The Ones that Saw it Coming

wallstreet

Although Wall Street got away with creating the worst economic crisis since the Great Depression, there were some who saw it coming, sniffed out the true nature of the mortgage backed bonds and the craziness of an out of control under-regulated housing market.    Those people are the subject of the Michael Lewis book The Big Short mentioned in the previous post.

They cover a range of character traits.  There is the self-promoting Greg Lippmann whose desire to spread the news in bombastic fashion helped convince a number of people that the housing market was a bubble and the securities backed by those mortgages were toxic.  Then there is Steve Eisman, a blunt, honest hard nosed investor who would offend just about everyone he met.   He started as a conservative Republican but realized as he learned about the game on Wall Street that the real mantra was “fuck the poor.”

Mike Burry of Scion Capital was the first to really understand the scope of coming crisis

Mike Burry of Scion Capital was the first to really understand the scope of coming crisis

The first one who really sniffed out what was happening was a one eyed doctor turned stock blogger turned investor, Michael Burry.  He read through the material with an almost superhuman patience and attention to detail.  He realized that the investments were crap, especially the bonds backed by subprime mortgages.   When his son was diagnosed with Aspergers syndrome he realized he had it too.  That had given him the focus to figure out what everyone else was missing as early as 2003 – and also explained the lack of social skills that alienated his investors who were planning to sue him before suddenly his bets paid off.  They never thanked him.

Ultimately they figured out that not only were the big banks creating mortgage backed bonds that seemed to pass off risk, but when they didn’t have enough of those they packaged the bonds into CDOs that, thanks to rating agency incompetence, would magically turn BBB mortage backed bonds into AAA investments.   Then they took it a step further with synthetic CDOs.   To Burry, Eisman, Lippmann and a few other characters Lewis describes, this was blatant fraud.  For Eisman it was a moral cause – the big banks were pulling in billions, earning their traders bonuses in the tens of millions – because they were able to create bonds so complex that the rating agencies didn’t realize they were crap.  Investors thinking they were getting very low risk bonds were being fleeced.

CDO's were a method by which banks could take low rated bonds and package them to create a AAA rated toxic bond

CDO’s were a method by which banks could take low rated bonds and package them to create a AAA rated toxic bond

The thing that shocked them, however, is that when the inevitable collapse hit, the big banks themselves were exposed.  They had rigged the game, but played the sucker anyway.   Corporate leadership didn’t understand the way this new derivative bond market operated, and individuals looking only to maximize their bonuses didn’t care about the long term.  At some point they had to keep playing because that was the only way to keep the game alive.   But it was unsustainable.

What I find intriguing is the personality characteristics of those who figured it out.   They share a few traits.  First, they were honest and not afraid of what others thought of them.  In a world where most people seek approval from others and want to be liked/appreciated, these guys didn’t care.  Eisman would blurt out comments offending powerful CEOs giving a talk, not care what he wore to the golf course, and genuinely didn’t seem to mind what others thought of him.

Second, they were remarkably self-confident.   If it were me figuring out the insanity of the derivative market and how the big banks were setting the entire world economy up for disaster, I’d say “wait, these are the most intelligent big institutional investors on Wall Street – they must know something I don’t.”   And while the thought crossed their minds now and then, they had confidence in their analysis and conclusions.  They were willing to place multi-million dollar bets on an outcome the media, Wall Street and government dismissed as impossible.

Some of most entertaining moments in Lewis' book are the ways in which Steve Eisman would confront the big players on Wall Street and tell them their products were crap

Some of most entertaining moments in Lewis’ book are the ways in which Steve Eisman would confront the big players on Wall Street and tell them their products were crap.  Eisman’s latest crusade is against for-profit on line universities

Finally, they were oddly moral.   For Eisman it was righteous indignation at how big money was not only screwing the small investor but also putting democratic capitalism at risk.  For Burry it was a strong sense that the truth mattered, and he needed to follow it.  Lippmann was grandiose and self-promoting, but was up front trying to help others see what was happening.   In fact, they all tried to shout out warnings only to find that the rich and powerful either responded like deer in a headlight or laughed them off.

Jamie Mai, Charlie Ledley and Ben Hockett, who created Cornwall Capital and discovered first that even the AAA rated CDOs were certain to fail, were pre-occupied by what this meant for society as a whole.   The system was sick, could it potentially fall apart?

Those traits:  honesty, lack of concern for what others think (as long as you’re being honest), self-confidence and a strong moral streak gave them the capacity to truly comprehend what was happening.  They were not intimidated by the big names in media and on Wall Street who dismissed such concerns, did not feel like “I must be wrong because the big guys all say differently,” and stoked a sense of moral outrage and purpose.

Once considered an economic guru, Greenspan's cheap credit and anti-regulatory stance now make him a villain in this story

Once considered an economic guru, Alan Greenspan’s cheap credit and anti-regulatory stance now make him a villain in this story

There is something to learn from this example.   These traits gave them the capacity to avoid the hypnotic effect that culture, media and “conventional wisdom” can have on people.   All around experts repeated the mantra that “the bonds are safe, housing prices won’t fall, this is real, the money will keep growing…”  They did not fall victim to the power of those suggestions; instead, they saw through the facade and ended up turning a huge profit.

They not only saw through it, but it was obvious to them.   Now whether one reads the book by Micheal Lewis or one of the others out there dissecting the crisis (The End of Wall Street by Roger Lowenstein, All the Devils are Here by McLean and Nocera, House of Cards by Cohan about the end of Bear Stearns, etc.), it is so obvious in hindsight that one has to ask “how could they have been so stupid?  How did more people not see it coming?”

The answer: groupthink and a kind of cultural hypnosis due to the power of pervasive suggestion.   The only way to keep one immune from falling into such a trap is to foster true honesty, not worry what others think if acting honestly, be self-confident, and have a moral core.   Not only might one see through scams and thus make money (or avoid losing it), but one will also live a life less controlled by the hypnotic suggestions permeating our culture and media, and instead develop the capacity to be true to oneself.

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  1. #1 by lbwoodgate on February 1, 2014 - 12:54

    “Those traits: honesty, lack of concern for what others think (as long as you’re being honest), self-confidence and a strong moral streak gave them the capacity to truly comprehend what was happening”

    Though apparently a few people within Wall Street retain these characteristics they are likely few and far apart to make any real difference. Greg Smith highlighted this failure in his NY Times resignation from Goldman Sachs. In the letter he pointed out that the leadership was no longer concerned “about ideas, setting an example and doing the right thing. … if you make enough money for the firm (and are not currently an ax murderer) you will be promoted into a position of influence. … Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them.”

  2. #2 by Alan Scott on February 1, 2014 - 13:27

    I read the post and was looking for mention of the hedge fund manager John Paulson. I believe you would have to include him in a list of important people who saw this coming.

    • #3 by Scott Erb on February 1, 2014 - 14:19

      Lewis mentions Paulson in his book, though he’s more interested in those who directly bet against the market. Paulson used CDS’s more as a hedge, and he came to it later in the game (I believe learning about it from Lippmann).

  1. Housing Bubble – Who Created It | Tarheel Red

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