Archive for November 17, 2008

Michael Lewis on “Wall Street Boom and Bust”

Mark Latham of (here‘s his finance blog) passed along a link to this outstanding article written by Michael Lewis about the financial crisis. Lewis (author of Liar’s Poker and The New New Thing, among other books) sees the recent bust as the logical conclusion of a long accumulation of problematic practices on Wall Street. Lewis says that when he wrote Liar’s Poker in the 1980’s he thought he was writing about a culture and a set of business practices that must be on the brink of flameout. Instead the pathologies got more extreme over the next twenty years. It took a long time to blow up, but blow up it has.

Much of the article focuses on a hedge fund manager, Steve Eisman, who saw a lot of this coming and set up his fund to profit from the destruction. Based in part on what he heard from his cleaning ladies, Eisman knew that big banks were giving out home loans to people who were very unlikely to be able to repay them. He looked into the numbers and started shorting companies heavily involved in subprime lending. Then he started shorting the bonds that were derived from these mortgages (i.e. he was buying credit default swaps), essentially betting that people like his cleaning lady would not be able to pay their mortgages and the bonds based on her payments would default. The moment he realized things were colossally screwed up came after he started asking why the investment banks that were selling him the credit default swaps were so willing to bet on the cleaning lady’s side: the CDS’s he bought were the basis for a whole new set of financial products (called synthetic CDOs, although Lewis doesn’t identify them as such), which brought in more fees and kept everybody buzzing. Eisman (according to Lewis) started to see this part of the financial world as a “machine” that kept everybody happy by generating fees to go along with increasingly dubious financial products. Again and again, Eisman ran up against financial practices that he could not believe were legal, or, as he reportedly said on encountering an odious CDO product, “I cannot fucking believe this is allowed—I must have said that a thousand times in the past two years.”

The article closes with an interesting confrontation between Lewis and John Gutfreund, who was the CEO at Salomon Brothers when Lewis was there in the 1980s. (Gutfreund says to Lewis’s face that Liar’s Poker destroyed Gutfreund’s career and made Lewis’s.) Under Gutfreund, Salomon became a public company in the 1980’s, and Lewis’s claim here is that this was the beginning of the end for Wall Street. “The Wall Street firm became a black box,” Lewis argues.

The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith. . . . No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

It’s an attractive point, but I don’t think it’s true. I don’t know what careful research would say, but observation suggests that private firms were just as likely to be highly leveraged, deeply involved in exotic and risky derivatives, and gaming rating agencies. Certainly there are plenty of big hedge funds organized as partnerships that have made colossal risk management mistakes in derivatives markets. (LTCM is the highest-profile example, but certainly there are lots in this crisis as well.)

The question ultimately is how incentives would have been different if these firms had been partnerships rather than public companies. I would argue that incentives would not have been different enough to change behavior substantially. One possibility is that key decision-makers would have been focused on increasing the firm’s long-term value (as opposed to generating fees on dubious products) if the firm had been private. Yet in these public companies there was plenty of stock ownership at the top of the firm, where the partners would sit. (I don’t know how far down meaningful stock incentives went.) These executives have taken a serious financial hit as a result of the bets their firms made. It seems likely that they simply did not understand what the risks were, and that increasing their ownership of the firm (as might happen if it were a partnership) is unlikely to have been enough to motivate them to understand those risks.

One possibility is that stock incentives were not the right way to get executives to think about the long-term value of the firm. Certainly compensating based on stock options rather than grants encourages risk-taking, since there is lots of upside and limited downside. But even if we’re talking about stock ownership, it is likely that the stock market in the last several years was not in fact rewarding long-term value generation, but rather was rewarding firms that took the casino approach to high finance. Partners in a private firm, the argument goes, would not have tried to satisfy the demands of this myopic market, but would rather have focused on long-term firm value and ultimately avoided the fate Wall Street has seen. Such an argument comports with what Rajan has been saying about delinking executive compensation from the stock markets and tying it more closely to accounting profit, as I blogged about a few days ago.

I don’t know if there is good evidence on how the risk profile of a private firm would have been different (it’s hard when there aren’t any private firms that big still around), but again I suspect it would not be that different. I believe the best way to make a lot of money in 2005 and 2006 was probably to be deep in exotic derivatives, and I think most executives would chase after those opportunities whether they were trying to increase their stock price or increase their accounting profits.

I have a lot left to learn here, and I welcome any comments on what I’ve said. I highly recommend reading this article for understanding some of the pathologies of Wall Street, but clearly I think Lewis’s concluding point about the critical role of public ownership is a lot murkier than he makes it seem.


November 17, 2008 at 4:03 pm Leave a comment


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