How bankers make their money, and why we let them

Liar’s Poker is the first of Michael Lewis’s books I’ve read, but it certainly won’t be the last. It explains something that has always been obscure to me: how bankers can make huge amounts of money without doing anything remotely useful, indeed despite doing a great deal of harm.

Invaluable insights

Liar’s Poker was published in 1989, which means it’s way out of date. But ironically that only makes it all the more interesting, since it describes precisely the practices that would lead to the crash nineteen years later.

Here’s how they work. Somebody takes out a $100,000 mortgage to buy a house. Next the lending organisation gets worried for some reason, and decides it would like someone else to take over the debt. But no one will step up unless there’s something in it for them. So the original lender agrees to take less than the full amount of the debt, say $80,000, perhaps because its immediate need for cash means it prefers taking less now, than hanging on for a larger amount in the future. 

So someone has bought the debt and how holds a piece of paper, a bond, entitling him (it’s almost always a man) to cash in $100,000 for an outlay of $80,000. A good deal even if he has to wait 20 years for the profit.

But he may not even need to wait. Someone else hears of the transaction and says “wow! I missed out. I want a piece of that.” So he offers $90,000 to take over the mortgage himself. Buyer 1 doesn’t hesitate: a $10,000 profit after a few days is highly desirable even at the cost of a larger profit 20 years away.

Now something interesting has happened.

Initially, the transaction was about buying a house. That’s something made of brick and mortar, a solid, tangible asset. It has real value: you can live in it.

Then there was the mortgage. Well, that has value too, if at one remove: it made it possible to buy the house.

But then we started trading the mortgage itself, the bond. It’s two moves from reality. It has little value itself, but it does now have a price, since it can be traded.

The reality is that a bond won’t cover just a single mortgage, because that’s too open to risk: the borrower might default leaving the bond without value. Instead bonds cover a thousand loans, as the chances are that there will be defaults on only a small number, leaving enough to generate a healthy profit.

The really clever bit is what the broker does. He charges a fee, which means he makes money on each trade, whether the buyer or the seller does well or not.

My examples involve large percentages: $20,000 out of $100,000, for instance. What Lewis explains is that traders in bonds look for gains as small as one eighth of a percentage point. They might themselves charge one-eighth of a percent in fees. However, one-eighth of a percent of $100 million is $125,000, which is not to be sneezed at. And if the broker sells bonds to one buyer, and then persuades that buyer to sell them two or three days later to another, he’ll double that to over $250,000 for his firm, just by judicious use of a phone.

Not one person will have been fed, educated, housed, clothed, transported or cared for as a result of his actions. The trader will have moved a number from one account to another and then to a third, and generated in days the equivalent of six people’s average yearly earnings. That will doubtless be reflected in his annual bonus.

Remember that this is based on the price of the bond, not what was paid for the house or the size of the mortgage. As long as someone will pay a little more for the bond, the broker keeps making money. Where it all goes pear-shaped is when people stop feeling it’s worth paying a higher price than the last guy. Then someone is left holding a bond he can’t sell.

Imagine what happens if, to satisfy the demand for this kind of bond, people have been out there offering mortgages on properties that simply aren’t worth enough, to people who’ll never be able to pay them off?

Then the person left with the bond when the bottom falls out of the market – the bond market, mind, not the housing market – has only one way of cutting his losses. He forecloses on the mortgage holders, forcing them to sell their properties. And if it turns out that the properties aren’t worth enough to cover the debts, then both the homeowner and the bondholder are in serious trouble, with only one difference between them: if the bondholder is a large bank, the taxpayer will bail it out, but the now homeless borrower gets no help at all and is even blamed for the failure.

Lewis explains that what his company, Salomon Brothers, did with mortgage debt was done with corporate debt on a scale hundreds of times greater, by Michael Milken. He was the innovator in “junk bonds”, the debt of companies regarded as a bad risk. He found that many of these debts were undervalued, and Lewis explains why: “investors shunned [such companies] out of a fear of seeming imprudent.”

Michael Milken: pocketed half a billion while he had the chance

Milken persuaded banks to throw prudence to the wind and buy the debts of dodgy corporations. While the value of the bonds kept climbing, everybody prospered. In particular the brokers who traded these bonds made a fortune: at the height of his powers, Milken paid himself $550 million in a single year, according to Lewis. 

Since then, and since his release from gaol (he eventually spent a couple of years inside), Milken has made himself a name as a charitable donor, funding medical research in particular. That’s very commendable, though we ought to remember that he only made the money by awarding himself astronomical pay for contributing next to nothing to society – and arguably stoking the disaster that engulfed us all in 2008.

Lewis tells us that as a child he learned from his father to believe “that the amount of money one earns is a rough guide to one’s contribution to the welfare and prosperity of our society.” But Lewis himself had to abandon that comforting belief: “when you sit, as I did, at the centre of what has been possibly the most absurd money game ever, and benefit out of all proportion to your value to society...; when hundreds of equally undeserving people around you are all raking it in faster than they can count it; what happens to the money belief?”

He got out of banking, but the belief still pervades society. As Thomas Piketty points out, “modern meritocratic society, especially in the United States, is much harder [than the nineteenth century] on the losers, because it seeks to justify domination on the grounds of justice, virtue, and merit, to say nothing of the insufficient productivity of those at the bottom.”

It may be the belief that if you’re not making much money, you’re not worth as much as the Milkens of this world, that explains why we treat them with so much deference, allowing them to buy our politicians and helping them protect their privilege and power, even from the consequences of their own fecklessness.

There are a lot more of us than of them, and we all have votes. If we could overcome our obsequiousness towards money and those who control it, we could free ourselves of some particularly unpleasant parasites. What a great step forward in justice that would be. 

To say nothing of the of the damage we could stop them inflicting on us.