Ed Driscoll

Liar's Poker Meets the Community Reinvestment Act

Before flying back from New Jersey last week after visiting family over the Fourth of July holiday, I downloaded the Kindle version of Michael Lewis’s 1989 classic, Liar’s Poker. At the time of its initial publication, it seemed like a fun, breezy snapshot of Wall Street, written during that slightly disoriented period after the crash of 1987, but before the left was comfortable making money again once Bill Clinton was in office.

Today, the most interesting portion of the book by far seems to be the portion that documented the birth of the Collateralized Mortgage Obligation in the late 1970s and early 1980s, which allowed Wall Street to bundle together a savings & loan bank’s portfolio of home mortgages, and trade them on the bond market, complete with a quasi-government guarantee against default. As Lewis wrote in Liar’s Poker:

The problem [for Wall Street bond traders looking to develop this new market] was more fundamental than a disdain for Middle America. Mortgages were not tradable pieces of paper; they were not bonds. They were loans made by savings banks that were never supposed to leave the savings banks. A single home mortgage was a messy investment for Wall Street, which was used to dealing in bigger numbers. No trader or investor wanted to poke around suburbs to find out whether the homeowners to whom he had just lent money was creditworthy. For the home mortgage to become a bond, it had to be depersonalized.

At the very least, a mortgage had to be pooled with other mortgages of other homeowners. Traders and investors would trust statistics and buy into a pool of several thousand mortgage loans made by a savings and loan, of which, by the laws of probability, only a small fraction should default. Pieces of paper could be issued that entitled the bearer to a pro rata share of the cash flows from the pool, a guaranteed slice of a fixed pie. There could be millions of pools, each of which held mortgages with particular characteristics, each pool in itself homogeneous. It would hold, for example, home mortgages of less than $110,000 paying an interest rate of 12 percent. The holder of the piece of paper from the pool would earn 12 percent a year on his money plus his share of the prepayments of principal from the homeowners.

Thus standardized, the pieces of paper could be sold to an American pension fund, to a Tokyo trust company, to a Swiss bank, to a tax-evading Greek shipping tycoon living in a yacht in the harbor of Monte Carlo, to anyone with money to invest. Thus standardized, the pieces of paper could be traded. All the trader would see was the bond. All the trader wanted to see was the bond. A bond he could whip and drive. A line which would never be crossed could be drawn down the center of the market. On one side would be the homeowner; on the other, investors and traders. The two groups would never meet; this is curious in view of how personal it seems to lend a fellowman the money to buy his home. The homeowner would see only his local savings and loan manager, from whom the money came and to whom it was, over time, returned. Investors and traders would see paper.

* * *

Ranieri & Co. [Lewis Ranieri, then of Salomon Brothers, and the bond traders who worked under him] intended to transform the “whole loans” into bonds as soon as possible by taking them for stamping to the U.S. government. Then they could sell the bonds to Salomon’s institutional investors as, in effect, U.S. government bonds. For that purpose, partly as the result of Ranieri’s persistent lobbying, two new facilities had sprung up in the federal government alongside Ginnie Mae. They guaranteed the mortgages that did not qualify for the Ginnie Mae stamp. The Federal Home Loan Mortgage Corporation (called Freddie Mac) and the Federal National Mortgage Association (called Fannie Mae) between them, by giving their guarantees, were able to transform most home mortgages into government-backed bonds. The thrifts paid a fee to have their mortgages guaranteed. The shakier the loans, the larger the fee a thrift had to pay to get its mortgages stamped by one of the agencies. Once they were stamped, however, nobody cared about the quality of the loans. Defaulting homeowners became the government’s problem. The principle underlying the programs was that these agencies could better assess and charge for credit quality than individual investors.

What could go wrong?

Speaking of which, in 2008, Lewis added a postmortem of sorts to his book, in an article for the now-defunct Condé Nast Portfolio magazine in November of 2008, shortly after Obama was elected, and the MSM was at the peak of their stereo euphoria of “We Are All Socialists Now,” with a concurrent serious case of Depression Lust for their would-be FDR to oversee:

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.

Funny, you need even less experience in business to run for president, and play the ultimate form of Liar’s Poker, With Other People’s Money.

Until the commission checks run out, of course.

Related: Of “Beached Economists” — and killer debt maintenance.