How the Financial Collapse Actually Occurred

If you want to get really educated and infuriated about the current economic crisis, read this lengthy, entertaining, and highly disturbing piece by Michael Lewis on Portfolio.com. Thanks to kottke for the link.

The article is without a doubt, the best rundown of the hows and whys of almost everything about the crisis that I’ve read (this animated primer not withstanding). Just when you think you understand everything, you read something like this and realize how many layers of misdirection are between average investors and their investments. The key paragraph of the article to me was the explanation of how more bets were made on mortgages than the amount of mortgages that even existed (!):

Whatever rising anger Eisman felt was offset by the man’s genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. “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.'”

That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

The article gives more context and clarity around that, obviously, but it’s shocking enough on its face.

On a related subject, another thing that’s been irking me lately is this notion that’s been appearing on CNBC a lot lately that “buy and hold is officially dead”. What a stupid thing for anyone who knows anything about investing to say. Investing is almost by definition buy and hold. Trading is something entirely different. The notion that people won’t be able to buy stocks in companies they believe in and ride them up over the long term anymore is ridiculous. These people point to charts and say things like “if you held onto X stock from 10 years ago until now, you’d be down 10%”, as if this latest huge crash was just another normal, expected event. Nevermind that before the crash, they would have been up big. Corrections are supposed to happen, but crashes like this are the result of things that should never happen. Things from the above article. The perfect storm of manipulations to the system that should have been illegal and will never be seen again.

Sure, we’ll have more manipulators working on different ways to get ahead of the system in the future, but I don’t think something this big will be seen again in our lifetime. That in mind, buy and hold (with proper asset allocation) would still seem to be not just the best investment strategy, but really, the only one. Anything less is just gambling. And if there’s anything we need to see less of in the economy right now, it’s gambling.