An Aha! Moment
January 06, 2016
Once upon a time, a long time ago, my canvas boss boyfriend told me how the circus that we were on avoided their creditors and stayed in business.
"Easy," he said. "They just changed the name of the show."
Hold on to that thought.
Joe and I saw The Big Short over the holidays. You'd think it would be pretty boring or confusing, given that the subject matter is the financial crisis of 2008. On the contrary, it's great! I had already read the book by Michael Lewis, so I knew what it was about. I also used to work for Fannie Mae, so I had a tiny understanding of how this stuff worked. The movie tells the story of a group of people who recognized that the foundation of the surging housing market was a big shit bomb, then basically bet on the fact that the shit bomb would eventually explode, which it did. Now, you might wonder how that market managed to build itself on a big shit bomb.
The answer is simple: greed.
Let me try to explain it as simply as I can. (Disclaimer: I'll probably get some of the details wrong because this stuff is complicated and weird, and I am by no means a financial whiz kid.)(Also, the movie does a much better -- and way more entertaining -- job explaining all of this stuff than I will ever be able to do.)
One of ways that mortgage investors (like Fannie Mae, Freddie Mac, Wall Street investment banks) make money is to bundle up a bunch of mortgages into a mortgage-backed security, or MBS. For a long time, MBSs were pretty safe investments, because almost all of the people that took out the mortgages in the MBSs made their payments. Because it was a pretty safe investment, demand was very high. Wall Street, seeing a good thing, created a new type of investment: a Collaterized Debt Obligation, or CDO. A CDO is a whole bunch of MBSs packaged up together. Now, the housing bubble will never burst, right? So let's just fill up the CDOs with all kinds of mortgages, including sub-prime ones. Then we'll divide up the CDOs into tranches (which means "slice") and get people to invest in the tranches. If they want the really safe ones, they'll get a lower rate of return; if they're willing to invest in the riskier tranches, they'll get a higher rate of return.
When the people who had the underlying mortgages made their payments, the investors in the CDOs got paid -- first, the folks with the safe tranches, then the folks with the less safe tranches, and so on until the folks with the riskiest mortgages got paid.
But! If some of those risky mortgages failed, the folks who owned the risky tranches didn't get paid, because there wasn't enough money to pay them.
(But wait, there's more. There's also a thing called a "Synthetic CDO", which is similar to betting on a bet. For example, I make bet that I'll win a poker hand; you make a bet with someone else that I won't. Then yet another two people bet on that bet. And so on and so forth.)
But -- who decides what's safe and what isn't?
The rating agencies, like Moody's and Standard and Poore's.
Anyway, the supply of safe mortgages ran low, so Wall Street started creating CDOs with more and more shitty mortgages, until there really weren't any safe tranches. Meanwhile, mortgage brokers and mortgage lenders, seeing a good thing, started making loans to anybody with a pulse. No down payment? No problem? No job? No problem! Here, take this subprime adjustable-rate interest-only mortgage. Yeah, sure, that tiny little interest rate is only good for two years, but hey -- just refinance!
But those rating agencies kept everything on the up and up, right? If they rated the CDOs correctly, the investors who bought them would know what they were gambling on, right?
Well, um, no. The rating agencies succumbed to pressure from Wall Street and ended up rating the shit not as "shit", but as "gold."
For a while, everything worked just fine, because the housing bubble will never burst, right?
And then it did. Home prices plummeted. The teaser rates expired. And all of those people who had those risky mortgages couldn't make their payments and lost their houses. And even some people who could make their payments walked away, because why make a payment on a $500,000 loan when the house is only worth $100,000? And all of the investors who bought the shit-filled CDOs lost all of their investment. Those investors were not the Wall Street moguls, but pension funds, individuals, and so on. That's why your 401K took a beating.
Now, the group of folks that saw this coming -- and knew that the crash was inevitable -- bought a ton of Credit Default Swaps, or CDSs. A CDS is like insurance, only the holder of the CDS doesn't own the stuff that they're buying the insurance on. Basically, they're betting that the CDOs will fail; in other words, they shorted them. And when the CDOs did fail, the Wall Street firms that sold all of those CDSs had to pay the folks who bought them.
Except they didn't have the money. Because who woulda thunk that the housing market would collapse? Oh, only the folks who bought the CDSs!
They owed so much, in fact, that our government bailed some of them out -- Bear Stearns and AIG in particular. Lehman Brothers, though, went bankrupt. Those folks who bought the CDSs made squillions of dollars, because they recognized shit for what it was. One firm, in fact, realized a 489% return on their investment. Mind boggling.
But surely, surely, Wall Street learned its lesson!
Well, guess what? There's a new financial instrument out there now: a "Bespoke Opportunity Tranche." It's essentially the same thing as a Synthetic CDO.
And that's when it hit me. Wall Street didn't learn a thing.
They just changed the name of the show.