Monday, August 30, 2010

The End of Wall Street

The End of Wall Street, by Roger Lowenstein

This is by far the best account of the financial crisis and its origins. Part historical, part journalistic, part thriller. The ending however peters out somewhat. A must-read on the whole.

This book is far the most complete account of the financial crisis of 2008. It begins with a chapter each on the players that were to play their part, dutifully, in bringing down, well almost, the economic foundations of western capitalism - each chapter providing a peek into the players and the maladies that afflicted the financial system: the origins of the housing boom, the NINA mortgages (No Income No Asset), Countrywide, New Century, subprime lenders, S&P, Moodys, Fitch, the ratings corruption that enabled the subprime "Niagara", CDOs, Lehman, AIG FP (AIG Financial Products), and more.
The second part, though there is no clear delineation, is a very tightly scripted account, reading almost like a racy thriller, a minute by minute, hour by hour retelling and reconstruction of the proceedings and discussions and negotiations and the back-and-forth that went on to save Lehman, and not Bear Sterns, how Bank of America wanted to buy Merill Lynch, then not, and then did eventually, are described very, very well. The almost non-stop negotiations, the preparatory work for filing for bankruptcy (it's not as simple as we tend to think it is). Can't stop reading.

The book's eponymous chapter, "The End of Wall Street", unfortunately, is the weakest of the book, relatively speaking. It could have been better written, and could have done a better job of explaining why or how this is the end of Wall Street. By all accounts, it is back to business as usual for Wall Street. With fewer players for sure. Which means more concentration of financial muscle.

To palm off securitized mortgages, you had to first sell enough mortgages. One way you did that was to sell mortgages to people whose credit worthiness should have disqualified them. How you can sell them a mortgage is by approving them to be eligible for one. And you approve them if you overlook falsification of the mortgage applications.
It was widely believed among the staff that stated borrowers brazenly lied (employees referred to these loans as "liar loans"). But underwriters were discouraged from scrutinizing their applications. [page 30]
Remarkably, customers who had been rejected after documenting their income were urged to re-apply, this time on a no-doc basis. According to former employees, Countrywide loan officers would "assist" them - in short, coach them to lie - whereupon the loans were approved. One highly productive loan officer from in Massachusetts simply cut and pasted files from the Internet to concoct a fraudulent verification of an applicant's employment. [page 31]
When you read this, the paragraph below, it does make you realize just how manipulative and exploitative the mortgage market is in India; perhaps a reflection of a lack of regulatory foresight, or the emerging nature of the mortgage market and its size still too small to warrant a close enough look, or perhaps the marketing genius of home loan providers in convincing customers that getting fleeced is in fact a good thing.

Like Countrywide, WaMu offerd a smorgasbord of exotic loans - subprime, piggybacks, and option ARMs - and each innovation incrementally weakened credit. As home prices rose, fewer people could afford to buy with conventional loans. Thus, traditional mortgages gave way to adjustable loans. Fluctuating interest rates enabled banks to charge a little less at the outset, making mortgages a tad more affordable. Adjustables were followed by interest-only loans - more affordable still - on which the customer need not repay principal for years. Most permissive of all, option ARMs deferred a portion of the interest as well as the principal and affixed an adjustable rate. [page 33]
Here is where the author seems to take the position that speculators were in fact also contributing to the mess that ensued. Perhaps, but I would disagree. The analogy the author constructs - of a driver being refused insurance because his neighbors are betting on his having an accident - goes only so far and is incomplete. What if the reasons the thus-far-accident-free driver's neighbors have been betting on him having an accident is that he has taken to driving on the highway at speeds of 100 miles per hour. With failing brakes. And driving drunk.
... Wall Street had constructed an alternative way of speculating against troubled corporations, via derivatives. and this wholly unregulated market doubled back on its Wall Street creators with a vengeance. Credit default swaps had been invented by financial engineers at Bankers Trust as a form of insurance on corporate defaults. The initial purpose was supposedly as a hedging vehicle.  ... Unfortunately, such hedges dulled the bank's incentive to perform the one function for which society depended on it: thoughtfully rationing credit to worth borrowers. [page 157]
A larger problem was that anyone - not just a lender with a stake in the corporation's well-being - could purchase a swap. In the world of traditional insurance, there are long-standing rules that prohibit dis-interested parties from taking a flier... But speculators, short-sellers, or anyone else could buy credit default swaps. The market evolved into a casino in which market sentiment determined the supposed odds of default. [page 158]

That Goldman Sachs was seen as insulated from the sub-prime crisis, partly because of the fact that so many past Goldman Sachs employees had gone on to positions of influence in the US administration, working for Presidents on both sides of the political spectrum, is further underlined when Paulson, US Treasury Secretary in the Bush Administration, installed Edward Libby as the new chairman of AIG:
The choice was astonishingly obtuse. Liddy was a Goldman Sachs director (a post he immediately quit), and Paulson was already relying on far too many former cronies, violating at least the appearance of impartiality. The Treasury was infiltrated with Goldman bankers who presumably harbored at least a passing loyalty to their former firm. Also, Paulson in this period spoke frequently to Blankfein, the self-effacing former gold trader who had succeeded him at Goldman. Blankfein ... had been groomed by Paulson for his present post. The connection was close, and it was whispered (and later asserted in press accounts) that Paulson had engineered the AIG bailout to spare Goldman from further loss. [page 214]
The author however goes on in the very next paragraph to explain why this charge is not necessarily accurate.

When Paulson announced, one would say quite unilaterally, to the CEOs of the leading banks on Oct 13, that the US government was purchasing a preferred stock in these banks, "it was the greatest intervention in the financial system in seventy years, and perhaps ever, enacted under a conservative president, a Treasury secretary who hailed from Goldman Sachs, and a Fed chief reared on the virtues of financial models and the supposed perfectibility of the market." [pages 271, 272]

© 2010, Abhinav Agarwal. All rights reserved.