Are you curious about the roots, the principle actors, and the interconnectivity that caused the housing bubble and its financial support system to inflate and then implode?
If you are and want to satisfy that curiosity in a painless way, I suggest you secure a copy of Michael Lewis’s 2010 book “The Big Short”.
Lewis’s reporting is not pure academic research, but it seems to be an accurate and especially lively record of this wealth destroying event. Michael Lewis is the ultimate storyteller. His most recent book, like those before it, is filled with fascinating characters who played a major role in the development and resolution of the crisis, and permit Lewis to present the complex details of its financial underpinnings (like collateralized Debt Obligations (CDO) and Swaps of these opaque products) in an understandable and comprehensive manner.
“The Big Short” reveals the incentives and the financial machinery that was invented and introduced by a Wall Street that was mostly driven by the profit motive. Lewis names those responsible, and offers no forbearance. The book is filled with villains, but also identifies some unlikely heroes.
At the base of the villain list are the individual home buyers, many of whom simply lied about their jobs and incomes. In the end, the no-documentation loans originated by the loaning agencies and accepted by unqualified home buyers were doomed. Lewis reports about a Bakersfield, California strawberry picker who received a $724,000 loan, the total selling price of the house, when his annual income was merely $14,000. Do you think he survived the market downturn, or could even pay his summer air conditioning electrical bill?
The deceptive practices and misleading interest rate quotes generated by outfits like the failed Household Finance Corporation (HFC) were highlighted. The discredited HFC operation sold loans to uneducated buyers by improperly citing the interest rate on an equivalent 30-year mortgage, that was actually signed on the basis of a 15-year contract. This trickery permitted the unscrupulous lender to quote a false annual rate that was almost one-half the rate he was charging in reality.
The big Wall Street Investment Banks were major players. They not only invented many of these highly leveraged products, but they also did themselves a disservice using grossly faulty statistical analyses methods that underestimated default probabilities and their own Value-at-Risk. In the end, they bought into their own junk science.
Lewis identified Goldman-Sachs, Deutsche Bank, and Morgan Stanley as essential innovators, participants, and big time losers. Some of these firms kept selling their defective products to sophisticated, but unknowing, institutional investors and hedge funds even while the markets for these dubious products were collapsing.
Lewis described several financial advisors whose incentives were profit alone, without regard to protect their unsuspecting, far too trusting, clients. These advisors demanded and were rewarded with high fees for this disservice.
The analytical models were based on a set of doubtful assumptions. The data set timeframe was far too small to be statistically relevant. The modeling wrongly assumed diversification, not only in location, but also in product mix. The models postulated low correlation coefficients when in fact, the correlations approached the perfect level. A normal Bell Curve distribution was embedded in the Black-Scholes formulation that was used to price the products. That also proved to be erroneous. As did the fact that statistical fat-tails and the likelihood of Black Swan events were totally ignored
The statistical characteristics of the various loan pools and their tranches were incompletely documented. Most reports only listed averages without even including standard deviation data. For example, only an average FICO score was reported. That’s equivalent to saying that a group of nine unemployed workers plus Bill Gates had a millionaire’s average earnings level. Improperly formulated statistics can present a very distorted picture. The housing loan statistical modeling was a disaster zone, and gave True Believers a false sense of security.
Almost all housing bubble participants did not recognize the pervasiveness of the subprime lending. Almost nobody recognized that it was the 800-pound gorilla in that segment of the marketplace. Joe Cassano, chief boss at AIG Financial Products, never understood what fraction of his firm’s risk profile was tied to this particular financial structure. Yale professor Gary Gorton, the expert who built the AIG-FP model, never appreciated the percentage of subprime loans to which AIG was exposed. True risk mitigation by diversification was not accomplished in any of these first tier financial firms.
The rating agencies, Standard and Poor’s, Moody’s and Fitch, also participated in the Kabuki dance. They were complicit in allowing substandard housing loans that were well below triple-A quality to be repackaged in a manner that allowed these defective loans to be reevaluated as investment grade quality. The rating agency people were hoodwinked by the Wall Street crowd. That’s almost to be expected since the rating agency pay scale is so depressed relative to what Wall Street pays its employees. The smartest financial folks migrate towards the deep money incentives.
Somehow these rating companies deceived themselves that they possessed the power to convert Lead unto Gold. The Gold Rule wins again; he who has the Gold, dictates the Rules. And Wall Street has the Gold.
As a sidebar, the Rating firms claimed that their scoring was misinterpreted and misused. They argued that their assessments were quantitative, not qualitative. Hence the outfits using their judgments should not have assigned a failure probability based on the scoring; the scoring only yielded a relative ranking.
This is a rather long list of villains. But there were some heroes, at least given a modest definition of hero. There were a few individuals who recognized the pitfalls that were imbedded in the sub-prime real estate derivatives markets. Michael Lewis gives the story heart and pathos by introducing these less than perfect money managers to us. Although this small group viewed the market from distinctly different perspectives, they each saw the cracks in the smoke and mirrors charade.
Here is a short list of some of the unlikely heroes; Michael Burry of Scion Capital, Charlie Ledley of Cornwall Capital, and Steve Eisman of FrontPoint Partners. These men were short sellers during the mid-2000s and made enormous profits for their hedge fund clients. Each of their stories is unique and captured in Lewis’s engaging storytelling.
You must read the Lewis book to get a more precise picture of the short sellers contribution to the story line. I recommend that you do. The Big Short documents the chicanery that bank lenders and Wall Street perpetrated on a too trustworthy public. It once again demonstrates the need to be a skeptical investor. As one of the characters in the Lewis book constantly asked: “How are they going to screw me?” In Wall Street dealings, that is a relevant and necessary question.
There are plenty of lessons to be learned from the housing market debacle and from the financial mess that fueled and exacerbated the bubble. From a grand macroeconomical perspective, it demonstrated the complexity, the interconnectedness of that rugged landscape.
In economics, things do not happen in isolation. As the French economist Frederic Bastiat noted by the title of one of his most important essays “That Which is Seen, and That Which is Not Seen”, it is critical to identify and to assess the secondary and perhaps unanticipated effects of any market action. The subprime housing debacle is yet another illustration of unintended consequences.
Another enduring lesson learned from the housing market crisis was that leverage kills. The Wall Street investment banks were typically leveraged by multiples of over 10 to 1 ratios in their oversized commitments to CDOs and the insurance CDO swaps that they also sold. They lost billions.
On a very practical lessons learned level, the housing bubble and its crash demonstrates yet again the pervasiveness of the money incentive. That’s almost a given since we are mostly in the marketplace to satisfy our financial goals. As always, its good investment policy to follow the incentive money trail.
You will enjoy the stories that make “The Big Short” a lively read. You will also learn some of the how, who and why of the subprime real estate derivatives fiasco. You will be a wiser investor from learning its lessons.
In his book’s Epilogue section, Lewis finds that “Everything is Correlated”. Indeed it is. The primary theme of Complexity Theory is the interconnectivity that ties global agents together. Especially today, one event triggers many reactions, some positive and some negative. Expect a cascade of primary, secondary, and tertiary avalanches. Marketplace correlation coefficients have become tighter with time. Recall, no happening is an island onto itself. We often can not identify the potential network of interactions.