“I agree with most of the commentary that the strong fundamentals support a relatively soft landing in housing.” – Ben Bernanke at his first Federal Reserve Open Market Committee meeting as chairman in March 2006
“We just don’t see troubling signs yet of collateral damage [from the housing price decline] and we are not expecting much.” – Timothy Geithner then president of the Federal Reserve Bank of New York at the Federal Reserve Open Market Committee meeting in September 2006
The Big Short: Inside the Doomsday Machine
In early 2006 U.S. housing prices peaked and then started to decline. Increased foreclosure rates over the next couple of years led to a U.S. financial crisis in August 2008. The minutes from 2006 Federal Reserve Open Marketing Committee meetings, released in January 2012, show that the best and brightest economic minds at the Fed were behind the curve in realizing the severity of the downturn and the magnitude of its affect on U.S. financial markets. However, a small group of contrarian investors foresaw the coming crisis.
Michael Lewis previously chronicled his three years in the late 1980s as a bond salesman at Salomon Brothers in his first book, Liar’s Poker. That experience gives him a keen insight into mortgage-backed securities (during the 1980s, Salomon Brothers was noted for its innovation in the bond market, selling the first mortgage-backed securities). In The Big Short, he details how a few investors saw through the mass euphoria, purposely-opaque prospectuses, and misleading credit ratings to made bets that would reap billions as the U.S. mortgage derivatives markets collapsed. Michael Lewis excels at character-driven narrative, and I highly recommend the book to anyone who wants to read an interesting, well-written, entertaining story about the complexity of the bond market that contributed to the financial crisis.
However, the purpose of my writing is to examine risk and risk-management. The first three posts in this series covered, respectively, the history of risk (Part 1), the evolution of quantitative financial trading (Part 2), and the underestimated role of chance in financial markets (Part 3). In this post, I simply relay quotes from The Big Short that illustrate how the market for derivatives was perverted to a degree that amplified risk by an order of magnitude not recognized or realized by all but a few investors until after it nearly caused a global financial market collapse.
When Michael Burry bought a credit default swap based on a Long Beach Savings subprime-backed bond [effectively shorting a mortgage-backed security], he enabled Goldman Sachs to create another bond identical to the original in every respect but one: There were no actual home loans or home buyers. Only the gains and losses from the side bet on the bonds were real.
Once they [Goldman Sachs] had this package (a “synthetic CDO,” it was called, which was the term of art for a CDO composed of nothing but credit default swaps), they’d take it over to Moody’s and Standard & Poor’s. “The ratings agencies didn’t really have their own CDO model,” says one former Goldman CDO trader. “The banks would send their own model to Moody’s and say, ‘How does this look?’” Somehow, roughly 80 percent of what had been risky triple-B-rated bonds now looked like triple-A-rated bonds. The other 20 percent, bearing lower credit ratings, generally were more difficult to sell, but they could, incredibly, simply be piled up in yet another heap and reprocessed yet again, into more triple-A bonds. The machine that turned 100 percent lead into an ore that was now 80 percent gold and 20 percent lead would accept the residual lead and turn 80 percent of that into gold, too.
The pretense that these loans were not all essentially the same, doomed to default en masse the moment house prices stopped rising, had justified the decisions by Moody’s and S&P to bestow triple-A-ratings on roughly 80 percent of every CDO.
It was a stunning opportunity: The market appeared to believe its own lie. It charged a lot less for insurance on a putatively safe A-rated slice of a CDO than it did for the insurance on the openly risky triple-B-rated bonds. Why pay 2 percent a year to bet directly against triple-B-rated bonds when they [investors betting on a decline in the housing market and mortgage defaults by home owners] could pay 0.5 percent a year to make effectively the same bet against the double-A-rated slice of the CDO? If they paid four times less to make what was effectively the same bet against triple-B-rated subprime mortgage bonds, they could afford to make four times more of it.
Financial options were systematically mispriced. The market often underestimated the likelihood of extreme moves in prices. The options market also tended to presuppose that the distant future would look more like the present than it usually did. Finally, the price of an option was a function of the volatility of the underlying stock or currency or commodity, and the options market tended to rely on the recent past to determine how volatile a stock or currency or commodity might be.
The market for “synthetics” removed any constraint on the size of risk associated with subprime mortgage lending. To make a billion-dollar bet, you no longer needed to accumulate a billion dollars’ worth of actual mortgage loans. All you had to do was find someone else in the market willing to take the other side of the bet.
For more than twenty years, the bond market’s complexity had helped the Wall Street bond trader to deceive the Wall Street customer. It was now leading the bond trader to deceive himself.
Even the winning investors in the financial crisis were conflicted in their feelings. “Being short in 2007 and making money from it was fun, because we were short bad guys,” said Steve Eisman [one of the main characters in The Big Short]. “In 2008 it was the entire financial system that was at risk. We were still short. But you don’t want the system to crash. It’s sort of like the flood’s about to happen and you’re Noah. You’re on the ark. Yeah, you’re okay. But you are not happy looking out at the flood. That’s not a happy moment for Noah.”
However, was the financial crisis really the fault of a few bad guys? That’s the subject of the next post in this series.
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