If you analyse any disaster that has happened ever, you will find four components. One is a set of intelligent people that created the situation which led to the disaster. Two is the lack of involvement, motivated or due to lack of knowledge, of those who were responsible for providing the necessary oversight to prevent the disaster. The third factor is the presence of strong personalities who effectively blocked the free flow of information and the concomitant transparency. Fourth, a group of people who benefited from the disaster.
The theme of the book is the US Sub prime mortgage loan crisis that brought down the global financial markets and led to a prolonged global slow down beginning 2007. The book explains the crisis in ways which a layman (well, almost a layman !) can understand. After reading this book it is difficult to understand how the potential crisis went undetected for so long by so many.
What is the status of the loan now? The loan has gone out of banks hands to the investors hands. In return banks have got cash which they used to provide more loans !!
So far, as they say, so good.
What do the investors do? They have significant exposure to mortgage loans. They approach insurance company to insure these loans. In return for insuring these loans, the investors paid a regular premium to the insurance company.
What is the end result? Average public has got almost 100% loan from banks and other lenders to buy houses. So they do not have any of their own money invested in these houses and hence no personal stake in these houses. They will keep these houses till they are able to repay the loan. The moment they are not able to pay back on these loans, they will just walk away.
By transferring the loan from their books to the investors' books, Banks effectively transferred the risk of loan default. Since Banks did not have any risk in their books, they went on providing loans to the public with minimal due diligence. As the housing prices were going up, banks were giving people new loans on their houses (purchased with the previous loans) and selling these loans to investors. The book cites the case of a Mexican gardener whose annual income was 14000 dollars and who was given a loan of about 700000 (Yeah, you read it right !!) to buy a home. Another case is of a lady who was working in the house of one of the protagonists of the book, who, at one point of time possessed 5 homes !!
Such recklessness....
So, neither the average public has a skin in the game, nor the banks. What about the investors who purchased these loan packages? They also did not have a skin in the game since their loans were insured by the insurance companies (well, mainly one company, AIG).
What about the insurance companies themselves? By a queer arrangements, the insurance companies themselves were able to convert the regular premium payments into a kind of 'bond' and sell the same to investors.
So far we have not spoken about the investment banks. As we all know, they were the main players in this game. What was their role, you may ask.
Well they had dual roles. Initially they played the part of intermediaries between the Loan Originators, banks in many cases, and the end investors. By facilitating these deals, they got their commission from both the parties. Over a period of time, their role changed and they became active players in this game. They purchased these loans from the Originators and repackaged these loans to esoteric products like CDO (Collateralized Debt Obligations), ABS (Asset Backed Securities) and others (All these instruments and the complex math behind them were a PITA for those who were pursuing MBA during those times, like the author of this review. Countless are the hours that he has spent in understanding the difference between CDO, ABS and CDS. What for, pray, what for? ). Once these were created, they got rating agencies to rate these products as Triple A (Highest Safety of Principal and Interest) and sold them to these investors.
To encourage the people to take more loans, Banks offered 'Teaser' rates, artificially kept low , fixed rates valid for about two years. On completion of two years, the loans would become floating rate and would be linked to the prevailing interest rates. The first of these 'Teaser' rates started in 2005 and were expected to move to floating rates from 2007.
How could this 'Ponzi' scheme crash? What can go wrong? Well, many things...
The entire scheme was based on the expectation that American Public will repay their loans on a regular basis. And that would happen as long as housing prices were going up. That was the main assumption behind this entire scheme. US Housing prices will continue to rise.
Any analyst worth his financial statement will tell you that home mortgage is an asset and like any asset, it is impossible for the prices to continue going up. Sooner or later the prices will stop increasing and then it will start falling.
Other than housing prices slowing down (or falling), there were other triggers for this scheme to fail. One was if the insuring companies stopped insuring the loans. Other was if the rating agencies started rating these products at their real worth.
Author is at his acerbic best when he discusses the role of rating agencies. Since the customers of the rating agencies were the investment banks, the rating agencies were reluctant to take tough stance against these banks. The rating agencies abdicated their responsibility for oversight and just played along with the investment banks to provide high credit rating to what were essentially junk bonds. Another area where the rating agencies failed was in not updating their credit valuation models. The smart guys in the investment banks quickly figured out ways of beating the Credit Rating agencies at their own game. Rating agencies went through a moral hazard of having to evaluate the same customers who gave them business and they failed in their job.
It was not that everyone were gung-ho on this new money making scheme. There were skeptics aplenty. The book tells the story of few such individuals. They identified the impending disaster in the US Sub prime market and shorted (hence the name 'The Big Short') the US Sub prime bonds. While everyone around them was convinced about the stability of the Sub prime market, these guys recognized quiet early that the whole sub prime bond market was perched on very weak foundation. They anticipated the fall, and starting from 2005, took the necessary investment actions and waited for their forecasts to come true.
There was Dr.Mike Burry, a certified Neurosurgeon, who read books on Value investing and made a fortune as a self taught Value Investor before investing his entire portfolio on buying Credit Default Swaps (CDS) on the US Sub prime market. There is Steve Eisman, a Wall Street Professional, who saw the madness evolve right in front of him and anticipated how it was all going to end and shorted the Subprime Market and stock of the companies invested in the market. Then there were Charlie Ledley and Jamie Mai, two small time investors whose only claim to fame till then was making money by going against the conventional wisdom of the markets.
The wait was not easy. Each of them had to wait patiently for their predictions to come true. At least in the case of Dr.Burry, he also lost the confidence of his investors in his ability to make money. These were the same investors for whom he had made about 250% return when market as a whole had give about 7% !. Due to the complex nature of the sub prime market, coupled with the complexity of the instruments themselves, many investors did not understand the significance of what Dr.Burry was doing and hence went aggressive on him.
Finally in the mid of 2008, the much anticipated and dreaded collapse came. The collapse took along with it Lehman Brothers and Bear Sterns. It crashed the US Banking system and this had a domino effect on banks across the globe. The markets crashed, US went into recession, Other countries went into recession. Stock markets entered into bear phase.
The 'Big Shorts' who anticipated this crisis made tons of money. Their only fear at one point was that their creditors will declare bankruptcy or that the US Government would intervene. That happened, but, fortunately, after our protagonists had made money.
Who were the villains in this peace? First were the investment banks who created these esoteric instruments. It is hard to tell if they were villains, since their creations turned out to be Frankenstein monsters that ended up bringing them down. Credit agencies were definitely at fault for abdicating their oversight roles. Some strong personalities in AIG and Credit Rating Agencies who, through the force of their personality, prevented intelligent analysis of these products were also villains. The US Media, which ignored the potential crisis though presented with facts is another culprit. US Government who looked the other way when the excesses were going on cannot escape blame either.
Once the dust settled, the US Congress passed TARP (Troubled Assets Relief Program) which bailed out most of the investment banks. Citi Group got about 300 Billion USD and AIG got another 300 Billions.
And, finally, the key villains of the story, who knew what was happening and took advantage of it to fleece the american tax payer, ended up rich.
Discredited? may be, but rich, nonetheless.
No comments:
Post a Comment
As a policy I publish all the comments except SPAMS. Please be moderate and constructive in your comments