Inside the Writer’s Brain

Last night Derek and I went to a party at a squat on Western in a no-man's-land area of LA. Apparently, the kids who were squatting there are about to be kicked out, so this was one last bash. We went because the Sharp Ease were playing. Several other bands were playing as well, and throughout the show people were sporadically destroying the place, a set of abandoned apartments above a non-descript furniture store. The place was already very trashed from months of parties. The doors to many of the rooms had been ripped off the hinges and the graffiti-covered walls were pockmarked with holes and dents. The Sharp Ease played their usual, drunken, high-energy set, and the crowd got pretty rowdy. By the time they finished singing, people were tearing down the walls and launching things - cans of paint, small appliances, cinder blocks - through the windows and leaving a litter of glass and debris all over Western Ave. Derek and I, sensing that it would get worse before it got better, drunkenly headed back to our homes.

Last week, Max directed our attention to a major new piece of reporting on the financial crisis: a Portfolio article by Millions favorite Michael Lewis. The author of Liar's Poker, among other books, Lewis is a gifted explainer of an industry badly in need of explanations. In the Portfolio piece, for example, he immerses us in the world of short-sellers who saw the subprime meltdown coming. However, the key paragraph - wherein trader Steve Eisman has an epiphany about how investment banks are leveraging subprime bonds - resorts to a sports metaphor, and thus fails to demystify an elusive instrument at the center of the financial crisis: the credit default swap (CDS)."When a fantasy player drafts Peyton Manning, he doesn't create a second Peyton Manning to inflate the league's stats," Lewis writes.But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. 'They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford,' Eisman says. 'They were creating them out of whole cloth. One hundred times over! That's why the losses are so much greater than the loans.'I've heard financial insiders inveigh against peons who "don't know a credit-default swap from a turnip," but how are we to wise up, if explanations only come in the form of metaphors (athletic or agricultural)? Grabbing a fig leaf from the N+1 playbook, as it were, I decided to ask a friend in finance to explain the Peyton Manning analogy, as simply as possible. Here's what he had to say (wait for "the rub"):Assume the following: Eisman buys a crappy mortgage security (say, a $1,000 bond from a mortgage given to a strawberry picker who makes $14,000 dollars per year). Say the mortgage rate the strawberry picker pays is 15%. This means he's agreed to pay $150 a year to Eisman. But Eisman is worried that the strawberry picker will default because the guy's house value has collapsed and his income is drying up. Thus, Eisman wants to buy insurance on the $1,000 he's loaned. The way he does this is via a credit default swap.A CDS is essentially an insurance policy on a loan, and here's how it works. Eisman finds a counterparty willing to sell him insurance on his loan (a big investment bank like Lehman Brothers). Eisman agrees to pay the bank a fixed rate every year for protection of the mortgage security he owns (the crappier the loan, the higher the rate). Let's say for the $1,000 loan to the strawberry picker, his rate will be 10%. The bank pays him nothing on a regular basis, BUT, if the borrower defaults, they pay him the full $1,000.So: if times are good and everyone makes payments on time, the payments are structured as follows: The strawberry picker pays $150 per year to Eisman; Eisman pays $100 per year to Lehman (which then uses some of the cash to provision for losses, and uses the rest to make more loans). The strawberry picker gets to keep his house, Eisman keeps $50 per year (loan payment from strawberry picker minus the insurance premium he pays to Lehman), and Lehman gets $100.Got the structure? Now here's the rub.Imagine Eisman never actually had exposure to the loan in the first place. Being the brilliant skeptic he is, Eisman would never lend $1,000 to a strawberry picker with little income. He thinks that strawberry man is doomed to default on that loan, and he actually wants to bet AGAINST him. So instead of giving the loan and buying insurance, he just buys the insurance (hence the often used and rarely understood term "side bet"). To do this, Eisman still has to pay the "premium" for the insurance he's bought, and since it's a risky loan, the rate is high (e.g. $100 per year in the example above). [Though he stands to win $1,000 if the loan defaults.] In effect, Eisman is paying a "subprime-like" interest rate to Lehman every year! That's what Lewis was getting at.I would have used a different metaphor. I would have said it's like a New Yorker buying a bunch of home insurance policies in New Orleans because you are expecting that there will be a massive hurricane coming to wreck them. Now lets say that the insurance company took the money you were giving it, didn't provision for the coming doom, and instead, used that money to lend to more people building and buying houses in New Orleans.That's leverage upon leverage upon leverage. And that's the mess that is unraveling before us.

Millions contributor and ardent Canadian, Andrew Saikali, dropped me a line to let me know that Ryszard Kapuscinski, the Polish journalist and one of my favorite writers will be on the CBC Radio program Writers and Company this Sunday, June 5th. If you're interested, you can listen live by clicking through from here. (Check that page to see when it will air in your time zone.) It appears as though the show will also be available here for download for a week after it airs on Sunday.