The Big Short by Michael Lewis

I'd have thought Michael Lewis was just a financial writer, as I ran across a reference to this book along with his book about the Wall Street junk bond scandals of the Eighties, Liar's Poker, but it turns out he does write other things, most notably the book adaptation of The Blind Side - a great tearjerker feel-good movie if ever there was one. He still has the chops to write about the seamy side of Wall Street though, and this provides a pretty good picture of what really led up to the huge financial collapse of 2008, from the point of view of some folks who actually saw the disaster coming, and placed their bets accordingly.

I learned quite a bit more about CDOs, tranches, and credit default swaps that I hadn't understood before. For a long time, bond investors were reluctant to invest in home mortgage loans. The problem with home loans, from an investment standpoint, had always been that people would refinance their homes whenever interest rates dropped. When the loans are paid off, the bonds are, in effect, "called", and the investor gets back his principal, which he now has to re-invest in the middle of a lower interest rate environment than before. In order to lure investors into bonds, the big investment banks, starting with Salomon Brothers, created giant pools of home loans divided into tranches, which behaved like the floors of a building.

The loans most likely to be paid off when interest rates dropped were put in the lowest floors of these structures, and people who invested in these lower tranches got a higher interest rate on their bonds to begin with, which would make up for the trouble and cost of re-investing when the loans got paid off. As the likelihood of a payoff decreased for the multiple tranches, lower interest rates were paid on the bonds. When these types of investments first appeared, investors were more worried about getting paid back too quickly, but not so much about losing their entire investment because the loans went bad.

As a result of the loosening of lending standards, and the political pressure brought to bear by the Community Reinvestment Act, banks and consumer finance businesses began to make more risky loans than had been the case in the past. One of the quotes from the book says it quite well, and may as well have been the motto of several recent administrations. "How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans." What was called the subprime lending industry got started in the early 1990s, and really hit its stride around the turn of the century, as everyone jumped on the bandwagon.

I can recall during that time many of my coworkers who had gotten laid off going into business for themselves as mortgage brokers, real estate agents, or even financial planners. The market was booming, the bubble inflating, and the pigs were feeding at the trough all up and down the subprime pipeline. Ordinary people were using their houses as collateral to borrow far more than they could afford to pay back, and many of them were buying into the stock market bubble that was created by a ton of ready cash.

One of the really fascinating things about this book was that it shows numerous examples of the people who were in charge at the investment banks, and those who packaged and sold these CDOs, really had no idea how bad the underlying loans were, and how little it would take to collapse the house of cards. They all seemed to think, since it hadn't happened in 70 years, that housing prices could never decline. The folks who saw more clearly, and created their own hedge funds to bet against the subprime packed CDOs, understood that prices couldn't go up forever - the typical 3 to 1 ratio of median housing prices to median income had rapidly gone to 4 to 1 nationwide, and was as high as 10 to 1 in many metropolitan areas - and after some analysis, they discovered that it wouldn't take a price decrease, just for prices to level off would cause nearly all of these loans to begin defaulting.

I really had no idea just how crazy the lending practices had gotten, and one of the options I read about here just floored me. It was called a 100 percent floating rate negative-amortizing mortgage.  The borrower could choose not to make even the interest payment for a set period of time, and the interest would just be added to the principal of the loan, growing larger and larger until they either decided to pay or to default on the loan.

Something I've thought on occasion about the job of senior management was expressed quite eloquently by one of the hedge fund managers who had worked for Deutsche Bank. "Sentior management's job is to pay people. If they f**k a hundred guys out of a hundred grand each, that's ten million more for them. They have four categories: happy, satisfied, dissatisfied, disgusted. If they hit happy, they've screwed up: They never want you happy. On the other hand, they don't want you so disgusted you quit. The sweet spot is somewhere between dissatisfied and disgusted."

After reading this, I began to see the logic in which investment banks failed when things crashed, or had their stock prices decline horribly, mostly based on how many of these bonds backed by shaky loans they kept "in-house". Credit default swaps were invented as a kind of insurance on these investments. If you bought a CDS on a particular tranche (part of the big bond bundle), you paid a premium every year to keep it in force, and if the bonds went bad, you were paid the entire value of the bond. Since the premiums on a billion dollar bond might only be two million dollars a year (chuckles - only?), when these things began to default, it was a big payoff on the bet for the hedge fund guys who saw what was coming. Some of the investment banks also owned this "insurance" on the CDOs, and a large number of those policies were backed by...you guessed it...AIG. Who got 80 billion in TARP money?

After reading this, I still firmly believe that there's plenty of blame to go around. The number of "innocent" consumers who were possibly duped into taking out unpayable loans pales in comparison to all of the greed and incompetence displayed at all levels of this debacle, from the loan originators to the investment banks, to the ratings agencies, to the insurance companies who went along with the deals...It boggles the mind.