A lot of noise has been made about the major failures that occurred during the financial crisis, but the story took much longer to develop than most people realize. These 6 books follow the Wall-Street side of the mortgage investments story, from the very beginning.
Let’s start with the people who contributed to the losses:
Before the 1980’s, investing in mortgages could only be done one at a time. It was not possible to invest in groups of mortgages.
The investment bank Salomon Brothers solved this problem by introducing the mortgage-backed security, a security that would later become infamous.
One of the most interesting points in this book is how very little Salomon Brothers cared about their customers (a common theme among investment banks): They made much of their money on the fees associated with trading, and not whether the trades are actually good ones. The foolishness of their customers was an ongoing inside joke.
In 1991, Warren Buffett took over as Salomon’s Chairman after a huge trading fraud scandal. It was later purchased by $C Citigroup.
This book was written by an insider at Morgan Stanley. It follows some of Wall Street's cultural shifts that came after Liar's Poker was written.
In the 1990’s, derivatives traders become more aggressive and ratings agencies begin to relax their rules. It was so bad that the investment banks could actually pay the S&P (about $10,000) to get an AAA rating. If that did not work, they could create shell companies that own the bad debt, and issue the shell company's debt with an AAA rating.
The point of getting a good credit rating was to make it possible to sell junk bonds to customers who were unable to check the real quality of the bond. A fancy name was considered a great way to sell a crappy derivative contract.
Again, the point is made very clearly that investment bankers do not care about their customers: They are going to chase returns every time, even if they know it will "blow up" in the future, because when the investments inevitably blow up, the original traders are usually no longer there. And even if they are still there, they have already made money on the fees.
Long-Term Capital Management (LTCM) was a hedge fund founded in 1993. The firm was managed by elite academics and traders, including 2 Nobel Prize winners. Some people would have called it too smart to fail.
Its trading strategy was purely mathematic and highly leveraged. The idea was related to “picking up pennies” and multiplying the returns on those pennies. It was considered a statistical certainty that the trades would always be good.
But, their math models didn't account for financial crises. Investments in foreign bonds started to go bad in 1997.
In 1998 the firm really needed help, so it asked Goldman Sachs, AIG, and Warren Buffett for additional money. The potential deal meant opening the secret trading books to Goldman’s traders, who used this information to make money off the firm’s continued failure. LTCM got nothing.
Eventually, the firm blew up, and its failure led to the potential of a huge financial crisis. The major investment banks agreed to come together to prevent a crisis (without government help). Only one, Bear Stearns, declined to participate.
This is a long book that covers in detail (almost minute-by-minute) the events surrounding the financial crisis. It is truly an inside story. I can’t cover every story-line involved with this book, but it does pick up from some of the earlier story-lines.
The main one being: The mortgage trading market (started in the 1980s), combined with aggressive leveraged derivatives trading (which became popular in the 1990s), created this part of the 2008 crisis.
Here are some of the highlights:
Morgan Stanley, and every other investment bank, was forced to become a "real" bank that takes deposits.
When Bear Stearns began to fail, the investment banks had a meeting to decide whether they should save it. They didn't forget how Bear Stearns had snubbed them when LTCM failed, and they rejected saving Bear Stearns. Bear Stearns was bought out by J.P. Morgan.
When Lehman Brothers began to fail, they, like LTCM before, asked Warren Buffett and Goldman Sachs (and other banks) for help. Warren Buffett said no. And, like they did with LTCM, Goldman Sachs used this as an opportunity to profit from Lehman’s failure. Lehmen Brothers got nothing.
After Lehman Brothers failed, the government stepped in to prevent the crisis from spreading.
Now, let’s get to the people who saw this coming:
On the other side of this mess, there were traders who made tremendous amounts of money from these failures. They were considered outsiders to the mortgage industry, and it helped them see what the insiders could not see.
John Paulson was a hedge fund manager who specialized in mergers.
That is, until he was lucky enough to hear about the absurd mortgage deals and learn about the complex trades used to bet on them.
After being convinced of the trade's potential, he worked with Goldman Sachs to structure mortgage investments to bet against. These were sold to Goldman’s clients, labeled as safe investments. From this one bet, Paulson made billions.
Goldman Sachs was later sued for their involvement in these trades.
This is the sequel to Liar’s Poker. It covers smaller names who made the same trade as John Paulson. These guys were true outsiders (Paulson was at least a Harvard Graduate).
Michael Burry is probably the most famous of these smaller names. He made the same trade that John Paulson made, but he was a few years too early. When the trade initially moved against him, his investors threatened to abandon his fund, so he froze their withdrawals. After he was proven right, he decided to quit.
Another smaller name was Cornwall Capital, who kept their account with Bear Stearns. Their biggest concerns were losing their money from Bear Sterns failure and losing their money by having the government nullify their investment. In the end, their trades went through.
Michael Lewis completes the story with a reflection on Wall Street culture and investment banking standards:
It started with the investment banks going public. When that happened, the risk of failure was no longer on the partners, it was on the shareholders; and eventually, on the government. It ballooned to the point where the people involved with creating these crazy investments either knew they would fail and didn't care, or didn't have a clue how they worked.
Ultimately, the people on both sides of the bet became rich, and everyone else paid for it.
Andrew holds a Master's in Economics from Kansas State University with a focus on the Technology Sector. He enjoys writing about value investing and thinks learning new investment strategies is more useful than hot stock tips. He considers fundamental analysis to be the key to making great long-term investment decisions. You can follow his SprinkleBit portfolio here.