The Big Short, Longer Version

We watched “The Big Short” the other night! I thought it was great – Steve Carell was just amazing as a serious guy. But, the terrible brilliance of the situation, as well as the lessons for today, are not evident from the movie.

I’m writing for myself as much as anything. Even after reading this and many other books on the subject it’s still challenging for me to fully understand the past, much less the parallels to today. I will share my amateur understanding of it, and welcome corrections and thoughts from those that know more. I am quite sure that some of what I say is at least partially wrong so help me out!

The movie portrayed a simple story. The mortgage industry pushed bad loans. The banks bought them, repackaged them into CDOs, and sold them to unsuspecting large investors. A standard huckster story. And the lessons appear equally simple – bankers are bad so regulate them, jail them, fine them, etc…

But the actual situation was much more complex. Anyone can buy high-risk, high-reward “junk” bonds anytime. It’s not deception for a bank to sell C-rated bonds – that’s just an investment choice. But in this case, the banks discovered how to take one investment, the subprime loan, transform it, and dramatically increase it’s credit rating. The interesting story is how they did that.

Pandora’s box was opened in the 80’s and 90’s with general banking deregulation and the 1999  repeal of most of the Glass-Steagall act. The act was created during the depression to separate consumer banking (where your savings account is) from investment banking (the part that takes risks, makes investments, creates and sells financial products). The made both parts fairly boring. Your savings account was safe and invested prudently. And investment banks could play only with their own money, or the money of their customers.

Recombining them created immense opportunities for creativity and innovation. Much of this could and probably did benefit the economy and consumers. But it also helped enable “to big to fail”. If a banks investment losses exceeded their assets and it went bankrupt, it would also wipe out the money in all those savings accounts. Because savings accounts are government FDIC insured, the government will have to step in. If the bank makes a huge risky investment and it pays off, they get to keep all the money. If they lose, the government covers it. They don’t lose their company, their jobs, their paychecks or bonuses. What thinking person would not take advantage of this situation? Would you turn down millions of dollars because you’re worried about hurting the economy?

These changes didn’t cause the meltdown, but they created favorable conditions.

The first technique used was diversification. A diversified mutual fund allegedly provides a portfolio of stocks that is, in aggregate, less risky than the individual stocks. The banks allegedly do hard work and use their unique knowledge to do this, and therefore, they can charge a premium (expenses) for owning the fund. But ever owned a diversified portfolio of “diversified” mutual funds during a recession? It doesn’t feel so diversified when they all go down by 40% give or take 10% (alpha). Still, you buying a mutual fund and paying expenses is an investment choice, not fraud.

Housing loan CDOs are similar, but they are a collection of loans instead of stocks. The theory was that Florida housing might go down. Or Seattle. But not all together. So by grouping them together, allegedly with sophisticated financial models to minimize risk, they were worth more. With CDOs, instead of paying expenses you pay for the added value with a higher rating and correspondingly higher cost.  You take a pile of C ratings and through the magic of diversification create a B. This is the literal equivalent of printing money. But it’s still not fraud. It’s standard operating procedure. If you don’t want it, don’t buy it.

Enter the ratings agencies. Three companies: S&P, Moodys, and Fitch, control 95% of the world’s ratings. Ratings on all kinds of things – corporate bond offerings, municipal offerings, companies themselves including the banks, and even countries. When banks create any new bond they have to take it to one of these three to get rated. The agencies are allegedly impartial and well-informed. But they are also paid for rating the bond, not accurately rating the bond. There is no accountability. They do not suffer if they rate incorrectly (though there could be some desire to use one agency over another based on both accuracy, and inaccuracy).

When rating something like a corporate bond, banks don’t care that much what the rating actually is. The company comes to the bank to create the bond, they get it rated, and it’s the company not the bank that benefits from a better rating. This is that boring banking talked about in the beginning of the film. So the bank appreciates a high rating for their customer, but there’s no money in it for them.  There is also a long history of procedures and practices used to evaluate the company.

In this case the banks created these CDOs based on a large number of individual loans that they themselves owned, not their customers. They then used complex math to allegedly made them less risky. They then took these CDOs to the ratings agencies. The first problem here is that unlike corporate bonds, the banks themselves are the ones to profit if the ratings are higher. In fact, the only way this business will exist for either the banks or the ratings agencies is if the ratings are indeed higher than their constituent parts. So not only do they have incentive to put their thumb on the scale, it is just about the only way they can compete.

The second key factor is complexity. In my experience few companies openly and intentionally violate the law. Not necessarily because they’re moral, but because it’s just too hard to keep a secret. What they do is bend rules in their favor, especially when the rules are complex or unknown. It was honestly very difficult to know how to price these things. Complexity increases the uncertainty around what the rating should be, which inherently increases the range of possible ratings.  So if you’ve got some flexibility, why not rate them at the high end? So they did.

If complexity creates pricing flexibility which leads to higher ratings which leads to immense profits. How do you make more money? Increase complexity!

Enter tranches. In the past consumers bought broccoli. Consumers had to buy the stems but usually threw them away. So producers decided cut them off and sell broccoli crowns. Consumers are willing to pay more because they get just the part they want. But what to do with the stems? They cut them up into little shreds and put them in salad mix, which also costs more. Consumers feel good because they get their broccoli without having to even really notice it. And everyone wins. Yay!

So instead of selling the CDOs themselves they began dividing them into categories (tranches). Not by sorting the loans, but by making different promises. If 10% of the underlying loans fail, the lower tranches lose but the higher tranches would be unscathed. It might take a default rate of, say 70% before the higher rated tranches would be affected. They then got each of these rated, essentially taking a big B-rated CDO and creating C-rated and A-rated CDOs. Both products are attractive in their own way. The low-rated CDOs have an attractively high return if they don’t fail (the term “aggressive” appeals to investors…), and the A-rated CDOs are solid safe investments.

And now feed both of these products back into the machine. Create CDOs made up of these new CDO tranches with really fancy math that further diversifies the risk. This lower risk justifies higher ratings than their constituent parts. And the immense complexity makes the rating into more and more of a judgement call, which means flexibility to incorporate a bias. It’s literally a money machine. You take a synthetic financial product, run an algorithm on it, and turn it into other products that you can sell for more. Fun!

All you need for this machine is a steady supply of high-risk loans. And the riskier the better. Solid loans have little room for improvement, the process only works on the bad ones. People place responsibility for the subprime loans on the home buyers, the mortgage brokers and companies, and the banks involved. But this is like blaming the drug dealers on the drug problem. If there’s supply, demand, and immense money to be made, chances are good that a way will be found.

The third key factor here is leverage. If you buy a subprime loan and then sell it, the leverage is 1. If the loan defaults the total loss to the economy is the amount of the loan and nothing too crazy happens. But the ability to create a synthetic product that is based on the attributes of the loans and not the loans themselves can greatly increase leverage. It’s like going to Vegas and taking out a loan to make a bet on the horses. Then taking the potential future value of that bet and using it as collateral on a new loan. Then making a bet with that loan, and repeating… If you win you win big, but if you lose you loose much more than you even have.

I’m not going to get into it much here as it’s neither new nor unique, it’s just what investors of all kinds do. The key takeaway is that leverage meant that one loan defaulting meant a total loss that was very much larger.

Note that at this point there’s still no way to bet against these CDOs. Banks could theoretically create a completely synthetic product to do so but this is where my knowledge runs out. I think it’s complicated and/or prohibited.

But the story gets better. At the end of the day the loans inside all these CDOs are risky and people know it. And banks really like the highly rated bonds better because the market is much bigger – pension funds, money-market funds, etc. How could you fundamentally change the game?

The answer, and the next piece of the puzzle, is insurance. A car loan is actually a fairly risky proposition. You can crash your car or it can get stolen. By itself, a car loan interest rate would be many times what it actually is because the interest rate would have to incorporate this risk. Instead of doing this banks require you to carry insurance. The insurance company takes on this risk in return for the premium they charge the car owner. The loan itself roughly matches the equity in the car that can be repossessed in the case of default, so it is both secured and insured, and therefore very low risk. This makes it highly rated when it is sold, and gives it a low interest rate. It’s not bad or fraudulent, it actually nicely separates the two different functions.

Despite dealing with risk, insurance is rather boring. The companies are pretty good at assessing the risk of cars, houses, lives, boats, etc.  And they compete against each other based on rates. That’s no fun. What they needed was something new to insure. But what?

How about these CDOs? Investors fear high-risk investments for the same reasons they would have a hard time dealing with car loans without insurance. There are all kind of messy, nitty-gritty real-world details like repossession, hurricanes, and floods that are hard to price. That’s what insurance companies do.

AIG led the way here. Banks showed their CDOs to AIG, which wrote up insurance policies against default, which banks then bought. Almost like car loans. These are credit default swaps (CDS). With an insurance policy, the only way the CDOs could default is if the insurance company itself failed, or if the bank failed and stopped paying the premiums. They were therefore, only as risky as the companies themselves, which were rated AA+, or the same as US treasury bills. The insurance policies made any financial instrument as safe as US treasuries. cha-ching!

Cheap money, easy loans, and subsequent rises in housing prices fueled consumer spending, building, and general economic growth. This economic growth created a huge demand for high-rated investments – safe places for people and pensions to put their new money. And the loans used for the housing, combined with financial genius, provided the fuel. Absolutely genius.

Stopping here for a key takeaway. Bad people are generally limited in the damage they can cause. The big danger is a robust system that appears perfectly fine to most people involved, and at most marginally immoral, but as the whole, rewards negative behavior with huge rewards.

At this point there would have been a global meltdown, but no movie. There was still no way for individual investors or funds to profit from it. Remember the scene where the Deutsche Bank salesperson was so eager to sell their credit default swaps? A good question to ask of anyone eager to sell is “why?”. If an investment is such a good deal for me, why did you fly here, come into my office, and spend your day pitching it to me?

Why would Deutsche Bank want to sell investments that they think will be great for the investor and a bad deal for themselves? The salesman was portrayed as a rogue trader who knew the system was going to fail and thought his own employer was stupid. This was fun for the movie but is not how global financial systems work. The banks thought they were going to win from the transaction. Why?

Remember how the banks bought those swaps? They used those to increase the rating on their CDOs, and then they sold those CDOs to investors. At that point they pocket the difference between what they paid for the subprime loans and what they were able to sell the CDOs for and enjoy their new yacht.

But there’s one problem. Swaps, like insurance premiums, must be paid for each and every month. Big-ego investment bankers on their new yacht really hate paying money each month to dumb old insurance companies. They want this stuff off their books. Why it took Michael Burry to bring the solution to them is one of the remaining mysteries to me. They should have figured it out for themselves.

Back to the car analogy – imagine you buy a car, buy insurance on it, and then sell that car to someone else for a higher price because you promise to pay the insurance on it for the life of the car and will replace it if it gets lost or totaled. If insurance is, say $3,000 per year, you might be able to charge $12,000 more than you paid. You could then pocket the difference. One problem is the risk of the car being lost or totaled, but you’re convinced that won’t happen. The remaining problem is the $3,000 per year to maintain the insurance.

Michael Burry called them up and offered to not only pay the premiums, but also pay them for the opportunity to do so. It must have been an exceptional moment for them! They are sitting there with this unfortunate byproduct of the money machine that they think is just an annoying financial obligation, and now someone wants to buy it from them. It’s beautiful. This is why the banks were quite happy to create this financial instrument and sell it to the traders.

It also left the banks with what is called naked risk. They owned neither the car nor the insurance, but they were responsible for the payoff if it got totaled.

I’ll admit I’m over my head on the last bit. Does anyone know exactly how the bank responsibility to cover default on the CDOs is expressed? Do they come with some kind of a contract?

From there on the story is simple and predictable. Couple naked risk with massive leverage and an inevitable government bailout if something goes wrong and the rest is obvious.

I think the main takeaway for today is to look for systemic flaws in ratings. One thing that would have prevented the crisis is if the ratings had accurately reflected the risk.

What jumps out at me is the ratings on the sovereign debt (treasury bills here) of most countries. They seem quite optimistic. The levels of debt are so high that there is little margin for error. Any significant economic problem at this point would decrease the ability of many countries to make good on their debt payments. This would then decrease their credit rating, and correspondingly increase the cost of any further borrowing.

This happens at the same time that government spending is most needed to spur a recovery to get out of the recession.

It would also lower the value of their currency, which generally fuels inflation as imports become more expensive. The US is in a unique and advantageous position here as our debt is denominated in our own dollars. So if the value of our currency falls, so does the value of our debt and interest payments. It’s like inflation with your home loan – your own saving and income are decreased, but so is your mortgage. But other countries are not so lucky. Their debt is valued in external currencies so if their own currency devalues their debt and debt payments actually go up.

This is a nice example of a vicious circle…

But beyond individual countries, the CDO crisis was global not just because there were risky decisions, but because the banks were all intertwined. They each bought and sold all this stuff so that at the end of the day, even figuring out who owed what to who was nearly impossible.

This interdependency is at least as true on the government level. Little old Greece threatening to default led to the brink of global economic collapse. Why? Who cares if Greece defaults? The answer is lots of people. Their debt is held by governments and financial institutions that are themselves leveraged to the edge of failure.

Debt inherently requires growth. If I borrow $10,000, and promise to pay you $11,000 next year, I am making the assumption that my income will grow over the year to come up with the $1000 interest. Global debt requires global growth that is equal-to or greater than the interest rate on that debt (minus inflation of the currency in which the debt is held). Otherwise there is default. It’s not opinion, just boring math.

In 1998 a highly-leveraged hedge fund called Long-Term Capitol Management went bust. This is normal, funds historically go under and close. What was different is that their position was so large, so highly leveraged, and so intertwined with banks that it posed systemic risk to the entire banking system. To avoid this the fed orchestrated a bailout, but it was paid for by other banks. Banks could save other banks.

In 2007 the crisis was similar but it hit so hard and happened to so many banks that there were no good banks left to save the other banks. Governments had to step in to save them.

In recent years, Greece, Ireland, and other countries have teetered on the brink of default. This is quite normal – countries default. Greece defaulted as early as the 4’th century BC, and in the modern age in 1826, 1843, 1860, 1894 and 1932. Defaults used to mainly effect the country defaulting.

Today the world economy is much more interdependent, and also more leveraged. Even the threat of default of a little country like Greece now threatens to bring down the global financial system. Today, the IMF and strong countries like Germany can step in to save them. This seems to me similar to LTCM. Countries can save countries, just as banks bailed out the fund.

The question for the future is will sovereign default risks continue to be confined to small manageable countries, or will more, and larger countries succumb? The 2007 subprime crisis happened because risk was not, in fact, localized. It all went down together. Diversification failed to matter.

So as you look at the world, the question is, are countries like Greece unique? Or are they just the first one to succumb? As I look at debt and growth rates for the world, it doesn’t look to me like Greece is that much different from a lot of countries, even our own. Sure there are lots of other factors to consider – culture, tax collection, etc… But that sounds a lot like the real-estate arguments that the L.A and NYC markets were inherently different. I don’t see it.

If 2007 happens with government debt there’s no bailout unless we find some wealthy aliens.

In the end, I’m actually not that gloomy. I think homes and land will continue to have value. Companies and their products will continue to have value and grow, and employ people. And generally people have proven to be very good at dealing with issues and somehow finding solutions. We always have until now, no matter how bad it’s been!

But I think governments are in for a very interesting time. At the same time they are becoming a massive financial risk and liability, their relevance is decreasing due to technology and the Internet. I feel a lot safe in a rated, privately-managed Uber care than in a government regulated NY taxi.

The Internet has transformed a great many economic sectors. But there are several important and huge ones that it hasn’t yet. I would say education, medical care, and finance are still lightly touched. Yes they use technology, but the Internet hasn’t gone in and ripped their heart out as it did with say, bookstores, record companies, and travel agencies. And government is also largely untouched. This will change. Hopefully we will be skillful in managing the transition.