delanceyplace.com 8/26/11 - "stocks are a zit compared to bonds"

In today's excerpt - as told in The Big Short, Michael Lewis's chronicle of the sub-prime mortgage debacle, Steve Eisman and Vincent Daniel were two brilliant investment managers who were among the very few to figure out the problem early on. Along the way, they discovered that the stock market (also called the equity market) was small and relatively well regulated compared to the bond market (also called the fixed income market)—which was huge, sprawling and had eluded serious regulation:

"In the fog of the first eighteen months of running his own business, Eisman had an epiphany, an identifiable moment when he realized he'd been missing something obvious. Here he was, trying to figure out which stocks to pick, but the fate of the stocks depended increasingly on the bonds. As the subprime mortgage market grew, every financial company was, one way or another, exposed to it. 'The fixed income world dwarfs the equity world,' he said. 'The equity world is like a fucking zit compared to the bond market.' Just about every major Wall Street investment bank was effectively run by its bond departments. ... Ever since the 1980s, when the leading bond firm, Salomon Brothers, had made so much money that it looked as if it was in a different industry than the other firms, the bond market had been where the big money was made. 'It was the golden rule,' said Eisman. 'The people who have the gold make the rules.' Most people didn't understand how what amounted to a two-decade boom in the bond market had overwhelmed everything else. Eisman certainly hadn't. Now he did. ...

"[By] February 2006, Steve Eisman knew enough about the bond market to be wary, and [his colleague] Vincent Daniel knew enough to have decided that no one in it could ever be trusted. An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons. It was possible to get ripped off by the big Wall Street firms in the stock market, but you really had to work at it. The entire market traded on screens, so you always had a clear view of the price of the stock of any given company. The stock market was not only transparent but heavily policed. You couldn't expect a Wall Street trader to share with you his every negative thought about public companies, but you could expect he wouldn't work very hard to sucker you with outright lies, or blatantly use inside information to trade against you, mainly because there was at least a chance he'd be caught if he did. The presence of millions of small investors had politicized the stock market. It had been legislated and regulated to at least seem fair.

"The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they'd be reported to some authority. Bond traders could exploit inside information without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation—one reason why so many derivatives had been derived, one way or another, from bonds. The bigger, more liquid end of the bond market—the market for U.S. Treasury bonds, for example—traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn't know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers."


author:

Michael Lewis

title:

The Big Short: Inside the Doomsday Machine

publisher:

W.W. Norton & Company

date:

Copyright 2011, 2010 by Michael Lewis

pages:

25, 61-62
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