"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

[William R. Cumming]

Thanks and agree!

[Jack]

You are missing the point!

They were and have always advocated credit inflation. That is the central tenet. The response to any economic or financial downturn has been more of the hair of the dog that bit you. And government has been at the core of this as they have provided the backstop and socialized the losses.

[Fred]

Richard,

Thank you for this post and the prior ones. I have quite a bit to learn and am grateful to the excellent teachers here.

[Stag Deflated]

I'm a long time lurker and appreciator of this site, I'm also a former mortgage bond and interest rate derivative trader, although I was not there during the crisis. I just wanted to offer to try and answer any questions you all may have.

[Mark Logan]

wised,

Obviously not. It was the public in general, which benefited from the money injection. I believe that key to they mystery of no appreciable effort to investigate what was causing the boom.

[tensegrity]

Happy to have been of even a tiny bit of help! Unfortunately, the whole episode has many dimensions and facets with, in my view, a great deal of fuzziness even after the fact. In that sense, it doesn't lend itself well to a 2hr movie script. It's also worth mentioning that, while people in the finance/investment industry are often demonized for causing the whole thing, the after effects of the financial crisis on those in the finance/investment industry have been truly devastating, as the combination of massively increased investor risk aversion and Dodd Frank has created a brutal environment for most anyone who doesn't happen to already be employed by one of a handful of already largest investment managers or banks, as most all other firms have struggled just to survive and the creation of new businesses in the industry has been made almost impossible.

[drpuck]

Your additions here are very critical to lining up the entire story.

Except, pardon me, I don't understand this: "stupid homeowners increasingly became ridiculous in thinking that everyone could be a real estate magnate."

Does this have to do with mortgage market makers seeking out both ripe new customers in the crap cash flow/balance sheet realms, and, also, in the second home and flipping realms?

Am I correct that lots of defaults took place in the second home market--as borrowers jumped out of interest-only and teaser mortgages?

[Blaker]

In regards to regulation and Wall Street, my favorite comment of all time came from a high school friend who lied all the way through a series of interviews at a Wall Street firm to obtain a job as a stock Trader. His comment on regulation after 30 years in the trenches trading stocks "Regulation, I hate it with all my heart. But it provides the structure of rules that we (Wall Street) work to get around and make our profits." Thus the financial industry which is the most powerful lobbying group in our political system crafts the regulations through which, and around which, they continuously make their profits.

[Thomas]

How about a short analysis on what you thought went wrong?

It is interesting how the Treasury Secretary was full of delight the morning he burst the bubble. It seems he only wanted to make an example for all the firms by coming down hard on one. That the select example was his former commercial rival never brings up the question of abuse of authority.

[MRW]

You don’t understand the difference between federal government accounting and non-federal government accounting.

[Jack]

MRW, the government spending uber alles quack heard from again!

Your faith-based theory of infinite government spending = nirvana, demonstrates with no shadow of doubt how much accounting, finance or common sense knowledge you have. Zero.

Are you sure you're not a former failed Soviet central planning commissar?

[Jack]

Blaker

Take one simple example. They said that Citi, Morgan Stanley, Goldman, et al had to be bailed out because they were too big to fail. Then they shout from the ramparts that never shall that happen again. So they create this gigantic regulatory obfuscation in Graham-Dodd. End result these banks are even bigger and have an even larger share of total assets. If they are in reality wards of the state then they should be nationalized. At least there will not be any pretense and Blankfien and Dimon will get a government salary.

There are thousands of small and regional banks. Most had healthy balance sheets and would have loved to pick up assets from a bankruptcy court. But no capitalism must not be allowed to work instead government must interfere and favor the implicit cartel of the politically well connected.

[Stag Deflated]

I think first its important to understand that a lot of things, in several different areas, had to go wrong in order to experience a crisis of the magnitude that we did. I tend to think about the crisis in two different pieces, the first being mortgage related and the second being credit related.

To start, its important to realize that there are two fundamentally different mortgage markets in the United States, an Agency mortgage market and a Non-Agency (or private label) mortgage market. The agency mortgage market, which is a much larger share of the market, are mortgage bonds that have their principal and interest insured by a GSE (Fannie Mae, Freddie Mac, Ginnie Mae). While non-agency bonds are underwritten by financial institutions and have no insurance against loss of principal (unless its built into the bond structure, but that is an aside).

The beginnings of the crisis occured in the Non-Agency area, where all of subprime is located. I think there was at first a fundamental disconnect between the poeple making the loans, many of which were predatory on unqualified borrowers (NINJA and no doc loans etc), and the people who traded/invested in the bonds created by those loans. Investors do not typically analyze individual loan data (remember there can be thousands of loans, this is why burry's analyst was so aghast when asked to pull the data in the movie) but rather look at aggregates and trends. Then to tie it all up and really make it all worse, through functionally alchemy the street created very complex financial instruments, and asked very non-complex (traders) people to trade them. The issue was that the pricing of these instruments is extremely sensitive to a small number of key assumptions that where based on a very small and limited data set. Without getting into the real nitty gritty the fundamental error in the assumptions was that a default in one part of the country would not be related to a default in another part of the country, which obviously turned out the be scarily false in the wake of a broader economic recession. Greed and other incentives led traders and investors to both take for granted the quality of the underlying loans and to make aggressive assumptions in their models that led to a drastic bubble.

However, I do not think the mortgage crisis alone would have created the financial crisis on the scale that we experienced, the real issue was the system risk inherent in the financial system. There are two not very well understood aspects of the financial system that I think led primarily to what ultimately happened. The first is the reliance on overnight and very short term funding Banks and other financial institutions fund themselves by borrowing overnight on a secured basis vs securities that they place on hold with the lender as collateral. Naturally, as more and more of these non-agency bonds where made, they were used more and more as collateral, which was fine when the prices where going up since a higher price could justify more borrowing (see the vicious circle?), but when prices are going down that collateral all of a sudden doesn't look as good, and if for one day (JUST ONE DAY) your counterparties are too scared to lend to you becuase they are worried about your solvency, you fail. This is exactly what happened to Bear Stearns, a firm that had been profitable since the civil war, but which funded a quarter of its balance sheet overnight.

The other issue, that is probably even less understood, is the interconnectedness of the street via derivative contracts. This is complicated but essentially imagine a loan you take out from the bank, and imagine you repay that loan, but instead of you just giving the bank cash, you actually keep the old loan, and create and offsetting loan with the bank. The net exposure is 0, in that neither you nor the bank owes each other money, but instead of one legal document saying you owe the bank money that is then cancelled, there will be two offsetting legal documents that say you two owe each other the same money. If we expand this concept to the real world, there are millions (im guessing, maybe tens of millions?) of legal contracts kind of just out there in the ether that all net to 0. BUT they only net to 0 if you and the bank continue to be going concerns, if one of you fails, then what was then a hedged position is now a massively naked risk position. Magnify this by the trillions and you begin to understand why these banks are too big too fail, since a domino effect of one bank dropping out of their derivative commitments leading other banks to default on their commitments and so on and so forth until the whole system collapses.

To this end, a lot of the post crisis regulation has looked to solve these two issues (and by virtue create new ones, but so it goes) through the requirement of more stable funding sources and derivative clearing, but we are not nearly out of the woods yet.

I hope this was helpful, there are many many aspects to the crisis and many good books about it, but I tried to highlight what I thought were the main drivers.

[Patrick D]

Mark Logan,

Obviously not. It was the public in general, which benefited from the money injection. I believe that key to they mystery of no appreciable effort to investigate what was causing the boom.

Exactly! I watched the housing bubble grow, was not surprised to see it pop but underestimated the reach of the damage. I wrote the item below on Oct 2, 2008 to capture my thoughts at the time. Note that they are laced with a good deal of bitter sarcasm.

I was thinking through this the other day to “follow the money” and remember what was going on at the time. It highlighted a number of issues that demonstrate how much of what is being said today is BS.

As I recall, the circumstances that prevailed for roughly the previous 10 years were as follows:

Money is cheap. Lenders have cash they need to move. Lenders and borrowers get reckless. Lenders and borrowers agree to mortgages the borrowers can barely manage to buy houses they cannot really afford. Risk? Most borrowers don’t know the meaning of the word… nor, apparently, the meaning of the word “variable” or “adjustable”… nor are they capable of comparing that initial mortgage payment to their monthly income, nor calculating what that payment could be in a few years when the rate adjusts. For the shrewd borrower with little to lose, they just got a juicy option on a house for little or nothing. If the value goes up, sweet! If it drops, they can just walk away. For the lenders, they’re selling this loan eventually and, besides, there’s a piece of land with a house standing there. That’s worth something.

All these new buyers drive up prices for existing inventory and demand for new inventory. Transactions take place and money moves. For existing inventory, sellers take most of it with a nice profit. If they go back into the market and upgrade most of the money moves on. Mortgage brokers and real estate agents get a percentage of the inflated sales prices and are making some serious coin.

For new inventory, builders and developers take most of the money to pay their suppliers, employees and subcontractors and take a profit if they’re competent. Times are great for equipment and materials suppliers and distributors, carpenters, electricians, plumbers, painters, etc.

Homeowners who don’t sell love it too. Their home equity inflates so they are eligible for bigger lines of credit at those lower interest rates to buy stuff. It is better than a credit card because mortgage interest is lower and has tax benefits. Let’s not forget the ego factor either. An appreciating house makes one feel good about one’s investment decisions and optimistic about retirement.

All these new real estate transactions at higher prices are great for property tax revenue. Local gov’t may get a bit stretched supplying new infrastructure for the new homes (these are good problems to have) but school districts are bringing in more. Seems like a lot of Main Streeters are doing pretty well, no?

At the macro level, the construction industry is a major driver in the U.S. economy generating income tax revenue for the states and the feds when they are running deficits and juggling debt. Politically, those construction jobs are important for keeping the unemployment numbers down as well. Many of those jobs are Union too. YES! Geographically, a lot of that construction takes place and creates jobs well outside the major metros, for a change, and in areas with stagnant economies (a.k.a. Small Town America… and why are real estate values jumping in Detroit??).

So, now the banks have loans but they want to make more and, besides, those potatoes are HOT. That’s what Fannie and Freddie are for. It is why they exist. They enjoy privileged regulatory status and lobby Congress hard to maintain it. They make all sorts of guarantees and everyone from the Bank of China to my father-in-law “knows” they are backed by the Federal Government so they are confident lending them money or investing in them. Risk? Don’t you have faith in the government’s money?

Fannie and Freddie take most of the conforming loans but the rest of the conforming and all of the “jumbos” have to go somewhere. American real estate is the biggest game around and everyone wants a piece of the action. New players like investment banks are game now. They’ll take whatever is left. Money is no object when you play the game leveraged (30-40/1 debt to equity range I’ve heard?). Everyone from the original lender up the financial services ladder takes a cut. Nice business. A little bit of many mortgages adds up. Risk? Portfolio management will take care of that and, besides, we can buy insurance. Insurance companies know all about risk.

Now that things have started to collapse everyone wants to know why someone didn’t stop it. I don’t see that anyone had an interest in doing so. I guess the Federal Reserve could have raised interest rates but it is embarrassing to blame a handful of individuals for not “protecting us from ourselves”.

The government proposes “bailing out Wall Street” according to the common view. That cut (commissions, bonuses, salaries) for each level of the secondary “Wall Street” market is a small percentage of the money those mortgages represent. It’s not like Wall Street is working with a private pool of money consisting of their personal savings. The bulk of the money lent belongs to other people. Who? Wall Street? Main Street? Asia? Europe? Hard to say who the ultimate lender is. Shareholders and bondholders of the firms involved would be comprised of all of the above.

Now that things have started to collapse, whose money is at risk on the lenders’ side? Who is really getting bailed out? Who is losing their house? If its value is less than the mortgage is it really their house or are they just renters? If someone bought and borrowed with little or nothing down aren’t they as much a high-risk speculator as any Wall Streeter?

[Patrick D]

Mr. Sale,

Thank you for writing this piece. I hope you explore the crisis further and continue to share your thoughts as you do.

My $.02:

- While I have no doubt there was criminal activity it would be a mistake to approach the topic with the idea that that is all it was. Just like bogus political science and international relations theories are at the core of many of the U.S. foreign policy issues regularly discussed here, bogus economics and finance theories are at the core of U.S. and global economic issues.

- Little fish engage in activity that breaks the law. Big fish change the law before they engage in that activity or have friends who make sure the law is not enforced. The collapse of MF Global is a good example. Jon Stewart did a pretty good job with explaining that one although I believe Corzine's easy manipulation of government went beyond getting the regulators called off to lobbying Congress to change the regulations that would have prevented MF Global from investing in European government debt in the first place.

http://www.cc.com/video-clips/8slg1j/the-daily-show-with-jon-stewart-the-walking-debt

[Thomas]

Landis,

Thank you for sharing your insight.

[Babak Makkinejad]

You might like to read the Isaac Beshiver Singer's story: "The Gentleman from Krakow".

[turcopolier]

All

From Richard Sale "I want to apologize to the readers of this site. I completely botched the opening to my article on “The Big Short.” I was taking notes on Lewis’ book and typing them out, my head turning from one to the other, and at times I wrote sheer nonsense. My wife, an excellent proofreader and editor, usually takes out my stupidities, but she had not read it, and the stupidities remained.

Everyone was very polite about it, and it was a very poor performance, so please be patient." pl

[different clue]

HDL,

The American jobs lost during the Free Trade Bonfire of the Industries were mainly well-paid-with-benefits shinola jobs in manufacturing. The jobs gained during that same "Bonfire of the Industries" period were mainly low-paid McSh*t jobs in the service-sector.

[different clue]

Walrus,

Obama certainly telegraphed that punch with his effort to degrade and attrit Social Security in order to weaken it for eventual Yeltsinization. Obamacare provides for stealth defunding of Medicare over time time in order to privatize it and voucherize it to recipients to flush all the money down the Wall Street and down Big Insura. We could call it the "Ryan-Obama" plan. Hopefully enough bitter opposition can stop it.

I expect the Tea Party Republicans will become defenders of Medicare and Social Security. Some legacy New Deal Democrats will join them in that effort. The Wall Street Republicans and the Wall Street Clintonite Obamacrats will join forces to privatise Social Security and Medicare . . . or at least begin sliding them that way.

A President Clinton poses a greater threat to Social Security, Medicare, the VA Hospital System, etc. than a President Trump would. Clintonistas can tell us what a President Trump would pose a greater threat to. And we can all decide which "greater threat" really is the Greater Threat. I hope Sanders stays in the nominaton race to a bitter end on the convention floor . . . to put the Democratic Party through excruciating changes and tortures in front of God and C-SPAN.

Of course if the Rs nominate one of their name-brand figures instead of Trump, then I will vote for Clinton.