IF YOU CAN'T EXPLAIN IT, DON'T TRADE IT. There's a Peter Lynch video depicting some Boston middle-schoolers researching companies to do their Stock Market Game (TM) projects in which Mr. Lynch tells the students not to buy a company if they can't explain what it does. Presumably those students will not be foolish enough to buy tranched mortgage-backed securities, even if the president of the investment banking house is making the pitch. That's one of the nuggets in Michael Lewis's The Big Short, a timely Book Review No. 7. The incompetent president in question makes a cameo appearance on page 218. And fans of the military aphorism "Bullshit Baffles Brains" will find the glossary on pages 126 and 127 particularly instructive. An overpriced bond is "rich." The s*****est bonds (thank you, Senator Levin) in the packages of bonds that are themselves convex combinations of mortgages in which the commingled interest and principal payments are the income out of which the package pays interest are the "mezzanine tranches." If nothing else good comes of the shakeout in financial markets, perhaps we will see the end of MBA bafflegab and the cult of the CEO.
It helps, however, if a few individuals (perhaps someday our Stock Market Game (TM) students) do more than see their way through the bafflegab and wordnoise, and figure out how to hedge against the complicated financial products. That's what Steve Eisman and Michael Burry, who gets off one of the greatest lines in the history of obsession, "Only someone who has Asperger's would read a subprime mortgage bond prospectus" (p. 183) did. The currently notorious John Paulson, of the Goldman Sachs trades, makes a cameo appearance, but most of the action is on the up-and-up, and it features people who made a straightforward inference: some assets will fail catastrophically, and valuing them with a model in which failure occurs according to a slow and manageable stochastic process leads to a stinking pile of rich mezzanine tranches. Which, if the proper short contract exists, can make the person holding that contract stinking rich when that catastrophic failure occurs. Which it did. And what's more amusing was how cheaply the people who created those short contracts made them. None of the Smart Money believed those contracts would ever come due. Until they did. Oops.
The book also notes, in more than one place, an important tradeoff in the creation of mortgage-backed securities, tranched collateralized debt obligations, and default swaps. When those instruments were working correctly, people who otherwise might not have been able to obtain houses were able to obtain houses, and banks and savings and loans were able to originate more loans than otherwise they could. Had the lenders been more careful, the new financial products might have become accepted as ways to enhance the wealth of people previously consigned to rental housing. If memory serves, other spectacular failures including junk bonds and the technology stocks, also had the effect, for a while, of enhancing the wealth of people otherwise consigned to the margins of the asset markets, or to doing business with loan sharks.
The book makes clear some rather technical ideas, and it is a quick read.
(Cross-posted to 50 Book Challenge.)