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Michael Lewis on the Financial Panic

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Michael Lewis' books include Liar's Poker, The New New Thing, and Moneyball, and he is the editor of a new anthology, Panic: The Story of Modern Financial Insanity. Last week, I had the opportunity to talk to him about the current financial panic. In this first of three installments, Lewis talks about the causes of the crisis and offers up some solutions. For the full audio version of the interview, click here.

Mac Greer: Michael Lewis, it is ugly out there. Where did it all go wrong?

Michael Lewis: There is a short answer and a long answer. I will give you the short answer first. The very short answer was the ability of Wall Street to repackage subprime mortgages as an investment-grade security. That is the heart of the immediate problem.

Then, having done that, [Wall Street] created alongside this market, which grew to a couple of trillion dollars, a casino in side bets where smart people could bet against the subprime mortgages going bad -- which smart people did do -- this market in side bets, with many trillions more than the original market. So you have got -- because the subprime mortgages have all turned out to be, or mostly turned out to be kind of rotten -- you have got many trillions of dollars of supposedly investment-grade securities that are suddenly worthless. That is a traumatizing event for the global economy, but that is the very short answer.

Greer: And Michael, you say that the common thread in all financial panics, or at least recent financial panics, is the underpricing of risk.

Lewis: Yes, I think it is true that the models that have been used on Wall Street since the early 1980s to price financial risk -- to essentially price financial insurance, which takes different forms, but the most common form is an option -- work reasonably well in normal financial environments, when things aren't too volatile. When there are really extreme moves, they fall apart. And over and over in the past 25 years, we have seen really extreme moves in which they fall apart. This is another example of that.

There is a logic to, for example, why subprime mortgages were reclassified as investment-grade securities. It is the diversiphilia that has swept the ratings agencies in the last 20 years, and it grows out of academic research. And if you make assumptions about these different subprime mortgages that are -- and the assumption is that they are not correlated with each other -- well, then when you throw them all together in a single package, well, maybe the people who get the first payments out of that package do have an investment-grade security.

But the fact is, the financial markets have been growing increasingly correlated over the last 20 years, and subprime mortgages in particular are all correlated perfectly with one another. So it is as if Wall Street has been writing catastrophe insurance -- say, insurance against houses on Miami Beach being destroyed by hurricanes -- as if it was auto insurance. They have sort of systematically misclassified the nature of the risk that they are dealing with.

Greer: So along those lines, Michael, how could this crisis have been prevented?

Lewis: Well, that is a really great question, because a lot of things could have happened to prevent it. It took a conspiracy of many forces for it to be as bad as it is, but why don't we start from the top down? If the financial regulatory system had controlled the leverage that investment banks were able to run, that would have dramatically reduced the amount of risk in the system. But they didn't, not properly. If the ratings agencies had done their job properly and not caved to pressure from Wall Street to ... not allow themselves to essentially be gamed by Wall Street into putting investment-grade stickers on things that were essentially crap, then all of it would have been avoided.

Greer: Michael, you are telling me Moody's (NYSE: MCO  ) was asleep at the switch? I think of Moody's as this like sleepy old company, not taking many risks.

Lewis: Isn't it sleepy old companies that fall asleep at the switch?

Greer: I guess that works both ways.

Lewis: Moody's had an incredible run there, where their profits were incredible. In fact, the whole of the financial system was running on the profits from the American mortgage securitization industry. It was a vast industry, and Moody's was making huge sums of money rubberstamping these CDOs [collateralized debt obligations] -- Moody's that is 20% owned by Warren Buffett. And so if they had done their job, if they had behaved with real total integrity or not been stupid -- who knows exactly what they were thinking? -- then the problem would have been prevented.

However, those are just the top-tier culprits. If the Wall Street firms had been partnerships instead of corporations, if the people in them had had total long-term engagement with the risks they were taking, they never would have done what they did. If American culture had not evolved to inure people to the risks of leverage, then I don't think nearly so many people would have borrowed money they couldn't repay. So this is just the beginning, off the top of my head.

Greer: And along those lines, what is the solution to the current mess?

Lewis: I think you let more institutions fail. I think there is no solution that is not a painful solution. I think that this top-down approach of trying to sort of hand over taxpayer dollars to failed banks, hoping that they will become successful banks, is a mug's game ...  what they should do is target homeowners in their homes, and use that subsidy to subsidize those people so they stay in their homes, and re-jig the mortgages so they lower principal balances, and so and so ... you start with the level of the crisis, which is the level of the individual homeowner. And if, above that, and while you are doing that, some of these institutions fail, then they fail.

Mac Greer: And Michael, what are you going to do about the automakers [General Motors (NYSE: GM  ) , Ford (NYSE: F  ) , Chrysler]?

Michael Lewis: Bankruptcy is the best option, I think. I think if you give them money, you are going to make it harder for them to change what they need to change. They need to be reorganized in bankruptcy. The unintended consequences of handing huge sums of money to failed enterprise are seldom appreciated. I hope that the Treasury and the Congress has already learned something from the money they have handed out to the banks. It wasn't a smart thing to do.

For the full audio file of Mac's interview with Michael Lewis, click here.

Mac Greer does not own any of the stocks discussed. Moody's is a Motley Fool Stock Advisor and Motley Fool Inside Value selection. The Motley Fool has a disclosure policy.

Read/Post Comments (9) | Recommend This Article (71)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 26, 2008, at 3:53 PM, PSerrano wrote:


    Who is going to buy a car from a company that could be out of business in a year? What bank is going to approve a car loan for a company in bankruptcy?! The gov. must set up a bridge loan for GM, Ford, etc or American will not have an automobile industry - reorganize, fire managers, whatever, but bankruptcy will end these companies.

  • Report this Comment On November 26, 2008, at 4:02 PM, whereaminow wrote:

    For a reasoned analysis of why the automakers should be allowed to fail, please visit the Austrian School of Economics at


    Shouting at me in all capital letters does not improve your position. You should instead try to justify it, somehow, if you can.

    And after you have done that, please visit where all of your justifications will be shown to be easily refuted with introductory economics.

    Viva Hazlitt!

  • Report this Comment On November 26, 2008, at 6:41 PM, GoNuke wrote:

    Michael Lewis is indeed wise. I agree with everything he has stated here. Once the meltdown occurred I began studying the murky world of CDO's, CDS's, and risk rating models. If I knew then what I know now I would have cashed out of the stock market in 2007. The global financial system was a house of cards that had almost zero tolerance for a decline in US house prices while that sector was in a bubble.

    GM must go bankrupt. It has to shed itself of all the costs that are not associated with making cars that people want. That means jettisoning the UAW and all of its retired employees. That means reducing labour costs, dealerships, and brands. The government can guarantee GM's warrantees. With all its excess baggage removed GM will emerge from chapter 11. Then government support will be of value. Giving GM money before it goes bankrupt will just lead to destruction of capital. The UAW must be sacrificed so the far more numerous parts suppliers can keep their jobs. The notion that nobody will buy a car from a company that is in chapter 11 is nonsense. GM has been technically bankrupt for years. The risk of bankruptcy has been hanging over its head for some time. People kept buying GM products.

    The most important lesson to be learned from all this is that financial institutions cannot behave so recklessly. The derivatives market mushroomed as a way of circumventing capital adequacy ratios. The bond rating companies were irresponsible rating so many highly leveraged assets as anything but junk.

    Too much faith has been placed in bond rating services and too many rules are based on the ratings these services give. Given how badly the bond rating agencies have performed one must now analyze each debt instrument with the same rigour one analyzes share purchases.

  • Report this Comment On November 28, 2008, at 10:54 PM, baksheesh wrote:

    "Moody's that is 20% owned by Warren Buffett."

    That's the take-home line here. The sage of Omaha owned one out of every five shares of the entity that mis-handicapped the whole horse-race. The race has been run. The top-ranked horses were nags. Wherefore is he still called the sage of Omaha?

  • Report this Comment On December 01, 2008, at 4:47 AM, mikejw wrote:

    There are plenty of brand name companies that have gone bankrupt and did not miss a step.

    Look at the airlines, some have even gone bankrupt and left passengers stranded. But life goes on.

    If the big 3 in Detroit can't make a car that the consumer wants to buy, then let them go bankrupt so that they can reorganize and retool with a better business plan. Having the government bail them out would be ridiculous. The CEOs went to Washington, D.C. with no plan and had the audacity to ask for money to "save them"

    Just my two cents,


  • Report this Comment On December 01, 2008, at 7:11 PM, zenwizard wrote:

    "Who would buy a car from a company in Chapter 11?"

    I would--for the right price.

    I have owned classic Corvettes that have not been made in 30 years and I have never had a problem getting a part or finding some Goober Pyle to work on the car.

    (Something like OnStar might pose a problem--but even that, I would think worst case some company would come in and provide the service or a similar service.)

    Chapter 11 would force them to reprice their depreciation machines--read, "New Cars"--to a more realistic price.

    I say this as a guy who loves American cars and American workers.

    I simply do not trust the heads of the Big Three to make good, painful decisions.

    Example of a painful decision that a BR judge could make: Cancel a redundant brand like Mercury.

    What's the difference between a Grand Marquis and a Crown Victoria? Badge and trim. But still Mercury has a separate brand manager, advertising strategy, dealership network, etc. costing unnecessary dollars to sell basically the same engine and chassis to the consumer.

    There are similar redundancies in Buick and Pontiac. Maybe one of those two brands has to go.

    I say that with a heavy heart because I have a lot of love for those brands.

  • Report this Comment On December 05, 2008, at 6:12 PM, beaconps1 wrote:

    The securitization, synthetics, leverage, cheap Fed dollars to borrow short and lend long, risk taking, 100 to 1 CDS protection actually generated counterfeit money. We have too much digital counterfeit money which became apparent when the players tried to cash in their casino chips. We lost control of our monetary system. There is no Free Market monetary system. Money is supposed to be closely regulated.

  • Report this Comment On December 07, 2008, at 12:09 PM, sharkl wrote:

    Mr Lewis in his second answer regarding underpricing of the risk in these hybrid securities uses a form of the word "assume" more than once. Is not this a lesson we all learn early on in life, because it is so funny and so true: When you ASSUME you make an ASS of U and ME. Tada! They've proved it at Moody's.

    Also when he says that those who got in FIRST on these deals may be the only ones who actually profited from it, it sounds suspiciously like every Ponzi or Pyramid scheme out there.

    Learning from the past? I guess that's just like beating a dead dog.

  • Report this Comment On July 01, 2009, at 11:23 PM, jesse2159 wrote:

    Michael Lewis understands the problem clearly and provided the solution,....except he didn't take the political equation into the mix. No President is going to allow the banks or auto makers to fail on his watch. And that, is the more difficult part of any equation.

    As for Moody's: Have the decency to give back the money you made by providing AAA ratings on crap.

    As to the banks: You've made the Taliban and Al Quida proud. No one else could have destroyed as many Americans as you have managed to do.

    As to Wall Street: How many homes do you need? How many cars do you drive, how many yachts are necessary?

    You've all managed to turn my stomach.

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