Yesterday I had bad hay fever and a headache: so I decided to throw myself at one of the countless books in my in-tray, Michael Lewis’ (2010) “The Big Short”. 24 hours later, and I found that I’d accidentally read the whole book: it’s certainly an engrossing read. 🙂
I already knew a fair bit about the causes of the 2007 / 2008 financial market collapse and how it played out: but Lewis foregrounded the people not so much at the eye of the storm, but rather encouraging the storm to get on with it and smash everything up. (Basically, because they’d each found ways of taking a huge short position against the stupid, mad, exploitative system that had rapidly been built atop an unsustainable industry selling mortgages to people who could barely begin to afford them.)
But then Lewis got a big detail wrong (something which I happen to know about), and I think that throws his overall judgment sideways. He writes (p.78):-
“Wall Street’s newest technique for squeezing profits out of the bond markets should have raised a few questions. Why were supposedly sophisticated traders at AIG FP doing this stuff? If credit default swaps were insurance, why weren’t they regulated as insurance? Why, for example, wasn’t AIG required to reserve capital against them?”
This is where Lewis drops the ball. As I understand it, the reason Joe Cassano (“a guy with a crude feel for financial risk but a real talent for bullying people who doubted him”, [p.86]) ran AIG’s operation from London was because, compared to the US, the UK had unbelievably lax rehypothecation rules – the rules that should stop you borrowing a hundred times over against the same collateral asset.
It’s true that Cassano’s group was sold one of the biggest pups in history by companies gaming the ratings agencies in ways that were, from my perspective, completely unethical. But what gave AIG the ability to insure the repackaged subprime tranches at all was simply that because they were operating out of London, they could do whatever hypothecation they f*&king well liked.
Ultimately, Goldman Sachs and the rest may have encouraged AIG to pull the trigger, but it was London’s lax rehypothecation rules that loaded AIG’s submachine gun. Without a gigantic
sucker insurer to sit on the other side of the trade who just happened to have the means to scale it up, the subprime market would surely never have happened in the first place.
So was London no more than a passive passenger in the meltdown, one hijacked by those nasty old US investment banks; or did its (lack of) rules actively help derail everything? I suspect the latter… but you’ll have to make up your own mind.
What scares me most is that, thanks to the ridiculous bailouts that ensued, nobody involved seems to have learnt anything. Rehypothecation in London remains infinite. What will trigger the next meltdown?