Inside The Doomsday Machine
Virtually no one — be they homeowners, financial institutions, rating agencies, regulators, or investors — anticipated what is occurring.
— Deven Sharma, President of Standard & Poors,
Testimony before the U.S. House of Representatives
October 22, 2008
Readers will recall that in the fall of 2008 the subprime mortgage debacle had blown up Wall Street firms and banks who had made these loans were going under. Lehman Brothers had failed and declared bankruptcy. Bear Stearns had rec’d a bailout from U.S. Taxpayers via TARP enabling it to be bought by another Wall Street firm in a sweetheart deal. Merrill Lynch became part of Bank of America. The default rate on subprime mortgages was through the roof. Foreclosures were causing people to lose their homes at an unprecedented rate.
Of course, the whole mess was caused by banks making loans to people who would never be able to pay them back. The new book Reckless Endangerment tells that story. A strawberry picker in Florida got a loan to buy a $750,000 house, as just one example. People earning less that $35,000 a year had bought 3 or 4 houses on speculation that housing prices would continues to go up and they’d make a profit. The houses were bought with generous loans and no verification of their ability to make the payments.
It wasn’t true that “virtually no one” anticipating any of this. Michael Lewis wrote a book, The Big Short, that tells the story of how at least 9 or 10 individuals as early as 2005 anticipated what would eventually happen. These were the buyers of new type of security called a “Credit Default Swap (CDS).”
Nothing is swapped in a CDS. It is really a kind of insurance policy. It’s a hedge against the possible default on a bond. The buyer pays an annual premium that guarantees payment of the amount of a bond should that bond go into default. The seller of the CDS carries the same financial risk as if he owned the bond. The buyer need not be the owner of the bond. In fact, in most CDS transactions neither seller nor buyer were the owner of the bond or package of bonds that were covered by the CDS. The difference between investing and gambling is blurred in a CDS. The gambling aspect in the CDS’s Michael Lewis writes about in his book is removed because the odds just happen to favor the buyer of the CDS to the point of near certainty. The buyers didn’t have to pull a fast one on anybody. They were making honest deals on one side of a transaction, and wondering why the other side was willing, and who really was on the other side. It seemed too good to be true. Were the Wall Street firms that were selling CDS’s to them as stupid as they appeared, or where the CDS investors missing something?
The key to CDS’s features in this story was the subprime loans being made by banks. Wall Street was packaging these loans into a new type of bond, subprime mortgage bonds called CDO’s, or collateralized debt obligations. The subprime mortgage loans were being made to people who could not repay them. It didn’t take a genius to see that the resulting CDO’s were going to default unless housing prices continued to rise in the future at the same rate they had been rising during the early part of the decade.
The amazing thing about CDO’s is that Wall Street was able to get triple A bond ratings on them from the rating agencies. They had convinced Standard & Poors and Moody’s that when you aggregate thousands of subprime loans which individually might deserve a very low rating, bundling them together resulted in a sufficient spreading of risk making the bonds worthy of a AAA rating. That was the key to selling CDO’s to investors.
Thus the individuals Michael Lewis writes about saw an opportunity. Take a short position is all this subprime lending and when housing prices stop rising, and probably start to decline, this whole scheme would crash to earth and they would make a fortune. The vehicle for the Big Short was the CDS. By the Fall of 2007 subprime mortgages were going into default at an alarming rate and by the Fall of 2008 our elected representatives in Washington D.C. were busy passing the losses on to us saps, we lowly taxpayers.
The holders of the CDS’s got rich off the bets they made on the Big Short, and the incompetent fools on Wall Street were protected from their losses by U.S. Taxpayers, who got a royal screwing. The borrowers who bought homes they couldn’t afford lost them, and had their meager financial prospects set back to a level lower than it might have been if they had never been given loans they couldn’t repay in the first place.
Near the end of The Big Short, Michael Lewis writes this sentence:
At the top of the list of concerns [of the purchasers of CDS’s ] was that the [government] might step in at any time to prevent individual American subprime mortgage borrowers from failing. The [government] never did that, of course. Instead [it] stepped in to prevent the failure of the big Wall Street firms that had contrived to bankrupt themselves by making a lot of dumb bets on subprime borrowers.
Regarding Wall Street financiers and Government Officials, Lewis says this:
[They] shared a distinction: They had proven far less capable of grasping basic truths in the heart of the U.S. financial system than a one-eyed money manager with Asperger’s syndrome [referring to stock market investor Michael Burry who discerned an opportunity to make money shorting subprime lending and discovered the CDS as the vehicle for doing it.]
Lewis started his book with the following quote from Leo Tolstoy:
The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.