Short Sellers as Heroes

by Michael Osinski


Twenty years ago, when I worked at Salomon Brothers, every person on Wall Street had read two books: Frank J. Fabozzi’s “Fixed Income Analysis” and Michael Lewis’s “Liars’ Poker.”


The latter was Lewis’s debut, a devastating account of his four-year career as a bond trader at Salomon, which culminated in the crash of 1987. He has gone on to write best sellers on politics (“Trail Fever”), Silicon Valley (“The New New Thing”), sports (“Moneyball,” “The Blind Side”) and fatherhood (“Home Game”). The man, as they say, has range.
Still, Lewis is best known for writing about money and the people who will do anything to make it, so it’s not surprising that two decades after leaving Wall Street he has returned to survey the scene of the latest crash.

“The Big Short” is a chronicle of four sets of players in the subprime mortgage market who had the foresight and gumption to short the diciest mortgage deals: Steve Eisman of FrontPoint, Greg Lippmann at Deutsche Bank, the three partners at Cornwall Capital, and most indelibly, Michael Burry of Scion Capital. They all walked away from the rubble with pockets full of gold and reputations as geniuses.


Short-sellers are usually cast as villains, but by pitting them against the deluded complacency of most in the finance industry, Lewis turns them into paragons of courage and virtue. Like all great storytellers, he loads the dice. We hear from the good guys’ wives and learn plenty about the personal traumas they’ve overcome. The bad guys wear their hair slicked back and say stupid, venal things. Their wives were not interviewed.


Perils of Shorting

If subtlety is scarce in “The Big Short,” the story is nevertheless told with a brisk and riveting style. Lewis does an extraordinary job elucidating the perils of shorting the very bonds that buoyed the American economy after Sept. 11, 2001, and made a fortune for every firm on the Street.

He also explains the arcane details of these securities with surprising fluidity. Lewis shows how the risky, subordinate bonds in structures of subprime mortgages (or “towers” as he calls them) were shuffled together to make the misunderstood and extremely unstable collateralized debt obligations (CDOs) and -― hang in there folks, almost done ―-how insurance policies called credit default swaps (CDS) were created to short, or bet against, the CDOs and subprime structures.

Read the rest here.

Michael Osinski retired from Wall Street and now runs the Widow’s Hole Oyster Co. in Greenport, New York.

Why Did the Credit Default Market Grow So Large?

It was because of the damn econometricians and their faulty equations, again. This time they assumed risk = 0. Michael Lewis explains:

...What really happened was that traders on Wall Street have the risk on their books measured by their bosses, by an abstruse formula called Value at Risk. And if you're a trader on Wall Street you will be paid more if your VaR is lower -- if you are supposedly taking less risk for any given level of profit that you generate. The firm will reward you for that.

Well, one way to lower your Value at Risk as a trader is to sell a lot of credit default insurance because the VaR formula doesn't count it as risk. Because it's so unlikely to happen, the formula doesn't grab it. The formula thinks you're doing business that is essentially riskless. And the formula is screwed up. So this encouraged traders to sell lots and lots of default insurance because, while they get a small premium for it, it doesn't matter to them because the firm is essentially saying, "Do it, because we're not going to regard this risk you're taking as actual risk."

It's insane. That market is huge as a result...

The Transfer of Risk to Idiot Shareholders...and Then To Taxpayers

Michael Lewis, author of Liar's Poker, explains (ViaMP):

John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation. He ignored the outrage of Salomon’s retired partners. (“I was disgusted by his materialism,” William Salomon, the son of the firm’s founder, who had made Gutfreund C.E.O. only after he’d promised never to sell the firm, had told me.)

He lifted a giant middle finger at the moral disapproval of his fellow Wall Street C.E.O.s. And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders.

But it made fantastic sense for the investment bankers. From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

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.

Obviously, the government shouldn't be in the game. The shareholders at Goldman Sachs and Morgan Stanley should have been allowed to fail just like Bear Stearns and Lehman Brothers shareholders. Burned shareholers wouldn't be investing in investment banks again any time soon, and new financially grounded partnerships would rise from the ashes.