High-frequency trading is not likely to hurt disciplined, long-term, low-frequency-trading investors. In fact, it might even help.
Would you like to know EXACTLY what caused the financial crisis? While I can’t sum it up in a way that will leave you fully satisfied in a mere blog post, I can point you in the direction of a resource that will entertain you while giving you a crash course in the creation of a financial crisis. But I must disclaim that if you want to really know what caused the crisis—and what is likely to cause the next one—you’ll need to have the ability to consume more than just a few “choice words.” The true story of the destruction of our financial system is both profane and profanity laden. It’s The Big Short, by Michael Lewis.
Michael Lewis has written some incredibly important books. His breakthrough came when he wrote a tell-all exposing the moral ills of Wall Street entitled Liar’s Poker, but the book you’ve probably heard of—or the movie based on the book—is The Blind Side. It’s the incredible story of Michael Oher, the current left tackle for the Baltimore Ravens, who escaped occasional homelessness to become one of the NFL’s finest. Lest you think the point of my digression into Lewis’s other works is a not-so-veiled attempt at giving props to my home team taking on the dreaded Pittsburgh Steelers this Saturday at 4:30 pm in the divisional playoffs, I assure you it IS. But my point also serves to demonstrate that Michael Lewis is indeed a gifted writer, capable of giving the financially savvy more than enough to chew on and novices a manageable framework for the financial events that brought down even the most the legendary of Wall Street firms.
“Holy s—, that’s just f—ing crazy. That’s fraud.”
“This is a fictitious Ponzi scheme.”
Those words are spoken by the “good guys” in The Big Short, traders who dug further and further into the deceit and greed to discover that Wall Street had created synthetic investment products (credit default swaps) designed to bet against other synthetically created investment products (CDOs). CDOs were designed to defraud investors by manipulating incompetent rating agencies, thereby hiding the inherent danger in the investments they aggregated—sub-prime mortgage bonds—comprised of the ill-conceived sub-prime mortgages.
Hmmm… that was hard to follow, wasn’t it? Let me try that again: “Sub-prime” is the moniker for a mortgage loan given to a buyer with poor credit. The borrowers were charged higher interest rates to help off-set the risk (for the banks), but the rates were so high that it made it hard for the borrowers to make the payments, especially when the housing market went south. Sub-prime mortgage bonds were created and sold, designed to pay bond-holders a higher-than-average rate of interest for accepting a higher chance that the borrowers will default. CDOs—or Collateralized Debt Obligations—were used to group different “tranches” (bunches) of sub-prime mortgage bonds together. The same firms who originated the loans created the bonds made up of the mortgages… then they created the CDOs made up of the bonds and sold “insurance” to the firms who purchased the CDOs in case the CDOs would lose money. The insurance was termed a credit default swap. So what happens when the borrowers walk away from the loans? The bonds default and the CDOs tank, which require the firms who created all this stuff to pay the insurance benefits through the credit default swaps, but they don’t have any money left to pay!! The financial crisis of 2008-2009.
Like I said, it’s complicated. That’s why Lewis takes a whole book to explain it, and he does so masterfully. He spent enough time as an insider to understand how the system works, but even more time off of Wall Street so he knows how to help us understand. And instead of lecturing, he tells the story through the narrative of three different firms and their unlikely leaders who found a way to buy the insurance—or “short” the entire sub-prime mortgage market—without even owning the junk for which they were purchasing the insurance. These guys are (or were) traders, and having spent 28 months of my professional life on a trading floor, I can confirm that their colorful vernacular is (unfortunately) the norm. It’s more akin to a locker room environment than any professional realm you could imagine. Lewis even tells us of the impact that navigating these waters had on the traders personally, on their families and friends.
It’s an ugly story, but it’s a vitally important one. And if, like me, you decide to “read” the book via the CD series in your car, don’t forget to turn it off when you’re driving your kids!