"The Big Short" by Richard Sale

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

 

From Wikipedia

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.^[1] 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.^[2]

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,^[3] falling to $26.3 trillion by mid-year 2010^[4] and reportedly $25.5^[5] trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.^[6] 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.^{[7][8][9][10]} 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.^[11]

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.^[1]

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.^[7][8][9] 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".^[2]

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.

Comments

[Babak Makkinejad]

Richard Sale:

Surely you cannot be faulting Burry.

He acted like Rhett Butler, profiting where he could "when a civilization is being destroyed".

[alba etie]

Richard
That was a good brief synopsis of the Big Short. Any thoughts as to why there were never criminal charges come out of the 2008 meltdown ?

[Fred]

Richard,

"No one ever went to jail for this fraud that almost destroyed the U.S. economy."

Yes. Which is one of the reasons Trump is so popular.

[Fred]

Babak,

But then Rhett didn't contribute to the collapse of a civilization being destroyed.

[doug]

One of the things I've been following closely is the re-creation of the credit bubble. The "recovery" we have had, as one sided as it is, is based on asset re-inflation. To do this interest rates have been pushed down to historical lows. The current risk associated with this is not factored in the traditional sense and, IMO, exceeds significantly the current interest rates. The Fed, and all of us actually, are now trapped. It is impossible to inflate our way out and that leaves only one option. Restructuring. This goes by various names. Bankruptcy, bail-ins, negative interest rates. But this is constrained. People won't accept easily the notion that savings can decrease in value. They will prefer saving cash stuffed in the mattress to bank accounts. Controlling this will require increased restrictions on cash v electronic (bank) accounts.

This is a financialization of economies is a pervasive problem in the entire developed world. No idea how it will play out but it looks like an unstoppable force encountering an immovable object. One of which will prove wrong.

[doug]

Bubbles are created when too few Michael Burrys counter bubbles. There is always a lot of political pressure to limit or outlaw short selling. Mostly from the investors who are riding the bubble up and don't want anyone peeing in the punchbowl.

Lots of people participated in the fiasco. People that knew better. It wasn't just the fools that got suckered into "pick-a-payment" seconds. Like this guy, an economics reporter for the New York Times.

http://www.amazon.com/Busted-Inside-Great-Mortgage-Meltdown/dp/0393067947/ref=sr_1_3?s=books&ie=UTF8&qid=1458580517&sr=1-3&keywords=busted

[Valissa]

And here's another one...

What Republicans did 15 years ago to help create Donald Trump today https://www.washingtonpost.com/news/wonk/wp/2016/03/21/how-republicans-helped-create-donald-trump-more-than-15-years-ago/
The Republican establishment began losing its party to Donald Trump on May 24, 2000, at 5:41 p.m., on the floor of the House of Representatives.

Urged on by their presidential standard-bearer, Texas Gov. George W. Bush, and by nearly all of the business lobbyists who represented the core of the party’s donor class, three-quarters of House Republicans voted to extend the status of permanent normal trade relations to China. They were more than enough, when added to a minority of Democrats, to secure passage of a bill that would sail through the Senate and be signed into law by President Bill Clinton.

The legislation, a top Republican priority, held the promise of greater economic prosperity for Americans. But few could predict that it would cause a series of economic and political earthquakes that has helped put the GOP in the difficult spot it is in today: with the most anti-trade Republican candidate in modern history, Trump, moving closer to clinching the party’s nomination.

... The 2000 vote effectively unleashed a flood of outsourcing to China, which in turn exported trillions of dollars of cheap goods back to the United States. Over the next 10 years, economists have concluded, the expanded trade with China cost the United States at least 2 million jobs. It was the strongest force in an overall manufacturing decline that cost 5 million jobs. Those workers were typically men whose education stopped after high school, a group that has seen its wages fall by 15 percent after adjusting for inflation.
-----------------------

[cynic]

Things would improve if many of those 'too big to jail' were shortened by a head.

[Cvillereader]

If I recall correctly, there were plenty of rank and file conservatives who warned about the dire consequences of both NAFTA and MFN trade status for China. The problem was that they were tarred and feathered by the "conservative" political class as isolationists who supported protectionism.

It's not surprising that the Washington Post fails to address the real problem-- a political class that no longer thinks it is required to represent the American people, and a cosmopolitan elite class that prefers to think of themselves as citizens of the world.

[shepherd]

Just to clarify the bonds a moment. There are two different securities discussed here. The subprime mortgages were compiled into something called a collateralized debt obligation (CDO). The credit default swap (CDS) is insurance against the failure of a security.

The way a so-called subprime CDO works actually makes sense on paper. Essentially, let’s say you want to extend credit to people with bad credit ratings. Actuarially, people of a certain credit rating are likely to fail to pay a certain percentage of the time. But that won’t usually be 100%, more like 50%. So the way a CDO works is that you take a bunch of loans and pool them together. Then you cut them into what are called tranches. The tranches basically say in what order people get paid. So Tranche A is always paid first, and if there’s any money left over, that goes to Tranche B. Once Tranche B gets his full share of interest and principal, and if there’s any left over, it goes to Tranche C. So if you’re first in line, voila, what had been a risky set of loans becomes much less so. Not everyone will default so at least you'll get paid.

Then the banks faced the problem of the middle tranches, which are known in the biz as "mezzanine" tranches. What to do with them, since they were risky. Again, not all of those B and C tranches are going to go unpaid, so you model the risk and create still more CDOs. With enough of them, you can recycle truly bad stuff, again into a first rate security.

Suddenly a lot can go wrong. In this case, the credit ratings of the people and the loans extended to them grossly overestimated their ability to pay. Instead of a 50% failure rate, it went to more like 90. The mezzanine securities were wiped out. And by the way, nobody read these documents. Each one is hundreds of pages long, filled with impenetrable stuff. Investors had no idea what they were buying and simply trusted ratings agencies to do their homework, which they didn't.

Still, as loony as this seems, you’re not at a mammoth disaster yet. Next comes the CDS, or insurance policy. Let’s suppose you’re a big holder of these securities and you want to make sure nothing goes wrong. You take out insurance on it. Again the person issuing the CDS doesn't read the CDO or have any idea what's in it. He simply looks at what rating it has. Where it gets crazy is that you can even take out insurance on something you don’t own as a way of betting on a default. That way if a CDO fails, you get paid, even if you don’t own it. Banks issued tons of these, and way more than they could pay for in a systemic collapse. Now you have a huge bubble in the making. Only a few CDOs have to fail before the CDS system goes haywire, and banks can't make payments.

[Richard Sale]

I agree.

Richard

[Fred]

Valissa,

"But few could predict..." You mean like Ross Perot and plenty of others, especially union leaders?

I think the last series of posts by Richard have laid the groundwork for understanding the discontent. What to do about it is another thing entirely. The political leadership seems to be doubling down instead of actually trying to learn anything from the past.

[Walrus]

I too enjoyed "The Big Short" and I thank Mr. Sale for his comments.

There are a number of other enabling factors that have brought us to where we are now; which is up the creek in the proverbial barbed wire canoe.

The prime cause, which is ultimately going to destroy the country, is the relationship between money and political power, unless Trump can slay the beast.

The repeal of the Glass- Steagalll act that prevented banks from also speculating in markets was another cause.

Then of course there was the move to a fee based financial system such that the originator of financial vehicles like CDO's always on sold them and had no interest in the quality of the goods.

That no one has gone to jail is a direct result of the aforesaid relationship between political power and money.

The next target for Wall Street, assuming Clinton becomes President, is social security, private pension funds and any remaining pools of capital like insurance businesses.

[SmoothieX12]

"... The 2000 vote effectively unleashed a flood of outsourcing to China, which in turn exported trillions of dollars of cheap goods back to the United States. Over the next 10 years, economists have concluded, the expanded trade with China cost the United States at least 2 million jobs."

This may be, and most likely is, very true but that is just one of many factors. American DE-industrialization started way earlier than that. Actually, in 1980s.

[HankP]

doug -

This is absolutely correct, and the result of Congress refusing to do what it has done since the 1930s - stimulate demand with government spending. If that's not available, asset reinflation is the only thing left, and it's like trying to push a wet noodle. The problem is lack of demand, not lack of supply. The problem is also deflationary pressure, as we can see with lower and lower interest rates.

Believe it or not, the US is actually doing better than Europe since they've been overcome with a push for austerity - the exact opposite of what's called for in this situation. Not to mention their other major problem, which is countries not being in charge of their own monetary policy.

[Origin]

An amusing explanation of how the subprime debacle really worked and what caused it--a simple question.

https://www.youtube.com/watch?v=mzJmTCYmo9g

[johnf]

Three times between 2009 and 2014 I tried to sell Michael Lewis's original and lengthy article on the subject, and then his book "The Big Short" based on the article, as a drama adaptation to the BBC. The rights were available.

Three times they turned it down.

Their reason each time was that by the time the adaptation was broadcast, everyone would have forgotten about the financial crisis. Their sheer ignorance of the reality of the crisis amazed me.

I went to see the film with mixed feelings. I thought it was superb. Thank God someone's done it.

[MRW]

@Mr. Sale,

Michael Lewis doesn’t get it exactly right, but then he does not have a white-collar criminology education nor the experience with its intricacies to get it right. For a much clearer (and deadlier) explanation which will open your eyes, AND a highly entertaining 45 minutes, I *urge* you to listen to this:
"Bill Black Interview with Harry Shearer” May 1, 2011.
http://harryshearer.com/le-shows/may-1/

You won’t regret it. Sit back and listen with a cigar and a brandy, if you imbibe. ;-)

[Valissa]

IIRC it goes back to the 1970's. While searching for a good link for that I found this short slideshow presentation that gives a simple overview of US industrialization starting in the '70s. [note: there are no arrows, just click on the page to move to next slide]

[Valissa]

Link http://www.d.umn.edu/~epeters5/Cst1201/Presentations/Stories%20on%20De-Industrialization.swf

[Bill Herschel]

I thought the movie was great. Having comedy writers script it was a stroke of genius. Yes, reading the book is the way to get the best understanding of the crime, but the movie conveys a lot of it. The movie is very funny which I know is a lot like making Thénardier a comic character, but it works.

[MRW]

@Mr. Sale,

After Black, listen to this:
http://www.thisamericanlife.org/radio-archives/episode/365/another-frightening-show-about-the-economy

I heard this on OCT 3, 2008, three weeks after the crisis hit. Still germane. You’ll understand credit default swaps ‘crystal-clear’.

[SmoothieX12]

Really appreciate this link. Thank you.

[Ante]

Richard Sale

The Big Short is a good story, but it's fundamentally misleading. I'll paraphrase Yves Smith to spare you block quotes.

The 'big short' wasn't a heroic trade, it was a series of actions that turned what would have been a serious problem echoing the savings and loan scandal into a global crisis that nearly killed several of the most important capital markets.

http://www.nakedcapitalism.com/2015/12/debunking-the-big-short-how-michael-lewis-turned-the-real-villains-of-the-crisis-into-heros.html

Her book about the crisis and the economics that led to it, Econned, is very good.

I think it's important, when considering these things, to step back and see that these pieces are all part of a larger puzzle. Outsourcing, cutting wages, stealing pensions, races to the bottom over tax breaks, pushing debt on everyone, are all part of a strategy of accumulation. Once there, we can reject these dogmas and do what needs to be done for the betterment of the nation and all its citizens.

[HankP]

shepard -

That covers half of the problem. The other half, which I witnessed personally, was mortgage companies blatantly lying on mortgage applications as to the financial situation of their applicants. And the reason why they lied? They made more (much more) in commissions from high risk mortgages than they did from conforming mortgages.