The U.S. housing market in 2008.
(US Atomic Energy Commission/Department of Energy)
Copyright © 2017
by Ralph F. Couey
Written Content Only
Movies come out by the dozens every year, some good, most so-so, some which were not worth the effort. But once in a while, a film is released that touches a nerve, opens some eyes, and changes the way the world is viewed.
For me, such was The Big Short, the cinematic treatment of Michael Lewis' book of the same name which recounted the factors leading up to the devastation of the U.S. housing market in 2008.
Investment banking, in fact Wall Street in general is something of an esoteric field, rife with its own language purposefully designed to keep from the rest of us what is truly going on with the markets, and our money. The story is one of shocking incompetence, willful blindness, collusion, and an absolute contempt for the welfare of the public at large. If you haven't seen it, you should, if you have any kind of institutional retirement account. Especially if you were one of the faceless millions who were financially raped in 2008.
I'll try to briefly summarize, but it is a complex subject and for full understanding, you need to read Lewis' book and then see the movie, several times.
A major component of what is euphemistically called "The American Dream" is owning a home. Having that real asset with your name on it (albeit along with the bank holding your mortgage) was a penultimate symbol of independence and financial achievement. No longer would Americans be beholden to someone else for the roof over their family's collective heads. If one couldn't be one's own boss, than we could certainly By God be our own landlord.
Qualifying for such largess was difficult. Once a person applied for a mortgage, the lending institution had carte blanche to rip that person's life apart in the effort to determine if, once the loan was granted, it would be repaid in full. For that reason, mortgages were considered safe, if boring investments, knowing that homeowners would sacrifice almost everything else in order to make that monthly payment.
The benefits of home ownership went beyond the financial considerations. Communities with high percentages of home ownership were considered stable and safe. Unlike renters, homeowners had a financial stake in their neighborhoods. They watched each other, enforcing the unwritten rule of "You'd better take care of your place, because a ratty lawn and ugly house affects the value of my home." The stable tax base generated by those homes provided the benefits of public safety, good streets, great schools, and even influenced the kind of businesses willing to hang out their shingle. Suburbia became the shining example of the American way of life, and the envy of the rest of the world.
The beginning of the end came in the early 1970's. A bond trader named Lewis Ranieri came up with the novel idea of bundling a bunch of mortgages into a bond and selling those bonds to institutional investors. It was an attractive deal. Mortgages were safe, housing prices were sure to always go up, and the payoff, while small from individual loans, would prove to be very significant when all those safe loans were piled together.
In the beginning, it was very profitable. The qualification standards for mortgages were still stringent, so the individual loans making up those bonds were very strong. But over time, the "good loans" were all used up, and the banks began to look elsewhere in order to keep this prodigious profit machine turning. Little by little, the qualifications for individual mortgages began to slip.
The primary basis for determining credit worthiness was a metric we know today as the FICO score. It was invented by a data analytics firm called Fair, Isaac, and Company in 1956, out of sunny San Rafael, California. The calculation process was very complex, well beyond the comprehendible reach of the average Joe. The scores run from the very low of 300 to the shining perfection of 850, and not only determine a person's credit worthiness, but also in part becomes a reflection of that person's perceived character as well. The first mortgage bonds consisted of loans with FICO scores in excess of 650. But as the available pool of loans steadily shrank, the qualifying scores fell to the low 500's. But the lawyers who put these mortgage bonds together, realized that they could engineer them so that the lower FICO scores were offset by higher scores, thus while there were a bunch of risky loans in that bundle (dubbed "subprime"), the average score for all the loans were acceptable enough to encourage the ratings agencies, Standard & Poor's, Moody's, and the like, to rate them in the "A" bracket, "A", "AA", and "AAA".
Beginning in the 1980's lending institutions began offering adjustable rate loans. These were loans that allowed the interest rate to float in concert with trending market. These were attractive to homebuyers in the rubble of the Carter economy when interest rates for home loans rose into the upper teens. Rather than being locked into a high rate, homeowners could take advantage of falling rates common during the Reagan years. The initial rates were always lower than the market, so it seemed like a good deal, which opened the door a bit wider for new loans to put into the bonds.
In the 1980's housing prices began to skyrocket. We were living in Southern California at the time, and almost every week there were reports in the paper of, for example, one man who bought a home, still to be built, in a new community in Diamond Bar, which just months earlier had been scrub land. He paid $175,000, and less than a week later, he sold it for $300,000. Bear in mind that it was still a vacant lot, before yet a single shovel of dirt had been turned. The desire for new homes was so great that people were camping out at the development offices for days so that they could be the first in line to buy. People began to buy houses, not in which to live, but rather in the expectation that the value of the home would rise fast enough so they could re-sell and use the equity for an even bigger home. This led to ridiculous situations like someone living in a very nice home with no furniture because every dime they had was going to the mortgage.
As nutty as this was, it could continue as long as home prices continued to go up. In fact it got so insane that in many cases, the new homeowner never had to make a single payment, because all they had to do was to keep re-financing the loan.
Meanwhile, back on Wall Street, new mortgage bonds were still being created, but filled with ever riskier loans. The bonds themselves were separated into layers, or in Wall Street-speak, Tranches, a French term for "a portion of something." At the top of the bond were the gold-plated AAA rated loans, and at the bottom were the very risky B's. Someone came up with the novel idea of taking the lower-rated portions and grouping them into something called a Collateralized Debt Obligation, or CDO. In practice, once there were enough of these bad loans lumped together, the ratings agencies would consider them diversified, and would then bless them with the highly-prized AAA rating. The problem was that the ratings agencies themselves were becoming prostituted to the big banks. If S&P for example refused to grant the high rating, the bank would go to one of their competitors, like Moody's, who would gladly take the business. Thus the institutions who were supposed to be guarding the gates, so to speak, were in fact not even at their posts.
As time went on, those CDOs began to be used as a betting tool, not just on the original bonds, but on the CDOs themselves. In the movie, there is a conversation where it is revealed that a $50 million bond might have as much as a billion dollars in "bets" riding on it.
The rot was in place, the infection was there, but Wall Street, the ratings agencies, and even the government (actually, I should say "especially the government") were so enamored with the incredible profits being generated that they neglected to monitor the health of the underlying securitizations.
Enter three groups who actually took time to look.
Dr. Michael Burry on the right. On the left, Christian Bale who portrayed him in the movie
Dr. Michael Burry ran a hedge fund in California called Scion. He had started with a small inheritance, and due to his talent for picking stocks, perhaps aided by his later-diagnosed Asperger's Syndrome, attracted investors and grew his fund to over a billion dollars of liquidity. In 2005, Burry began looking closely at the loan-level data and was shocked by what he discovered. Low FICO scores, many loans with no documentation of income or employment, a growing number that were at least 90 days delinquent. Armed with that knowledge, he went to Wall Street and announced his intention to short the housing market. To short an investment means to bet against it, that it would go down rather than up. At that time, there was no instrument in existence for such a trade, so he got the big banks to invent one, called a Credit Default Swap, or CDS. It was essentially an insurance policy that would pay huge benefits if and when the underlying housing bonds failed. In the deal, Burry had to agree to pay premiums while the value of the bonds went up, but he was willing to do so because he was completely certain that armageddon would occur when the adjustable rate teaser rates began to expire in early 2007. That, coupled with the expected drop in housing prices, would drive those monthly mortgage payments up 200 to 300 percent. Defaults would snowball, the bonds would fail, and along with them, the institutions associated with them. For two years, he had to wait until these effects became apparent. Along the way, he discovered that the banks were so purblind that they would refuse to acknowledge the growing problem and fail to mark his swaps appropriately. During that time, Burry was savaged by the investors in his fund, especially when he moved to limit withdrawals.
Gregg Lippman on the right. Ryan Gosling the actor on the left.
Gregg Lippman (Jared Vennet in the movie) was a low-level bond trader at Deutsche Bank, who discovered Dr. Burry's analysis and also began to short the housing market, collecting fees and commissions for doing so. Like Burry, he took a lot of flak for doing this.
Steve Eismann on the right. Steve Carell on the left, who portrayed Eismann in the movie.
Something as mundane and silly as a wrong telephone number brought the whole issue to the attention of Steve Eismann (Mark Baum in the movie). Eismann, after doing analysis of his own, also saw the unexploded bomb ticking away at the heart of the housing market. He bought millions in CDS's from Lippman, while discovering along the way the incredible and willful blindness, and the frankly fraudulent behavior of the banks and the government.
Jamie Mai Finn Wittrock in the Movie
(Lord Google doesn't have a picture of Charlie Ledley or Ben Hockett)
Cornwall Capitol was a...well the term used was "garage band hedge fund," (Brownfield Fund in the movie) run by two young men, Jamie Mai (Jamie Shipley in the movie) and Charlie Ledley (Charlie Geller in the movie), assisted and guided by a veteran retired trader Ben Hockett (Ben Rickert in the movie). Another impressive performer, the fund started with $110,000 and grew it into $30 million. They also stumbled on the opportunity to buy credit default swaps. Where their approach differed, was in their decision to short the upper levels (tranches) of the bonds, the A's and AA's, with the understanding that the loans in those upper tranches were way over-valued.
In 2007, the loans began to default, and the housing bonds began to fail. Still, the big banks refused to see reality. it wasn't until those big banks, like Lehman Brothers, began to fail that facts were squarely faced. Millions were rendered homeless and unemployed. Trillions of dollars in market value, pensions, and savings accounts were liquidated. Loan requirements were tightened, and the pool of buyers shrunk accordingly, leading to a glut of houses where the owners simply defaulted and walked away. Housing prices plummeted, and the country teetered on the brink of financial ruin.
Even today, some seven years later, the debris of the crisis can still be seen. Las Vegas, for example has around 14,000 vacant homes, which has produced a leasing scam targeting the poor and immigrants, and a law enforcement nightmare for the already overburdened Las Vegas Metropolitan Police and the Clark County Sheriffs.
It is clear that the behavior of the miscreants on Wall Street and in the government was fraudulent and illegal. Yet in the aftermath of the disaster, the government used trillions of dollars to bail out the big banks, which then used the money to pay huge bonuses to the very criminals responsible for the crisis. And the people, the homeowners who took the brunt of the disaster? They got nothing. Even those who were current on their payments and still wrongfully evicted from their homes received no recompense whatsoever.
"The Big Short" is the worst kind of horror film; because it's true. But it reveals a glaring weakness in our own attitudes and perspectives. We, the people, are easily seduced by big, shiny corporations with big, shiny buildings populated by people for whom a single suit of clothes cost more than the monthly paycheck of a lot of people. It reveals the arrogance of the people who run such enterprises, and their utter contempt for the rest of us. The greed involved in the runup to the crisis was epic. And before we tender hero status on the three groups who saw through the whole mess, remember that they all made out very well, in the billions of dollars.
I bought the book on Kindle after I saw the movie multiple times. I was shocked by what I saw but tempered by the idea that Hollywood prefers sensationalism over truth. But reading Lewis' book, and discussing the subject with my own financial planner, I was saddened to discover that, while some details were convenienced, the story was absolutely true. It's scary and depressing to realize that the institutions who take our money and fling it around so carelessly didn't really learn their lesson, except that if such a disaster happens again, the government (that is to say "we") will fork over billions to bail them out. Why? Because as it turns out, Wall Street contributes equal amounts of money to both mainstream political parties, a revenue stream those politicians are loathe to deny themselves. Even Hollywood, an industry that prides themselves on campaigning against the greed of the wealthy, won't see the hypocrisy of their own lives.
My experience in government had already made me a cynic. The knowledge gained through The Big Short has made me cynical and sadly pessimistic about the sand upon which our economy has been built. I have no doubt that this kind of thing will happen again, and the price will be paid, not by those whose greed will precipitate the crisis, but by the ordinary among us who will be crushed in the fallout.
I know I am getting old. But after studying recent history, part of me is relieved that I probably won't be around to experience the next disaster.