Did market efficiency cause the sub-prime mortgage meltdown?

I just finished Michael Lewis's newest book, The Big Short: Inside the Doomsday Machine. Lewis explains exactly what caused the sub-prime meltdown. The real origins of the meltdown, he points out on page one, go back to early 1985. This is when Michael Lewis was working at Salomon Brothers, which was the background for his first book: Liar's Poker.

I decided to read Liar's Poker again, since I hadn't read it since it first came out. Back in the mid-1980's I had just graduated from law school and didn't really yet grasp how “things really worked.” Like many people I believed that people who worked in high finance had a certain level of ethics. Or that at least they understood the underpinnings of the financial markets that they shaped.

I was obviously naive.

Re-reading Liar's Poker is very strange, and not because I'm now reading it on a Kindle. The book is a stark portrayal in how 'mortgage bonds' quickly went from being in complete disfavor to becoming a darling of Wall Street.  Greed played a role, as you might imagine. In the 1980's the mortgage bond market was populated by some greedy folks. The numbers of greedy traders grew over the years as the mass delusion spread and people around the world somehow got the notion that American home prices would never go down, so credit could be extended to pretty much anyone who was buying a house, regardless of whether they planned to live in it. And regardless of whether they could actually afford it.

What's shocking to me is not that the 'average person' got taken advantage of in the sub-prime fiasco, but that seemingly knowledgeable financial people were also taken advantage of. Lewie Ranieri was one of two key people who created “mortgage backed securities” while at Salomon Brothers.  Here is Lewis's enlightening description of Ranieri (at Kindle location 1558):

“Lewie was not just a trader, though: he had the mentality and the will to create a market.  He was tough-minded.  He didn't mind hiding a million-dollar loss from a manager, if that's what it took.”

And here is another great observation of the man who helped create what twenty years later wound up being the core of a complex financial world that not even the ratings agencies (e.g. Standard & Poors) could understand.

“Lewie was willing to take positions in things he didn't fully understand.”

The key to making money in certain financial markets is not so much from understanding financial underpinnings as much as it is creating complexity that confuses people, and then taking advantage of their confusion.  In The Big Short (Kindle location: 1320), Lewis supplies a key observation:

“Financial markets are a collection of arguments.  The less transparent the market and the more complicated the securities, the more money the trading desks at big Wall Street firms can make from the argument.”

The bond market was, by comparison to the stock market, less regulated and less understood. I remember being baffled, when I first read Liar's Poker, that bond trading could be so lucrative. If so, then why did more people seem to care about the stock market?

This time around I learned something even more interesting from Liar's Poker: the most important thing for a young Wall Street trader to learn (from the perspective of the firm's 'mentors') was how to take advantage of the firm's customers. You see the greatest market inefficiency turns out to be trust. Anyone who went to a large Wall Street firm like Salomon Brothers in 1985 seeking financial advice was pretty much like an African wildebeest without the ability to smell lions.

If you happen to have a copy of Liar's Poker on your Kindle I would direct you to location 2954 – 3060 (about 65% of the way through the book). This is where Lewis describes his first experience “helping” a customer. He was set up by people within Salomon Brothers to push bonds that were likely to devalue, which caused his first (and very trusting) customer to lose so much money that he was soon fired from his nice job. Why would some trader at Solomon Brothers push bonds on a customer that were likely to devalue? Because Solomon Brothers owned the bonds and needed to get rid of them before they devalued more than they had already.

Do you sense a conflict of interest? Yes, and so did Lewis (only because he was a newbie).  When Lewis found out he had been used he confronted the trader who had set him up. Instead of being sheepish, the trader responded harshly to Lewis: “'Look,' he said losing his patience,'who do you work for, this guy, or Solomon Brothers?'” In other words, internally, the traders and managers didn't even pretend that they were supposed to serving their customers.

So if you think that unregulated markets will automatically settle into an efficient market, then let's first talk about the proper definition of market efficiency. Oh, and another thing that's worth keeping in mind is this:

“The only thing that history teaches us, a wise man once said, is that history doesn't teach us anything.”