The Big Short: Chapter Summary (Chapter 3)
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. The U.S. Treasury bond market used screens for its trading, but in many other cases, 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. The bond market, also known as “fixed income,” 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.
Capitalizing on Burry’s strategy--It was against this background that Steve Eisman and his team at FrontPoint first met Greg Lippmann, Deutsche Bank’s head bond trader, in February 2006. Lippmann, who had dealt with Burry, had picked up on his logic and recognized the extraordinary advantage to short selling subprime mortgage bond credit default swaps. His mission was now to convince other potentially interested parties to do the same through him, for which he would collect hefty fees. To this end, he had created a presentation totaling more than forty pages, which he called “Shorting Home Equity Mezzanine Tranches.” His aim in showing it to various prospective investors was to demonstrate that subprime mortgages had been set up so that America’s low-income homeowners would not be able to handle the real interest rates that would kick in once the teaser rates had expired. The idea was to get the borrowers to refinance so that they would owe the lenders even more. Lippmann had determined that in order for homeowners to default, housing prices, which had been rising at an unprecedented rate, did not even need to fall. He had calculated that if a home’s value increased by only 1 to 5 percent, the borrower of the mortgage would be four times more likely to default than one whose home’s value increased by 10 percent. The credit default swap solved the issue of having to time exactly when this would happen, and it gave its investors the chance to lay down only a fraction of the cost in return for huge potential wins that, given the state of the market, were practically guaranteed.
Lippmann’s back-up data--Lippmann’s presentation was strengthened by the fact that his quant, Eugene Xu, an analyst at Deutsche Bank, had won second place in a Chinese national math competition. Apparently, no one dared to argue with Lippmann’s data once they became aware of Mr. Xu’s credentials. Lippmann had also done his homework and came prepared with all sorts of interesting facts to support his arguments, including the erratic practices of the credit rating agencies, Moody’s and Standard & Poor’s; the high incidence of mortgage fraud; the large number of German investors from Düsseldorf who had bought into this market and were placing their money on the wrong side of the bet; the past patterns of American homeowner behavior.
A question of motives--Eisman could certainly see the logic in Lippmann’s presentation, but he wasn’t so sure about his motives. Lewis quotes Eisman as saying that his problem was not that he mistrusted Lippmann but that he didn’t understand him. He wanted to know why Lippmann wanted him to short one of Deutsche Bank’s own products—one that it had even bothered to influence the rating agencies to misrepresent by giving some of the bonds better ratings than they deserved. The entire scenario made no sense to him.
Lippmann’s personality and appearance were no help when it came to creating trust, although Eisman was too shrewd and clear-minded to not be able to look past those things. In fact, Eisman’s reaction to Lippmann was generally good. Greg Lippmann was considered a great bond trader, but in many ways, he broke the Wall Street code of behavior. He sported loud ties, slicked back his hair, made obnoxious comments, dropped blatant hints about his exorbitant earnings, and even went so far as to openly project his own self-interested motives onto others—with no apologies. Some considered him crazy; others thought he was a jerk. Transparent in some ways, he was cryptic in others: he loved to drop obvious hints about subjects that were taboo for one reason or another, and he often seemed not to care at all about what his peers or bosses thought.
Back in San Jose, Mike Burry had guessed correctly that the entity on the other side of the huge bet he was making against the subprime mortgage bond market was not Goldman Sachs or any of the other Wall Street investment banks who were selling him hundreds of millions of dollars worth of credit default swaps. He had also guessed that it had to be a large triple-A-rated corporation, since only a company of significant size with a top rating would have the capability of handling the risk involved. He was right about that as well: the company was AIG Financial Products—AIG FP for short, a branch of the insurance corporation American International Group, Inc.
AIG FP had been founded in 1987 by Howard Sosin and other Drexel Burnham survivors to assume some of the large corporate risks being created at the time. One such risk—briefly mentioned in Chapter 2—was the interest rate swap, which involved exchanging a floating interest rate for the other party’s fixed interest rate, thus creating automatic financial risk which needed to somehow be accounted for. The only sort of company that could do this without raising eyebrows had to have the highest credit rating and a huge account where it could easily hide the issue. Unlike a bank, a firm of this type would be exempt from restrictive banking regulations as well as the need to maintain adequate back-up capital. AIG FP was one of the prototypes of this category of company, and it and others like it played a critical role in acting as a cover for the new risky financial instruments. Unfortunately, these same companies would be done away with when the real nature of the risks they had created became apparent. In the meantime, though, the new instruments seemed to be genuine moneymakers, so when J.P. Morgan first invented the credit default swap, AIG FP was willing to stand behind it.
Short history of the credit default swap--As described in Chapter 1, 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.
Obliviousness of AIG FP--Interestingly, few at either AIG FP or its parent company AIG seemed to notice how shaky the underpinnings of these investment instruments actually were. Somehow AIG FP had been misled into thinking that the bonds they were now insuring were the same quality as those they had originally taken on. The Wall Street firms that brokered them received fat fees simply for acting as intermediaries between the buyers and sellers of what was essentially garbage, so from a self-interested point of view, they had no reason to mention the difference.
Misratings and the synthetic CDO--Matters were made worse by the rating agencies’ 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. One of the main disguises, invented by Goldman Sachs and responsible at least in part for the rating agencies’ apparent blindness, 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.
It’s helpful to be aware that Lewis’s writing can sometimes be a little circuitous. He ultimately gets around to explaining the synthetic CDO as it’s described above, but it takes him a few paragraphs to do so. In the meantime, he explains this particular version of the synthetic CDO as though it was a regular CDO. He states that they were backed by subprime mortgage bonds and that they had the same tranche structure as the mortgage bond itself, except that these CDOs were created from the lowest, riskiest tranches, meaning that the new tower was backed exclusively by triple-B-rated bonds. Somehow the significance of this eluded the rating agencies, who chose to rate these new towers on a relative rather than an absolute basis, giving the greater part of the contents (80 percent) a triple-A rating. This obvious error in rating 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. 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.
The roots of financial irresponsibility--In his cursory explanation of the reasons for this sleight of hand, Lewis suggests that the causes lay in a combination of a sluggish economy (limited earning power) and a habitual appetite for consumption. This shortsighted greed was not limited to the homebuyers but extended to large segments of the culture, both rich and poor. That is the most obvious explanation for why so many dubious subprime mortgage loans were made to begin with; why the Goldman Sachs traders saw fit to pull the wool over AIG FP’s eyes, convincing them that some subprime mortgage bonds were more stable than others; and why AIG FP bought their story.
Definition of “synthetic” CDOs and subprime credit default swaps--There was still one difficulty left, though. CDOs were not created out of thin air. Generating one subprime mortgage CDO meant that you first had to have fifty times the same dollar amount in subprime mortgage loans. That was easier said than done when dealing with billions of dollars of triple-B-rated mortgages, but the easiest way was through the synthetic CDO. As Lewis explains later in the chapter, synthetic CDOs are complex derivatives made up of credit default swaps. He goes on to explain credit default swaps on subprime mortgage loans in three different ways:
· 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 or payers of the premiums do not actually own the thing that is being “insured”
· a bet either for (on the long side) or against (on the short side) 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 Emperor’s new clothes: blindness and delusion--More than any other, this third point brings home the realization that there was no real substance to these particular financial instruments. They were nothing more than glorified gambles. Beyond that, it was unclear whether there was actually anything in them. Since synthetic CDOs were portfolios of credit default swaps, the same issues applied to them, as we will see in a later chapter. In fact, Lewis openly wonders why no one seemed interested in answering some rather disturbing questions, such as
· why AIG FP’s traders, who supposedly knew what they were doing, were falling for “this stuff”
· how credit default swaps could be treated like insurance without having to comply with equivalent regulations, such as requiring back-up capital
· why—not to mention how—the rating agencies were getting away with giving triple-A ratings to masses of subprime mortgage loans
Apparently, the convenient shortsightedness that made these conditions possible was so rampant that few even considered anything but looking the other way.
The death of ethics and wisdom--The above scenario explains to some extent how Goldman Sachs managed to persuade AIG FP to underwrite $20 billion in subprime mortgage bonds. The fact that neither the credit default swaps nor AIG FP itself were regulated meant that they were not required to post collateral. What is clear is that AIG FP was taking a huge financial risk and that no one within the division or even the parent company of AIG, Inc. said anything. Goldman was profiting handsomely, and others—primarily Deutsche Bank—instead of questioning the validity, ethics, or wisdom of the situation, wanted to follow suit.