Thursday, March 24, 2011
The Big Short: A (Short) Review
This best-selling book showcased Michael Lewis' excellent writing style even on such an opaque topic as sub-prime mortgage backed securities. Filled with an intriguing cast of characters and colorful dialogue Lewis recounts the events leading up to the largest financial collapse in the history of Wall Street. He tracks
four groups of men: Scion Capital, FrontPoint, Cornwall Capital, and Deustche Bank who noticed that (or heard from others and believed that) loans were essentially being given to Americans who would soon have no ability to repay them. The mystery that befuddled these men was that Wall Street did not seem to pay attention to this fact. Lewis tells the story as if Wall Street financiers were under a trance and the misguided delusion that these people repay their loans. If that wasn't the case then a less savory explanation exists ---they knew and they didn't care (because these sub-prime mortage backed securities were making them rich).
Financial economics is not an area that I'm familiar with; however, it was interesting to get a perspective from "inside the doomsday machine". There were also interesting discussions at the end of the book about moral hazard, risk, and agency problems. People have an incentive to engage in risky behavior when they do not experience the negative consequences of their actions. Moreover, bosses could not easily monitor what their employees were actually doing with the firm's money. Some food for thought at the end was whether all this could be traced back to the 1980s. When Salomon Brothers transitioned from a partnership to a publicly traded company they essentially shifted the risk away from their clients and themselves and onto the shareholders. Also, as new financial instrument became more exotic they became more opaque and nobody could really understand them. If you can't explain what is a "collateralized debt obligation" or which mortgages are contained in the sub-prime mortgage backed securities then we're in trouble.
This leaves me with a final thought: Charles McDaniel spoke at ASSA meetings in a special session for the Association for Christian Economists a couple years ago. He was citing GK Chesterton and his belief that if the economics was too complex to explain there was probably something wrong and perhaps that road should not be traveled. After reading this book I couldn't agree more.