Fool's Gold - Gillian Tett (Free Press, 2009)

The other side of the story that ends with The Big Short.  The history of the development of CDS and their limits as tools for risk and how those limits were overlooked in pursuit of profit buy some banks with catastrophic consequences.  [332.660973]

The Financial Times columnist offers a history of the development of the credit default swap (CDS), the derivative financial instrument that cost so many banks so much in losses as to bring on the financial collapse of 2008.  Gillian Tett focuses on the derivatives team at JP Morgan while tracing developments at other banks to create new financial instruments. 

Along the way, Ms. Tett points to the pieces of the history that combined to make the disaster.  She recounts the efforts by the Wall Street banks to leave the derivatives business essentially unregulated (or, at most, self-regulated.)  She covers the work by industry committees to draft ISDA rules, including avoiding creating a third-party clearinghouse, as a way to put off regulation by the Federal Reserve and their further work to lobby against four separate bills in Congress in the 1990s to regulate derivatives trading.   

The other great problem was how to keep these instruments from impairing the balance sheet: if they carried any risk for the bank, the bank would have to maintain adequate reserves behind them.  By breaking the CDS into separate tranches according to the risk implicit in the underlying securities, it would be possible to find buyers who matched the level of risk of each tranche with their own preferences for a balance between yield and risk tolerance. There was, however, a particular problem with the "riskless" tranche, the most senior and lowest risk tranche since it was difficult to imagine that this tranche would ever be at risk.  Fortunately, the insurance giant AIG was willing to take on this instrument as an asset.  The return would be small, but with sufficient scaling up, the total would be significant.  Eventually, lobbying by the industry convinced regulators that the senior tranche was sufficiently safe that it didn't need to leave the balance sheet or impair operations by requiring reserves behind it.  Since there was much to be made by selling CDS, the banks went into it fully and this meant they were accumulating a lot of the senior tranche.  Thus both AIG and the banks were set up to take on risks they could not measure.

The key problem was whether the underlying logic of the instruments was correct; there was no way to be sure.  The assumption was that each security (mortgage) had an independent probability of failure.  Even if they were not perfectly independent, the correlation among the constituent securities was assumed to be low.  Experience with corporate failures made the assumption seem safe; the assumption was on far shakier ground when new instruments were designed to use only mortgages.  It was difficult to calculate the probability of general collapse in real estate.  The problem was ignored or assumed away.

The collapse came, quietly at first, but with increasing fury as derivatives began to melt on the balance sheet.  When it was over, few banks were left standing firmly.   Although there were heroes whose rationality and ability to avoid jumping in to the risk pool saved their banks much grief (and Jamie Dimon appears to be one of Ms. Tett's heroes), most banks were caught by the very instruments that had been paying them so well.  The cost in wiped out value reverberated throughout the markets and into the real economy.  The recovery continues eight years later.

This book is highly recommended.

The Big Short: Inside the Doomsday Machine - Michael Lewis (W W Norton, 2010)

An engaging story of the challenges facing a few individuals who bet against common wisdom  to profit on the 2007-8 housing market collapse. [330.973]

One path to good storytelling when dealing with complex issues is to report from the point of view and actions of someone involved in the events.  This doesn't necessarily make the event itself any clearer; instead it trusts that the reader may appreciate the challenges the protagonists face and it conveys a feeling about the events.  This look at the financial implications of the housing market collapse in 2008 attempts to explain events by following three hedge funds and a banker as they try to make sense of what appears to them to be an asset bubble and to find a way to take the opposite side of the trade.  It takes great self-confidence, or foolhardiness, to take a short position when the world is convinced prices can only move upward.

The uninitiated reader is unlikely to come away from this book with a clear understanding of derivatives trading, credit default swaps, or collateralized debt obligations, but this book is not intended as a CFA textbook on derivatives.  In fact, this book should be read alongside Gillian Tett's book Fool's Gold to really understand how such a market developed.  The pair of books gives a richer context to the trading.

Michael Lewis is, nonetheless, a talented writer.  The traders and bankers he describes are complex personalities.  They are not heroic; they see an opportunity to make money and have to develop a way to exploit the situation.  They have to keep their financial backers and investors behind them while the action they propose violates accepted wisdom.  They have to abandon any faith in the leading names in the financial community.  Once events begin to run their way, they have to decide how long to hold the trade before it becomes worthless.  Here is Lewis' talent: giving the reader a sense of the inner workings of these people.

We are still living with the results of the crisis.  It still plays a role in the political campaigns this year because it has affected how we interpret the work of Wall Street, the government, and the markets in a broad sense.  This book is still timely even as it describes events that are a decade ago.

(NB.  The movie of the same name is equally enjoyable and should be watched in conjunction with Margin Call to see both sides of the story, but it has fictionalized some parts of the story and simplified other parts.)

This book is recommended although with the suggestion that the experience improves if one takes time to learn more about the derivatives and the securities discussed.