My finance professor handed out a fantastic article called "The End" written by Michael Lewis, the writer of Liar's Poker, about the mortgage melt-down and some reasons for what fueled the bubble on Wall Street. The main take-away from the entire article for me is that incentives on Wall Street are totally mis-aligned - as I'll talk about shortly.In the article, Lewis tells the story of Steve Eisman. Eisman started his career as a corporate attorny, then turned to become an equity research analyst at Oppenheimer, and finally moved on to a hedge fund (Front Point Partners). At Front Point, Eisman built up short positions across the entire subprime mortgage lifecycle - mortgage originators, homebuilders, mortgage bonds, CDO's, etc. The article describes in colorful detail Eisman's journey in uncovering the roots of the industry and at every turn how shocked Eisman himself is.
Eisman repeatedly questions how it was even possible (or legal for that matter) for the system to be operating as it was:
“They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”I haven't read Liar's Poker, but from what I gather, Lewis did not think fondly of Wall Street. He saw it as a place run by people fueled by greed that didn't really know what they were doing. Now, greed's a strong motivator. But when you couple that greed with a totally misaligned incentive structure, bad things are bound to happen. And I think that's the main point of Lewis' article.
I thought a really telling exchange in the article was between Lewis and John Gutfreund, the former CEO of Salomon Brothers. In the exchange they talk about the implications of investment banks going public:
No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.[...]Now I asked Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.
This is not a new problem. This is one of the oldest economic problems - the principal-agent problem. I suppose it's only makes sense that when the risks for moral hazard can not possibly be any higher - i.e. we are talking about the temptation on Wall Street's part to play with the entire U.S. economy's investments - that agents will respond negatively to those temptations.
It's interesting timing reading this article given the research I just read about how the top M&A banks actually destroy value rather than create it and my conclusion that incentives have to be changed. What's Wall Street going to look like 5 years from now?
PS - On a side note, I thought this was a hilarious excerpt from the article that I just had to cut out. It describes why Eisman decided to short Merrill Lynch. His description of Merrill is absolutely hysterical!
“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.That's a great quote!
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