This article will explain the Big Short and the 2008 subprime mortgage collapse in simple terms.
This post is a little longer than usual–maybe give yourself 20 minutes to sift through it. But I promise you’ll leave feeling like you can tranche (that’s a verb, right?!) the whole financial system!
First, I want to introduce the players in the financial crisis, as they might not make sense at first blush. One of the worst parts about the financial industry is how they use deliberately obtuse language to explain relatively simple ideas. Their financial acronyms are hard to keep track of. In order to explain the Big Short, these players–and their roles–are key.
Individuals, a.k.a. regular people who take out mortgages to buy houses; for example, you and me!
Mortgage lenders, like a local bank or a mortgage lending specialty shop, who give out mortgages to individuals. Either way, they’re probably local people that the individual home-buyer would meet in person.
Big banks, such as Goldman Sachs and Morgan Stanley, who buy lots of mortgages from lenders. After this transaction, the homeowner would owe money to the big bank instead of the lender.
Collateralized debt obligations (CDOs)—deep breath!—who take mortgages from big banks and bundle them all together into a bond (see below). And just like before, this step means that the home-buyer now owes money to the CDO. Why is this done?! I’ll explain, I promise.
Ratings agencies, whose job is to determine the risk of a CDO—is it filled with safe mortgages, or risky mortgages?
Investors, who buy part of a CDO and get repaid as the individual homeowners start paying back their mortgage.
Feel lost already? I’m going to be a good jungle guide and get you through this. Stick with me.
Quick definition: Bonds
A bond can be thought of as a loan. When you buy a bond, you are loaning your money. The issuer of the bond is borrowing your money. In exchange for borrowing your money, the issuer promises to pay you back, plus interest, in a certain amount of time. Sometimes, the borrower cannot pay the investor back, and the bond defaults, or fails. Defaults are not good for the investor.
The CDO—which is a bond—could hold thousands of mortgages in it. It’s a mortgage-backed bond, and therefore a type of mortgage-backed security. If you bought 1% of a CDO, you were loaning money equivalent to 1% of all the mortgage principal, with the hope of collecting 1% of the principal plus interest as the mortgages got repaid.
There’s one more key player, but I’ll wait to introduce it. First…
The Whys, Explained
Why does an individual take out a mortgage? Because they want a home. Can you blame them?! A healthy housing market involves people buying and selling houses.
How about the lender; why do they lend? It used to be so they would slowly make interest money as the mortgage got repaid. But nowadays, the lender takes a fee (from the homeowner) for creating (or originating) the mortgage, and then immediately sells to mortgage to…
A big bank. Why do they buy mortgages from lenders? Starting in the 1970s, Wall St. started buying up groups of loans, tying them all together into one bond—the CDO—and selling slices of that collection to investors. When people buy and sell those slices, the big banks get a cut of the action—a commission.
Why would an investor want a slice of a mortgage CDO? Because, like any other investment, the big banks promised that the investor would make their money back plus interest once the homeowners began repaying their mortgages.
You can almost trace the flow of money and risk from player to player.
At the end of the day, the investor needs to get repaid, and that money comes from homeowners.
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CDOs are empty buckets
Homeowners and mortgage lenders are easy to understand. But a big question mark swirls around Wall Street’s CDOs.
I like to think of the CDO as a football field full of empty buckets—one bucket per mortgage. As an investor, you don’t purchase one single bucket, or one mortgage. Instead, you purchase a thin horizontal slice across all the buckets—say, a half-inch slice right around the 1-gallon mark.
As the mortgages are repaid, it starts raining. The repayments—or rain—from Mortgage A doesn’t go solely into Bucket A, but rather is distributed across all the buckets, and all the buckets slowly get re-filled.
As long as your horizontal slice of the bucket is eventually surpassed, you get your money back plus interest. You don’t need every mortgage to be repaid. You just need enough mortgages to get to your slice.
It makes sense, then, that the tippy top of the bucket—which gets filled up last—is the highest risk. If too many of the mortgages in the CDO fail and aren’t repaid, then the tippy top of the bucket will never get filled up, and those investors won’t get their money back.
These horizontal slices are called tranches, which might sound familiar if you’ve read the book or watched the movie.
So far, there’s nothing too wrong about this practice. It’s simply moving the risk from the mortgage lender to other investors. Sure, the middle-men (banks, lenders, CDOs) are all taking a cut out of all the buy and sell transactions. But that’s no different than buying lettuce at grocery store prices vs. buying straight from the farmer. Middle-men take a cut. It happens.
But now, our final player enters the stage…
Credit Default Swaps: The Lynchpin of the Big Short
Screw you, Wall Street nomenclature! A credit default swap sounds complicated, but it’s just insurance. Very simple, but they have a key role to explain the Big Short.
Investors thought, “Well, since I’m buying this risky tranche of a CDO, I might want to hedge my bets a bit and buy insurance in case it fails.” That’s what a credit default swap did. It’s insurance against something failing. But, there is a vital difference between a credit default swap and normal insurance.
I can’t buy an insurance policy on your house, on your car, or on your life. Only you can buy those policies. But, I could buy insurance on a CDO mortgage bond, even if I didn’t own that bond!
Not only that, but I could buy billions of dollars of insurance on a CDO that only contained millions of dollars of mortgages.
It’s like taking out a $1 million auto policy on a Honda Civic. No insurance company would allow you to do this, but it was happening all over Wall Street before 2008. This scenario essentially is “the big short” (see below)—making huge insurance bets that CDOs will fail—and many of the big banks were on the wrong side of this bet!
Credit default swaps involved the largest amounts of money in the subprime mortgage crisis. This is where the big Wall Street bets were taking place.
Quick definition: Short
A short is a bet that something will fail, get worse, or go down. When most people invest, they buy long (“I want this stock price to go up!”). A short is the opposite of that.
Certain individuals—like main characters Steve Eisman (aka Mark Baum in the movie, played by Steve Carrell) and Michael Burry (played by Christian Bale) in the 2015 Oscar-nominated film The Big Short—realized that tons of mortgages were being made to people who would never be able to pay them back.
If enough mortgages failed, then tranches of CDOs start to fail—no mortgage repayment means no rain, and no rain means the buckets stay empty. If CDOs fail, then the credit default swap insurance gets paid out. So what to do? Buy credit default swaps! That’s the quick and dirty way to explain the Big Short.
Why buy Dog Shit?
Wait a second. Why did people originally invest in these CDO bonds if they were full of “dog shit mortgages” (direct quote from the book) in the first place? Since The Big Short protagonists knew what was happening, shouldn’t the investors also have realized that the buckets would never get refilled?
For one, the prospectus—a fancy word for “owner’s manual”—of a CDO was very difficult to parse through. It was hard to understand exactly which mortgages were in the CDO. This is a skeevy big bank/CDO practice. And even if you knew which mortgages were in a CDO, it was nearly impossible to realize that many of those mortgages were made fraudulently.
The mortgage lenders were knowingly creating bad mortgages. They were giving loans to people with no hopes of repaying them. Why? Because the lenders knew they could immediately sell that mortgage—that risk—to a big bank, which would then securitize the mortgage into a CDO, and then sell that CDO to investors. Any risk that the lender took by creating a bad mortgage was quickly transferred to the investor.
So…because you can’t decipher the prospectus to tell which mortgages are in a CDO, it was easier to rely on the CDO’s rating than to evaluate each of the underlying mortgages. It’s the same reason why you don’t have to understand how engines work when you buy a car; you just look at Car & Driver or Consumer Reports for their opinions, their ratings.
The Ratings Agencies
Investors often relied on ratings to determine which bonds to buy. The two most well-known ratings agencies from 2008 were Moody’s and Standard & Poor’s (heard of the S&P 500?). The ratings agency’s job was to look at a CDO that a big bank created, understand the underlying assets (in this case, the mortgages), and give the CDO a rating to determine how safe it was. A good rating is “AAA”—so nice, it got ‘A’ thrice.
So, were the ratings agencies doing their jobs? No! There are a few explanations for this:
- Even they—the experts in charge of grading the bonds—didn’t understand what was going on inside a CDO. The owner’s manual descriptions (prospectuses) were too complicated. In fact, ratings agencies often relied on big banks to teach seminars about how to rate CDOs, which is like a teacher learning how to grade tests from Timmy, who still pees his pants. Timmy just wants an A.
- Ratings agencies are profit-driven companies. When they give a rating, they charge a fee. But if the agency hands out too many bad grades, then their customers—the big banks—will take their requests elsewhere in hopes of higher grades. The ratings agencies weren’t objective, but instead were biased by their need for profits.
- Remember those fraudulent mortgages that the lenders were making? Unless you did some boots-on-the-ground research, it was tough to uncover this fact. It’s hard to blame the ratings agencies for not catching this.
Who’s to blame?
Everyone? Let’s play devil’s advocate…
- Individuals: some people point the finger at homeowners, saying, “You should know better than to buy a $1 million house on a teacher’s salary.” I find this hard to swallow. These people, surrounded by the American home-ownership dream, were sold the idea that they would be fine. The mortgage lender had no incentive to sell a good mortgage, they only had an incentive to sell a mortgage. So, it’s hard for me to put too much blame on the homeowners.
- Mortgage lenders: someone knew. I’m not saying that all the mortgage lenders were fully aware of the implications of their actions, but some people knew that fraudulent loans were being made, and chose to ignore that fact. For example, check out whistleblower Eileen Foster.
- Big banks: Yes sir! There’s certainly blame here. Rather than get into all of the various money-grubbing, I want to call out one specific anecdote. Back in 2010, Goldman Sachs CEO Lloyd Blankfein testified in front of Congress. Here it is:
To explain further, there are two things going on here.
First, Goldman Sachs bankers were selling CDOs to investors. They wanted to make a commission on the sale.
At the same time, other bankers ALSO AT GOLDMAN SACHS were buying credit default swaps, a.k.a. betting against the same CDOs that the first Goldman Sachs bankers were selling.
This is like selling someone a racehorse with cancer, and then immediately going to the track to bet against that horse. Blankfein’s defense in this video is, “But the horse seller and the bettor weren’t the same people!” And the Congressmen responds, “But they worked for the same stable, and collected the same paychecks!”
So do the big banks deserve blame? You tell me.
Inspecting Goldman Sachs
One reason Goldman Sachs survived 2008 is that they began buying credit default swaps (insurance) just in time before the housing market crashed. They were still on the bad side of some bets, but mostly on the good side. They were net profitable.
Unfortunately for them, the banks that owed Goldman money were going bankrupt from their own debt, and then Goldman never would have been able to collect on their insurance. Goldman would’ve had to payout on their “bad” bets, while not collecting on their “good” bets. In their own words, they were “toast.”
This is significant. Even banks in “good” positions would’ve gone bankrupt, because the people who owed the most money weren’t able to repay all their debts. Imagine a chain; Bank A owes money to Bank B, and B owes money to Bank C. If Bank A fails, then B can’t collect their debt, and B can’t pay C. Bank C made “good” bets, but aren’t able to collect on them, and then they go out of business.
These failures would’ve rippled throughout the world. This explains why the US government felt it necessary to bail-out the banks. That federal money allowed banks in “good” positions to collect their profits and “stop the ripple” from tearing apart the world economy. While CDOs and credit default swap explain the Big Short starting, this ripple of failure is the mechanism that affected the entire world.
Betting more than you have
But if someone made a bad bet—sold bad insurance—why didn’t they have money to cover that bet? It all depends on risk. If you sell a $100 million insurance policy, and you think there’s a 1% chance of paying out that policy, what’s your exposure? It’s the potential loss multiplied by the probability = 1% times $100 million, or $1 million.
These banks sold billions of dollars of insurance under the assumption that there was a 5%, or 3%, or 1% chance of the housing market failing. So they had 20x, or 30x, or 100x less money on hand then they needed to cover these bets.
Turns out, there was a 100% chance that the market would fail…oops!
Ratings agencies—they should be unbiased. But they sold themselves off for profit. They invited the wolves—big banks—into their homes to teach them how to grade CDOs. Maybe they should read a blog to explain the Big Short to them. Of course they deserve blame. Here’s another anecdote of terrible judgment from the ratings agencies:
Think back to my analogy of the buckets and the rain. Sometimes, a ratings agency would look at a CDO and say, “You’re never going to fill up these buckets all the way. Those final tranches—the ones that won’t get filled—they’re really risky. So we’re going to give them a bad grade.” There were “Dog Shit” tranches, and Dog Shit gets a bad grade.
But then the CDO managers would go back to their offices and cut off the top of the buckets. And they’d do this for all their CDOs—cutting off all the bucket-top rings from all the different CDO buckets. And then they’d super-glue the bucket-top rings together to create a field full of Frankenstein buckets, officially called a CDO squared. Because the Frankenstein buckets were originally part of other CDOs, the Frankenstein buckets could only start filling up once the original buckets (which now had the tops cut off) were filled. In other words, the CDO managers decided to concentrate all their Dog Shit in one place, and super glue it together.
A reasonable person would look at the Frankenstein Dog Shit field of buckets and say, “That’s turrible, Kenny.”
BUT THE RATINGS AGENCIES GAVE CDO-SQUAREDs HIGH GRADES!!! Oh I’m sorry, was I yelling?!
“It’s diversified,” they would claim, as if Poodle shit mixed with Labrador shit is better than pure Poodle shit.
Again, you tell me. Do the ratings agencies deserve blame?!
Does the government deserve blame?
Yes and no.
For example, part of the Housing and Community Development Act of 1992 mandated that the government mortgage finance firms (Freddie Mac and Fannie Mae) purchase a certain number of sub-prime mortgages.
On its surface, this seems like a good thing: it’s giving money to potential home-buyers who wouldn’t otherwise qualify for a mortgage. It’s providing the American Dream.
But as we’ve already covered today, it does nobody any good to provide a bad mortgage to someone who can’t repay it. That’s what caused this whole calamity. Freddie and Fannie and HUD were pumping money into the machine, helping to enable it. Good intentions, but they weren’t paying attention to the unintended outcomes.
And what about the Securities & Exchange Commission (SEC), the watchdogs of Wall Street. Do they have a role to explain the Big Short? Shouldn’t they have been aware of the Big Banks, the CDOs, the ratings agencies?
Yes, they deserve blame too. They’re supposed to do things like ensure that Big Banks have enough money on hand to cover their risky bets. This is called proper “risk management,” and it was severely lacking. The SEC also had the power to dig into the CDOs and ferret out the fraudulent mortgages that were creating them. Why didn’t they do that?
Perhaps the issue is that the SEC was/is simply too close to Wall Street, similar to the ratings agencies getting advice from the big banks. Watchdogs shouldn’t get treats from those they’re watching. Or maybe it’s that the CDOs and credit default swaps were too hard for the SEC to understand.
Either way, the SEC doesn’t have a good excuse. If you’re in bed with the people you’re regulating, then you’re doing a bad job. If you’re rubber stamping things you don’t understand, then you’re doing a bad job.
Explain the Big Short, shortly
You’re about 2500 words into my “short summary.” But the important things to remember:
- Financial acronyms suck.
- Money flowed from the investors down to the mortgage lenders, and the risk flowed from the mortgage lenders up to the investors. In between, the big banks and CDOs acted as middle men and intermediaries.
- When someone feels like their actions have no risk, or no consequences, they’ll behave poorly (big banks, mortgage lenders)
When someone is given what seems like an amazing deal, they’ll take it (individual home owners).
- CDOs are like empty buckets. Mortgage payments are like rain, filling the buckets. Investors buy tranches, or slices, across all the buckets. If mortgages fail, then the buckets might not fill up, and the investors won’t get their money back.
- CDOs are intentionally complex. So complex, that not even the people grading them understood what was going on (ratings agencies).
- Buying insurance on something your do not own is a behavior with potential for abuse (big banks)
- Buying insurance on something for more than it’s worth is a behavior with potential for abuse (big banks). This is where most of the money in the financial crisis switched hands.
And with that, I’d like to announce the opening of the Best Interest CDO. Rather than invest in mortgages, I’ll be investing in race horses. Don’t ask my why, but the current top stallion is named ‘Dog Shit.’ He’ll take Wall Street by storm.
P.S. – If you enjoy podcasts, check out the Best Interest Podcast!