Debunking Michael Lewis’ The Big Short
nakedcapitalism.com
nakedcapitalism.com
Although I agree that there are weaknesses that flow from Lewis using the forms of fiction story telling (plot arc, conflict, protagonists, etc.) to tell a non-fiction story, I think a weakness of this review is that it ducks the main scandal: the lack of regulation.
[Note, this may be covered in the author's book, EConned, I don't know, I haven't read it, though I did just order it.]
Obviously, the people participating in the market who made money were "part of the problem" -- but the bigger problem was the lack of regulation for an area of the economy that is so significant the rest of us have to bail it out (privatized profit, socialized risk). This allowed, among other things:
1. rating agencies to lie -- they had an economic incentive to do so (fees from investment banks) and no one to stop them (so much of the market is legally bound to use/rely on them). It's incredible in the wake of this that S&P, Moody's, etc. still exist. They participated in the largest fraud in capitalism's history.
2. an opaque market in instruments that grew so large the rest of us were on the hook for it. This is the largest transfer of wealth in history and it's still not clear what the hell happened.
The BP oil spill looks transparent compared to what went on here.
I agree that it is amazing that these organizations still exist after having arguably been the main cause of so much chaos.
Except that the problem was actually the regulation. Let's look at your examples.
> 1. rating agencies to lie -- they had an economic incentive to do so
The rating agencies had a govt mandated monopoly - that's a creation of regulation. That pretty much guarantees that their failures will cause system failures. Note that the regulation in this case pushed that failure into the core of the banking system. The ratings determined whether something counted as an asset, so when they got it wrong, banks tanked.
Note that regulation also said that "insurance" on mortgage-backed securities made them safe. The regulators did this because they wanted banks to hold more MBS, which makes them cheaper, which causes more of them to be created, and so on.
> 2. an opaque market in instruments that grew so large the rest of us were on the hook for it. This is the largest transfer of wealth in history and it's still not clear what the hell happened.
Sure it is. Politically connected institutions were made whole. (Example - We gave money to AIG to pay its debts to Goldman Sachs.) We're still pissing money into Fannie and Freddie.
Regulation is systemic risk.
Note that regulators don't have any skin in the game and politicians have even less. (I'm looking at you Barney Frank and Chris Dodd.)
Although I'm not sure that the guys making money from Credit Default Swap agreements on CDOs are on morally safe ground, I disagree with Yves that Steve Eisman, Mike Burry et al were "the moving force behind otherwise inexplicable, superheated demand for the very worst sort of mortgages." Ultimately, irresponsible mortgage lending was the root cause of the crisis: it was a superheated supply scenario.
It was only when the rate of defaults on home loans dramatically increased that the CDOs dropped in value, and the Credit Default Swaps could be redeemed.
For example, in addition to the high number of defaults that occurred after an initial two year, fixed-interest period, (when the interest rate jumped in some cases from 6% to 12%) some of the loans even defaulted on their very first payment. Lewis makes the point in the book that the question is not "who defaults on their first loan repayment?", but rather "who lends to someone who can't even make a single repayment?"
As for Magnetar being undocumented, Chicago Public Radio did a great podcast about it a couple weeks ago, which was where I got the recommendation for 'The Big Short'. It's well worth a listen: http://www.propublica.org/ion/podcast/item/bernstein-and-eis...
The only problem with shorts, but this is equally true of the longs, is that investment activity is secret and information fails to be spread around; big risks creep into the markets without enough discussion taking place. If markets run on information, our markets are running on fumes. No wonder they sputter a lot.
And of course, that's what they're paid to do - they're just good at their jobs. Which is why there's a larger issue at stake here about what constitutes ethical trading behavior in modern markets, and I think this is part of that discussion. It's completely inaccurate to say that short bets are wrong, because as you say, they are so crucial to keeping liquidity in the marketplace. At the same time, to take a position that you know for a fact will drive the bubble up to be larger, to fall harder, well - are you completely irresponsible for the consequences of those trades?
When you get right down to it, this is why regulation is necessary. This is why we have referees in sports - nasty behavior is encouraged and necessary in competition, so there needs to be some sort of line to say what is in and outside of the realm of acceptable behavior. And the boundaries of what is and is not acceptable are always changing. Rules aren't static in baseball and football - they change as people figure out how to play within and around them and change strategies.
A long position drives prices up and inflates the bubble. A short position lowers prices and lets a little bit of air out of the bubble.
Real transparency would allow problems like these to be seen and analyzed by people with the skills to do so--perhaps you yourself. And we don't have to pay such people a cent--just don't shoot them when they don't like the bets others make and take the other side by shorting.
I can understand why short sellers who operate with little information get a bad rap. In a market starved of information, it pays to start panics with rumors. Let's add more information to the market so these people can serve some use.
Most of my understanding of how these short positions drove the bubble comes from articles like this propublica report: http://www.propublica.org/feature/the-magnetar-trade-how-one.... Any explanation I'd give would just be a summarization of what I've picked up there. I found the case pretty compelling.
I'd hate to be in the same room as 2010 Lewis and 2007 Lewis:
"But the most striking thing about the growing derivatives markets is the stability that has come with them. More than eight years ago, after Long-Term Capital Management blew up and lost a few billion dollars, the Federal Reserve had to be wheeled in to save capitalism as we know it." http://bit.ly/cg9H6w
Also this fun one from Janet Tavakoli:
"I was in the Salomon Brothers' 1985 training class that Michael Lewis lampooned in his amusing book, Liar's Poker. Imagine my surprise to see him billed as a trader on 60 Minutes, since he was actually a junior salesman. Well-heeled male peacocks strutted the trading floor, and junior salesmen were girlie-men, mere eunuchs serving their pashas." http://huff.to/9pclUR
JT: http://www.youtube.com/watch?v=WA20Am0pwtA ML: http://www.youtube.com/watch?v=x387_k963yY