ECONOMICS MAY 14, 2010
The Big Short || by Michael Lewis
The Quants || by Scott Patterson
W.W. Norton & Co., 266 pp., $27.95 || Crown Business, 352 pp., $27
If any single sentence sums up the people at the heart of our “boom-bust-bailout” decade, it is this: “They were cool and lucid, these men, men of mathematical precision whose very professions sometimes sounded uncivilized to the humanist.” These people had scaled the peaks of academic achievement, mastered the toughest problems of the private sector, and cracked wide open the analytical issues of the day. They were really the smartest people available—in a society that values smarts and knows how to put brains to good use. The fact that they were also well-heeled did not hurt: this is America and we believe deep down that if someone studies hard, works long hours, and gets just a little bit lucky, he (or she) can and should make out like a bandit.
They were going to get America moving again. There was a sense that these were brilliant men, men of force, not cruel, not harsh, but men who acted rather than waited. There was no time to wait, history did not permit that luxury; if we waited it would all be past us…. Things were going to be done and it was going to be great fun; the challenge awaited and these men did not doubt their capacity to answer that challenge…. We seemed about to enter an Olympian age in this country, brains and intellect harnessed to great force, the better to define a common good.
Yet all this brilliance was for naught—or worse. The genius, it turned out, was precocious, but it did not scale. These people could (arguably) run a decent-sized business, but when you put them together what you got, collectively, was miscalculation, and hubris, and denial. We had to struggle to extricate ourselves from the sophisticated mental models that they had thrust upon us, to say nothing of the budgetary cost and the appalling human devastation these models imposed.
If this sounds like our financial system over the past decade—and even more so now, post-bailout—then you have been paying attention. But these quotations and judgments are not from Michael Lewis’s epochal The Big Short or Scott Patterson’s equally brilliant but relatively underappreciated, The Quants. I have taken them from David Halberstam’s The Best and The Brightest. The description of key figures and their thinking is disconcertingly similar.
You may recoil in horror from this comparison. Our global financial disaster is surely not Vietnam: “all” we lost since December 2007 was at least eight million jobs (over eleven million, by some counts), many middle-class futures, and most of our government’s previously uncommitted fiscal resources. No one is routinely shot, blown up, or maimed as a result of the madness that is our financial markets. No question about that.
And yet, with all the appropriate corrections and disclaimers, the parallels are eerie and the contrasts are telling. Halberstam completely nailed the characters who led us deeper into Vietnam: their combination of self-confidence, experience, limited worldly understanding, deficient empathy—and this was perhaps the most amazing discovery—collective lack of wisdom. Patterson’s characters have essentially the same attributes. His portraits are sympathetic and most of his individuals are enviably brilliant, although not generally charming. But put all these brains together and let them build mathematical systems of “risk management” and “hedging,” and what do you get? By far the most dangerous financial system ever known.
Michael Lewis tells this story through their antithesis on the short or negative side of the market. His characters are exceedingly reminiscent of Daniel Ellsberg, a smart yet quirky fellow who confronted Defense Secretary Robert McNamara with skepticism and finally—in deep disgust—took it upon himself to leak what became known as the “Pentagon Papers.” Lewis’s heroes face down authority, but not in meetings and with memos or in the back of Air Force planes. Instead they run around trying to find ways to place bets on the collapse of the entire system of “subprime” mortgage financing in this country. They face an amazing wall of incomprehension—a wall constructed from group-think.
You cheer for Lewis’s men, particularly Steve Eisman—a man who succeeds because he “thinks different.” Eisman and his colleagues are smart, but they are not like the others: they are from equity, while the market in question is fixed income (whose proponents traditionally look down on equity analysts as people who do not understand the deeper mathematics of bonds). The collective brainpower against Eisman and the short sellers was formidable—if we had reasonable units of measurement, it would presumably have been in order of ten thousand or more to one. But Eisman sees intuitively that this dog simply will not hunt.
For Ellsberg, it was the unfiltered realities on the ground in Vietnam—and his understanding of how standard military reporting completely distorted what was really going on. For Eisman, it is many years of thinking deeply about relatively poor people and how they get ripped off by the financial system. As he explains: “I now realized there was an entire industry, called consumer finance, that basically existed to rip people off.” And then Eisman meets the people, face-to-face, on the other side of the market—and the penny (or billion dollar sign) finally drops. Sure, they are smart, but they have no incentive to be careful. The “long side” is paid to keep the doomsday machine cooking, to run crappy mortgages through the system.
Eisman makes even more money as a result. It is a great victory: the underdog prevails, and everyone who is truly sensible (not just smart) becomes really rich. Except that this is not really the whole story. The system—no fault of Eisman: in fact he warned people, sort of—built up so much debt and in such a complicated fashion that when the bust came, it was not like anything we have seen, at least since 1929.
As Lewis acknowledges in his prologue, this is actually the end of a story that he started many years ago with Liar’s Poker, a brilliant description of the corporate culture in Salomon Brothers, the great bond trading house of the 1980s. What seemed extreme to Lewis (and his readers) at Salomon became totally mainstream on Wall Street during the next two decades. The rules were swept aside—typically at the behest of people who were making monstrous amounts of money trading bonds—and the movement of smart types into finance became a flood. This (mis)allocation of talent flows out of Liar’s Poker, into Patterson’s story, and then back into The Big Short.
The problem is not just that “efficient markets” turn out to be an oxymoron. It is also that “for profit” companies are not necessarily better run than—say—the Pentagon during the 1960s. People in the private sector are trying to advance their own careers, and their fame, just like McNamara’s generals. We are almost all gaming the system, in some sense—it’s just that some of us have acquired a much greater ability to damage other people along the way.
And quantitative finance involves great complexity—in the form of both subtle mathematics and vast quantities of digital data. The idea is simple: to find value where others do not detect it, by squeezing out returns while not taking on extra risks. But it is awfully easy just to load up on risk, take the cash returns today, and let someone else worry about the consequences tomorrow.
To the trader on the ground, the details of this risk-return combination are clear—but to his or her supervisor, everything can readily be made opaque. Even the brightest CEO may have no clue and if that CEO decides to relax controls in the name of competitive pressure, well, you know what happens next.
Lewis is a sharp and lively writer and Patterson has the broader history and the math in riveting detail, but perhaps the person who completely nailed our current predicament is Calvin Trillin—who recently related in the New York Times a conversation he purportedly had with an experienced Wall Street type in a bar. “The financial system nearly collapsed,” [the Wall Street man] said, “because smart guys had started working on Wall Street.”
“But weren’t there smart guys on Wall Street in the first place?” I asked.
“Did you ever hear the word ‘derivatives’?” he said. “Do you think our guys [the lower third of a college class, who—Trillin argues—were the typical people who went to Wall Street a quarter of a century ago] could have invented, say, credit default swaps? Give me a break! They couldn’t have done the math.”
“When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that. All of that easy money had eaten away at their sense of enoughness.”
Trillin reflects: “I found myself contemplating the sort of havoc a horde of smart guys could wreak in other industries. I saw those industries falling one by one, done in by superior intelligence. ‘I think I need a drink,’ I said.”
You will never see the likes of finance in any other industry; Patterson and Lewis make this quite clear. Modern quantitative finance presents unique opportunities for smart people to run amok. But we have not fixed our financial system, or reined in the havoc that it can wreak. And there remain countless innovative ways for genius—stimulated by greed and groupthink and an open unregulated field—to lead us seriously astray and into more great danger.
Simon Johnson is the coathor of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown.