The Big Short: Key Concepts
Prime Mortgage Bonds
The mortgage bond market, originated by Salomon Brothers in the 1980s, was unusual in that it was the first time the high finance world of Wall Street coincided with the world of middle and lower middle-class Americans. At the time, mortgage-backed securities were still limited to prime loans. They were different from government or corporate bonds in that they consisted of thousands of pooled individual loans rather than one large one. They also lacked the fixed-term feature, making one of their main problems the fact that borrowers could choose to prepay at any time, which they usually did whenever interest rates decreased. That way, the homeowner could potentially refinance at a better rate, but this left investors with the issue of their investment being terminated before maturity.
In an effort to mitigate the problem of prepayment, Salomon Brothers created what are called “tranches.” The purpose was to provide different levels of investment for different estimated mortgage prepayment schedules, each of which had corresponding interest rates designed to compensate for varying levels of risk. Lewis likens tranches to the stories of a building in relation to a possible flood: the bottom floor receives the highest interest rate in return for the highest risk, which in this case means being the first to accept prepayments; the next floor up receives the next highest interest rate in return for the next set of prepayments; and so on up to the highest tranche.
Subprime Mortgage Bonds
With the introduction of subprime mortgage bonds in the 1990s, prepayment was no longer the problem facing mortgage bond investors. Instead, the issue now revolved around the possibility of default. Unlike prime mortgage bonds, the loans that constituted the subprime mortgage bond were not guaranteed by the government. They had the same tranche structure as prime mortgage bonds, but investors in subprime mortgage bonds took the risk of losing their investment altogether. This possibility was offset by attractive interest rates adjusted to each level of risk. Their overuse and misrating in the creation of complex financial instruments played a significant role in the market crash of 2008.
Burry’s investigation led him to the realization that short selling a mortgage bond was not a logistical option. That would mean borrowing them, which wasn’t possible. The solution was the credit default swap, which Lewis explains as being similar to an insurance policy. The buyer pays a percentage of the total purchase amount for a fixed period in return for a guaranteed payment of the total by the seller (or insurer) in the event of a default. The advantages were that you could never lose more than the cost of the premiums and that you stood to gain much more if you bet wisely. Setting up the purchase of credit default swaps on subprime mortgage bonds from the large investment banks was a process that included the creation of contracts that would ensure payment by the seller in the event of a default. This was done through the International Swaps and Derivatives Association (ISDA), created by Salomon Brothers in 1986 to deal with interest rate swaps.
Lewis notes that there were three ways of looking at credit default swaps:
· a setup similar to insurance in that the purchaser pays a premium for a set period of time, in return for a (supposedly) guaranteed payment in the event of default, with the difference that the payer of the premiums does not actually own the thing that is being “insured”
· a bet either for or against the subprime housing market
· an almost identical replica of a subprime mortgage bond, with one distinct difference: it doesn’t actually contain any subprime mortgage loans
The decline in lending and investment standards
Credit default swaps were initially invented as a tool for dealing with corporate risk, which made them seem far safer than they ultimately became. It wasn’t until the early 2000s that the loans they comprised shifted to such items as auto loans, credit card debt, student loans, prime mortgage loans, and so on. The reasoning with the corporate loans had been that they would be unlikely to default—certainly not all at once, and in the meantime, they generated impressive profits. With the new types of loans, the logic was similar. The loan recipients, being numerous and various, would certainly not all default; or if they did, it was hardly likely to happen all at once. In 2004, the lending standards declined even further: the loans constituting the credit default swaps were now made up almost exclusively of subprime mortgage loans.
Lending standards had reached an all-time low as banks actually extended loans that required no payment at all. Instead, through the so-called ARM, or adjustable-rate mortgage, the homebuyer had the option of transferring the owed interest to the principal, the problem being that future interest payments could easily become unaffordable. In other words, banks were making mortgage loans to people who couldn’t afford to pay them. Lenders seemed mainly interested in increasing the volume of loans, and they would then minimize their own risk by selling these substandard loans to the large Wall Street investment banks, who packaged and sold them as mortgage bonds.
Unlike the stock market, which had become increasingly regulated and transparent because of the sizable number of investors, the bond market lacked the equivalent guarantee of legal regulation and social pressure to at least appear fair and up-front. With the exception of U.S. Treasury bonds, there was no way to determine whether you were being given a fair price unless you consulted another trader who knew something about the specific type of bond you were considering. Bond traders could get away with exchanging insider information, creating increasingly complex, opaque, and diverse investment instruments, and essentially doing whatever they pleased without incurring the consequences that would certainly follow in the more heavily regulated stock market. Also known as “fixed income,” the bond market had gained a reputation for being predatory, so it was no wonder that those on the outside found it more and more difficult to trust its traders.
Collateralized debt obligations (CDOs) were backed by subprime mortgage bonds and had the same tranche structure as the mortgage bond itself, except that subprime CDOs were created from the lowest, riskiest tranches, meaning that the new tower was backed exclusively by triple-B-rated bonds. For the investment banks, these CDOs were cash cows that solved whatever difficulty they had selling the lowest grade of subprime mortgage bond, and their opacity most likely facilitated some of the sleight of hand that seems to have been taking place in some of the larger banks’ accounting departments.
One of the main disguises, invented by Goldman Sachs and responsible at least in part for widespread misratings, was the synthetic collateralized debt obligation (synthetic CDO). A regular collateralized debt obligation was like a mega bond: a mortgage bond was a tower of loans; a CDO was a tower of bonds. A synthetic CDO is generally defined as a portfolio of credit default swaps—that is, not the assets themselves but a bet on the likelihood of default on the underlying loans.
For some reason, the rating agencies—Moody’s and Standard & Poor’s (S&P)—manifested a sudden unexplained inability to tell the difference between securities deserving a triple-A versus a triple-B rating, with the result that these shaky investments seemed safer than they actually were. Their obvious rating errors may have partly been influenced by the inaccessible nature of CDOs, which have been called “black boxes.” Another factor in the misratings may have been that the investment firms paid the agencies for each rating, thereby creating a conflict of interest. Whatever the reasons, the significance of the prevalence of triple-B-rated bonds seems to have eluded the rating agencies, who chose to rate the new CDO towers on a relative rather than an absolute basis, giving the greater part of the contents (80 percent) a triple-A rating.
Short selling simply means to bet against a given event or given odds. Going long means the opposite—to bet in favor of the event or odds. FrontPoint, Scion, Cornwall Capital, and Lippmann had all bet against the housing bubble, the abysmal lending standards, Wall Street’s shaky investment strategies, and a system that seemed generally out of control. Firms like AIG FP, who apparently thought that hiding their foolishness in the firm’s books would somehow cover the situation, took the long side of the bet until they were warned to withdraw or risk bankruptcy. Most of the Wall Street investment banks were merely acting as intermediaries, until the last minute, when they all wanted to cash in on the bets—in many cases, on the wrong side. To some extent, that final statement about Wall Street’s role as an intermediary explains how so many people got rich in spite of their positions.