No one saw it coming. In April 2005, former Federal Reserve Board Chairman Alan Greenspan spoke glowingly of the burgeoning subprime mortgage industry. At his Senate confirmation hearings a few months later, current Chairman Ben Bernanke similarly disavowed any danger of a housing bubble. Policymakers, financiers, and captains of industry have spoken in near-unanimous chorus: no one saw it coming. Michael Lewis’s The Big Short is the story of some of those who not only anticipated the collapse but made a fortune betting on it. Clearer and more comprehensive accounts of the tumult have been written, but none delivers with such force its human particulars.
The central figure in Lewis’s character-dominated account is Steve Eisman. As an analyst at Oppenheimer, Eisman earned a reputation for being brash and excessively honest about the dim prospects of the companies he evaluated. “Even on Wall Street, people think he’s rude and obnoxious and aggressive,” his wife tells Lewis. He left to run a hedge fund in 2001, and by spring 2005 his pessimism focused chiefly on the same subprime mortgage industry lauded by Greenspan. Lenders seemingly couldn’t issue mortgages quickly enough, often with little or no proof of the borrower’s capacity to make good on the payments. Eisman began looking for ways to bet against bonds backed by subprime mortgage debt. What he found was the now-infamous credit default swap (CDS).
The buyer of a CDS effectively owns insurance against the default of a bond. But why would anyone want to be on the other side of the bet, buying the risk associated with these bonds? It is one of the strengths of Lewis’s book that he embeds lucid explanations of arcane concepts in an engrossing narrative. He unpacks one more needed piece of terminology here: the collateralized debt obligation (CDO). Picture many towers of credit default swaps backed by subprime mortgages. At the top of each tower are the highest-rated bonds and at the bottom are the riskiest bonds. In a collateralized debt obligation, slices from the lower levels of each tower are packaged together into one financial instrument. Ratings agencies accepted the argument of Wall Street firms that because the slices were coming from different mortgages all over the country, they couldn’t possibly all default at the same time. And so, although each slice was risky, the new tower couldn’t beÂ?or so said the ratings agencies (who are the targets of some of Lewis’s sharpest criticism), pronouncing the CDOs worthy of AAA ratings, safe enough for pension funds and insurance companies (AIG, for instance), who couldn’t get enough of them.
Lewis recounts that one night in (where else?) Las Vegas over dinner with a CDO manager, Eisman realized how these pieces fit together. “I love guys like you who short my market,” the manager tells Eisman. “Without you, I don’t have anything to buy.” Wall Street’s demand for subprime-backed CDOs couldn’t be met by the stock of actual mortgages, no matter how many of them were issued. But when Eisman bought credit default swaps on those mortgages, he wasn’t merely making side bets; he was actually providing a stream of income that replicated the bonds, effectively synthesizing new mortgages without the hassle of finding an actual house or borrower. Eisman’s pessimism about the subprime market was literally fueling its growth. (This is a good place to address the widely held notion that short-selling is inherently harmful. It is helpful to allow investors who believe that the price of an asset will fall to place bets to that effect; these help to prevent bubbles from developing. Short positions that generate more of the asset against which they are taken, of course, are another matter.) Freed from the fetters of being backed by actual homes, the market could grow without bounds, which is why its collapse was capable of such universally devastating effects. “There’s no limit to risk in the market,” Eisman explains. “A bank with a market capitalization of one billion dollars might have one trillion dollars’ worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!” As the book ends, reality is setting inÂ?Bear Stearns is no more and Lewis’s protagonists are wondering just what they’ve done.
Twenty years ago, Lewis was shocked when readers of his first book, an autobiographical account of the greed he encountered in his stint as a Wall Street analyst, treated it like a how-to manual for getting ahead in finance. The same dynamic is on display here: No one who could see how rotten the subprime market had become had any incentive to do anything but seek to profit from it. The book logically leads to an appeal for better regulation to keep greed in check, a conclusion of inescapable merit. Reformed Christians are, of course, familiar with the civil use of the law to restrain evil. But as Augustine put it, “[C]ertain laws are established which are called civil laws, not because they bring men to make a good use of their wealth, but because those who made a bad use of it become thereby less injurious.” Lewis’s elucidation of the human stories underlying the movements of vast and impersonal markets serves as a corrective to the tendency to place inordinate degrees of hope in regulation. Regulation can do no more than restrain the human heart, just as markets can do no more than channel our greed toward generally beneficial ends. But neither offers any ultimate remedy for what is so vividly depicted, though never named, in Lewis’s bookÂ?namely, sin.
Lewis’s book puts a human face on the financial crisis that dominates the news of the day. Those readers will be best served who can recognize their own faces in its pages. Neither Wall Street nor Washington, DC is the sole repository of human depravity, but it’s also the case that the institutions that dominate them do not exist independently of the people who fill them or of the need for regeneration in their hearts. To paraphrase G. K. Chesterton: What’s wrong with Wall Street? I am.
