Michael Lewis’ Flash Boys calls for US attention

Alan Greenspan, the chairman of the Fed as the US’s housing bubble grew, should have put down Ayn Rand’s Atlas Shrugged and picked up another of Lewis's books, Liar’s Poker. Washington should now take note of Flash Boys.

Michael Lewis’ Flash Boys is a ripping yarn filled with rip-off artists running rampant through American bourses. And we should take heed: Mr Lewis’s 1989 book, Liars’ Poker, a memoir of his beginnings at bond-trader Salomon Brothers during the Reagan era, told us everything we would need to know about the 2008 financial crisis, if only we had listened.

Mr Lewis was starting out at Salomon just as Italian-American trader Lewis Ranieri realised that an awful lot of money could be made out of trading mortgages. Almost every American, Mr Ranieri figured, took out a big loan to cover home ownership, and the total value of this outstanding mortgage debt in 1981 was around one trillion dollars. That was a huge, untapped pool of debt, complete with juicy interest repayments, that could, in principle, be tranched and traded like any other kind of debt product.

Loans from banks to householders could support bonds, with the interest payments from the mortgages hypothecated to form the interest component of the bond. Mr Ranieri saw no reason why an 11 per cent mortgage could not become a 10.5 per cent bond. So he invented a tradeable “mortgage bond” backed by home loans. Mr Ranieri’s next innovation, the Collateralised Mortgage Obligation, which pooled a number of mortgages into a bond with multiple tranches and approximate maturity dates – nowadays renamed the Collateralised Debt Obligation (CDO), and applied to all manner of consumer debt – has haunted the financial pages since 2008.

This period also saw the birth of the now notorious mortgage associations, Fannie Mae and Freddie Mac, alongside their older parent, Ginnie Mae. The latter converted loans of low-income homeowners into bonds, which were then guaranteed by the United States government and packaged with a triple-A rating by Standard & Poor’s and Moody’s. Fannie and Freddie converted and implicitly guaranteed the rest.

Here is the warning:

“Once the [mortgage] loans were [converted into securities and guaranteed] ... nobody cared about the quality of the loans. Defaulting homeowners became the Government’s problem.”

And here is the punchline:

“A cautious man would have inspected the properties he was lending against, for nothing but property underpinned the loans. But if you planned to run with this new market, you did not have time to check every last property in a package of loans.” Caveat emptor, indeed.

These sentences would not be out of place in a retrospective on the 2008 financial crisis – but they were written in 1989. The two major causes of widespread mispricing in a US$1 trillion dollar industry are there.

First, there was a clear information asymmetry between buyers of mortgage bonds and their sellers.

Second, Fannie and Freddie’s implicit government guarantees gave the assets a triple-A rating irrespective of the creditworthiness of the actual lenders. In 2008, two further sparks were added – a lightly-regulated mortgage sales industry, which led to systematic misselling of mortgages and mispricing of counterparty risk, and the wholesale slicing and dicing of mortgage-backed securities through absurdly complex derivative products: the CDO squared – a CDO built out of tranches of other CDOs – being a particularly mindbending personal favourite.

As global economic interdependence grows, clear, factual, investigative accounts of the real significance of high finance’s activities are more vital than ever. Alan Greenspan, who was the chairman of the Fed as the US’s housing bubble grew, should have put down Ayn Rand’s Atlas Shrugged and picked up Liar’s Poker. Washington should now take note of Flash Boys.