no dice


When I read Michael Lewis‘s book Liar’s Poker a few years ago, I was left with the uncomfortable feeling that the entire edifice of modern finance might just have become nothing less than the mother-of-all Ponzi schemes. And that the mutant moment could possibly have been the day Salomon Brothers’ Lewis Ranieri invented the mortgage-backed security, based on what amounted to a salesman’s whim. The securitisation business would transform itself over the next 30 years, until its unfortunate reconnection with reality in the mother-of-all Minsky moments. This is how BusinessWeek described Ranieri in 2004, celebrating him as one of the leading innovators of the previous 75 years:-

A less likely financial engineer would be hard to imagine. Ranieri, a Brooklyn native, set out to be an Italian chef until asthma ruled out work in smoky kitchens. A part-time job in Salomon’s mail room set him on the path to trading. A large, volatile man, Ranieri built the firm’s mortgage desk in his own image: “fat guys,” as author Michael Lewis described them in Liar’s Poker, promoted from the back office, who indulged in feeding frenzies and practical jokes while selling strange new bonds to doubtful investors.

Ranieri’s own mortgage bank, Franklin, was closed last week by regulators and has now been taken over by the FDIC.

Michael Lewis, who worked for Salomon Brothers in the 1980s–an experience on which the Liar’s Poker was based–has just written a piece this week in Portfolio in which he is, in effect, calling the end of an era on Wall Street. This is how it starts:-

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

If you did not see the Portfolio article, it’s worth reading all nine pages. It tells the story of a handful of people who saw that there was a wider problem, even if the full scale of the potential catastrophe eluded them too. Guys like Steve Eisman, of FrontPoint Partners, who did not play the standard Wall Street game and, when they had the chance, traded aggressively against the prevailing wisdom. It also paints a granular picture of what a short-seller really looks like, and why we should perhaps see them as the canaries in the coalmine rather than demonise them (as everyone from government to clergy did a few months ago here in the UK). There is a more interesting vignette in there too about how his short-selling was egged on by Wall Street firms for their own purposes. In all, it’s a great article. Lewis reveals, in the actions of his protagonists, some of that concept called bounded rationality, as identified by economist Herbert Simon and others. The following also stood out for me, highlighting the scale of the debt markets versus the more familiar stock markets which journalism, print and TV news, tend to focus on:-

By the spring of 2005, FrontPoint was fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds. But in 2005, there was $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds. Eisman couldn’t understand who was making all these loans or why. He had a from-the-ground-up understanding of both the U.S. housing market and Wall Street. But he’d spent his life in the stock market, and it was clear that the stock market was, in this story, largely irrelevant. “What most people don’t realize is that the fixed-income world dwarfs the equity world,” he says. “The equity world is like a fucking zit compared with the bond market.”

This reminded me of some of my own fish-out-of-water experiences, begging for some capital allocation from the selfsame Wall Street in 2001. I was in the middle of a management buyout attempt for the news agency that employed me, the parent of which had been plunged into a Chapter 11 bankruptcy administration. Unsure that this editorial cost centre would work in any other organization, we formulated a set of independent online subscription news services, slicing and dicing our coverage into what we hoped would be viable longterm businesses. The biggest slice had the world of credit derivatives at its core. But at that time the labyrinthine and mushrooming world of the credit markets was one that most journalists or news companies would not have heard of, nor wanted to touch. And so it was. When I offered it to the board of one major company (let’s call them Thomson Financial) I was advised I’d be more successful focusing the business on sectoral equities, because that was “what the market really needed”. Thomson was then aligned in some peculiar defensive editorial content strategy with Dow Jones (now owned by News Corp) against Reuters, now owned by err… Thomson.

Ah well, no dice.

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