Tag: Michael Lewis

Weekend Reading: The Undoing Project

I have read most of the books of Michael Lewis. When The Undoing Project came out last year, I grabbed a copy to read right away.

Mr. Lewis picks the story of Israeli psychologists Daniel Kahneman and Amos Tversky who created the field of behavioral economics. Their work came to the attention of Mr. Lewis after Moneyball came out. Cass Sunstein and Richard Thaler pointed out in their review that Moneyball was really about behavioral economics and mentioned the work of Kahneman and Tversky. That reference lead Mr. Lewis to write this book.

It seems like the classic formula for Mr. Lewis: take a complicated topic and explain it using interesting people.

But when I started reading The Undoing Project, I kept putting it down. A year later, I finally decided to read it. (I needed to read a book about social science for the Book Riot Read Harder Challenge.)

I found this to be the least favorite of the Michael Lewis books I have read. I think the problem is that the book is much more of a biography than a concept study using people. It’s not that Kahneman and Tversky are uninteresting. I just didn’t find the lengthier biographical sections of the book to be compelling to read. Most of the first half of the book is biographical.

The book really shines when it focuses on the work of Kahneman and Tversky.

Kahneman and Tversky showed that in decision-making and judgment human beings did not behave as if they were statisticians. Instead our their judgments and decisions deviate in identifiable ways from theoretical models. Human errors are common and predictable.

It’s not that The Undoing Project is a bad book. I just that I had much higher expectations. A mediocre Michael Lewis book is still better than 90% of the books on my shelf.

Weekend Reading: Flash Boys

flash boys

I admit to being a Michael Lewis fanboy. I consider him one of the best business writers. He has a knack for using characters as a lens to explain an issue.

The issue in Flash Boys is high frequency trading. Or high speed trading. Or electronic trading. It’s a bit of a confusing mix. Uncharacteristically, Lewis seems to stumble a bit around what the problem is. I think that is in part because the problem is complicated in a technical, legal and financial directions. Many of the people involved don’t fully understand it. Those that do fully understand it don’t want to explain it. They are too busy making money exploiting the issue.

Based on the speed you receive information, you can trade on that information and make money if you find out faster and trade faster than others. That has been true since markets existed.

For stock exchanges, the days of floor pits and individuals yelling buy and sell orders are long gone. It all happens in server stacked on top of each other with an algorithm matching buy orders and sell orders. There are multiple exchanges where trades can take place. That’s good for competition and innovation.

But those exchanges are located in different places. Not necessarily far apart, but milliseconds or microseconds apart. Just far enough that watching trades happen in one exchange can give a strong indication about what will happen in another exchange a bit further away. High speed traders exploit that information and make money. Lots of money if they are fast enough.

Lewis explores the issue in great detail and provides a good understanding. He uses Brad Katsuyama, a trader at the Royal Bank of Canada, as the focal point of his story.

The most disappointing part of the book is that it ends without resolution. The problems with high speed trading are still in the system and its hurting investors not involved in high speed trading.

 

Boomerang – Michael Lewis Looks at the New Third World

Michael Lewis packages his stories on the effects of the global financial crisis in Iceland, Greece, Ireland, Germany, and California into one book: Boomerang. If you had ready the stories when they were published in Vanity Fair, then you’ve ready the book. If you missed some (or all) of those stories then this book is great viewpoint on how five countries got themselves into trouble with excessive debt.

I had already read the first four articles when they appeared in Vanity Fair, but I had not yet gotten to the article on California. In fairness, Boomerang was a given to me as a gift so I did not come out of pocket to put it on my bookshelf. I enjoyed revisiting the four stories and the new California story.

They each seemed to work better in the collection than standing on their own. Since each story is relatively short, they lack the depth and understanding I’m used to getting in one of Michael Lewis’ books. Collectively, there is bit more depth as you can see how the five different countries got into trouble in different ways by becoming over-leveraged.

It’s a Michael Lewis book, so that means it’s easy to read and smart. He has a gift for taking complicated subjects and using individuals to highlight how his theories work in the real world.

My gripe is not with the book, but with Vanity Fair who sponsored Lewis in writing the five stories, each of which has appeared in the magazine. I purchased a subscription to Vanity Fair just because of these Lewis articles. I thought I was choosing to upgrade the freemium model.  I was willing to pay more for the superior experience of reading the article in the magazine instead of online. However, the publisher would put them on the website (for free) before the magazine ended up in my mailbox. One premium of getting access to the content first, was actually the opposite. I was getting the content later than if I had chosen not to pay for it. It’s not like the magazine is ad-free.

So why I would I renew my subscription?

Germany, Sub-Prime Mortgage Backed Securities, and Scatology

Michael Lewis continues his around the world tour of the 2008 financial crisis from the view of Germany: It’s the Economy, Dummkopf!. The story in the September issue of Vanity Fair seems to be all about excrement. We heard that there were big chunks of the mortgage securities business that were terrible. There is the famous email describing the Timberwolf as on sh*tty deal.

Lewis did great job offering some insight from Ireland, Greece, the Iceland. In this story he seems distractedby feces and Nazis. The biggest insight I took away was:

At bottom, he [Dirk Röthig, of the German financial institution IKB] says, the Germans were blind to the possibility that the Americans were playing the game by something other than the official rules. The Germans took the rules at their face value: they looked into the history of triple-A-rated bonds and accepted the official story that triple-A-rated bonds were completely risk-free.

IKB and many of the other German banks thought they were getting a good return on the mortgage-back securities with little risk, but were actually getting a sh*tty deal. I get it. But I think he belabors the metaphor.

Michael Lewis could write about the economics of a paper bag and I’m sure it would be interesting story to read. In fact, I paid for a subscription to Vanity Fair just because of his articles. This one came up a bit short. Maybe he just thought the underlying story was not interesting enough so he spiced it up with lots of stories about German scatology. He layers in some Jewish alienation in Germany for some spice in his the discussion of feces.

It’s the Economy, Dummkopf! is still worth reading and still offers a few great insights into the 2008 financial crisis.

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Compliance and Liar’s Poker

Michael Lewis has written some great stuff on our most recent financial crisis: The Big Short, Iceland’s Meltdown, Greece and Corruption, and Popping the Irish Bubble. This was not his first rodeo. Lewis had a brief career in finance working as a London-based bond salesman for Solomon Brothers during the mid eighties. His finance career came to crashing halt in 1988 just after the big stock market crash of 1987. He tells his tales of finance and the excesses of Wall Street in Liar’s Poker.

Lewis covers the birth of the mortgage securitization market and trading of mortgages at Solomon Brothers. The firm dominated the market for a few years. They helped shepherd through the regulatory changes and convinced the bankers at S&Ls to buy and sell their mortgages. They essentially created greater liquidity in the American housing market. This would grow tremendously over the next twenty years, leading to the events Lewis later documents in The Big Short.

As a young, inexperienced, and mostly incompetent bond salesman, Lewis mostly screws his customers selling them bad products. But it was good for Solomon Brothers. It was good for his wallet. Wall Street greed is on full display.

It’s eerie reading this book, realizing that it was not 2008, but 1986. The book is not as good as The Big Short, but is still a very good book. I think it’s important to look back to make sure we don’t keep making the same mistakes.

Popping the Irish Bubble

In compliance, you need to learn from your mistakes so you can prevent future problems. There were many mistakes that lead to the 2008 financial crisis, not just in the United States, but also abroad. Michael Lewis wrote The Big Short, taking a look at the Unites States financial crisis and has written great stories on the financial crises in Iceland and Greece.

His latest story in Vanity Fair focuses on the troubles in Ireland: When Irish Eyes Are Crying.

He makes this one look easy. Ireland’s banks made too many bad real estate loans and the Irish government foolishly guaranteed the obligations of the Irish banks.

Lewis quotes Theo Panos, a London hedge fund manager: “Anglo Irish was probably the world’s worst bank. Even worse than the Icelandic banks.” The bank faced losses of up to 34 billion euros. A big number, but the sum total of loans made by Anglo Irish was only 72 billion euros. This one Irish bank had lost nearly half of every dollar it invested.

The signs of an immense real estate bubble sound obvious. A fifth of the Irish workforce was employed building houses and the construction industry had become a quarter of the country’s GDP. As for prices, since 1994 house prices in Dublin had risen more than 500 percent. As a measure of affordability, rents had fallen to less than 1 percent of the purchase price. Your $833 in rent would be for a home with a sales price of a $1 million.

There was a tight link between the Irish banks and Irish real estate. Lending to construction and real estate has risen from 8% to to 28% since 2000.

The Irish government stepped in to help save the banks from their poor underwriting and poor investments. Instead of merely standing behind the deposits at the Irish banks, the government guaranteed all of their obligations. Investors who were looking to dump bonds issued by the banks for pennies on the dollar, were rewarded for holding on to them.

There are plenty critics of TARP and the bailout of the US banks. But it was a significantly smaller intervention than what happened in Ireland.

It’s worth your time to take a few minutes and read When Irish Eyes Are Crying.

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Michael Lewis, Greece, and Corruption

Michael Lewis has moved from Wall Street, to baseball, the left tackle, Iceland, the credit collapse and on to Greece. He takes a look at Greece’s financial crisis in the October issue of Vanity Fair: Beware of Greeks Bearing Bonds.

One issue is the debt hangover. Greece has about $400 billion in outstanding government debt and $800 billion in pension obligations. That $1.2 trillion is about a quarter-million for each working adult.

Another is the generous wages paid to government works. The average government worker makes three times the wage of the average private-sector job. The national railroad has annual revenues of €100 million, but has an annual wage bill of €400 million and another €300 million in other expenses.

Then there is the corruption. “It’s simply assumed, for instance, that anyone who is working for the government is meant to be bribed.”

The government is notorious for pulling tax collectors off the streets during election years. An estimated 2/3 of Greek doctors report incomes of less than €12,000. Self-employment means self reporting of income. Only those salaried employees who have taxes taken from their paycheck get stuck paying taxes. Greece is a poor country full of rich people.

Just to prove the point, he didn’t get a receipt for his coffee with a whistle-blowing tax collector. Even the fancy hotel was not paying the sales tax it owed.

“Everyone is pretty sure everyone is cheating on his taxes, or bribing politicians, or taking bribes, or lying about the value of his real estate. And this total absence of faith in one another is self-reinforcing. The epidemic of lying and cheating and stealing makes any sort of civic life impossible; the collapse of civic life only encourages more lying, cheating, and stealing. “

Greece was desperate to become part of the European Union. That meant they needed to get their deficit under control and prove a stable economy. It seems like they did it by “cooking their books” instead of economic policy. They simply moved expenses and obligations off their balance sheet to earn their 2001 entrance to the EU, swapping the drachma for the euro.

What went wrong?

Prime Minister Costas Karamanlis was involved in a scandal, leading to his ouster and the ouster of his government. The new finance minister took the more honest approach and began finding all of the financial skeletons.

[He] found so much less money in the government’s coffers than it had expected that it decided there was no choice but to come clean. The prime minister announced that Greece’s budget deficits had been badly understated—and that it was going to take some time to nail down the numbers. Pension funds and global bond funds and other sorts who buy Greek bonds, having seen several big American and British banks go belly-up, and knowing the fragile state of a lot of European banks, panicked. The new, higher interest rates Greece was forced to pay left the country—which needed to borrow vast sums to fund its operations—more or less bankrupt. In came the I.M.F. to examine the Greek books more closely; out went whatever tiny shred of credibility the Greeks had left. “How in the hell is it possible for a member of the euro area to say the deficit was 3 percent of G.D.P. when it was really 15 percent?” a senior I.M.F. official asks. “How could you possibly do something like that?”

The other focus of the Lewis’ story is the Vatopedi Monastery that was part of the Karamanlis scandal. The monastery had title to a lake in northern Greece. They convinced the Greek government to trade for the ownership of the lake with government owned property. This included the gymnastics center from the 2004 Olympics. The lake was worth roughly €55 million and the government property they received is probably worth many time that amount. It’s even more valuable now that the monastery has convinced the government to re-zone big chunks of the property for commercial purposes.

It seems the monks just want to use the money to rebuild their monastery. Nobody is claiming the leadership of the monastery is pocketing the money.  The same is not true on the other side of the transaction.

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Image of the Parthenon is by Simon Tong.

Weekend Book Review: The Big Short

Michael Lewis has put together a great book on subprime loans, home mortgage bonds and how their crash led to the Great Panic.

The Big Short starts with this quote:

The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him. – Leo Tolstoy, 1897

That was the challenge in 2006. To not be considered insane when standing apart from the mass hysteria to say the financial news is wrong and “the most important financial people are either lying or deluded.” People were quitting their jobs to become real estate investors. House buyers, lenders and the purchaser of home mortgage bonds seemed to think that house prices in the United States would never decrease.

I really enjoyed The Blind Side: Evolution of a Game. (The book not the movie. The book was about the evolution of football, using the unusual background of Michael Oher as a lens. It was not the sappy family story that was in the movie.) That turned me into a Michael Lewis fan. (Even though Liar’s Poker and Moneyball have not yet risen to the top of my reading list.)

In The Big Short, Lewis uses two people who saw the problems to act as the lens for the story. Michael Burry is a one-eyed hedge fund manager with Asperger’s syndrome. Burry liked to remain isolated from public opinion and human contact. He focused on hard data and the incentives involved in the human behavior in the financial markets. Steve Eisman was another money manager. Eisman was convinced that the subprime mortgage market was full of corruption and exploitation.

Lewis points out how Wall Street was gaming the rating agencies. One example is that the agencies were looking at an average credit score of the borrower, not each individual borrower. So Wall Street would package a barbell of loans. Throw together a bunch of credit scores that are horrible and very likely to default. Then sprinkle in enough loans with high credit scores to get the average credit score just right.

The rating agencies has flawed formulas and Wall Street knew it. After all, Wall Street helped create the formulas. Lewis paints a very dim view of rating agencies.

The rating agencies gave bonds full of floating rate loans a higher rating than those with fixed interest rates. The flawed logic was that borrowers would be just as likely to make payments at 12% as they were at 8%. Obviously, the bigger problem was that borrowers couldn’t make the payments at 8% in the first place.

Eisman and Bury both saw the flaws in the system and made big bets against sub-prime mortgage bonds using credit default swaps. They saw lots of subprime loans being made with loan interest rate teasers that would reset in two years. The borrowers couldn’t afford the property at the teaser rate and would clearly default when the rate reset unless property values continued their astronomical increases.

Lewis did write a great article in Vanity Fair on Iceland’s Financial Metldown if you need a taste of his writing. That story paints a similar of tale of over-exuberance in the financial markets.

The Big Short does a great job of explaining how loans are packaged into commercial mortgage backed securities (CMBS), then sliced up into tranches and sold as bonds, repaid by the cash flow from underlying mortgages. The tranches that get paid first receive the highest rating of AAA, labeling them as nearly risk free as US Treasury bonds.

Then Lewis focuses squarely on collateral debt obligations (CDOs) that repackage the poorly rated tranches of CMBS into new mortgage bonds. As with the CMBS, the tranches that got repaid first received the AAA rating. That was the alchemy, turning garbage into gold.

Lewis does a good job of explaining how all of these mortgage bonds work. If you want more detail on the market for subprime mortgage-backed CDOs read the thesis from A.K. Barnett-Hart, a Harvard undergraduate: The Story of the CDO Market Meltdown: An Empirical Analysis. Lewis cites her thesis as being more interesting than any Wall Street research on the topic.

The Tolstoy quote points out that many on Wall Street did not understand how they worked and did not understand the risks involved.

I recommend that you add The Big Short to your reading list and move it to the top of the list.

The Collapse of AIG

AIG

There have been many stories about the collapse of AIG. There have also been many stories about the internal flaws at AIG. The pitchforks were out when bonuses were announced in March. One of those executives was Jake DeSantis who wrote a New York Times OP-ED about his bonus. (AIG Bonus – My Thoughts) It turns out that Mr. DeSantis also contacted Michael Lewis.

The end result is a story in the August issue of Vanity Fair: The Man Who Crashed the World. As you can guess from the title, Lewis pins much of the blame on one man: Joe Cassano, the former president of AIG Financial Products.

After reading the article, I am not sure it’s fair to pin so much blame on Mr. Cassona. The article does provide a great deal of insight and clarity into the interconnections between AIG, sub-prime lending, credit default swaps, and the collapse of US house prices.

“There was a natural role for a blue-chip corporation with the highest credit rating to stand in the middle of swaps and long-term options and the other risk-spawning innovations. The traits required of this corporation were that it not be a bank—and thus subject to bank regulation and the need to reserve capital against the risky assets—and that it be willing and able to bury exotic risks on its balance sheet. There was no real reason that company had to be A.I.G.; it could have been any AAA-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. A.I.G. just got there first.”

At first, credit default swaps were mostly for commercial credit risk. Then, they started to expanding to consumer credit risk. The thought inside AIG Financial Products was that it was sufficiently diverse that it was unlikely to all bad at once.  At first, the consumer products did not include sub-prime loans. Then, in 2004, the less credit-worthy sub-prime loans started becoming part of the credit pools.  They eventually pulled the plug, feeling confident that their 2005 risks would not suffer any credit losses. (They were wrong.)

The bigger problem came when AIG lost its AAA rating, the day after Hank Greenberg was forced to resign. With its AAA rating, AIG has resisted being required to post collateral to back up its outstanding obligations under the derivative products it was selling. With a downgrade in its credit rating, it had agreed to post collateral. When the debt AIG insured started going bad, AIG had to put up cash collateral to back up its obligations. There was the equivalent of a run on a bank.

Lewis alludes to AIG’s risk-taking for residential loans may have been one of the factors that contributed to the dramatic run up in house prices, that eventually lead to more sub-prime borrowing, to a further increase in home prices and to more bad debt. That liquidity and poor underwriting lead to loans being made that, in retrospect, should not have been made.

Lastly, since AIG turned off its supply of risk-taking for residential mortgage loans, banks kept more of that risk on their books. That may have lead to the collapse of Bear Stearns, Merrill Lynch, and Lehman Brothers.

Lewis pins the blame on Cassano for not realizing that AIG was increasing taking on more sub-prime risk than they realized. At one point, when pools were up to 95% sub-prime, many internal risk analysts guessed that there was no more than 20%. Even when confronted with this Cassano dismissed the problem, conluding that house prices could never fall everywhere in the United States at once. (He was wrong.)

You can read the article and determine for yourself if Cassano should really be the fall guy.

In the end, the lesson to be learned for compliance and risk professionals is the importance of listening to your front line employees. They see many problems coming long before you do.

If you like that article, Michael Lewis also did a great story in the April issue of Vanity Fair on the financial collapse in Iceland: Iceland’s Meltdown.

UPDATE: The Wall Street Journal published an article indicating that Mr. Cassano is the subject of a grand jury inquiry. Prosecutors Are Poised to Impanel AIG Grand Jury. The possible case against Mr. Cassano (and others) could rely partly on tape recordings of 2007 phone calls involving AIG Financial Products employees who discussed the value of their derivatives trades.

Iceland’s Meltdown

iceland-flag

With all of the focus in the United States on the collapse of Bear Stearns, AIG, Lehman Brothers, and Merril Lynch, we may be a bit myopic in not noticing other issues around the world. Iceland stands out as a country that has really run into trouble. As Michael Lewis wrote in Wall Street on the Tundra: “Iceland instantly became the only nation on earth that Americans could point to and say, ‘Well, at least we didn’t do that.’”

The collapse has been so big that Iceland is abandoning its own currency to join the European Union. Until the collapse, Iceland had little interest in joining the EU. They do want the bureaucrats in Brussels messing with their fishing. Iceland put some excellent regulatory controls on fishing that have lead to stable fish populations and rich fishermen.

They failed to do the same with their financial system. They ended up having fisherman quitting the sea to engage in currency trading.

There are lots of lessons to be learned from a compliance and risk management perspective.

Legend has it that Joe Kennedy cashed out of the stock market when his shoeshine boy gave him stock tips. Maybe a warning sign should be fishermen engaging in currency trading. We saw similar events in the U.S. as people quit their jobs to be real estate entrepreneurs. I heard a success story from an acquaintance who told of buying a house for 100, putting in 10 and selling it for 120. I didn’t have the heart to tell him that house prices has risen by 15% during that same time frame. A rising market makes everyone look like a genius.

As Michael Lewis points out “One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem.” You saw that with Iceland’s collapse and you saw that with the collapse in the United States. The most publicity shined on Goldman Sachs for its profits in September 2007 made from shorting mortgage positions. I am sure that there were quite a few mortgage originators who knew they were peddling garbage. But they had no incentive to stop the income coming from origination fees.

The three biggest banks in Iceland, a country of only 310,000, made loans totaling over 850% of Iceland’s Gross Domestic Product.  Only 1/5 of the loans were in Iceland’s currency. They instead borrowed from their banks in cheaper currencies such as yen and Swiss francs. To compare, the balance sheet of Britain’s banking system was at 450% of GDP and the US at 350%. Clearly, carrying too much debt is a problem. Especially when their are few alternative sources of capital besides more debt.

Iceland’s debt load increased from 200% of GDP in 2003 to almost 1000% in 2008. That is an enormous growth curve. Even steeper than the rise of housing prices in the United States.

Economic cycles are part of human nature. We overbuy into good times and oversell in bad times. It easy enough to look back a few years to the Dot-Com bubble focusing on market share and eyeballs at the expense of the bottom line.

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