I have been listening to The Big Short by Michael Lewis, an interesting account of the bond market crash of 2007 that nearly crashed the world economy. Lewis considers the story from the point of view of men who made a ton of money betting that the sub-prime mortgage market would collapse in just the way it did. After all, lots of people made noises about how bad things were on Wall Street, but only a handful actually bet big money on this outcome.
What strikes me most about the book is the psychology of this bold bet against the whole direction of Wall Street. The mortgage bond market was a trillion dollar industry generating huge profits for insiders and reliable returns for investors, employing tens of thousands of people, making it possible for millions of lower-middle class Americans to own their own homes. The people who bet against this vast edifice were all very much outsiders, and they defined themselves as outsiders. The first guy to figure out that the market was a doomed ponzi scheme, and to figure out how to make money off its inevitable collapse, was a very strange, self-taught trader who had classic Aspergers and couldn't look people in the eye when he talked to them. Another was a leftist who saw himself as a crusader against capitalist excess, and had made a specialty of picking which sleazy lending firms were going to go bust and betting against them. Two were self-taught trust-fund kids who were just investing their own money, and whose biggest problem was getting banks to take them seriously. A few were self-styled bad guys, the kind of investors who name their yachts Queen Anne's Revenge and love to be seen as pirates. Only one of them was an insider who actually understood the mortgage bond market.
The bond market was set up for institutional investors, and the credit-default swaps these gamblers bought were only sold in million-dollar increments, so all the players were hedge fund managers or traders with big firms. Still, that's a good ten thousand people, and Lewis found fewer than 20 guys who bet against these bonds before the very end of the run. As they told the story to Lewis, after the collapse, they all had the same reaction to their realization that the market was insane. "This is too good to be true," they thought. "We must be missing something. This is the greatest investment opportunity in history, and how can we be the only guys who have figured that out?"
What these guys did was buy credit default swaps on bonds that were based on low-end sub-prime mortgages. The value of the bonds depended on the performance of the loans, so if too many of the borrowers defaulted, the bond would become worthless. A credit default swap is an insurance policy on a security, like one of these bonds. The buyer of the swap payed an insurance premium for as long as the security existed, and in return would be payed for any losses on the security. The bond market was based on the assumption that housing prices would keep going up forever, so that few people would default on their loans. So they priced the insurance at only 2 percent of the value of the bond each year. The investors who took this bet all thought that whatever the real risk was that the bonds would go bad, it was certainly a lot higher than 1 in 50. So they bought these insurance policies and held onto them, waiting for the bonds to fail. They knew this might take years, but they thought the chance of a huge return was worth those payments.
Making this play required these gamblers to take losses every year for an indefinite period of time, while their competitors were still making good money in stocks and bonds, in the hope that something bad would eventually happen. It was hard to watch those losses mount, month after month, hard to cling to their lonely positions while the rest of Wall Street laughed at them and called them fools. Those who had investors had to explain again and again why they were losing money in a rising market, and had to watch their customers pull money out of their funds in the midst of what they were sure was the smartest play they ever made. Only people who already thought of themselves as outsiders, and who saw their competitors as fools or crooks, could tough it out. They had an especially hard time in the spring of 2007, when the mortgages that made up the bonds started to go delinquent in record numbers, and yet the value of the bonds did not fall as it should have. Some of these investors figured out that the big banks were artificially propping up the market, and they started to wonder if they would ever be allowed to cash in their bets. Eventually, though, the losses in sub-prime mortgages got so enormous that even Goldman-Sachs and Morgan Stanley couldn't prop up the bonds any more. The whole sub-prime market unraveled, and those insurance contracts were suddenly gold. The two trust fund kids Lewis followed sold their swaps for 60 times what they paid for them and instantly become two of the richest men in America.
It is hard, very hard, to go against a culture as powerful as the one on Wall Street. Insiders in such a system find it almost impossible to get their minds outside it and see that it is based on bad logic and fraud. Only the most stubborn of eccentrics can swim against such an overwhelming current.