

What we don't expect is ignorance on the part of the professional investment bankers on Wall Street. Yet Lewis reports that most of the "rocket scientists" on Wall Street who structured the sub prime mortgage bonds simply did not understand what they were doing. Or, if they did, they conned the ratings agencies (Moody's, Standard & Poor's and Fitch) into giving them wildly unrealistic ratings (80 per cent of the sub prime mortgage securities were rated as triple A securities, the same rating for U.S. Government securities) that only fueled the crisis.

Lewis unravels all this through the eyes of a disparate group of young, brash financiers who figure out why the mortgage securities are full of risk. They conclude that the best way to bet against all this risk is to buy insurance that will pay them off when (not if) the structured sub prime bonds fail. Of course, insurance of that sort would seemingly be difficult to find, but the group found a solution at the investment banks where they persuaded them to create (and sell) "Credit default swaps" that eventually brought down the market when housing prices collapsed and the original securities became worthless.

The creation of the mortgage-backed security securities in the 1980's gave Wall Street free license to generate new, fixed income securities. Packages of mortgages were bundled into securities and broken into "tranches" that were based on the likelihood that the mortgages would be prepaid early, or in the worst case, default. The securities, known as MBS, were very profitable, because the banks that originated the loans sold them to investment banks that then flipped them into the consumer market. The financial institutions took their cut of course that generated the profits.

But then in an effort to expand profits, Goldman Sachs created a new, synthetic security that repacked the MBS tranches into new bonds.

"...Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic sub prime mortgage bond-backed CDO, or collateralized debt obligations....(a variation of) the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of sub prime mortgage loans."

Lewis estimates that Wall Street created $300 billion in sub prime CDO's, and $240 billion of those questionable securities were rated triple A by the compliant rating agencies, and he adds:

"The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold."

The eight young investors that Lewis profiles are not necessarily joyful about their sophisticated bets against the housing market. Indeed, some view the process as an ominous sign for the nation and its economy.

"I said to my mother, `I think we might be facing something like the end of democratic capitalism,'" said Charlie Ledley, one of Lewis unsung heroes, who later said: "I think there is something fundamentally scary about our democracy...because I think people have a sense that the system is rigged and it's hard to argue that it isn't."

In his final chapters, Lewis explores the reasons for the financial collapse. He has lunch with his old boss, John Gutfreund, the ex-CEO of Solomon Brothers, the investment bank that started the rush into mortgage-backed securities. At the time, in the 1980's, Solomon Brothers was a private partnership like most of the major institutions on Wall Street, but Gutfreund took Solomon public, and that was the beginning of the end, according to Lewis.

Shareholders replaced partners as the ultimate control of the investment banks, and passive shareholders had absolutely no idea of what was happening. Traders and salesmen went wild as they dreamed up synthetic securities and foisted them onto the public. One reason they did so, was that the more they sold, the bigger the bonuses. At least in the old days, partners had some sense of moderation - an aversion to the excess of the last 20 years.

Lewis had pilloried Gutfreund in his book, LIARS POKER, and the meeting was a bit sensitive in the beginning. But as they loosened up, they found they were on agreement on a number of issues.

"We agreed that the Wall Street CEO had no real ability to track the frantic innovation inside his firm. We agreed, further, that the CEO of the Wall Street investment bank had shockingly little control over his subordinates...He thought the cause of the financial crisis was `simple. Greed on both sides - greed of investors and greed of the bankers.'"

But Lewis also held Gutfreund responsible for starting the trend toward greed.

"He'd lifted a giant middle finger in the direction of the moral disapproval of his fellow Wall Street CEO," wrote Lewis. "And he'd seized the day. He and the other partners not only made a quick killing, they transferred the ultimate financial risk from themselves to their shareholders."

And the American taxpayer.

The writer was Vice President for Market Content for the Knight Ridder newspaper group that was developing electronic financial news and infomration systems during the 1980's.
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