Both books are pretty good. They both go back to try and explain the origins of the subprime mortgage crisis. In that respect the stories are consistent with each other, but in another there seems to be a discrepancy. Short focuses on a few people who saw the crisis coming early. Implicit in Lewis’ decision to focus on these people is the idea that they are special in some way: outside-the-box thinkers who challenged convention. But All the Devils Are Here makes it seem as if it wouldn’t have taken anything beyond rudimentary common sense for those involved in creating the mess to see what was happening. They may have been deliberately practicing fraud, or were just being unimaginably greedy and/or stupid. It doesn’t really matter either way. We got screwed over just the same.
One concept I’m still trying to wrap my head around: what eventually caused the financial crisis to reach the enormous proportions it did was the amplification of derivatives. I’m not a financial expert—for the sake of this argument, I will call a derivative a ‘bet’ between different parties, stating conditions under which one party has to pay the other. During the housing bubble banks created derivatives based on bundled mortgages—the bets were on how those mortgages would perform. For whatever reason mortgage-based derivatives turned out to be insanely profitable, so banks really wanted more mortgages to make bets on. So mortgage originators started giving mortgages to people who shouldn’t have gotten them. But that wasn’t nearly enough to satisfy the banks’ appetites. So they started creating derivatives based on other derivatives (this is where it gets kind of fuzzy for me, so I’m not sure if my understanding is 100% accurate, but I think it captures the gist). This kind of amplification seemingly had no limit. You could create side-bets that were worth fifty times as much as the original mortgages.
Question 1: a bet involves someone making money and someone else losing money. But until the bubble burst it seems like everyone was making money. What gives?
- Example: One party issues a derivative which states that it would pay a second party in the case that a certain mortgage-bundle’s price drops. In return for this insurance, the second party pays a steady fee to the first.
- Wait, why would the second party keep paying this fee if the price never drops?
- Well, it’s a hedge against a future price drop. So it’s insurance of a sort.
- But actually the second party is likely to be involved in some kind of derivative-selling of its own, based on either the original mortgage bundle or its bet with the first party.
Question 2: But wait. Where’s all this money coming from?
- Institutional investors, I guess. Neither book deals with that too much.
Question 3: What’s the point of all this?
- I don’t think it provides any tangible benefit to society or economic productivity. Derivatives do allow banks to manage risk, by hedging against market changes. That’s the ironic thing, actually: the financial product that was supposed to control risk actually magnified that risk to astronomical levels.
As you can see, I am still no expert on the subject. There are holes in my story you could drive a Mac truck through. But a bubble’s a bubble, and for a short time a bubble can make it seem like everyone can magically create money without really doing anything. In the case of the mortgage crisis, the fact that home prices just kept going up and up every year propped up the bubble, and all of the profiteering based on it.
The lesson seems to be that it is literally impossible to stop something if enough people are making money off of it. If you could jump in a time-traveling DeLorean, go back to 1998 and get President Clinton to elect you Secretary of the Treasury, and you devoted your entire career to making sure the financial crisis never happens, you would fail.