Earlier this summer, I spent a week on a cruise ship sailing the Atlantic and had a chance to do some interesting reading. The most interesting read was The Big Short by Michael Lewis, author of the best selling Liar’s Poker. If you haven’t read Liar’s Poker, I highly recommend that book since it gives you a view inside a large bond trading house from the perspective of a college graduate going through their training program.
The Big Short tells the story of the financial crisis which came to a head in the United States in 2008 with the failure of Bear Stearns, and Lehman Brothers and the rescue of a several large financial companies in the US. The book demystifies many aspects of the crisis which continues to be poorly understood by nearly everyone and leaves us with a larger picture of dysfunction in financial markets which continues to this day.
At the heart of the crisis was a financial instrument called a Mortgage Bond was invented back in the early 1990’s by Lew Ranieri from Salomon Brothers and described in Liar’s Poker. Mortgage Backed Securities or Mortgage Bonds took a large number of individual mortgages and packaged them together into a single security which could them be sold to an institutional investor such as a pension fund or college endowment fund.
At its face, mortgage bonds were a good thing since they allowed credit to be extended to segments of the population which otherwise would not be credit worthy. Credit issuers did not have to worry so much about the credit worthiness of an individual borrower since the questionable loans could be re-packaged and sold to an investor. And since the risk of default was spread across a large number of borrowers, the risk of default was theoretically reduced. After all, while it was possible that a subset of mortgage holder would default on their mortgages, it seemed unlikely that they would default en masse. Also, since the mortgages themselves were secured by the underlying properties, each mortgage was effectively a call option on the underlying property which would pay off even if the borrower defaulted and would pay off anyway as long as property prices continued to rise.
What struck me right away was the difficulty in understanding the true characteristics of these bonds. While it was fairly straightforward to analyze the risk of a default of a single corporate or municipal issuer or even an individual mortgage holder, how could an investor possible quantify the risk of default without understanding the characteristics of each individual borrower?
It wasn’t possible of course and to make it more obscure, the bonds were given names such as NHEL 2004-1 which identified the issuer and the general time frame issuance of mortgages it contained. And each security was accompanied by mind numbing 130-page prospectus that almost nobody read except for the lawyers who drafted them. To make the risk/reward equation more palatable to investors, mortgage bonds were divided into segments or “tranches”.
Lewis describes these as a “tower” of mortgage bonds where the buyers of the lower floors were the first to take a loss and therefore were paid a higher interest rate. Buyers of the upper floors of the tower assumed less risk and were therefore paid a lower rate. Rating agencies rated each tranche of the security where the upper floors got triple-A ratings and the lower floors got lower ratings such as BBB. Institutional investors loved these securities of course since they could get an annual yield 1.5 to 2.5 percentage points above the risk free rate an still receive a triple-A rating from the rating agencies. This made the securities palatable to risk-averse investors since their charters indicated they could invest only in triple-A rated securities.
The challenge came with the lower-floors of the towers. Since these tranches were not triple A rated, they were harder to sell. Goldman Sachs found a solution for this problem by created a Collateralized Debt Obligation or CDO. These securities were simply a collection of the higher-risk and higher yielding portions of many, many mortgage bonds. Strangely, and almost magically, Goldman Sachs convinced the rating agencies to rate these CDO’s as Triple-A, thus making them palatable to risk-averse investors.
Thus was created a money machine that worked like this:
Sub-prime issuers such as the Money Store and Household Finance created and sold mortgages without regard to whether they could be repaid – and it didn’t matter since they simply originated and re-sold the mortgages and they got paid by volume
Large financials such as Goldman Sachs, Morgan Stanley, Citigroup and others purchases those bonds and re-packaged them into mortgage bonds and presented them to the rating agencies Moody’s and Standard and Poor’s.
The rating agencies analyzed and conferred AAA ratings on these securities and were paid (again by volume) by the issuer (Goldman Sachs, Morgan Stanley, Citigroup, etc).
Institutional Investors purchased the mortgage bonds and received fixed monthly payments without much regard to the risk of default – after all they were triple-A rated by Moody’s and Standard and Poor’s.
The worst of the mortgage bonds were re-packaged into CDO’s again receiving a Triple-A rating and re-sold to risk-averse investors.
Nearly everyone benefitted from the above arrangement except for the original borrowers who were saddled with mortgages which they could not possibly repay.
A disproportionate number of these mortgages took money from the poor and under- educated and fed that money to the already rich and educated.
At one point at about 2005, the demand for CDO’s became so great that there were not enough mortgage bonds to create more. As a result the big financials created the Synthetic CDO, or CDO’s created out of other CDO’s. In some bizarre arrangements, CDO #1 was created in with a part of CDO #2, a part of CDO #3 and a part of CDO #1. That’s right; there were circular or recursive arrangements of CDO’s!
A final and most confusing portion of the came in the form of the Credit Default Swap abbreviated CDS. These were essentially insurance contracts on bonds that worked as follows. The typical bond investor puts up a large amount of money (or a portion thereof) in order to receive fixed monthly payments but risks losing the entire principle amount. The purchaser of a CDS would essentially take the other side of the bet – put up a portion of the principal and pay out a fixed monthly amount in exchange for the opportunity to collect 100% (or some sub-portion) of the principle in the event of default of the issuer.
Default of the issuer was a binary event – the issuer either defaulted or they did not. In the event of a bankruptcy, assets of the issuer were liquidated and bond buyers would receive some portion of their principle back. Whatever portion they did not receive back was covered by the CDS. Purchasers of CDS could pay a small amount of the principle (between 0.15 and 2% per year) but have the chance to collect up to 100% of the principle in the event of default. Thus buyers of the CDS have a small chance to collect a very high payoff.
Some large financials – specifically AIG and their Financial Products division – sold large numbers of CDS, but were not required to reserve capital to cover potential losses. This alone was a colossal failure in regulation since AIG is an insurance company and therefore regulated by the State of New York where it is located.
A few very astute individuals realized early on that the CDO market was a disaster waiting to happen. As a result, they convinced some large financials into selling CDS or insurance on CDO’s in anticipation of collecting large payoffs when the CDO’s eventually failed. They expected to encounter a limited supply of these CDS instruments, but instead found an almost endless supply. We later found out that AIG FP was selling a large number of these CDS products and collecting huge monthly payments in exchange for insuring against losses that they could never possible cover.
The heroes of The Big Short were the few, astute individuals who foresaw the disaster and positioned themselves accordingly. Unfortunately, they never had their “champagne moment.” They ended up collecting huge sums of money, but only as a result of near collapse of the financial system. They positioned themselves for disaster in the face of huge odds and alienation of their own investors who were not patient enough to stick with the bet. They positioned themselves for a doomsday scenario, but took little joy when it arrived and instead suffered the human cost of betting against the large financials and against the capitalist system.
In the end, the Federal Reserve came to the rescue of the large financials. Citigroup, Morgan Stanley, Goldman Sachs and others received a total of 700 Billion Dollars from the TARP – Troubled Relief Asset Program. AIG Financial Products received a direct 80 Billion dollar loan from the Federal Reserve – and all of AIG FP’s products were paid in full – 100 cents on the dollar by money created out of nowhere by the Federal Reserve. Most of this money went into the hands of those who took the other side of the bet – about 14 Billion went to Goldman Sachs. The Fed’s justification was that they had to make whole on those commitments to avoid a cascade of defaults – so called systemic risk.
What about the management and employees of AIG and all the millions of money they collected selling insurance that they could not cover? Did they have to give back all those millions? The answer is no since they did not break any laws.
So what can we take away from all of this?
1) Understand the risks you are taking with your investments. Traders of these products did not understand the risks, nor did their own management much less their boards of directors and shareholders. Those who truly understood the risks made big money but paid a cost in human terms.
2) Don’t borrow money you can’t afford to repay. If someone is stuffing money into your pockets, understand where that money is coming from and what it is going to cost you down the line.
3) Be careful with doomsday scenarios whether it is in Europe or the United States. The world’s governments and central banks have an almost unlimited ability to create money out of nowhere to continue the status quo in the financial system.
In essence this last item means do not be afraid of doomsday scenarios. There are plenty of reasons to fear financial contagion in Europe and the United States. The investors who ultimately profit are the one who realize that the world’s central banks will do almost anything required to prevent collapse of the global financial system.
That’s enough for now, go forth, prosper and don’t fear the reaper.
