Why the Germans Bought the Toxic Waste: More on Michael Lewis

My last post on Michael Lewis’ scatological screed at Vanity Fair drew a fair number of comments regarding German bankers’ problems with toxic-waste securities sold by American investment banks. Why the world supported America’s housing bubble by purchasing derivative securities (collateralized debt obligations, or CDO’s, backed by sub-prime mortgages) is a separate question. For years, I gave presentations to German money managers (often in German) on these securities, as head of Credit Strategy at Credit Suisse (1998-2002) and head of debt research at Bank of America (2002-2005). B of A, to its credit, stayed out of the subprime origination business until Ken Lewis bought Countrywide in 2008, with consequences we read about every day. I quit B of A in 2005 over what the bank and I agreed to call “philosophical differences,” and later joined a credit hedge fund — Asteri Capital — which cashed out its investors with a profit in August 2008, just before Lehman went under. We survived the crisis by shorting the banks.


The Germans bought the toxic waste because they had to. I wrote about this in 2008:

The German financial system wanted to consume low-quality American assets, but did not want to look on what it was eating. German banks have written down about US$25 billion in securities derived from low-quality (“subprime”) American mortgages, and doubtless will lose a great deal more. But it is silly to blame the sausage-grinder. Why didn’t the Germans and all the other overseas investors buy mortgages in their own countries, instead of scraping the bottom of the credit barrel in the United States? It is because there aren’t enough Germans, or Italians, or Frenchmen or Japanese starting families and buying homes. There weren’t enough Americans, either, and therein lies a tale.

The aging pensioners of Europe and Asia must find young people to pay interest into their pensions, and they do not have enough young people at home. Germans aged 15 to 24, on the threshold of family formation, comprise only 12% of the country’s population today and will fall to only 8% by 2030. But one-fifth of Germans now are on the threshold of retirement and half will be there by mid-century.

Germany’s low birth rate means that the domestic economy can’t generate enough assets to meet the investment requirements of prospective retirees. The great Robert Mundell, the grandfather of supply-side economics and 1999 Nobel Laureate, observed in an obscure but important article that demographics explain almost all the chronic current account deficits in history: countries with aging populations lend to countries with young populations.


The trouble is that America’s population was aging, but more slowly than Germany’s. From a demographic standpoint America had overbuilt single-family homes, but the change was slow enough for Americans to kid themselves that they would be able to sell that McMansion in an exurb to fund their retirement. There are plenty of countries with very young populations, e.g., Brazil and Nigeria, but nobody wanted to lend to home buyers there. So the world came to America’s capital market. And Wall Street, with the blessing of the federal housing regulators, reached into the bottom of the credit barrel to provide the product.

The world kept shipping capital to the United States over the past 10 years [through 2007] because it had nowhere else to go. The financial markets, in turn, found ways to persuade Americans to borrow more and more money. If there weren’t enough young Americans to borrow money on a sound basis, the banks arranged for a smaller number of Americans to borrow more money on an unsound basis. That is why subprime, interest-only, no-money-down and other mortgages waxed great in bank portfolios.

America’s financial market could not produce enough pork chops, so the Europeans bought Spam and scrapple. America’s rating agencies assured them that derivatives created from subprime mortgages, second-lien mortgages and other dubious parts of the pig were the equivalent of pork chops, and foreign investors wolfed them down.


The financial crisis occurred because Democratic administrations pushed subprime mortgages to benefit minorities, because politicians treated the federal mortgage agencies as patronage piggy-banks, because the ratings agencies “sold their soul” (as one S&P official admitted in a now-public email), because the Greenspan Fed tolerated untold amounts of leverage on the leverage, because the investment banks issued mortgages with robo-signers, and the Germans bought them with robo-investors. But all of this occurred in the context of a demographic tragedy: the world doesn’t have enough young people in the venues where investors want to risk money to meet the income needs of a tsunami of soon-to-be pensioners.

Mr. Lewis seems to believe that the problem with German bankers is an obsession with excrement. In fact, the Germans did exactly what the French, British, Italian, Spanish, and Japanese bankers did. They bought what was available on the market. They didn’t like it; they held their noses at it; but they bought it nonetheless because they thought they had to.

The German economy, by the way, has long since moved on from dependency on its Southern or Western neighbors (die Welschen) for export growth: during the past several years virtually all the growth in German exports has come from the East, from China and to some extent Russia. That leads me to believe that after the proverbial decent interval, Greece, Italy and Spain will be thrown out of European monetary union, their debt will be reorganized along the lines of Brady bonds, their banking systems sold to foreigners at a fraction of book value — and no-one will care very much.


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