I recently read Michael Lewis’ The End of Wall Street.

1. The ratings agencies made a mistake by assigning an AAA rating to the senior tranches of mortgage-bonds whose underlying bonds were BBB. This converted crap investments into good investments enabling prudent investors like pension funds to pile in.
   • Question: is this always bad? or are there circumstances where this may be an acceptable practice?
   • Commentary: I can see this being somewhat “good for society” because it enables more investors (the prudent investors) to buy these bonds, This lowers the cost of capital for mortgage originators. If that is passed on to the home owner, then it is making it easier for ordinary people to afford finance for their home.
2. People originating the mortgages were fully re-selling them, and so had no ‘skin in the game’.
   • Commentary: this does seem necessarily bad and always bad.
3. These mortgages were further leveraged by investment banks, by creating synthetic-derivatives.
   • most succinct explanation is here. Search for “Synthetic CDO”.
   • Commentary: this is building a house of cards. Seems like getting too far away from the underlying risk is bad?

Takeaways:

1. Skin in the game:
   • Ratings agencies matter. Investment firms outsourced their risk-analysis to these agencies. Either that should be done in-house, or the ratings-agencies need to invest a bit along their own lines.
   • At a meta-level, Lewis talks towards the end about how Wall Street’s risk taking went awry when the firms moved from being partnerships to being public corporations. This moved the risk off each banker’s own net worth and onto distant shareholders.
2. Always pay attention to the underlying asset behind any derivative one is dealing with. Just as the stock market can be irrational for periods of time, so can any of these derivatives’ markets.