Top regulators, including Alan Greenspan, Ben Bernanke, Henry Paulson and Timothy Geithner, were caught flat-footed. Senior bankers like Robert Rubin, Charles Prince, Stanley O’Neal, Richard Fuld and James Cayne oversaw firms that lost hundreds of billions of dollars from mortgage holdings. Top analysts, traders, economists and academics expected housing to hold up. Real-estate, mortgage and derivative investors all missed the huge trade, as did so-called short sellers, investors who go to sleep at night dreaming of calamities they can bet against.  Some blame the difficult period on over-compensated bankers and the toxic products they created; others point the finger at cynical traders who rolled the dice with their firms’ money. The explanations are simplistic and overstated. Certainly, some Wall Street pros had concerns about housing and nonetheless peddled unsafe products, hoping to squeeze out one last, hefty bonus. Others embraced risky trades without worrying about the potential downside. But many more were shocked by the turn of events and squandered enormous wealth when sub-prime mortgages collapsed.  Why did the experts get it so wrong? And what can we learn from the episode?  The answers are varied. Products on Wall Street evolve, becoming more complicated with time, partly so hefty commissions can be charged and salesmen have something new to pitch to customers. In the case of the housing market, residential mortgage-backed bonds begat collateralized debt obligations, leading to CDO-squareds, and then synthetic CDOs. By the middle of the 2000s, top executives at global banks had little clue how dangerous these complex mortgage products had become, even as their own banks sold them to clients and retained huge pieces of them.  Rubin, chairman of the Citigroup board of director’s executive committee at the time of the housing bubble, testified before Congress in the spring of 2010 that until the fall of 2007 he didn’t recall learning about CDO investments his bank was creating, owning and selling. Sure, Rubin made $15m a year at Citigroup. But examining these complex products wasn’t what he was paid to do, he testified, partly because credit-rating companies deemed them super-safe.  “More senior level consideration of these particular positions was unnecessary because the positions were AAA-rated and appeared to bear de minimis risk of default,” Rubin testified.  At the same hearing, Prince, who walked away with more than $100m in compensation for his work as Citigroup’s CEO during the housing bubble, added: “We believed that the top level would be immune to the problems . . . Sitting here today that belief looks unwise.”  Citigroup ended up losing $30bn from CDOs, triggering a $45bn federal bailout, the largest of any financial firm.  Within the boardrooms of global banks, Rubin and Prince were no exceptions. Most senior bankers were clueless about CDOs and other complex mortgage products.  “If you find this confusing you should,’’ John Paulson told investors in earlier this year, referring to CDO investments. “Most people do. Even the people who participated in this market didn’t understand it either.”  Instead of mastering these complicated products, senior bankers generally deferred to mid-level specialists. How did these pros get it so wrong? They often relied on the high ratings placed on the investments by ratings companies. Others depended on sophisticated computer models suggesting that a national or international plunge for housing was unlikely – largely because such a downturn hadn’t occurred in seven decades.  A key reason a widespread housing downturn seemed improbable to many experts [was that] few were around with a memory of the early 1990s, when large swaths of the California, Texas and Massachusetts real-estate markets tumbled in value. Wall Street bankers, traders and investors tend to make so much money that they retire early, or find other things to do, leaving the financial business to younger executives. As a journalist, I can go days without speaking to anyone who experienced the difficulties of 1998, when hedge-fund power Long Term Capital Management collapsed. Those who remember the real-estate troubles of the early 1990s are an even rarer breed. Too few experts judged a real-estate collapse to be a realistic possibility because so few recalled previous housing difficulties.  It’s no coincidence that the biggest winners of the downturn – John Paulson, Paolo Pellegrini and Jeffrey Greene – were approaching 50 years of age. They retained vivid memories of past real-estate problems. Youth was a detriment to pulling off the greatest trade ever and to preparing for the downturn.  It’s also not an accident that many of those wracked by fears about the financial system in 2005 and 2006, such as Andrew Lahde [Lahde Capital] and Michael Burry, , [founder of the Scion Capital LLC hedge fund], didn’t work at big banks, government agencies or large companies. Those who climb to the top of big institutions, win elections or are picked for important government posts, tend to be optimists. They’re leaders who inspire others, usually with an upbeat, can-do outlook. Placing one’s feet on a desk, dimming the lights and worrying about what could go wrong and how to prepare for it usually aren’t steps that help an executive obtain a promotion. Ideas about how to top last quarter’s profits, meet a short-term revenue goal and stay a step ahead of rivals do.  On Wall Street, worrywarts tend to leave and work at hedge funds. Many of these individuals like to invest, but don’t entirely enjoy dealing with others, even their own clients. They get bored in meetings, have a hard time marketing themselves to investors, and enjoy poking holes in bullish arguments. They may not be much fun to grab a beer with, but they’re best suited to predict a coming disaster, as some did with the subprime collapse.  Wall Street talks a big game about the importance of taking a contrarian stance with investments. When it comes to a career in finance, however, there are few reasons to be a contrarian or to try to anticipate problems. Greg Lippmann took perhaps the most risk of any investor in pursuing the bearish housing wager.  He was being paid millions of dollars annually by Deutsche Bank in 2005 when he first had concerns about subprime mortgages. If Lippmann had continued to make investments predicated on housing staying afloat he would have lost money, like others at his bank and on Wall Street. But he likely would have kept his well-paid job. All he had to do was trot out the well-worn excuses of the business. Sorry, boss, but the downturn was a 100-year flood. Who could have predicted the perfect storm that damaged the global economy? By describing the collapse of the financial system as a natural disaster, rather than as a series of man-made errors, countless pros acted blameless and retained lucrative jobs.  Rather than take this route, Lippmann bought unpopular protection on sub-prime mortgages. He was teased and insulted. If real estate had remained strong Lippmann likely would have been fired. His wager was profitable and he ended up making millions, but his decision wasn’t the most rational one. Too much downside, not enough upside, most traders would say. Too often it makes little sense to make gutsy, contrarian bets in business, or prepare for difficult times.  Another reason Wall Street does a poor job foreseeing meltdowns is most firms do a poor job recruiting and promoting risk managers, or enabling them to examine the exposures of various parts of their global businesses. In early 2007, some traders thought their groups were facing danger, but they were sure colleagues elsewhere weren’t embracing similar risks. Too often they were. The problem - there are too many silos within big financial firms and too few executives who share information with each other.  Goldman Sachs’s risk managers enjoyed a fuller picture of the risks of various trading groups, partly because traders work more closely together, helping to explain why Goldman became concerned about housing before rivals, though still late in the game.  Perhaps the biggest reason outsiders like Paulson were able to see the approaching storm was they weren’t mortgage or real-estate practitioners. They didn’t buy into the group-think in those industries that the Federal Reserve or government wouldn’t let housing collapse, and that derivative investments were scary and dangerous. Paulson, Pellegrini and Greene didn’t know much about derivatives but took the time to educate themselves.  Paulson also ignored the concerns of many that buying insurance on mortgage bonds would enable a competitor to score better short-term results. The excessive focus on near-term results hand-cuffed many executives who tried to prepare for the downturn.  Some dismiss Paulson and the other prescient investors as flukes. In early 2010, former Federal Reserve chairman, Greenspan, called them a “statistical illusion”.  “Everybody missed it,” he said. “Academia, the Federal Reserve, all regulators.”  Fed chairman, Ben Bernanke, said there was little that could have been done, anyway. “We had neither the mandate nor the tools to be the financial system’s supercop,” he said this year.  It’s not encouraging that key officials haven’t taken full responsibility for their mistakes, such as ignoring warnings about loose lending standards and failing to caution borrowers about the risks of aggressive mortgage products. A better tack would be to learn from the few investors who got it right and avoid an over-reliance on industry experts.  Despite that, many of the financial reforms embraced in 2010 depend on new agencies and savvy regulators to spot future troubles. It’s not obvious why they will be more successful anticipating the next bubble than they were at predicting the last one. A better step would be to force large financial companies to set aside more cash as a buffer for the next brutal downturn, one that sadly may be inevitable in the new age of financial bubbles.  Greg Lippmann finally tired of working for Deutsche Bank. After years of bluffing that he would bolt over disappointing bonuses, this year Lippmann finally told his bosses he was leaving to launch his own hedge fund. Like Paulson, however, questions about how he made so much money betting against housing shadowed Lippmann. Though he wasn’t accused of any inappropriate actions, some CDO-related transactions created by colleagues at Deutsche Bank came under investigation by federal authorities, presenting Lippmann with a challenge as he tried to round up clients.  By the summer of this year Michael Burry, was still deciding what to do with the rest of his life. Some of his bitterness had dissipated, thanks to belated public recognition for his early work detecting a financial bubble. His trade didn’t turn Burry into the next George Soros but it did make him a wealthy man.  Burry even felt confident enough to publicly tangle with Alan Greenspan.  “As a nation, we cannot afford to live with Mr. Greenspan’s way of thinking,” wrote Burry in an op-ed in the New York Times in April. “The truth is, he should have seen what was coming and offered a sober, apolitical warning. Everyone would have listened; when he talked about the economy, the world hung on every single word.”  But Burry remained gloomy about how his clients had treated him, and how little had been learned from the dark period.  “I would say that I’ve lost a lot of faith in the human race, and that has yet to be restored,” he said in an email message. “That’s what really hurts – not so much what was accorded to me, but the tremendous failure of American society. It rips my heart out to think we are veering so far from what made America great. It’s remarkably sad on many levels.”
Three years on from the collapse of the sub-prime housing market in America,    Gregory Zuckerman asks who can help us avoid the next financial crisis.