the big short, inside the doomsday machine

18
DeSantis 1 The financial crisis of 2008 was one of the worst economic downturns in the United States which had adverse effects on the entire world. Stock markets around the globe crashed, big Wall Street firms such as Bear Stearns and Lehman Brothers collapsed because of a lack of liquidity, many investors lost a substantial portion of their portfolio in asset-backed securities, numerous citizens were left homeless because they could no longer afford to pay their increased mortgage rates, and debt outstanding was at an all-time high with the U.S. government left to clean up the mess through a bailout. The totality of these outcomes was basically the result of risky and undiversified lending as well as opaque accounting practices. The first question that must be answered is; what was the stage that allowed such a show to take place? More specifically, the show included an increase in real estate prices, home construction, no-doc mortgage lending, subprime mortgage bond creations and purchases, and other derivative securities based on underlying real estate assets. One part of the stage was the securitization of mortgages, meaning mortgages could be traded like any other security. This was a service line extension introduced by the government back in

Upload: gregory-desantis

Post on 07-Feb-2017

111 views

Category:

Documents


3 download

TRANSCRIPT

Page 1: The Big Short, Inside the Doomsday Machine

DeSantis 1

The financial crisis of 2008 was one of the worst economic downturns in the United

States which had adverse effects on the entire world. Stock markets around the globe crashed,

big Wall Street firms such as Bear Stearns and Lehman Brothers collapsed because of a lack of

liquidity, many investors lost a substantial portion of their portfolio in asset-backed securities,

numerous citizens were left homeless because they could no longer afford to pay their increased

mortgage rates, and debt outstanding was at an all-time high with the U.S. government left to

clean up the mess through a bailout. The totality of these outcomes was basically the result of

risky and undiversified lending as well as opaque accounting practices. The first question that

must be answered is; what was the stage that allowed such a show to take place? More

specifically, the show included an increase in real estate prices, home construction, no-doc

mortgage lending, subprime mortgage bond creations and purchases, and other derivative

securities based on underlying real estate assets.

One part of the stage was the securitization of mortgages, meaning mortgages could be

traded like any other security. This was a service line extension introduced by the government

back in 1970 through the establishment of the Government National Mortgage Association.

Instead of only the government or local banks essentially issuing loans, securitization provided

investors, both institutional and individual, the opportunity to buy and receive prorated shares of

the principal and interest payments on an underlying mortgage pool originated by the banks.

Such an action had two main effects. The first effect was it clearly increased capacity. Prior to

securitization, banks could only distribute as many loans as their capital would allow them to.

Pass-throughs permitted the mortgage originator to take on a great deal more of loans and sell

these loans in the secondary market. However, they still collected principal and interest

payments and passed these payments along to the mortgage purchaser for a percentage fee. In

Page 2: The Big Short, Inside the Doomsday Machine

DeSantis 2

regards to this service process, the government was able to act as an intermediary as they brought

together buyers and sellers of mortgage backed securities. The second effect was economies of

scale also were achieved. By redistributing the risk associated with home mortgage lending to

investors, the amount of lenders increased considerably. Therefore, interest rate levels offered

on mortgage loans decreased significantly and were more affordable to home buyers (Lewis

101).

Another part of the stage, which took place almost three decades later, was the answer to

the fall in stock prices around 2000. The Federal Reserve used a push strategy by dropping

interest rates from 6.5 percent to about 1 percent during this year. The reason this constituted a

push strategy is because the government lowered interest rates on home loans and the retailers

(mortgage originators) were forced to offer mortgages to home buyers at the 1 percent level.

Thus, the channel members were primarily targeted and then the consumers. This procedure had

two notable outcomes. First, low-interest rates allowed first time-homeowners to afford

mortgage financing and it also created the means for existing homeowners to trade up to more

expensive homes. Second, low interest rate mortgages created an excess demand for homes, thus

illustrating mortgage originators and home builders were implementing a pull strategy. The

surplus demand inevitably drove up prices substantially. This represented a pull strategy because

consumers expressed a market need and mortgage originators and home builders responded

through increased marketing and production efforts.

The last part of the stage was created in 1981 when John Gutfreund, the CEO of Salomon

Brothers, took the firm from a private partnership into Wall Street’s first public corporation

(Lewis 306). Shortly after, many other Wall Street firms followed suit and went public as well.

The purpose of such firms going public was to transfer the associated risk from the corporation

Page 3: The Big Short, Inside the Doomsday Machine

DeSantis 3

to the shareholders. Employees of these firms were being placed in situations where ethical

standards might be comprised in an effort to serve multiple conflicting demands at the same time

specifically to increase revenue (Fitzsimmons and Fitzsimmons 220). The shareholders who

financed the risk taking had no real understanding of what the employees were doing, and, as the

risk taking grew ever more complex, their understanding diminished (Lewis). In a metaphorical

sense, securitization, reduced interest rates, and Wall Street firms going public set the stage for

the many actors who would play a part in the show entitled The Big Short: Inside the Doomsday

Machine.

Before going into depth in each part of the show and discussing the service role of the

major actors, it is best to illustrate the interrelations and value added via swim lane flowchart

(See next page).

Page 4: The Big Short, Inside the Doomsday Machine

DeSantis 4

Page 5: The Big Short, Inside the Doomsday Machine

DeSantis 5

According to this chart, it is possible to observe that there are nine classifications of service roles

in The Big Short: Inside the Doomsday Machine. These service roles include the government,

banks (mortgage originators), home buyers, home builders, home sellers (real estate agencies),

investment banking and security firms, rating agencies, insurance companies, and institutional

and individual investors. Although the flowchart incorporates separate entities, each role is

necessary for value adding activities. This model provides an effective visual of a lean service

system because only activities that add value in the eyes of the customer are being performed

(Fitzsimmons and Fitzsimmons 195). At the first level, the government added value to the

system by making loan prices extremely attractive. At the second level, banks added value by

offering loans (which served as the capital for the down payment on the house) rather easily

regardless of consumer credit history. At the third level, home buyers added value by providing

equity for the houses and cash flows for bond holders which represent the mortgage premiums.

At the fourth level, home builders added value by constructing houses which served as the assets

backing the debt securities (subprime mortgage bonds). At the fifth level, home sellers added

value by increasing the worth of the home through amenity enhancements. Real estate agents

acted as service intermediaries and they added value by increasing the chance that a home

owner’s house would be sold on the market. At the sixth level, investment banking and security

firms added value by purchasing loans from mortgage originators and packaging the various

loans into subprime mortgage bonds. These firms further added value by taking risky bonds and

redistributing the risk by pooling them together similar to an exchange traded fund. At the

seventh level, rating agencies added value by inflating the grades of subprime mortgage bonds to

increase the demand for them. At the eighth level, insurance companies added value by

replicating subprime mortgage bonds, thus creating more securities which could generate profit.

Page 6: The Big Short, Inside the Doomsday Machine

DeSantis 6

At the ninth level, the end users are the institutional and individual investors and they added

value by making a liquid secondary market for subprime mortgage bonds.

This swim lane flowchart of services involved with an asset-backed security is also useful

because it is possible to determine the critical path. The critical path is the unbroken chain of

activities from the start to end of the system (Fitzsimmons and Fitzsimmons 375). In the

diagram above, the critical path begins at the node with the government lowering interest rates

and ends when the investor purchases an asset-backed security. From the interest rate reduction

node, the critical path continues through the home builders level until the home is placed on the

market for sale. From there, the next level the critical path proceeds to is the local bank level

which experiences bottlenecking because it takes significant time to review mortgage

applications and pool them together so that they are ready to be sold off to investment banking

and security firms. At this node loan pools are packaged into bonds and sent off to be rated.

Again, bottlenecking is experienced at this part of the critical path because the bond’s selling is

contingent on its rating and also because the process is being outsourced. Finally, the critical

path ends when a subprime mortgage bond is purchased in the bond market. Now that the flow

of value activities and relationships among service providers has been displayed, various service

models will be used to analyze the performance of the actors in each part of the show.

The first segment of the show included the enticement of home buyers. For this to occur,

interest rates would have to appear to be lower through price incentives. This was accomplished

through a two year fixed “teaser” rate. There was a trend from 1996 to 2005, where such

floating rates increased on subprime mortgage loans from 35 percent to 75 percent (Lewis 44).

As a result, demand for subprime mortgage loans increased from 5 percent to a little over 20

percent during this time frame. At the end of the two year fixed “teaser” period, the interest rate

Page 7: The Big Short, Inside the Doomsday Machine

DeSantis 7

would reset to a percentage about five times the amount of the original (usually the interest rate

would start at around 2 percent and would spike to 10 percent or higher). As long as the value of

a home buyer’s house increased they could opt to refinance, thus allowing them to continue

payments at an affordable interest rate. Price was this order-winning criteria that that attracted

home buyers and kept the assets alive which later would back the bonds.

The second segment of the show incorporated the banks which originated the

mortgages. As mentioned previously in reference to the supply chain, once banks distributed

enough loans they were pooled together and sold off to investment banking and security firms.

The floating interest rate fit marvelously into this service process because it increased capacity

utilization. Banks were approving subprime mortgage applications in 2005 at about four times

the amount they were in 1996; but why? “Loan originators like Option One and New Century

preferred to make floating-rate mortgages: To them the default was a matter of indifference, as

they kept none of the risk of the loan” (Lewis 209). This is imperative because it implies that

during the review of mortgage applications banks were accepting applications outside the control

limits they normally would use given that they were taking on the loans themselves. The

standard distribution for FICO scores on individuals who have received a mortgage loan from a

particular local bank can range from 300 to 850. Assuming that the bank was taking on the risk

of all the loans it processed the bell curve would apex around a 720 FICO score with the lower

specification limit set at 620, meaning there are limited applicants below this level. The actual

scenario provided by The Big Short: Inside the Doomsday Machine suggested a much different

bell curve; “from any given pool of loans-the average FICO score of the borrowers in the pool

needed to be around 615 [to be marketable]” (Lewis 129). Therefore, the apex of the bell curve

or FICO score average shifts from 720 to 615 with a new lower specification limit of 520. By no

Page 8: The Big Short, Inside the Doomsday Machine

DeSantis 8

means were mortgage originators operating close to the Six Sigma level because they had no

incentives to. In fact, there was a 20 percent chance that subprime mortgages issued in 2005 and

2006 would completely fail (Lewis 234).

The third and fourth segment of the show was highly integrated, as each part depended

greatly on each other to create value. Enter investment banking and security firms: Bank of

America, Bear Stearns, Citigroup, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill

Lynch, Morgan Stanley, UBS; and rating agencies such as Fitch, Moody’s, and S&P. When

Wall Street firms purchased loan pools from mortgage originators and repacked them into bonds

the concept was that more value would be linked to them considering they were integrated and

thus diversified. It was conceived that one piece of mortgage alone was too risky but several

complied together eliminated such threats. It is possible to see the thought process behind

certain investors who believed this to be true as many calculated the correlation between various

rated bonds and found it them to be relatively unrelated. Unfortunately this was not valid since

the assets backing the bonds were all driven by the same economic forces. Nevertheless, the

subprime mortgage bonds were in demand and classified in different tranches including the

equity, mezzanine, and senior with a risk and return trade off at each level (the equity level being

the most risky and the senior level being the least risky).

The risk on subprime mortgage bonds was determined by the rating agencies. Obviously

the market for triple-A rated bonds was more liquid as many institutional investors such as

pension funds were only allowed to invest in essentially risk-free securities. Therefore, the

strategy behind many of the Wall Street firms was to win customers by delivering quality.

However, it was impossible to achieve this goal legitimately seeing as the loan pools which

comprised the bonds were all subprime (low or limited FICO scores and no-docs). Regardless,

Page 9: The Big Short, Inside the Doomsday Machine

DeSantis 9

Wall Street firms were able to jigger with the perceived quality because of the feeble forces in

the structured finance industry. First off, there were not many investment banking and security

firms packaging asset-backed securities so competition was limited. As a result, the bargaining

power of suppliers was low because they only had a few options and more importantly the loans

they were holding were poor so they did not want to be left with any of them. Secondly, the

bargaining power of customers was also low. Information asymmetry stayed with the Wall

Street firms as the complexity of structured finance was extreme. Thirdly, the threat of

substitutes existed with different investments but most Wall Street firms offered these peripheral

services and during the time, specialty finance investments were very attractive. Lastly, the most

important factor in the five force analysis, which again pertains to the Wall Street firms’

suppliers, is the power over the rating agencies. Because the rating agencies had a lack of

service diversification and rating specialty finance securities comprised half of their revenue they

were dependent on the Wall Street firms for business. Understanding the advantage Wall Street

banks had over the rating agencies, these firms persuaded them into inflating the grades on

securities. To this effect, many subprime mortgage bonds were then able to be sold with more

ease. However, some bonds were unable to me marked up higher than a triple-B, mainly the

ones located in the equity tranche. To increase capacity utilization, the collateral debt obligation

was invented. Basically a CDO was a service line extension where 100 ground floors from 100

different subprime mortgage buildings were compiled (100 different triple-B-rated bonds)

(Lewis 101). Once again, Wall Street firms persuaded the rating agencies that these were a

diversified portfolio of assets. “The rating agencies, who were paid fat fees by Goldman Sachs

and other Wall Street firms for each deal they rated, pronounced 80 percent of the new tower of

debt triple-A” (Lewis). Although the CDO originally increased capacity utilization for many of

Page 10: The Big Short, Inside the Doomsday Machine

DeSantis 10

the Wall Street firms and especially Goldman Sachs, it significantly increased costs because it

took time and effort to lend billions of dollars.

The denouement of the show began with the introduction of a service line extension

known as the credit default swap with AIG FP on center stage. AIG FP was ideal to stand in the

middle of swap trading because it had an AAA rating and avoided regulation commonly

enforced on banks thus being able to hide a substantial amount of risk (Lewis). A few hedge

fund managers such as Mike Burry of Scion Capital and Steve Eisman of FrontPoint Partners

had a much dimmer view than most about the subprime mortgage bond market. It was possible

to purchase corporate credit default swaps on companies that were involved with subprime home

buyers. However, there was no derivative that was strictly based on shorting subprime mortgage

bonds. Then in 2005, Mike Burry completed the first credit default swap trade with Deutsche

Bank worth $60 million, which is yet another example of demand pull in this show. The cost

driver Mike Burry was able to capture through this action was timing. The credit default swap

was an insurance policy with a semiannual premium payment and a fixed term usually which

was over a many year period (Lewis 50). When individual homeowners went into default the

owner of the credit default swaps would be paid off incrementally (Lewis 74). The Wall Street

firms such as Deutsche Bank and Goldman Sachs acted as service intermediaries as they brought

together the buyers (Cornwall Capital, FrontPoint Partners, and Scion Capital) and sellers (AIG

FP) of credit default swaps while taking a two percent fee off the top of every trade.

Now back to the matter with the CDO being too cumbersome to continuously create,

credit default swaps were the answer to this bottleneck activity. To form a CDO, billions of

dollars had to be lent to home buyers. On the other hand, the credit default swap was simply a

synthetic replica of a CDO that was already created, based on the same underlying asset the

Page 11: The Big Short, Inside the Doomsday Machine

DeSantis 11

CDO used as collateral and it could be made many times over. Using the example of the trade

between Mike Burry and AIG FP, Mike Burry paid insurance premiums which were similar to

the semiannual cash flows coming from the original CDO and AIG FP basically owned the CDO

meaning in the event of a total default, the CDO went to zero (AIG FP would have to pay 100

cents on the dollar to Mike Burry). Not only did this increase efficiency for Wall Street firms (a

credit default could be formed in a few days as opposed to a CDO which takes much longer) but

it also brought them a new revenue stream.

In 2005, AIG FP left the market for selling credit default swaps on CDOs. This

obviously left an empty void to fill. “Now that AIG FP had exited the market, the main buyers

were CDO managers like Harding Advisory” (Lewis 177). These CDO firms were essentially

attached to big Wall Street firms and used as a way to launder a high amount of risk. When the

market for subprime mortgage bonds crashed in September 2008, it was conceivable that many

of the big Wall Street actually kept CDOs and were on the long side of credit default swaps.

Managers from Cornwall Capital assumed they sold the triple-A CDOs but the way Bear Stearns,

Lehman Brothers, and Merrill Lynch went under suggested otherwise (Lewis 292). The value

chain at every level in this system was fluent until the home buyer could no longer refinance do

to a decrease in home equity worth. The greed of the end user (Wall Street firms) was onset by

the simple notion that they were public corporations. “No investment bank owned by its

employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs”

(Lewis 307).