Thoughts|Books|The Big Short

The Big Short ,written by Michael Lewis described what happened during the 2007 subprime mortgage crisis in detail. Even though it was written like a novel, it accurately reflected a broad picture of the whole crisis with no loss of generality. Here I provide a brief introduction of the book:

The whole process starts from thousands of mortgage-loan companies made loans to low-income families. Borrowers with poor credit ratings were drawn into making mortgage loans by a 2-year teaser rate, say 8 percent on the contract. However, most of them fell to meet their interest payment when the interest rate went up to 12.5 percent. The mortgage-loan companies turned a blind eye on this because they assumed the house price would keep going up, and their client would come and refinance their loans. To these companies refinancing mean more fees to collect from their clients. Most importantly, they could resell mortgage loans to Wall Street big firms, like Goldman Sachs, Credit Suisse, and Merrill Lynch.

Fix income departments in Wall Street firms collected thousands of mortgage loans and packaged them into subprime mortgage bonds. Within each subprime mortgage bond, there are different tranches. They start from AAA-rated loans on the top to BB-rated loans on the floor. Investors had to decide on which level of the tower they want to invest in. The investors in the first tranche received the lowest rate of interest but had the highest protection against defaults. Wall Street big firms then sell subprime mortgage bonds to other investors.

Credit default swaps are insurances against defaults of bond issue companies. In 2005, Dr. Michael Burry, the hedge fund manager of Scion Capital, asked Wall Street firms to sell him credit default swaps against handpicked AAA-rated subprime mortgage bonds. The trading process was like Goldman Sachs stood between Dr. Michael Burry and AIG (American International Group), an AAA-rated bond insurance provider. Goldman Sachs charged Dr. Michael Burry 250 basis points and paid AIG 12 basis points. Dr. Michael Burry did not own a single subprime mortgage bond, so he was not hedging, but betting against the whole U.S. housing market.

Until the end of 2005, AIG would insure as many mortgage bonds as possible. As the main supplier of credit default swaps, AIG needed to purchase subprime mortgage bonds and CDOs to cancel out the credit default swaps it sold.

Wall Street firms had a difficult time selling BBB-rated and BB-rated subprime mortgage bonds. Goldman Sachs came up with an idea of collecting hundreds of BBB-rated and BB-rated mortgage bonds and bundled them together. This new financial product was called synthetic subprime mortgage bond backed CDO(Collateral Debt Obligation). To lower perceived risk, Goldman Sachs made CDOs complicated enough that no one can understand them and managed to get rating agencies, like Moody’s, S&P, and Fitch, to give 80 percent of CDOs AAA rating or AA rating. CDOs were fundamentally the same since CDO A could contain a part of CDO B, and CDO B could include a part of CDO C. If CDO A went bad, all other CDO went bad. From my point of view, CDOs were simply permutations of BBB-rated and BB-rated subprime mortgage bonds.

Wall Street firms had gamed the risk models of rating agencies. For example, when evaluating a pool of mortgage loans, Moody and S&P did not require a list of the FICO scores but the average FICO score of loans. The average FICO score of borrowers needed to be around 615. There were so many ways to arrive at that average number and therefore opened up rooms for manipulations. Rating agencies whose profit depended on the volume of evaluations they made tended to give ratings Wall Street firms wanted.

Other than ordinary CDOs, there was another new financial product, synthetic CDO. Synthetic CDOs were credit default swaps on subprime mortgage bonds. However, a synthetic CDO was not insurance against default, but replication of bonds back by actual home loans.

In November 2006, some home-loan borrowers were not able to pay interest payments, and yet the price of subprime mortgage bonds had not budged. I guess that Wall Street firms were buying BBB-rated, BB-rated subprime mortgage bonds to package them into CDOs and thus provided price supports for the subprime mortgage bond market. Likewise, though the first few months of 2007, though the mortgage loans made in 2005 started to reset and borrowers went default, the market price of credit default swaps did not budge because Wall Street firms were bringing more money from their clients to support CDOs and subprime mortgage bonds. Also, in the short run, it was them to determine the market value of credit default swaps. They did not want to acknowledge they had taken positions that were on the opposite side of credit default swaps.

It turned out that these Wall Street firms did not sell all of the CDOs they created to investors, but kept them for themselves. Late until June 14, 2007, two Bear Stearns subprime-mortgage-bond hedge funds went belly-up. Bear Stearns went bankrupt and was sold to J.P. Morgan. Lehman Brothers filed for bankruptcy, and Merrill Lynch had sold itself to Bank of America.

One interesting thing is that Freddie Mac and Fannie Mae were mentioned only at the end of the book, both of which had played significant roles in providing guarantees to mortgage loans.

Key takeaways:

  1. It was irrational and unreasonable for the whole market to believe house prices would continue to go up.
  2. People believed in ratings. Investors did not bother to look into what was inside subprime mortgage bonds, or CDOs simply because they were rated AAA.
  3. The consensus in the financial market was, given the historical data, the probability for a pool of mortgage loans to go bad altogether at one time was too small.
  4. In addition to relying on models to evaluate financial products, one should always look into what exactly constituents are in them.

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