The Big Short

I recently read The Big Short by Michael Lewis on the financial crises of 2008. It re-tells the true story of a few fortunate investors who had the foresight to see the bubble in housing before it collapsed. John Paulson, a NY Hedge Fund Manager, was the most famous one. He made $20B for his investors, and $4B for himself, as probably the single biggest individual benefactor of this prescient trade, namely to short Collateralized Debt Obligations (CDOs). In this article, I will try to summarize the elements that comprised this trade as explained in this book.

However, before I do so, it’s worth noting the following individuals who were willing to challenge the conventional wisdom of Wall Street. Greg Lippmann, a Bond Trader at Deutsche Bank, Steve Eisman, a Portfolio Manager at FrontPoint Capital (suby. of Morgan Stanley ), Michael Burry, an ex-Physician turned independent Hedge Fund Manager of Scion Capital who worked out of a small office in San Jose, CA, and Jamie Mai & Charlie Ledley of Cornwall Capital, a couple of young 30-somethings who started out with $110K in a Charles Schwab account working out of a garage in Berkeley, CA. Their portrayals as somewhat maverick investors were fascinating, but you will need to read the full story, which I highly recommend, to fully appreciate their backgrounds and development as independent, forward-thinking, contrarian investors.

Other players worth mentioning were Joe Cassano, who ran AIG FP (Financial Products), the London based unit of AIG that provided the vast insurance against the default of these risky subprime investments, and Gene Park, also of AIG who, along with Joe Cassano, began to realize the folly of this insurance in early 2006 thanks in part to Gregg Lippmann’s appeals to them. Howie Hubler of Morgan Stanley who was fired in October of 2007 for losing $9B, the largest trading loss in the history of Wall Street, receives a noteworthy mention as well.

“A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages.” Salomon Brothers, the creator of this mortgage bond market, would take pools of these home loans and segregate the payments into different sections called tranches.

The buyer of the first tranche, considered the ground floor and most risky, were dissolved in first wave of mortgage prepayments. In exchange, however, the investor received the highest interest rate payment as long as his mortgages were not pre-paid or refinanced. The top floor tranche was the least risky, but as a result received a lower interest rate and the best odds that his investment would continue to reap the cash flow from these monthly mortgage payments.

“The pool of loans underlying the mortgage bond conformed to the standards, in their size and credit quality of the borrowers, set by one of several government agencies, Freddie Mac, Fannie Mae, and Ginnie Mae. The loans carried, in effect, government guarantees; if the homeowner defaulted, the government paid off their debts.”

As this mortgage bond market evolved, bonds were later created for subprime loans that did not qualify for government guarantees. These subprime bonds not only included prepayment risk, but actual losses from non-payment of the loans. The first floor tranche was exposed to losses until his investment was entirely wiped out, whereupon the next losses affected the next investor.

One factor that led to the boom in subprime lending was the growing income disparity among borrowers in the United States. Additionally, as credit card debt increased overall, lenders targeted these borrowers with offers to consolidate their higher interest credit card debts into lower interest rate mortgages, often as a second mortgage on a house (or a refi).

“In 2000, there had been $130B in subprime mortgage lending, and $55B had been repackaged as mortgage bonds. In 2005 there would be $625B in subprime mortgage loans, $507B of which found its way into mortgage bonds.” These subprime lenders would make the loans, and then sell them off to the fixed income departments of Wall Street investment banks, who, in turn, packaged them into bonds to sell off to their own investors. This was considered the originate and sell model, used to remove these risky loans from your books.

A credit default swap (CDS) was an insurance policy on a corporate bond which required two premium payments per year. An investor (CDS Buyer) might pay $200K per year to buy a ten-year credit default swap on $100M in GE bonds. At $200K per year for 10 years, their total risk was $2M. However, if GE defaulted on its debt any time over this time period (10 years), the bondholders recovered nothing, and you, the CDS Buyer, made $100M. The risks associated with buying a credit default swap were therefore pre-determined, and JP Morgan is credited with inventing the first corporate credit default swaps in the mid-1990s, as a tool for hedging.

Michael Burry notices in early 2005 that the US housing market was being driven by irrational lenders extending easy credit and he decides to short the real estate market by purchasing credit default swaps (CDS’s) on subprime mortgage bonds. Essentially, he was betting these subprime bonds would default as the housing market bubble burst.

The dealers of credit default swaps, led by Deutshe Bank and Goldman Sachs, developed the pay-as-you go swap. “The buyer of the swap (the buyer of insurance) would be paid incrementally as individual homeowners defaulted. These agreements were formalized by an organization called the International Swaps and Derivatives Association (ISDA).

“On May 19, 2005, Mike Burry completed his first subprime mortgage deals, buying $60M in credit default swaps from Deutsche Bank – $10M each on six different bonds. By the end of July (2005), he owned credit default swaps on $750M in subprime mortgage bonds.”

Greg Lippmann, a bond trader for Deutsche Bank, in an effort to attract investors created a presentation called “Shorting Home Equity Mezzanine Tranches.” Similar to Michael Burry, it was based on buying credit default swaps (CDS’s) on the worst triple B slices of subprime mortgage bonds. You could make a bet w/out a major up-front investment. Instead, you paid about 2% per year for at most-likely no longer than six years, which was the longest expected lifespan of the 30 year loans. Lippmann was convinced that it was just a matter of time before the defaults would happen. And when they did, your CDS’s began to pay out.

Michael Burry bought CDS’s from Goldman Sachs without knowing who was taking the other side of his trade until 3 years later. Goldman was the market maker, and it turned out AIG was the insurance company with the stellar credit (AAA bond rating from S&P, and Moody’s) supposedly able to back CDS’s to Burry thru Goldman. “In 1998, AIG FP entered the new market for corporate CDS’s: It sold insurance to banks against the risk of defaults by huge numbers of investment-grade public corporations. The CDS had just been invented by bankers at JP Morgan, who went looking for a AAA-rated company willing to sell them – and found AIG FP.”

Goldman convinces AIG to provide this same corporate credit insurance to the subprime mortgage market. Goldman created a security called the synthetic mortgage bond-backed CDO (Collateralized Debt Obligation). “In a mortgage bond, you gathered thousands of loans and, assuming that it was unlikely they would all sour together, created a tower of bonds in which both risk and return diminished as you rose. In a CDO you gathered 100 different mortgage bonds –usually the riskiest, lower floors of the original tower-and used them to erect an entirely new tower of bonds.” The rating agencies were also paid well by Goldman for each deal they rated.

A synthetic CDO was a security comprised of CDS’s on BBB rated mortgage bonds. Michael Burry paid 2.5% (250 basis points) to own credit default swaps on the worst rated BBB bonds, and AIG paid 12 basis points (.12%) to sell CDS’s on those same bonds, filtered through a synthetic CDO. “The insurance Mike Burry bought was inserted into a synthetic CDO and passed along to AIG. The roughly $20B in CDSs sold by AIG to Goldman meant roughly $400M in riskless profits for Goldman, each year.

Why didn’t AIG have to maintain capital reserves against these swaps as most insurance regulation stipulates? Why were there no collateral requirements? Senator Phil Gramm, a Texas Republican who chaired the Senate Banking Committee in the late 1990’s, pushed through the Gramm–Leach–Bliley Act (named after the 3 Republican Congressmen who sponsored the bill), which President Bill Clinton signed into law in 1999.

This bill repealed part of the Glass–Steagall Act of 1933, and relaxed the rules separating commercial banking from investment banking. But more importantly, it blocked the regulation of derivatives, disposing of any collateral requirements so the likes of AIG and Bear Stearns could sell CDS’s unabated. This provision also had the strong backing of the Treasury Secretaries from the Clinton administration, Robert Rubin and Larry Summers, who teamed up with Alan Greenspan, an Ayn Rand disciple himself, to prevent the regulation of these new financial instruments. Greenspan, admittedly, would later regret this decision which cast a pall on his tenure as Chairman of the Federal Reserve.

Lippman begins buying CDS’s from Deutsche Bank’s own CDO department. He also hires a Chinese Quant named Eugene Xu to study the effect of home price appreciation on subprime mortgage loans. He also flies to the London headquarters of AIG FP in an attempt to convince them of the impending housing crises which would ruin their CDS insurance business.

In early 2006, Joe Cassano, in charge of AIG FP, agrees with his employee Gene Park and Greg Lippman and decides to stop insuring these deals, although they would continue to insure the ones they already had. When a Mexican strawberry picker in Bakersfield, CA, earning $14K/year was lent over $700K to buy a house, you knew this house of cards was destined to fall.

A mezzanine CDO was a CDO composed of mostly BBB rated subprime mortgage bonds. The synthetic CDO was composed of CDS on the BBB subprime mortgage bonds. If a CDO ends up being worthless, so is the investment of selling a CDS on that same CDO.

In Jan 2007, BBB bonds had lost over 30% of their value from par (100) to the high 60s. Meanwhile, the CDOs created from those same bonds were still being sold by Merril Lynch and Citigroup. Bear Stearns and Lehman Brothers continued to publish reports supporting the bond market. Moody’s and S&P agreed to change their rating methods, but not on the old bonds they had already rated.

Bear Stearns is also a big seller of CDS’s, but is not required to post collateral on those potential debts, which is why Cornwall Capital becomes concerned about Bear Stearns viability in the financial crises. As such, they turn to the British Bank, HSBC (3rd largest bank in the world) to buy CDS’s on Bear Stearns.

Another problem was how the Credit Default Swaps were valued. There wasn’t really an open market to sell and buy these new financial instruments, and so they were valued by the big investment banks, namely the Goldmans, the B of A’s, and the Morgan Stanley’s of Wall Street. And because these banks may have been on the other side of the CDS trade, they were reluctant mark up their value even as evidence of the mounting defaults grew.

As a result, Michael Burry’s Scion Capital lost 18.4% in 2006 as the S&P gained over 10%. The market makers in his CDS investments were still not increasing their value, and meanwhile, he continued to have to pay out the annual premiums.
Howie Hubler, a bond trader (Buy Side) at Morgan Stanley was making large bets against the subprime market just as the Morgan Stanley brokers (Sell Side) were peddling these same investments to their own clients. In other words, their own trading desk was shorting the same investment they were marketing. Hence, the impetus for the Volcker rule, and the financial regulation (Dodd-Frank Wall Street Reform and Consumer Protection Act) passed by Congress and signed into law by President Obama in 2010.

In September of 2008, Lehman files for bankruptcy, and Merrill Lynch sells itself to B of A after announcing $55B in losses on subprime bond-backed CDOs. The US Federal Reserve rescues AIG with a loan of $85B.

The Wall Street Investment Banks convinced the rating agencies to bless these complicated CDO investments which were full of risky subprime loans. Before the rating agencies caught on, and adjusted their evaluation methodology, the writing was already on the wall.

“The mezzanine CDO was invented by Michael Milken’s junk bond department at Drexel Burnham in 1987. The first mortgage CDO was created by Credit Suisse in 2000 by a trader who had spent his formative years, in the 1980s and early 1990s, in the Salomon Brothers mortgage department. His name was Andy Stone, and along with his intellectual connection to the subprime crises came a personal one: He was Greg Lippmann’s first boss on Wall Street.”

These early bond investments pioneered by the likes of Stone and Milken eventually morphed into more complex agreements such as CDS’s and synthetic CDO’s based in part on a need to develop new vehicles to fuel Wall Street’s insatiable appetite for subprime loans, which exacerbated the fragility of the housing market. But, they needed these risky loans like a drug because they were the underlying assets, as shaky as they were, behind these increasingly complex investment vehicles.

Their complexity, and resulting obscurity, provided Wall Street, which profited for many years as the middleman, with the disguise to continue to prop up this fragile housing market until the bubble burst. Eventually the game ran out of believers, thanks in part to the efforts of Lippmann and Eisman, who were early to the scene and not afraid to challenge this charade, revealing it for what it truly was, a house of cards.


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