The Big Short
By Michael Lewis
The world of finance is one of losers and winners. When the sub-prime mortgage crisis hit the market in 2007, the big Wall Street firms with huge pile of sub-prime mortgage bonds lost while a few wise men betting against these bonds won. In Michael Lewis’ Book The Big Short, Lewis recounts the story of how a handful of Wall Street misfits anticipated the doom of the sub-prime mortgage bonds and made a fortune betting against the home-price inflation in mid-2000s. Lewis successfully tells the story with humor and clarity, considering the complexity of the sub-prime mortgage bond market before the crisis. However, his account of the financial crisis in 2007 is biased in that it exaggerates the effects of the public feature of investment banks, ignores factors such as government’s policies that lowered borrowing standards and neglects home owners’ speculative behavior.
Lewis overstates the effects of the public nature of the major investment banks. Lewis points out, toward the end of his book, that what lied at heart of the crisis was that all the major investment banks went public rather than functioned as partnerships. (Lewis traced the crisis back to a decision John Gutfreund had made- when he’d turned Salomon Brothers from a private partnership into Wall Street’s first public corporation.) Here is his logic: if a major investment bank were organized like partnership, each partner would have been more careful with their decisions and taken fewer risks. Now that these banks were public and the bankers were operating with shareholders’ money, they had few incentives to scrutinize their decisions or products because they could transfer risks to their shareholders; that was what led these firms to use high leverage and buy a great amount of sub-prime mortgages bonds without even knowing what were underlying these assets. (Lewis, 257) Lewis states that the incentives on these public Wall Street firms are entirely wrong because the bankers can get rich [even] when they are making dumb decisions. (Lewis, 256) In short, Lewis is saying that people within the investment banks took excessive risks because they had nothing to lose. This statement is not sound. First, the bankers did have many things to lose. Many individuals most responsible for the massive money loss during 2005-07 were the largest shareholders in their companies. These individuals lost money when their firms suffered.
In other words, they did not transfer much risk to the companies’ shareholders. Even though Howie Hubler, a former trader at Morgan Stanley, got away with large bonuses, the majority of the Wall Street professionals responsible for the crisis suffered from the crisis. Jimmy Cayne (CEO of Bear Stern)’s stock declined from 1 billion to 50 million. Richard Fuld (Lehman’s chairman) lost 550 million of his Lehman stocks when Lehman Brothers went under. The bankers had a great deal of interest within these firms. These individuals did want their firms to perform well. Even though the bankers are employees in a public company, they are effectively like partners in a partnership company because of their large stock holdings. Therefore, the employees engaged in careless behaviors not because they were in a public firm, but rather, because of some other factors. Second, we can refute the author’s contra-positive statement: if an investment bank were not public, bankers would not have been as careless. To refute this, just imagine that an investment bank were actually a partnership. In this case, a banker would still have bought those mortgage bonds because they were led to believe that they could make profits in these bonds. The only difference would be that the bank would not have had the ability to raise funds in the stock market. In this case, these partnership firms would just have found other creative ways to raise enough capital to buy the mortgage bonds, which would eventually lead to the 2007 crisis. To conclude, the mere fact that the major investment banks were public is not important in causing the crisis.
Moreover, the book is biased in that it gives all the blame to investment banks and ignores the government’s policies’ effects on the crisis. If the government did not lower the borrowing standards and encouraged lending at Fannie Mae and Freddie Mac, the crisis might never have had happened. Here is what happened: at first, the banks were making money with bundling mortgages backed securities backed with good credit and down payment and selling them to investors. Then they became greedy and wanted to make more money by making more loans. When there were not enough people with good credit, the banks invented credit default swaps. (In the book, a trader named Mike Edman within Morgan Stanley came up with this idea). With these swaps, a bank could give out loans to people with low credit score and little down payment. However, a loan could be granted only if it fulfilled the underwriting standards designed by the government. Therefore, the banks had to persuade the politicians to ease the underwriting standards. The investment banks then spent huge amount of money to get the government ease the standards. Then Barney Frank was saying that everyone deserves to own a home and Bush was saying that everyone deserves to live the American Dream. Clearly, if the government had not relaxed lending standards, the investment banks would have never got the chance to create the CDOs, which eventually led to massive defaults of people who should not have owned houses at first place. True, the investment banks were greedy. However, without the help of the government, they would have never been able to unleash their greed. The book also ignored that homeowner speculation also contributed to the crisis. In the book, the homeowners who got sub-prime loans were depicted as poor people who were told by the mortgage sellers to tell lies and who got deceived by the teaser rate and was later ripped off by the real rate. (Lewis, 19) These customers were truly the victims of the entire housing market scheme.
However, we had another crowd of customers who had more than one house, to whom we should not be as sympathetic. They were buying houses as speculative investments. During 2006, 22% of homes purchased were for investment purpose, with an additional 14% purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. The widespread speculation pushed house prices up dramatically. Housing prices nearly doubled between 2000 and 2006. Many homes were purchased even when they were still under construction and then sold for a profit without the sellers ever having lived in them. The housing bubble was so big that Warren Buffett stated that it was the greatest bubble he has ever seen in his life. The question is how did the broad speculation contribute to the crisis? The rising housing price gave mortgage sellers excuses to give out sub-prime mortgages, whose defaults eventually led to the crash. The inflating house prices also gave credit to the CDOs that investment banks created and encouraged large trading volume of CDOs, which increased the magnitude of the crash. As a reader, it is hard not to wonder how could Lewis know every time in advance that a crash was coming and went about documenting it, as what he did when he wrote Liar’s Poker and this book. It must be that the crash had shown its signs in times of prosperity and Lewis captured these signs.
We should learn to be as forward-seeing as Lewis is. We are just four years away from when the crash happened and our economy is still not fully recovered. As we gradually pull ourselves out of recession, let’s remember the lessons learned in the past and walk with great care. And here, we refer not only to investment banks, but also the government and every average American citizen.
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Editorial Staff
