For someone like me who is extremely interested in the world of business and finance, the movie “The Big Short” has been a game-changer and so is the book it’s based upon. Michael Lewis’ “The Big Short” is a riveting tale of the events that unfolded leading to the big crash of 2008. Lewis’ storytelling acumen brings this esoteric topic alive by viewing the financial crash thru the lenses of few major characters who caught on to the madness happening on Wall Street. The human side of the events will be best experienced by reading the book, but my summary below tries to capture the general mechanics of the reasons and nature of the crash –
In early 2000s, many banks started lending money to ‘subprime’ lenders or basically folks who were unlikely to afford repayment. The loans were mostly mortgage loans (for buying homes). The soaring demand for these loans was driven by the perception that home prices will always go up and so making repayments would be easy. Even at risk of higher default (non-repayment), wall street sanctioned more and more of these loans because of the higher interest rates.
To get risk of default off their hands, the banks packaged these subprime loans into a “mortgage bond” and sold them off to other investors. These investors now received the mortgage repayment as interest on the bond that they had bought. Also if any loan borrowers defaulted, then the investors holding the mortgage bonds would lose their principal money. The investment banks played a big part in facilitating these transactions between buyers and sellers of mortgage bonds, thus earning money on commissions. They also bought these bonds themselves.
To create even more ambiguity around these bonds, a new product called CDO (Collaterized Debt Obligation) was created. A CDO consisted of many of these subprime bonds put together to create the illusion that a CDO will be “diversified” across many underlying securities. In reality, most of the subprime bonds in a CDO were exposed to similar risks. A drop in incomes or home prices would lead to a wave of defaults in most of the bonds in a CDO at the same time, thus rendering the CDO to be worthless.
Investors looked at rating agencies like Moody’s and S&P to verify the safety of these bonds or CDOs. These agencies are responsible for giving a bond a rating based on how safe it is from threat of default. Despite the very real risk of default in these bonds/CDOs, Moody’s and S&P often rated them as triple/double A which were their safest designations. Multiple factors contributed to this – alleged influence/pressure from investment banks to give their bonds good ratings and also some structural weaknesses/blind spots.
E.g. one of the blind spots was that financial models used the average FICO credit scores of the borrowers in a bond to determine ratings. But these bonds were cleverly constructed to have just enough high FICO score borrowers to offset the many subprime borrowers to take the average above the thresholds needed by Moody’s/S&P.
Many wall street firms also acted as “CDO” managers which advised investors to buy CDOs based on their AAA/AA ratings. These managers earned millions in commissions for selling off these CDOs based on crumbling subprime loans.
Some market analysts like Michael Burry, Steve Eisman started digging into the details of all mortgages involved in these bonds and discovered that many of the borrowers had little chance of repayment. One representative was of a cherry picker who had $14,000 annual income and was being given a loan to buy a house worth $724,000. To benefit from this, these guys wanted to find a way to bet against these bonds/CDOs. To do it, they asked Wall Street banks to sell them credit default swaps (CDS) against these bonds. A CDS is basically like taking out an insurance for your car. You pay the insurance company (bank in this case) a fixed premium and they will pay you a big amount if your car is destroyed in an accident. The car in this case was a subprime mortgage bond/CDO and the “accident” was a default. The interesting thing was that Mike, Steve or the others were not needed to own the underlying bond unlike a regular car insurance buyer.
Presented with an opportunity for easy premium money, wall street banks like AIG sold multiple CDS on the same bonds, thus creating a huge potential liability if even one bond failed. They even packaged the CDS into new CDOs called synthetic CDOs and sold them off to eager investors. By this time you can see how the mortgage market had gone completely crazy with wall street trying to create one complicated security on top of the other to profit from it.
Soon most of the investment banks held billions of dollars worth of these bonds/CDOs, often bought with borrowed money which multiplied the risk. In 2008, when ultimately the subprime loan defaults started mounting up, the big banks started reporting huge losses. Bear Sterns collapsed and was bought up by JP Morgan at bargain basement prices. Lehmann went bankrupt. Merryl Lynch reported upto $50 bn of losses in subprime portfolios and was taken over by Bank Of America. The stock market collapsed and the U.S Govt had to step in to bail out billion dollar losses with tax payers’ money.
The worst part was that the investors, home owners and the general public bore most of the fallout while most of the big players on Wall street walked away with millions of dollars in commissions still intact.
Can something like this happen again ? As long as wall street incentives are aligned to doing more deals than ensuring investor good and the regulators continue to look the other way, we can unfortunately never rule out another 2008.