Prophets of the financial crisis

All geek to them

A handful of outsiders come out of the crisis in credit

Mar 18th 2010 | From The Economist print edition

The Big Short: Inside the Doomsday Machine. By Michael Lewis. Norton; 266 pages; $27.95. Allen Lane; £25. Buy from Amazon.com, Amazon.co.uk

No One Would Listen: A True Financial Thriller. By Harry Markopolos. Wiley; 354 pages; $27.95 and £18.99. Buy from Amazon.com, Amazon.co.uk

IN A normal panic, perception overwhelms reality. Shout “Fire!” in a crowded theatre and people do not wait to see the evidence before they rush for the exits. In the crisis of 2007-08, observes Michael Lewis in “The Big Short”, the reverse occurred. People remained in their seats while the building burned down around them. Both this work and another book, “No One Would Listen” by Harry Markopolos, show what it was like to see flames when most people did not.

Mr Lewis’s hugely entertaining tale follows a handful of investors who shorted America’s housing market. Steve Eisman, a hedge-fund manager with a love of comics and a talent for offending people, had witnessed the subprime market blow up in the 1990s and was convinced the same would happen again. Michael Burry combed through the prospectuses of mortgage-backed bonds and concluded that lending standards were sagging. Charlie Ledley and Jamie Mai, two investors with a penchant for finding mispriced options, reckoned that credit-default swaps on mortgage-backed bonds were just too cheap a trade to pass up.

If one thing stands out from Mr Lewis’s account of how a few individuals made fortunes from predicting the crisis, it is that it pays to be an outsider. The socially awkward Mr Burry, a one-eyed fund manager with Asperger’s syndrome, avoided contact with people if he could help it. Cornwall Capital, the fund run by Messrs Ledley and Mai, was too small to be taken seriously by most Wall Street firms, which nicknamed it Cornhole Capital. Mr Eisman had no grounding in the bond markets he wanted to short.

Armed with their own convictions, they took no comfort in AAA credit ratings, and were baffled by the failure of other investors who could not or would not see the widening cracks in the housing market. Nor did they understand until very late the dual role of the Wall Street banks—clever enough to exploit demand for subprime loans by creating ever more noxious piles of housing debt, but not clever enough to avoid the meltdown themselves.

Being a bit of an oddball may be an asset as an investor. It is less helpful if you need to persuade others to see things your way. When Mr Markopolos, an analyst and self-confessed “Greek geek”, was shown the returns of a money manager in New York in late 1999, he knew right away that something odd was going on. Normal charts in finance reflect the volatility of the market. This manager produced returns which rose at an impossibly smooth 45- degree angle. His name was Bernie Madoff, a former chairman of NASDAQ and an industry grandee.

Under pressure from his employers to replicate Mr Madoff’s returns, Mr Markopolos tried to pick apart his strategy. None of it made sense. The Madoff approach had virtually no correlation with the performance of the overall stockmarket. As Mr Markopolos and a small, informal team began to dig, it became clear that billions of dollars were being channelled to Mr Madoff, yet there was no trace of his transactions in the market.

The story of how Mr Markopolos discovered the world’s largest Ponzi scheme is interesting enough, but the real meat of his account concerns the investigations that did not happen. On five separate occasions starting in 2000 Mr Markopolos made submissions to the Securities & Exchange Commission (SEC) about Mr Madoff. His most detailed report, in 2005, outlined 30 reasons to suspect Mr Madoff of being a fraud. The SEC’s failure to follow up properly was horribly costly. Between the first submission and Mr Madoff’s eventual arrest in December 2008, the scheme had taken in more than $40 billion.

Mr Markopolos offers a simple explanation for this failure: incompetence and arrogance. Investigators knew too little about financial markets to assess the evidence. “If blank looks were dollar bills I would have walked out of that room a rich man,” is his stinging description of one interview with the agency. Mr Markopolos’s book is nowhere nearly as well written as Mr Lewis’s, but the frustration of the outsider could not be better expressed.