With nice irony, the release at the end of the month of The Big Short, the movie version of the 2010 book of the same name by Michael Lewis (still the best piece of sustained financial journalism that I have read) coincides with the news that the Financial Conduct Authority is shelving the enquiry into banking culture which was a substantial plank of its planned work.
The film is smart, quirky and acted with acerbic humour by the actors playing the handful of geeks and oddballs who almost incredulously, and with much uncertainty, in the run up to the crash found themselves alone betting against the whole of Wall Street (before, too late, the latter changed its mind), and indeed the entire US economy, in the financial play of the title. The film, like the book, leaves no doubt that the cause of the financial nightmare of 2008 – entailing an estimated $12tr in financial losses, together with 8m jobs and 6m homes in the US alone – was not abstract economic forces, but decisions informed by the banking culture that is even now being eased off the hook: a systemic culture so corrupt and multiply conflicted that the actors embedded in it ended up by comprehensively deceiving themselves (as Lewis noted of Howie Hubler, a Morgan Stanley bond trader who ran up losses of $9bn, the single largest loss in Wall Street history, ‘he was smart enough to be cynical about his market, but not smart enough to realise how cynical he needed to be’).
The story has lost none of its ability to amaze and appal in the intervening years. It builds from the inkling of a handful of investment contrarians that there's something not right about the US housing boom of the early 2000s. If that is the case, then not only they shouldn’t be investing in anything to do with it, they should be betting against it. What they discover, piece by piece, with mounting disbelief, is a system in which a grotesquely deformed housing tail has ended up wagging the entire Wall Street dog, now blindly lashed to what is destined to be its own Doomsday machine. As Citigroup's Chuck Prince’s memorably told the FT in 2007, ‘As long as the music is playing, you’ve got to get up and dance. We’re still dancing.’ The bricks and mortar of US dwellings, the outsiders begin to see, are the tiny fulcrum on which is erected a towering superstructure of ‘mortgage-backed’ derivative investment vehicles: first mortgage bonds and then increasingly abstruse collateralised debt obligations, or CDOs, which aggregate tranches of many individual bonds into a new derivative investment vehicle, and so on almost to infinity.
What they uncover is in effect a giant Ponzi scheme driven by wishful thinking based on one critical assumption, which falsifies everything else. With every addition to the gleaming edifice, the towers of debt become more unstable, but the consequences are so remote from the original action that no one connects the dots. The critical assumption, glaringly obvious in retrospect but long unquestioned by anyone in the chain, is that the instruments that compose the debt towers are creditworthy. Staggeringly, no one vets the quality of the mortgages at the bottom of the pile. On the basis that mortgage bonds are diversified assets (in all history it had never happened that mortgages had gone bad in all parts of the country at the same time), the rating agencies, Standard and Poor’s and Moody’s, classify them as investment grade. On the same grounds, CDOs backed by the mortgage bonds are rated triple-A or double-A, even though they are composed of sub-prime loans to people who will never repay them. Confronted in the film on this blatant credit laundering, a rating-agency official replies simply: ‘We’re competing with the other guys. If we don’t give the originator their double-A rating, they’ll just go up the road.’
For the bloody-minded loners sitting on the knowledge of this gross mispricing of risk, the frustration is that they have no direct way to profit from it. Then one has the bright idea of persuading a Wall Street bank to sell him another derivative – a credit default swap, or CDS – which is in effect an insurance policy against a CDO, paying out if that instrument fails. No one on Wall Street believes that’s possible (‘they’re triple-A, aren’t they?’), so CDSs are sold with gusto; and then combined into so-called ‘synthetic’ vehicles so opaque that it’s near impossible to work out which side of the bargain holders are… Some investment banks are later found to have been selling investments that they know to be junk to gullible clients ('dumb Germans' or 'Korean farmers') with the sole intention of using these arcane instruments to bet against against them.
In the end, it turns out that all the quants and super-managers on the Street are ‘far less capable of grasping basic truths in the heart of the US financial system than the film's oddball heroes, one of them 'a one-eyed money manager with Asperger’s’, and two or three other equally obstinate and persistent outsiders. (One of the sobering lessons of the episode is just how much obstinacy and persistence it takes to stand out against such powerfully self-reinforcing groupthink.) But when in 2008, as the short four predict, the sub-prime loans go bad and the CDOs fail, they take first Bear Stearns and then Lehman Brothers donw with them. Many others would have followed, including the giant insurer AIG which was the counterparty to many of the CDSs in play, but for the bailouts which transferred trillions of dollars of liability to taxpayers on both sides of the Atlantic.
Here perhaps lies the truly chilling explanation of the failure of the authorities to allow the the banks to reap the just rewards of their own venal stupidity and go bust under the weight of their colossal debts and ‘troubled assets’: what terrified them was not the direct costs of institutional failure but the prospect that the collapse would trigger a tsunami of payouts on the unquantifiable trillions-worth of CDSs that had been taken out against them. It wasn't the size of the banks themselves that made them too big to fail, but the number and magnitude of the side bets laid on them. The casino managers didn't even know the odds on the vast wagers they were taking.
Seven years on from the crisis, the film warns, the banking culture that produced it is still intact. A short-term, hire-and-fire culture in which the only motivator is money. ‘When you can be out of the door in five minutes, your horizon becomes five minutes,’ one City worker told a journalist. Where the traders who earned millions, sometimes hundreds of millions, screwing their customers have kept their gains. Where those who caused the disaster are now advising governments to get off their backs, and regulators such as the FCA are accordingly scaling back their attempts diminish the chances of the same thing happening again.
Meanwhile, the unreformed ratings agencies are still being paid by those whose products they rate.
CDOs are being marketed again.
Happy New Year.