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.

16 comments on “How the Financial Collapse Actually Occurred”. Leave your own?
  1. Guido says:

    Wow .. what a great and disturbing article.. great find.

    The problem is buy and hold today is dead, mostly because the stock market is totally broken – which is only reinforced by this article.

    It’s pretty obvious that the downfall was caused by deregulation. Allowing these “financial” companies to basically just make up things as they go along is unbelievable and deadly. I mean when the head of company is telling people to short his market, we got real problems.

    What has to happen is a totally re-write of the mortgage lending code requirements and end the whole bond speculating market. The numbers that shocked me the most were these:

    “In 2000: $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds
    In 2005, $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds”

    $507 billion in what amounts to junk bonds .. and no regulators to look and say, what the hell is going on here? Unreal

  2. Keith H. says:

    Yeah, I heard about a story about Credit Default Swaps on NPR and read more about them in Time (http://www.time.com/time/business/article/0,8599,1723152,00.html) and NPR (http://www.npr.org/templates/story/story.php?storyId=96395271).

    It makes me wonder how many other unregulated backdoor markets are out there. Even worse is that to my knowledge Congress still has not addressed or even acknowledged this issue.

  3. Dave F says:

    Thanks for the recommended reading Mike…. And I thought I was already filled with rage. ;-)

  4. james says:

    If you watch CNBC and expect to glean anything useful or insightful you only have yourself to blame. CNBC is the greatest disaster ever foisted on the american investor. Watch Bloomberg is you must watch TV and listen to Jim Rogers.

  5. Lee says:

    I see basically two systemic problems, one is Wall Street and the other is Washington DC.

    In regards to Wall Street government regulation is not the answer. A thousand lawyers can get around anything a few hundred politicians with their own agenda can come up with and agree on. What we need are systemic changes to corporate laws and regulations that are structured for self-regulation and the long term performance of the corporation FOR THE STAKEHOLDER and not the year to year performance for the benefit of management and employees. Carl Icahn has his arms around this and you go here for more: http://www.icahnreport.com

    The other problem is that Corporate America owns Congress. We need to get the corporations and foreign countries out of the halls of Congress. Lobbying should only be the privilege of natural persons that are American Citizens. Go here for more information: http://ezeques.newsvine.com/_news/2008/09/23/1900175-fixing-wall-street

  6. Tim says:

    That is a thoroughly depressing read. It is no surprise that there is a lot of corruption on Wall Street. But these guys who were running the show were just plain stupid.

    This is just shocking…

    …its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,”

    Analysts used models that didn’t allow negative inputs?! That isn’t analysis, that is just plain stupidity.

    The question on my mind is, how do we find our way out of this? Given their recent performance, can we have any faith in the intelligence and ability of the frauds who are still probably running Wall Street?

  7. Actually, the crash was a normal event, and it was definitely expected by anyone with any sense and knowledge about the housing and financial markets at all. No, really. If you haven’t been expecting it for at least two years, you don’t follow the markets enough to make any significant investment decisions on your own. Crashes like these happen now and then. For all we know, they are an intrinsic feature of markets that are driven by greed, fear and irrational exuberance just as much as by its underlying economic reality.

  8. Mike D. says:

    Michael: While a “housing bubble” may have been expected, the massive crash of the equity and debt markets was definitely not expected by “anyone with any sense and knowledge about housing and financial markets at all”. If that was true, then:

    a) You should have been massively short the market (were you? maybe you were, I don’t know). I don’t just mean sitting on the sidelines. I mean massively short.

    b) Many, many more people would have been short and even more people would have taken their money out of the market and sat on the sidelines.

    c) This would have been priced into the market somewhat before the Lehman collapse.

    I agree with you that some sense of “this isn’t right” should have been apparent ahead of time, but to essentially say that anyone with any brains could foresee the degree of this collapse is overstating the case. Almost every investment bank, every mutual fund, every individual investor, and every hedge fund have lost significant percentages of their equity as a result of this. If your statement is true, nobody in that group knows enough to be managing money.

  9. Michael Ströck says:

    Two issues: 1) An imvestment bank is only an entity by legal fiction, which is ultimately one of the reasons for this mess. 2) That’s just not how it works. Being right directionally is worthless on its own. Timing, access to the right instruments and money-management are equally or even more important. I’ll elaborate on this later, as I’m on my phone right now.

  10. Mike D. says:

    Michael: Agreed about the investment banks. My only point is that I don’t think you can make the leap from “we should have seen this coming” to “everyone’s an idiot”.

  11. WRT CNBC and What a stupid thing for anyone who knows anything about investing to say.

    That could be said about so many people and applied to so many ideas that rolled out in the last 8 years (and more, of course). Unregulated CDS markets? Sub prime mortgages that allow people with little money to bet on the housing market? One could say that hindsight is 20/20, but fundamentals and principals don’t go away, no matter the reason or person who is saying “no, its different this time”

    Now Peyton Manning, yeah, he’s going to win me the league :)

  12. Just reading the comments… “the crash was a normal event, and it was definitely expected by anyone with any sense and knowledge about the housing and financial markets at all.”“Crashes like these happen now and then.”

    Michael: Not sure what markets and players you watch.

    1. Crashes happen, bear markets happen; a crash like this one has never happened before, nor was it ever possible. Compare it to 1929 or whatever you want, the world is vastly different now.

    2. Crashes do happen, so expecting one is like expecting it to rain one day.

    3. “it was definitely expected by anyone with any sense and knowledge about the housing and financial markets at all.… I don’t think that there are many people with the scope of knowledge of the underlying structures, mortgages, housing market, unilateral private contracts backing sub prime risk and other risky positions taken by companies (+/- rogue traders) to think that your statement can be applied to more then 100 people the world over.

    There were more people beating their chests and tooting their horns in the media (lets call them bulls :) then there were bears, that’s for sure. And how many people up until 2 months ago were publishing “is this the end of the crisis” articles?

    “If you haven’t been expecting it for at least two years, you don’t follow the markets enough to make any significant investment decisions on your own…”

    Well obviously there are a lot of people in those shoes, including the author of a certain “The Age of Turbulence”…

  13. I just don’t think *anybody* realized there was so much leverage in the markets… Lots of leverage? Sure, but the private nature of the CDS market meant that a lot of leverage was unseen… (just had to add that).

  14. While I’m here commenting with nobody else (unilaterally?), its worth correcting “unilateral private contracts backing sub prime risk” to read bilateral

  15. Mike D. says:

    Mike P: :) I’m still here! Good comments…

  16. Thanks Mike. Now only if I had been massively short in the markets :)

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