The Outsiders Who Foresaw The Subprime Crisis
Nearly the whole financial system bought into subprime mortgages and the securities that were backed by them — and amounted to bundles of bad debt.
In his new book, The Big Short, Michael Lewis writes about people who didn't buy in. In fact, they bet against the colossal tower of debt that Wall Street built. They shorted it — and they profited from its eventual collapse.
For Lewis, The Big Short is his return to the scene of the crime. Twenty years ago, he wrote about his experience working as a young bond trader at Salomon Brothers. Liar's Poker was an astonishing tale of kids fresh out of Ivy League schools making huge decisions about other people's money with no qualifications for doing so.
By the time of the financial crisis, the generation he wrote about in Liar's Poker was established Wall Streeters, typically up to their eyeballs in mortgage-backed securities.
The people he writes about in The Big Short are outsiders by virtue of youth or personality.
Wall Street's Heroes And Demons
One of the characters in Lewis' latest Wall Street saga is an unlikely hero, Michael Burry. He's a young hedge fund manager based in San Jose, Calif., who has Asperger's syndrome.
Originally a neurologist, Burry quit being a doctor during his residency at Stanford Hospital because of a stock market blog he wrote in his spare time. One day, Burry posted a message saying that he was sick of medicine and he planned to go into investing. Two major stock market investors tracked him down to stake him to a business investing in the stock market.
Burry's track record over the next few years, Lewis tells NPR's Robert Siegel, was astonishing.
Discovering Disaster
Then Burry began to realize that the futures of several companies he was investing in turned on a weird lending market, the subprime mortgage bond market. So he started reading the prospectuses of subprime mortgage bond offerings. In the structure of the loans, Burry could see the future disaster. So he figured out how to use this knowledge to his advantage, and he became the first investor off Wall Street to make the big bet against them.
Burry went in so early that his investors thought he was crazy.
"He ends up feeling more cynical about Wall Street than anybody I've ever met because of his dealings with the Wall Street firms," Lewis says.
Because he didn't have much connection with people, everything Burry did was via e-mail. So Lewis says, in researching his book, he got to benefit from a perfect, real-time record of what was going on in these markets.
"The one guy that I could trust in the middle of this crisis was this fellow with Asperger's and a glass eye," he says "He became the moral center of this market for me because he was the most honest character."
Lewis profiles extreme characters — outsiders — who are the sane people in an insane world.
"You have this body of facts out there in the financial world, and the vast majority of the people in that world are organizing the facts into one kind of picture — and it's a pretty picture," he says. "And a handful of other people take the exact same facts, but they organize it into a different picture."
The people in Lewis's book were able to look at the situation in a different way.
And The Ugly
At the same time, only a handful of people had bad motives when it came to the crisis.
"More often than not, the people at the center of the doomsday machine were deluded themselves," Lewis says. "The problem isn't criminal behavior. ... The story of American capitalism in recent history is not really the story of Bernie Madoff."
Lewis says the story is one of bad incentives causing people to behave in bad — but legal — ways.
"The best thing we can do is focus our energies on how to create the rules that prevent people from enriching themselves while impoverishing the rest of us," Lewis says.
Course Of Action
Economic policymakers have acknowledged the disaster, but many say they're afraid of stifling innovation if they take action.
"In telling this story, I had my opinion of financial innovation changed," Lewis says. When he left Wall Street, Lewis thought that most of the innovation was leading to a smarter distribution of financial risk. But Lewis says since he left, innovation has run amok.
With the exception of a few people on Wall Street, investors would be better off if credit default swaps, for example, were never invented, Lewis says.
"The failure so far in the response to the crisis has not been the failure to lynch a few people," he says. "It's been failure to introduce some pretty obvious reforms."
The reason for that failure, Lewis says, is that financial crises move quickly while the political process moves slowly.
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MELISSA BLOCK, host:
From NPR News, this is ALL THINGS CONSIDERED. I'm Melissa Block.
ROBERT SIEGEL, host:
And I'm Robert Siegel.
Nearly the whole financial system bought into subprime mortgages and the securities that were backed by them, and that amounted to bundles of bad debt.
But in his new book "The Big Short," Michael Lewis writes about people who didn't buy in. In fact, they bet against the colossal tower of debt that Wall Street built. They shorted it, and they profited from its eventual collapse.
For Michael Lewis, "The Big Short" is his return to the scene of the crime. Twenty years ago, he wrote a book about his experience working as a young bond trader at Salomon Brothers. "Liar's Poker" was an astonishing tale of kids fresh out of Ivy League colleges, making huge decisions about other people's money with no earthly qualification for doing so.
By the time of the financial crisis, the generation that he wrote about in "Liar's Poker" had become established on Wall Street. It was a generation typically up to its eyeballs in mortgage-backed securities.
The people he writes about in "The Big Short" are outsiders by virtue of their youth or their personality. People like a young hedge fund manager based in San Jose, California, named Michael Burry.
Mr. MICHAEL LEWIS (Author, "The Big Short"): He is a trained neurologist. He quit being a doctor during his residency at the Stanford Hospital because he -on his spare time, he's blogging about the stock market. But pretty soon, his stuff is so good that he can see that Wall Street's reading it. He posts message at the end of his blog one day saying, I'm sick of medicine. I'm going to go invest money. And his track record over the next few years is astonishing.
As he's doing this, he realizes that a lot of the companies he's investing in, their fortunes turn on this weird lending market, called the subprime mortgage bond market. And because of who he is and how he's built, he doesn't like meeting people face to face. And he starts reading the prospectuses of subprime mortgage bond offerings.
And he sees that in the structure of the loans, you can see the future disaster. And so he sets out to figure out how to bet against this. He realizes that Wall Street is going to create a market insurance on these bonds; a credit default swap market on subprime mortgage bonds, and becomes the first investor off Wall Street to make the big bet against subprime mortgage bonds. And it gets him into all kinds of trouble...
SIEGEL: Yeah.
Mr. LEWIS: ...because everybody thinks he's crazy.
SIEGEL: He's in so early that his investors are saying, what are you doing with these bets against subprime mortgage-backed securities. You're the guy who can find under performing corporations and sell stock in them.
Mr. LEWIS: And he keeps trying to explain them in very lucid letters. He says to them: in this world now, you can't sanely invest in a lot of these companies that I was investing in because of what's going on in this lending market.
But what was interesting to me is because he didn't really have much connection with other people, everything he did he did by e-mail and he saved it all.
SIEGEL: Mm-hmm.
Mr. LEWIS: He had this perfect, real-time record of what actually had happened in these markets. Here was the one guy I could trust in the middle of this crisis, was this fellow with Asperger's syndrome and a glass eye. He also has a glass eye. He became the moral center of this market for me because he was the most honest character.
SIEGEL: You're describing people who, in a way, have to be outsiders to some degree because they're going to take the view of a very, very small minority. So in a way, it shouldn't be coincidental that the people you write about seem to be - their personalities seem to be in some way extreme.
Mr. LEWIS: Well, they are extreme characters and they're in a very - each of them is in the curious of position of being a sane man in an insane world.
For me, this story - I mean, the book to me was partly a book not just about financial markets but about human perception. That you have this body of facts out there in the financial world, and the vast majority of the people in that world are organizing the facts into one kind of picture. And it's a pretty picture. And a handful of other people take this exact same facts, but they organize it into a different picture.
And it reminded me, psychologists play with this conundrum all the time - these optical illusions that people are presented with. And you look at a drawing and from one angle, it looks like a gorgeous woman in profile. And from another angle, actually what you're doing is staring into the face of a horrible, old witch.
You know, 99.9 percent of the people in the financial system saw this beautiful woman in profile. And this .1 percent of the people saw this horrible, old witch. And the question was: Why did these people see this thing?
SIEGEL: How would you sum up the role that Goldman Sachs played in the period that you're writing about, when it was both betting for and against the subprime mortgage market?
Mr. LEWIS: Embarrassing and wildly irresponsible. Goldman Sachs was a relatively unscathed by the collapse of the subprime mortgage bond market because at the very end, just before it collapsed, they reversed their historical long position in that market and got short the markets, so that they actually made a bit of money when the market collapsed.
But along the way, they designed securities that were close to design to fail. The sort of reductio ad absurdum of their attitude toward the marketplace was their relationship with the insurer AIG. We all know that the big Wall Street firms used AIG through 2005 as a place to dump this mushrooming subprime mortgage bond risk that they were taking. So they got AIG to insure the riskiest subprime mortgage bonds.
But what's less well known is that Goldman Sachs led the way, that it was Goldman Sachs talked AIG into doing this business. And it wasn't just a few million dollars. It was $20 billion worth of insurance they got AIG to insure on things that would ultimately be worth basically zero.
SIEGEL: At least some of the people you write about who were shorting the subprime market, the young guys at Cornwall Capital, say. They thought this went beyond - or at least they said often - it went beyond wrong and irresponsible to fraudulent.
Should there be some more prosecutions of people who were fraudulently packing junk debt and calling it investment-grade securities?
Mr. LEWIS: The easy answer is yeah. You know, you can throw some people in jail but it requires you first to divine their motives. What I found is that more often than not, the people at the center of the Doomsday Machine were deluded themselves. And the problem isn't criminal behavior. That wasn't the problem in this case. The story of American capitalism in recent history is not really the story of Bernie Madoff.
It's a story of very bad incentives causing people to behave in very bad but perfect probably perfect illegal ways.
SIEGEL: But you compare what's happened since the fall of Lehman Brothers, let's say, with what happened during the S&L crisis. Dozens of prosecutions, I think hundreds actually of prosecutions coming out of the S&L collapse.
Mr. LEWIS: Yeah...
SIEGEL: In this case, one failed prosecution of two Bear Stearns traders is what I've been able to come up with.
Mr. LEWIS: Well, to your point, look how much the prosecutions in the S&L crisis achieved for us. We ended up with an even more insane financial system.
I think that rather than trying to get even with a handful of people who behave the worst, the best thing we could do is focus our energies on how to create the rules that prevent people from enriching themselves, while impoverishing the rest of us.
SIEGEL: I've heard any number of economic policymakers and some of the most highly-placed people in Washington acknowledge the disaster, the fiasco that took place in Wall Street, but then nod deferentially to innovation - and we don't want to stifle innovation.
Mr. LEWIS: In telling this story, I had my opinion of financial innovation changed. When I left Wall Street, I thought that most innovation was leading to a more - a smarter distribution of financial risk in the system.
SIEGEL: Mm-hmm.
Mr. LEWIS: I now think that the financial innovation ran amok since I left and especially the stuff that happened in the late '90s, early 2000s. That credit to fault swaps, for example. We would all be richer and we would all be better off - with the exception of a handful of people on Wall Street - if credit default swaps had never been invented.
And the failure so far in the response to the crisis has not been the failure to lynch a few people. It's been the failure to introduce some pretty obvious reforms. And I think it's - the reason for that is that, you know, financial crises, they happen very quickly, the political process moves slowly.
SIEGEL: Mike Lewis, thanks so much for talking with us.
Mr. LEWIS: Thank you.
SIEGEL: Michael Lewis, author of "The Big Short: Inside the Doomsday Machine." Transcript provided by NPR, Copyright National Public Radio.
