Those who made the losing bets still won when the toxic bubble burst. Is this any way to run a financial system?

by David Holt

When the American stock market crashed in 2008, it was a big surprise to almost everyone. Certainly to almost everyone in the U.S. financial industry, including the rating agencies that were supposed to assess the riskiness of stocks and bonds, and the regulators who were supposed to oversee the entire financial system. The whole shebang was brought down in large part by an obscure class of bonds based on home mortgages sold to those who couldn’t really afford them.

In The Big Short: Inside the Doomsday Machine, writer Michael Lewis follows the thoughts and actions of a small number of quirky financial players who had been dissecting the subprime mortgage market for years, and who ultimately placed large bets against it. Large, by their standards, but nothing compared to the risks the highly leveraged Wall Street firms were taking by creating and selling the instruments based on the subprimes. After the collapse, the International Monetary Fund (IMF) measured the losses incurred by U.S.-originated subprime-related assets at $1 trillion.

The most unlikely of this crew was Michael Burry, a young man with Asperger’s Syndrome, a form of autism. While still in medical school, he began to study investing at night. In 2003 he began to read the 100-page offering documents for the arcane financial products based on the subprime home loans.

After medical school, Burry started making small trades on “market asymmetries” (not subprime related) with huge rates of return. His emails and other messages began to be read by some of the financial elite, and a few of them staked him to his first fund. It soon became clear to Burry that instruments like “collateralized debt obligations based on a double–A tranche of bonds based on subprime loans” were in fact designed so that virtually no one could understand them, apart from the “quants” who created them and the lawyers who drafted the documents. The real toxic stuff was hidden deep inside, concealed by acronyms that remained undefined.

Burry soon discovered that most people in the financial industry, and certainly those who were actively selling the products, didn’t know the long-term risks of what they were selling. Eventually he realized that even senior managers, and certainly the CEOs, had no idea what was happening inside their own firms. As long as home prices continued to rise the risks remained hidden, and a lot of people in the financial industry continued to make a lot of money from this new market. So why worry? 

But Burry realized the U.S. was in the midst of a housing bubble, where cheap credit and easy access to loans by homeowners was in turn helping juice the rest of the economy, including the stock market. A little analysis showed that this madness would have to come to an end. Eventually, farm labourers would default on their million-dollar loans.  

In 2005 Burry began to short the market, buying credit default swaps (a form of insurance) that would pay off if the subprime market collapsed. This strategy was followed by a few others, such as the founders of the tiny investment firm Cornwall Capital and Greg Lippman, an aggressive bond trader at UBS who picked up the argument from Burry.

In the end, Wall Street firms went down or were bailed out by the U.S. government (read: taxpayers). The part that Lewis doesn’t understand is that those who made the losing bets (the CEOs on Wall Street), who were in fact ignorant of what their own firms were doing, still got their bonuses. The eccentric little crew who had studied the “gaming” of the market and bet against it made money, but so did the senior managers of the virtually bankrupt Wall Street firms that cost the American economy $1 trillion. As Lewis points out, one root cause occurred when these firms went from partnerships to public corporations in the 1980s, transferring the risks of their speculations from themselves to their shareholders.

This is where the argument goes beyond finance and into politics. At one point in the book, the guys from Cornwall Capital were telling each other the crash was “scary for our democracy. People think the system is rigged and it is hard to tell them it isn’t.”

Enter The Strategic Forum, the respected think-tank that covers geopolitics. In its May 24 newsletter, George Friedman argues that the recent financial downturn isn’t your garden-variety panic. He notes that the state has invented the modern limited-liability corporation and the labyrinth of rules that govern its transactions: “A moral regime justifies the complexity of the economic system: poor decisions are penalized and wise ones lead to an increase in wealth,” not just by the actors but by the system as a whole. This is the whole point of the system: to increase the wealth of not only shareholders but also of the system at large. 

“In the crisis of 2008, we saw behaviour that devastated shareholder value while appearing to enrich the management—the corporation’s employees,” Friedman writes. The financial elite enriched themselves, with the political elite taking no action to protect the victims. The contagion spread globally, with the same ramifications. Now there’s a crisis in Europe, and the integrity of the EU is in question.

Friedman points out two years after the financial panic, “the polity still has not absorbed the consequences of the event.” Markets are the result of political decisions, as it’s the political system that allows for allocation of risk, he says. When that system appears to fail and global elites are seen as being above the laws of the land, the consequences go beyond the financial realm into the political and then the geopolitical realm. 

Toss in the costs of two wars of no strategic benefit and an aging population. It may take a generation to sort this one out. 

David Holt is a writer and consultant on strategy and communications. He can be reached at dholt@eastlink.ca.