I recently interviewed Liar's Poker author Michael Lewis, and I didn't even ask him if the Moneyball movie was on again. (Apparently it is, with Aaron Sorkin doing a re-write.) We talked about his new book, Home Game: An Accidental Guide to Fatherhood, but we also got into his take on the financial meltdown and the bailout. This is Part One of some excerpts. You can hear the full podcast at terrencemcnally.net.
As a former Salomon Brothers trader, Lewis could understand how individuals got caught up in the high-risk bubble.
ML: There's a machine out there and a market... and as a trader you can borrow money cheaply, buy sub-prime mortgage bonds, and make the spread between the two.
Let's say you're a really smart guy who's sort of detached and intelligent about what's going on, and you see that this thing is totally irresponsible. The loans being made are likely to go bad; the lending standards are collapsing. The intelligent thing to do is not to buy sub-prime mortgage bonds but to bet against them, to sell them short.
As a trader inside a big Wall Street firm...you would face a decision: Do I exercise my independent judgment and bet against this market, or do I just keep going along with what my firm is doing? If you exercise your independent judgment and bet against sub-prime mortgage bonds, you not only probably run into some political conflict within your firm, but you'd never make the big score for yourself... The minute you make a bunch of money from your bet, your firm is doomed. They couldn't pay you. So the smart thing was just to go along and hope it lasted long enough for you to get rich.
So that accounts for single players and their firms, but what about the ratings agencies? We heard a lot of sports talk in the Sotomayor hearings. Weren't they supposed to be the impartial referees?
ML: The sub-prime mortgage bonds were rated triple A by Moody's and Standard and Poor's. Why? Well, they could give you an argument, but in retrospect, it looks like a very foolish argument.
TM: It looks worse than foolish to me, it looks corrupt.
ML: When you think about corruption, there's the simple kind where I give you $1000 to interview me on the radio so it will promote my book. That's corrupt and we both know it. But there's a different sort of corruption where we're all part of a system that is rewarding us very well to pay attention to certain things and not pay attention to others. We're paid to have blind spots. There's an awful lot of that kind of corruption in the financial system because people's incentives are all screwed up.
Ratings agencies were paid by the people who issued the bonds to put the triple A rating on them. Their incentive is to please the people who are issuing the securities. They can't at the same time independently judge the securities.
TM: Arthur Andersen went out of business for doing basically the same thing with Enron. How could someone not see that they were recreating something which had already failed in a huge way?
ML: Some people did see...The people I find most riveting are the people who saw the magnitude of the coming disaster. They were sane men in an insane world. They would call Standard and Poor's and Moody's and say, "How are you rating these things? Our models show that if house prices even go flat, all these bonds will be worthless." To the question of what happens to these bonds if house prices go down, Standard and Poor's would say, "We actually don't know because there's no place in our model to put a negative number."
TM: Obama, Geithner and the administration are putting out plans for new regulations. This isn't in there?
ML: No. It should be illegal for issuers to pay raters for ratings. It's a bribe. Instead the administration says they're going to give the regulators more authority to evaluate ratings agencies. That doesn't do anything; they already had that authority.
Lewis cited another example of a conflict-of-incentives that's nowhere to be found in the regulatory reform conversation.
ML: How can you possibly have a Wall Street firm that is at once owning securities, making bets on stocks and bonds for itself, and that it is also selling to customers? Inevitably, it will trade against its customers. It will deceive its customers for the sake of itself.
There's no reason both these functions have to be inside one place. You can have firms that provide financial advice but that don't take any positions in securities. Then you could have other firms that have their own trading accounts, but aren't allowed to deal with customers. Those functions should not be in the same place. It creates endless problems.
TM: And this also isn't in the Obama administration's reform plans?
ML: No it's not in there, and no one's even brought it up.
When Lewis suggests that the deeper problem is in "the air we breathe," he's not talking about the environment.
ML: Arthur Andersen was in place to examine Enron, the credit rating agencies were meant to be examining bonds. In both cases they had the incentive to exercise bad judgment because they were being paid by the wrong people. The rules of the game were totally screwed up.
Well, why are the rules of the game totally screwed up? This is the deeper problem, I think, and it goes back to the days of Liar's Poker. In the last 25 years, our economy has created this beast, the financial industry, that is much, much too big; that is doing lots of things that have nothing to do with productive enterprise; in which the rewards are so outlandish, they've distorted the upper tier of the income structure. The reason CEO's get paid as much as they do is that Wall Street taught them how to do it.
You get a huge sum of money for doing something is actually socially and economically counter-productive. People made fortunes out of the sub-prime mortgage bond market. That's insane.
So our society has created this very strange economic value system, where really smart people, the leadership class, thinks it's the done thing to go to Goldman Sachs or Morgan Stanley and get paid three or four million dollars a year -- even though you don't actually add value in any way. Now it's in the air we breathe.
Look for Q&A with Michael Lewis (Part 2): There's a Real Chance There's Going to Be an Uprising about This