19 Dec Tracing the Roots: Liar’s Poker

After deciding that I was tired of being a financial ignoramus, I spent some time looking for books and articles that would explain the vocabulary and the rudiments of the world of finance. The global economy had essentially imploded in 2008 and I didn’t understand why. Once I finished a couple of books, such as John Lanchester’s I.O.U., which laid out difficult concepts in simple terms to explain the financial crash, and Ron Suskind’s Confidence Men: Wall Street, Washington and the Education of a President, which detailed much of the politics behind national economic strategy since 2008, I felt as though I finally had at least a grip of the overarching story behind the crisis.

But it wasn’t until I picked up Michael Lewis’ Liar’s Poker that I really understood how far back the roots of the crisis stretched. Through the lens of his three-year tenure at Salomon Brothers, Lewis introduces us to the then-new world of mortgage trading, and the inevitable hysteria that accompanies the realization that there are tens or even hundreds of millions of dollars to be made and lost every single day by buying and selling mortgage bonds. And it becomes clear that today’s slumping global economy is due in no insignificant part to the decisions made thirty years ago on Wall Street, and particularly at this firm.

At that time, the idea of bringing together bond traders and homeowner loans was revolutionary. After all, as Lewis says of the traders, the “hotshot cowboys on Wall Street:”

The cowboys traded bonds, corporate and government bonds. And when a cowboy traded bonds he whipped ‘em and drove ‘em. He stood up and shouted across the trading floor, “I got ten million IBM eights and halfs (8.5 per cent bonds) to go (for sale) at a hundred and one, and I want these f**kers moved out the door now.” Never in a million years could he imagine himself shouting, “I got the sixty-two-thousand-dollar home mortgage of Mervin K. Finkleberger at a hundred and one. It has twenty years left on it; he’s paying a nine per cent interest; and it’s a nice little three-bedroom affair just outside Norwalk. Good guy too.” A trader couldn’t whip and drive a homeowner… For the home mortgage to become a bond it had to be depersonalised.

And so in 1978, Salomon Brothers created the first mortgage security department on Wall Street, and in 1983, the collateralized mortgage obligation (CMO), which depersonalized the homeowner loan by pooling it with thousands of others, turning it into something that the traders could “whip and drive,” as Lewis puts it.

Lewis’ description of this financial innovation sounds awfully familiar. He explains how the CMO model was designed to address the problem of prepayments—homeowners paying off their mortgages ahead of time, and thus leaving the investors with unwanted cash. They were divided into tranches, or slices. In a CMO with three tranches, investors in the third tranche didn’t have to worry about receiving any prepayments until investors in Tranche 1 and 2 had been paid off.

I was struck by the bizarre logic behind this. Up until very recently, I had always assumed, naively, that paying off debt promptly was a good thing. Yet when I met my husband, who bought a house when he was 20 and sold it a few years later, he had just finished paying off a loan that he’d taken out to fix up the home. He wasn’t allowed to pay it back in advance. This befuddled me, at the time. My extremely outdated assumptions about loans and repayments were based on two parties: the one making the loan and the one receiving the loan. The parties in the middle—traders, salespeople, investors—I was oblivious to them, although it would turn out that they were the most crucial players. And yet these players had completely escaped my notice. I was totally unaware of the bond market, despite its pivotal role it would play in the housing bubble and ensuing collapse.

Back at Salomon Brothers, by the time Lew Ranieri, the head of the mortgage department, was fired in 1987, he had met his goal, writes Lewis:

Ranieri had accomplished what he set out to do: put the mortgage department on equal footing with corporate and government bonds. The United States mortgage market is now the largest credit market in the world, and may one day be the single largest bond market in the world. Ranieri’s creation signaled a shift in the focus of Wall Street. Wall Street, historically, had dealt with only one side of the balance sheet: liabilities. Mortgages are assets. If home mortgages could be packaged and sold so could credit card receivables, car loans, and any other kind of loan you can imagine.

To my mind, this prescient observation, written nearly 30 years ago, documents the real start of our road to financial perdition. Other factors obviously contributed—deregulation, shoddy oversight, politics– but without these financial instruments, September 2008 would have been a very different month.

The books on my financial reading list have taught me plenty but they’ve also confirmed that history will repeat itself. Laws may be passed and new safeguards set up, but memory is short and the course of human events long. And in due time, we’ll ignore the lessons of past crises, and have to learn them again.

Emily Seftel Copyright(c) 2012 All Rights Reserved