The subtitle of this Michael Lewis book is “Inside the Doomsday Machine.” Lewis has written several popular books, and this one is an interesting and disturbing analysis of the 2007-2008 financial crises. As the dust cover says, it is about “…the bond and real estate derivative markets where geeks invent impenetrable securities to profit from the misery of lower- and middle-class Americans who can’t pay their debts. The smart people who understood what was or might be happening were paralyzed by hope and fear…” Lewis focuses the remarkably small number of smart people who recognized the insanity of situation. They often tried to warn others with very little success, perhaps because they were “socially awkward” in a variety of ways. They found a way to sell the market short so they would make incredible amounts of money when the collapse they predicted became a reality.

One constant theme in the book is how the Wall Street CEOs, in a gentle characterization “…had only the vaguest idea of the complicated risks their bond traders were running.” Meredith Whitney in October 2007 “…predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust.” She was less gentle. She “…wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid.” Lewis gives his own read of that when he describes how John Gutfreund, CEO of Salomon Brothers, was paid $3.1 million to run the business into the ground. (The Lewis book “Liar’s Poker” is about his days at Salomon Brothers before he walked away to become a best-selling author.)

The book works through the development of the subprime mortgage market and how those loans were packaged into a variety of complicated derivatives that could be sold for additional profits. The ratings agencies, where the author says people work when they can’t get a job on Wall Street, were complicit in the process because packages of very high risk loans were rated to be as safe as U.S. Treasuries. The people making the loans looked for ways to approve borrowers who had no chance of being able to repay the loans. The term “liar loan” became popular, because it described loans that were made without any proof the borrower was making enough money to make the payments or even employed. The average ratio of medium home price to income increased from the historical average of 3:1 to 10:1 in Los Angeles and Miami. Those making the loans didn’t care, because they knew the loans would be packaged, given ridiculously high credit ratings, and sold. There were tens of thousands of home loans made to borrowers who did not have enough income to make the monthly payment. There is a Warren Buffet quote, “Writing a check separates a commitment from a conversation.” Those making the loans were not making a commitment.

One observer said that “Any business where you can sell a product and make money without having to worry about how the product performs is going to attract sleazy people.” The subprime loan industry had the essential feature of a Ponzi scheme. More and more capital was needed to create more and more subprime loans. In 2005 there would be $625 billion in subprime loans and $507 billion sold after being repackaged as mortgage bonds with high credit ratings

Reading the book probably should turn off most investors from considering the individual bond market. Millions of small investors are participating in a stock market that is regulated to at least seem fair. Fewer people understand bonds and bond traders are characterized as always looking for a way to take advantage of unsuspecting buyers. The opacity and complexity of the bond market gives big Wall Street firms a huge advantage. “The bond market customer lived in perpetual fear of what he didn’t know.” The subprime mortgages and the incredibly complex derivatives invented to package and resell them were a boon to the bond traders. “The less transparent the market and more complicated the securities, the more money the trading desks at big Wall Street firms can make…”

The subprime bubble was supported by all those who believed home prices were always going to increase. A man named Gregg Lippman hired the “second smartest Chinese mathematician” who calculated that home prices did not have to collapse for the subprime market to collapse. Home prices only needed to stop rising so fast to achieve the collapse.  Prior to the collapse a unit of AIG began selling Credit Default Swaps, which allowed the few doubters to cheaply buy insurance that would pay them incredible amounts of money when the “house of cards” collapsed. AIG absurdly bet that home prices would never fall.

There is a disturbing description of gathering of thousands of bond traders in Las Vegas in 2007. It was an extravagant event where money flowed freely to those who trusted the ratings on the bonds that would soon lose all value. The few who had bet their money on the eventual collapse of the subprime bubble watched and wished they could find more money to bet.

The collapse began and escalated into a crises that threatened to take down the entire U.S. financial system. Even money market funds, which people had considered to be completely safe, fell as people drew out their deposits because they only trusted cash. The stock market tanked and many mortgage bonds dropped to zero in value. It all happened so quickly that “It felt like a black hole. The abyss.” Lehman Brothers and Bear Stearns ceased to exist and several others, including Merrill Lynch, had to be bought by the remaining firms to prevent the collapse from escalating into a complete abyss. Even those who had made incredible amounts of money betting this would happen are described as being in various stages of depression from the magnitude of the collapse. By October 2008 the U.S. government had sent the signal that it would absorb the losses to prevent further failures.

The Epilogue is a very interesting part of the book, and I recommend it to anyone wanting a quick tutorial in the collapse and the list of main characters. The Epilogue also describes how Lewis invited John Gutfreund, his Wall Street boss who he had trashed in “Liar’s Poker,” to lunch. Gutfreund was remarkably polite to a man who had successfully humiliated him in a best-selling book. Perhaps that is because he had made millions on Wall Street by taking Salomon Brothers public. That had made the principals of the company wealthy and resulted in escalating risk taking. The principals were no longer the owners and didn’t care that their traders were making big bets and hoping for a big score of their own. However, the collapse of Salomon Brothers did not send sufficient warning to prevent what came in the years to follow.

I often find a remarkable passage that sticks with me. This one, also in the Epilogue, describes “…the cleaning up of Wall Street trading culture. Wall Street firms would soon be frowning upon profanity (the author does not “clean up profanity” in the book). They firms also forced their male employees to treat women almost as equals, and they also fired traders for so much as glancing at a lap dancer.” Let’s hope they are also working hard to control risks.