My wife and watched the film, “The Big Short” recently. I did not think the screen play too incoherent, too hasty, and too hurried nor did it make clear where the subprime mortgage scandal began.
I am now reading, The Big Short, by Michael Lewis, and it makes for blood-curdling reading.
The whole scam had its source in income inequality. Its am was to defraud the middle class and the poor. Income distribution was skewed and was becoming more skewed in favor of the rich. That’s what started to whole subprime mortgage crisis. The pitch for subprime mortgage bonds was that you were helping consumers get free of high interest rate credit card debt and putting him into lower interest rate mortgage debt.
The subprime mortgage industry was at first seen as a useful addition to the U.S. economy. It soon turned into a doomsday machine.
The concept was based on turning home mortgages into bonds. One man’s liability was another man’s asset, but now liabilities would be turned into little bits of paper that anyone could sell to anyone. The small market in mortgage bonds was funded by all sorts of strange stuff: credit card receivables, aircraft leases, auto loans, health club dues. The most obvious untapped asset in America was the American home. People with first mortgages held vast amounts of equity in their homes. There was a stigma in going to own a second mortgage borrower, but the reasoning was that if we mass market the bonds, the cost of borrowing will go down. The lower middle class would replace high interest rate credit card debt with lower interest rate mortgage debt. Of course the target of the bonds was the “less credit worthy Americans.” The mortgage bond wasn’t a single giant loan for an explicit fixed term; instead, a mortgage bond was a claim on the cash flows of thousands of individual home mortgages.
The bond sellers took giant pools of home loans and carved them up to pay debts made to homeowners into pieces called tranches. Such loans carried government guarantees. The holders of such bonds could resell them to other investors. It was a fast buck business.
During the 1990s, the subprime business was only a small fraction of US credit markets. A few tens of billions. As income inequality grew, so did the subprime mortgage market. The accounting for subprime mortgages was increasingly arcane. Moody’s did an account that made clear that underlying the bonds were pools of underlying the individual mortgage bonds - how many were floating rate and how many of the houses borrowed against the owner occupier. The most important question was how many were delinquent? Wall St Firms were not disclosing the delinquency rate of the home loans they were making. The operator sold all the loans to people who packed them into mortgage bonds. “How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.
To maintain the fiction that they were profitable enterprises, the sellers needed more and more capital to create more and more subprime loans. Sellers manipulated interest rate buyers who were told they were paying 7 percent on there loans when were actually paying 12.5 percent. They were tricking their customers. It was usual practice to make sure that the middle lower income people received the most protection. This system gave them the least protection against such schemes. Eisman said the goal of the mortgage subprime market was “fuck the poor.”
Credit Default Swaps
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (usually the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. This is to say that the seller of the CDS insures the buyer against some reference loan defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by Blythe Masters from JP Morgan in 1994.
In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan. However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan.
Credit default swaps have existed since 1994, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010 and reportedly $25.5 trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the 2007-2010 financial crisis the lack of transparency in this large market became a concern to regulators as it could pose a systemic risk. In March 2010, the Depository Trust & Clearing Corporation (see Sources of Market Data) announced it would give regulators greater access to its credit default swaps database.
CDS data can be used by financial professionals, regulators, and the media to monitor how the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies. U.S. Courts may soon be following suit.
Mike Burry, a genius who was the first to detect the upcoming crash of the subprime mortgage market fraud, said that his strategy was not to get the best loans, but the worst loans and then bet that they would fail. The price of a loan was rated by bond rating agencies who usually gave a triple A rating on loans. Burry he had collected a lot of triple B-rated loans. They were risky, and the riskier they were, the greater the chance that they would default. Soon, he owned $750 million in credit default swaps in subprime mortgage bonds. These were bonds he had handpicked to explode. He said that the beauty of credit fault swaps was that they enabled him to make a fortune if only a tiny fraction of the dubious pools of mortgages went bad.
A final word on Burry from Wikipedia
In 2005, Burry started to focus on the subprime market. Through his analysis of mortgage lending practices in 2003 and 2004, he correctly forecasted the real estate bubble would collapse as early as 2007. Burry's research on the values of residential real estate convinced him that subprime mortgages, especially those with "teaser" rates, and the bonds based on these mortgages would begin losing value when the original rates reset, often in as little as two years after initiation. This conclusion led Burry to short the market by persuading Goldman Sachs to sell him credit default swaps against subprime deals he saw as vulnerable. This analysis proved correct, and Burry profited accordingly. Burry has since said, "I don't go out looking for good shorts. I'm spending my time looking for good longs. I shorted mortgages because I had to. Every bit of logic I had led me to this trade and I had to do it".
Though he suffered an investor revolt before his predictions came true, Burry earned a personal profit of $100 million and a profit for his remaining investors of more than $700 million
No one ever went to jail for this fraud that almost destroyed the U.S. economy.