The Big Short and Mass Financial Delusion

By John Kafalas, MBA530, Prof. John Dunn

[This was written for my summer-school law class in the MBA program at URI]

Michael Lewis’s The Big Short gives a concise and surprisingly simple explanation for the financial crisis of 2007. Besides being entertaining reading – even for someone who took heavy losses from the Great Recession that followed the crisis – Lewis has a good sense of the incentives, conflicts of interest, and groupthink that led to the largest financial catastrophe of our time. Ultimately, his dark vision of what our political/economic system has become is summed up neatly: “Free money for capitalists, free markets for everyone else.”[1] As we will see, Lewis’s account of the crisis, as being primarily related to unsound collateralized debt obligations (CDOs), is supported by Anna Katherine Barnett-Hart’s exhaustive 2009 study of 735 of these asset-backed securities, which determined that, in fact, the low quality of the mortgage loans underlying the bonds themselves made the CDOs highly dangerous investments. (Note: I refer to Barnett-Hart’s paper frequently, because Lewis notes, in the acknowledgements to The Big Short, that it was a significant source of analysis underlying his own work.)

Background

The basic problem, in my view, is that the wealthiest investors – the one percent, if you will – are not satisfied with returns that are based on growth of the economy as a whole. They’re always trying to beat the system and achieve higher returns than are really out there in the economy, at some level. This is the primary reason why bubbles happen.

During the bubble years – defined here as roughly post-9/11 until 2007 – investors who had just finished turning the technology industry into a casino via the dot-com bubble, were looking for the next outsized return, and saw residential real estate as fertile ground for speculation. The chronology was that the start of the real estate boom preceded the financial excesses of The Big Short by a few years. My own recollection of the period is that early in the 2000s, speculative fever trickled down to the middle class as well. Everyone got a real-estate license, and TV shows like “Flip This House” made it sound as though anyone with a few dollars to make a downpayment could buy a house, hold it for a few months, possibly upgrading a few things, and sell it at an enormous profit. Visiting my sister in San Diego in early 2003, I was amazed to find that residential real estate had just appreciated 36% in the past year, after several years of ridiculous appreciation before that. Meanwhile, the seeds of destruction were being sown by mortgage lenders, with their interest-only products. Just as the sure sign of a stock-market bubble is a cab driver giving investment advice, TV advertisements for these financial products signalled an unsustainable frenzy for real estate speculation. An interest-only mortgage isn’t a mortgage at all – the borrower is really just renting the property, not buying it. Lewis discusses interest-only and teaser-rate loans as major contributors to the collapse of mortgage-backed CDOs.

Living in Arizona from 1999 until 2006, between Phoenix and Las Vegas, I was at the epicenter of a major regional speculative bubble. In 2006, a golf course I used to play in Williams, AZ, was lined with brand-new empty houses, all with For Sale signs in front of them. Clearly, the pace of house-building and mortgage-pitching were unsustainable – something had to give. But in the meantime, with prices still going up 30%/year, it was difficult, as Lewis illustrates, to be the first to recognize what was going on. One can miss out on a lot of profit by being right too soon, and this was the case with Mike Burry and the other protagonists in The Big Short -- just as the gold-bugs who now believe that the national debt makes hyperinflation inevitable have nonetheless missed out on the profits equity investors have made since 2009.

Lewis paints a surreal picture of the spring of 2007, when homeowners began to default on subprime mortgage loans at an alarming rate, yet the CDOs made up of those loans were still trading at high prices, like Wile E. Coyote hanging in the air for some time after running off a cliff.

Lewis’s discussion of the financial products that grew up around the real estate bubble highlights an inconsistent government policy: deregulation of financial institutions and investment products, but an eagerness to step in and bail out those same institutions when they go bankrupt. The “synthetic” instruments of credit default swaps (CDSes) were not regulated as insurance nor as gambling games, which is closer to what they were. Lewis’s summary of the pre-crash situation mirrors my own incredulity at the gravity-defying real estate market I observed in the Southwest – the belief “that the collapse of the subprime mortgage market was unlikely precisely because it would be such a catastrophe. Nothing so terrible could ever happen.”[2]

Obviously, the rating agencies who allowed investment banks to game the system and achieve triple-A ratings for flimsy CDOs should have been held accountable for dropping the ball. Any auditor confronted with a client’s refusal to disclose critical financial information will issue a qualified opinion, stating that information necessary to give an unqualified opinion was not provided. The rating agencies should have had explicit, written policies requiring their analysts to refuse to rate a financial instrument unless complete information was provided. (Lewis doesn’t say, but most likely, the ratings agencies do have such policies but didn’t follow them, because to do so would have cost them a lot in fees.) The fact that rating fees are paid by the financial institutions is an obvious conflict of interest – analogous to the situation of auditors being paid by the companies they audit, a problem the accounting profession has not sorted out, either.

Barnett-Hart’s paper, written when she was an undergraduate at Harvard, states that CDOs were responsible for $542 billion in losses.[3] While losing this mind-boggling sum, the author states, “almost all market participants, from investment banks to hedge funds, failed to question the validity of the models that were luring them into a false sense of security about the safety of these manufactured securities.”[4] Judging from Lewis’s discussion, I would characterize their mindset as massive groupthink and denial, fostered by the enormous profits the CDOs (and CDSes, for a time) were generating for the companies issuing them. Residential real estate was traditionally thought of as an investment that only moved in one direction: up. This no doubt contributed to the denial, groupthink, or “false sense of security,” much as it contributed to my own puzzlement at the seemingly impossible rise in real estate values in Arizona at the time. Barnett-Hart also describes the rise of “synthetic CDOs created from pools of credit-default swap contracts, essentially insurance contracts protecting against default of specific asset-backed securities.”[5] If I’m understanding this correctly, these were bonds consisting of bundles of CDSes betting against other CDOs. Furthermore, CDSes themselves “gave CDO managers the freedom to securitize any bond without the need to locate, purchase, or own it prior to issuance.[6] In case that’s not abstract enough, there was even an ABX Index, a series of credit-default swaps based on 20 bonds made up of subprime mortgages, and investors could (and still can) speculate on ABX contracts. Barnett-Hart quotes Congressional testimony from a former Standard & Poor’s analyst who stated that essential credit information was not provided by CDO underwriters but that he was pressured to “devise some method” to provide a credit estimate nonetheless.[7] When you combine this with Lewis’s indictment of ratings analysts as being on the lowest rung of the ladder -- underpaid, not bright financial minds -- it’s clear that the phony bond ratings served as a major enabler for the whole unsustainable bubble in mortgage-backed securities. Barnett-Hart discusses how the rating agencies abdicated their responsibility to be consistent and meaningful, exemplified by the fact that, “Fitch’s model showed such unreliable results using its own correlation matrix that it was dubbed the ‘Fitch’s Random Ratings Model.’”[8] Barnett-Hart concludes that, “Overall, the credit ratings of CDOs have been an utter disaster.”[9]

Perhaps the most striking aspect of Lewis’s story, as he tells it, is how few people saw what was going on and tried to find a way to take advantage of it. When Burry, Eisman, Lippmann, and the others initially tried to short CDOs, they found that (a) investment banks had no idea what they were talking about, and (b) they were concerned that they must be missing something important, since no one else was doing it. For my part – and I was in business school at the time, studying accounting – although I sensed that this can’t possibly be right, I had no idea of the calamity that was in store, simply because of the sheer volume of nothing-but-up sentiment prevailing at the time.

Lewis saves his harshest criticism, however, for the group of government officials and financial executives charged with picking up the pieces. Much in the manner of officials who re-framed the 1906 San Francisco earthquake as a fire, the 2007-8 debacle was “framed as old-fashioned financial panic – but in 2008… a crowded theater burned down with a lot of people still in their seats.”[10] Further, the administrators of TARP were “the people in a position to resolve [the crisis and] had failed to foresee it… who should have known more about what Wall Street firms were doing, back when they were doing it.” Lewis calls out Treasury Secretary Henry Paulson and his future successor Timothy Geitner, Fed Chairman Ben Bernanke, Goldman Sachs CEO Lloyd Blankfein, and others as “far less capable of grasping basic truths than a one-eyed money manager with Asperger’s syndrome.”[11] Lewis stops short of actually accusing Paulson of corruption or abuse of power, but nonetheless he expresses disgust at Paulson’s having paid Goldman (his old firm) in full for the $13 billion owed to it by AIG.

The Wall Street titans who failed to see the crisis coming may indeed have known less about what was going on than a one-eyed money manager – and in the wake of the crisis, they have shown less insight into what happened than did a Harvard undergraduate. In Barnett-Hart’s view, “it was a combination of poor collateral quality, lax underwriting standards, and inaccurate credit ratings that allowed the construction of a trillion-dollar CDO ‘house of cards.’”[12] She cites Financial Accounting Standards Board Statement No. 157, Fair Value Measurements, adopted in response to the need for more realistic balance-sheet reporting of derivatives, as a standard that forced firms such as AIG, Merrill Lynch, and Citigroup to record multibillion-dollar write-downs in 2008. But this amounts to locking the barn door after the horse, cattle, and two-thirds of the tractor fleet have been stolen – there was no reversing the crisis at that point.

Barnett-Hart concludes that “the CDO may be unequivocally dead.”[13] But that was in 2009. In 2014, evidence mounts that people do not learn their lessons. Or, looked at another way, they learn their lessons too well. As Geithner argues in Stress Test, the government had no choice but to prop up failing financial institutions – and it couldn’t, or at least wouldn’t, punish the people who caused the crisis, either. So the investors who want artificially high returns are at it again -- synthetic CDOs are making a comeback, as reported in a June 29 story in Financial Times, noting that “investors flock to the higher yields on offer from buying the securitisations and as big banks feel more comfortable selling the loans.” History repeats itself.