The Big Short

[Jeffrey]

I may have understated the spread mentioned above...I know a ton of mortgages had rates in the 5-6% rate, but can't really
recall the precise savings rates, may have been more like 2-3 % (there were very few savings instruments then compared with today).

Agree, their net interest margin was probably more like 3%. Their fee income would have probably been substantially less than today, mostly composed of mortgage servicing and NSF fees.

Back then, operating expenses weren't that high...a lot of these banks didn't have a whole lot of branches.

Are you certain "operating expenses weren't that high"? No doubt, they had relatively less branches, but they were highly inefficient and had considerable staff levels relative to today.

[Jeffrey]

Sure in hindsight; going short on almost any financial asset except US Treasuries would have accomplished the objective. But even these guys didn't see the scope of the meltdown, and were unsure how long it would take for the bad paper to blow up. Shorting while you wait costs money. They wanted to short the toxic mortgage backed securities directly and not rely on a second or third level derivative.

Exactly, timing is not as easy as most think and waiting is costly. Sure, people knew lending standards were a joke, but that was not the sole issue. As long as home prices continued their historical upward trends, shorting was not such a great idea.

I assume we would all agree US interest rates are going to rise. But, how do you play that? And, what would have happened if you had done that five years ago, when most were making the same US interest rate forecast?

[swood1000]

I'm in the middle of the book and it's hard to put down. Then I'm going to see the movie. The book talks about the idiocy (much easier to see in hindsight) of (a) the rating agencies in giving such high ratings to these bonds, (b) those who accepted those ratings uncritically, and (c) allowing billions of dollars of insurance to be sold without requiring the standard reserves against loss, simply because this was not conventional insurance. Some people say that the lesson to be learned is that more government regulation is necessary. But would we have had this event without the government distorting the market by (a) setting up Freddie Mac and Fannie Mae in the first place to buy all these mortgages, and (b) establishing policies (in order to benefit both the lower middle class and the housing industry) that urged lenders to accept subprime mortgages from those who would not traditionally have been granted a loan because the lenders could be assured that Freddie Mac and Fannie Mae would accept them? Are we saying that we need more government intervention in the market because of the distortions caused by the earlier government intervention?

[Jeffrey]

Some people say that the lesson to be learned is that more government regulation is necessary.

IMO, regulators are frequently incompetent, almost always slow to react, usually misevaluating risks, etc. If regulators are the answer, then another failure is almost certain.

[77devil]

I'm in the middle of the book and it's hard to put down. Then I'm going to see the movie. The book talks about the idiocy (much easier to see in hindsight) of (a) the rating agencies in giving such high ratings to these bonds, (b) those who accepted those ratings uncritically, and (c) allowing billions of dollars of insurance to be sold without requiring the standard reserves against loss, simply because this was not conventional insurance. Some people say that the lesson to be learned is that more government regulation is necessary. But would we have had this event without the government distorting the market by (a) setting up Freddie Mac and Fannie Mae in the first place to buy all these mortgages, and (b) establishing policies (in order to benefit both the lower middle class and the housing industry) that urged lenders to accept subprime mortgages from those who would not traditionally have been granted a loan because the lenders could be assured that Freddie Mac and Fannie Mae would accept them? Are we saying that we need more government intervention in the market because of the distortions caused by the earlier government intervention?

There were no clean hands. Regardless of who one wants to blame, the key consequence was excessive and sometimes reckless risk taking. It's a little ironic that Michael Lewis's first book was about his experiences at Salomon Brothers when it created the mortgage back security.

IMO, it all started, if indirectly on a serpentine path, when investment banks became under-regulated public companies. They were not subject to the capital requirements and oversight of commercial banks because they did not hold government insured consumer deposits. While investment banks were partnerships, risky behavior was moderated by the fact that practically all of management's capital was tied up in the firm. After which, there was a steady, inexorable decline in risk management in the financial system by private and government financial institutions, politicians, regulation and regulators, notwithstanding the periodic blow ups along the way for which lessons were soon forgotten or ignored.

[budwom]

Agree, their net interest margin was probably more like 3%. Their fee income would have probably been substantially less than today, mostly composed of mortgage servicing and NSF fees.



Are you certain "operating expenses weren't that high"? No doubt, they had relatively less branches, but they were highly inefficient and had considerable staff levels relative to today.

Yes, I'm positive, primarily because they didn't pay anyone very much. The concept was kind of idiot proof. A bunch of these banks, including the savings bank I was at, were primarily
family operations...few made much money except for the owners. Not much judgment was required...almost all the mortgages had 20% down payments, not a whole lot could go wrong.
(Business loans, which they didn't make, require a whole lot more judgment and skill, at least they did back then.)

[Jeffrey]

The concept was kind of idiot proof.

...not a whole lot could go wrong.

I disagree, the idiots prevailed!

Interest rate risk is a simple concept and 1974 inflation levels clearly illustrated the risks of holding very large concentrations of 5-6% long-term fixed rate mortgages.

What would you estimate their total operating costs were as a percentage of total assets?

[mkirsh]

There were no clean hands. Regardless of who one wants to blame, the key consequence was excessive and sometimes reckless risk taking. It's a little ironic that Michael Lewis's first book was about his experiences at Salomon Brothers when it created the mortgage back security.

IMO, it all started, if indirectly on a serpentine path, when investment banks became under-regulated public companies. They were not subject to the capital requirements and oversight of commercial banks because they did not hold government insured consumer deposits. While investment banks were partnerships, risky behavior was moderated by the fact that practically all of management's capital was tied up in the firm. After which, there was a steady, inexorable decline in risk management in the financial system by private and government financial institutions, politicians, regulation and regulators, notwithstanding the periodic blow ups along the way for which lessons were soon forgotten or ignored.

Interestingly, Michael Lewis wrote a great article in Portfolio magazine in 2008 (that would eventually become the basis for the Big Short) that supports your entire post - tying the financial crisis of 2008 to back to his experience in the mid 80s, and highlighting the increases in risk and complexity when the investment banks moved from private partnerships to publicly traded companies. Long but worth a read for anyone interested in this topic:
http://www.mutualfundsbureau.com/doc...ineArticle.pdf

[budwom]

I disagree, the idiots prevailed!

Interest rate risk is a simple concept and 1974 inflation levels clearly illustrated the risks of holding very large concentrations of 5-6% long-term fixed rate mortgages.

What would you estimate their total operating costs were as a percentage of total assets?

It's just too long ago (35 years) for me to accurately recall what operating costs were...but like I said, while Vermont commercial banks had quite a few people making
pretty good money, the savings banks, even large ones, had no reason to pay more than a handful of people well...Ha, as you say, the idiots did prevail, but
for a long long time (i.e. generations) some of these operations did remarkably well. Then they died. Worked out well for me (and most others, almost all employees
ended up working for the acquiring bank) as the business was so obviously dying I made the reluctant choice to leave town, go get my MBA, a better long term strategy for me...

[swood1000]

Originally Posted by 77devil
There were no clean hands. Regardless of who one wants to blame, the key consequence was excessive and sometimes reckless risk taking. It's a little ironic that Michael Lewis's first book was about his experiences at Salomon Brothers when it created the mortgage back security.

IMO, it all started, if indirectly on a serpentine path, when investment banks became under-regulated public companies. They were not subject to the capital requirements and oversight of commercial banks because they did not hold government insured consumer deposits. While investment banks were partnerships, risky behavior was moderated by the fact that practically all of management's capital was tied up in the firm. After which, there was a steady, inexorable decline in risk management in the financial system by private and government financial institutions, politicians, regulation and regulators, notwithstanding the periodic blow ups along the way for which lessons were soon forgotten or ignored.

Interestingly, Michael Lewis wrote a great article in Portfolio magazine in 2008 (that would eventually become the basis for the Big Short) that supports your entire post - tying the financial crisis of 2008 to back to his experience in the mid 80s, and highlighting the increases in risk and complexity when the investment banks moved from private partnerships to publicly traded companies. Long but worth a read for anyone interested in this topic:
http://www.mutualfundsbureau.com/doc...ineArticle.pdf

Looks like a great article. Here's a segment that talks about the switch by the Wall Street investment firms from partnership to public corporation:

From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.'s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.'s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk?

Now I asked Gutfreund about his biggest decision. "Yes," he said. "They—the heads of the other Wall Street firms-all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it." He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. "When things go wrong, it's their problem," he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. "It's laissez-faire until you get in deep sh_t," he said, with a half chuckle. He was out of the game.

But by this logic only partnerships have an interest in safely managing the firm's assets and those running public corporations have little incentive not to be reckless. Or perhaps he is saying that businesses involved in complex and abstruse activities involving financial risk should not be allowed to be public corporations?

[Jeffrey]

But by this logic only partnerships have an interest in safely managing the firm's assets and those running public corporations have little incentive not to be reckless. Or perhaps he is saying that businesses involved in complex and abstruse activities involving financial risk should not be allowed to be public corporations?

The hand plays differently when the players are not buying chips with their own cash.

[swood1000]

The hand plays differently when the players are not buying chips with their own cash.

I suppose that if we are dealing with a business whose collapse will threaten the national economy it should be subject to special rules regardless of whether it is a partnership or a corporation. That aside, who forces people to invest in the stock of Wall Street investment firms? Should there be a limit on the amount of risk that a person should be permitted to take in his investments?

[77devil]

Looks like a great article. Here's a segment that talks about the switch by the Wall Street investment firms from partnership to public corporation:


But by this logic only partnerships have an interest in safely managing the firm's assets and those running public corporations have little incentive not to be reckless. Or perhaps he is saying that businesses involved in complex and abstruse activities involving financial risk should not be allowed to be public corporations?

Not at all. There are many incentives in most public enterprises that dissuade excessive risk taking most notably bankruptcy. But the moral hazard that Wall Street banks were/are too big or important for the government to let fail severely distorts incentives and behaviors.

[swood1000]

Not at all. There are many incentives in most public enterprises that dissuade excessive risk taking most notably bankruptcy. But the moral hazard that Wall Street banks were/are too big or important for the government to let fail severely distorts incentives and behaviors.

Are you saying that the shareholders of a corporate wall street investment firm had less incentive to rein in the activities of the firm because they believed that there would be no down side since the government would step in to bail them out? But why wouldn't the partners of a wall street investment firm organized as a partnership have an equal tendency to be reckless since the government would step in to bail them out? Actually, I think that nobody could conceive of the possibility that such a mighty colossus could ever go under.

I'd like to find a book or article explaining how the rating agencies could have given such high ratings to these bonds. If you take a number of obligations, each of which has a low credit rating, how can you, by grouping them together, produce a group with a higher credit rating? I can see how that might work if the obligations were subject to heterogeneous risks, since all the various risks would not likely happen simultaneously, but not when they are all subject to the same risk (and a likely one at that). I can also sympathize with people who assumed that Moody's must have known something that justified the high ratings, not knowing that Moody's, according to this book, did not have access to any more underlying information than did the investors (besides being staffed by also-ran analysts).

[swood1000]

Do mortgages really have to be sold? Of course, they can, and the MBS market makes it attractive to do so, but they don't have to be, do they? In fact it always seemed wise to me that everyone should have to eat a little bit of their own cooking.

Right, but if you're a government official wishing to help one constituency by enabling home loans that they otherwise would not qualify for, and another constituency by freeing up financing for the building of a number of new homes, this can only be done efficiently if the originators of the mortgage loans do not have to be concerned about repayment of the loan. So policies had to be in place to take this risk off their hands. And since housing prices had always gone up, and would obviously always continue to go up, it was clearly a win for everybody.

[pfrduke]

Are you saying that the shareholders of a corporate wall street investment firm had less incentive to rein in the activities of the firm because they believed that there would be no down side since the government would step in to bail them out? But why wouldn't the partners of a wall street investment firm organized as a partnership have an equal tendency to be reckless since the government would step in to bail them out? Actually, I think that nobody could conceive of the possibility that such a mighty colossus could ever go under.

I'd like to find a book or article explaining how the rating agencies could have given such high ratings to these bonds. If you take a number of obligations, each of which has a low credit rating, how can you, by grouping them together, produce a group with a higher credit rating? I can see how that might work if the obligations were subject to heterogeneous risks, since all the various risks would not likely happen simultaneously, but not when they are all subject to the same risk (and a likely one at that). I can also sympathize with people who assumed that Moody's must have known something that justified the high ratings, not knowing that Moody's, according to this book, did not have access to any more underlying information than did the investors (besides being staffed by also-ran analysts).

There was belief that by geographic distribution of mortgages in securitizations, you did in fact create obligations subject to heterogeneous risks. Save the Great Depression, real estate markets historically did not have identically timed downturns across geographies. For a variety of reasons, that proved not to be the case in 2007-08.

Also, the achievement of the higher credit rating typically was accomplished through structured subordination (or, in rarer instances, insurance). Basically, one person holding one loan secured by one property holds something riskier because there's little cushion if the one borrower defaults. One person holding several loans secured by several properties and protected by excess collateral that will absorb initial losses (to a point) does hold something less risky. The concept of taking low credit rating obligations and turning them into a higher credit rating investment is debt securitization in a nutshell.

[Jeffrey]

I can also sympathize with people who assumed that Moody's must have known something that justified the high ratings, not knowing that Moody's, according to this book, did not have access to any more underlying information than did the investors (besides being staffed by also-ran analysts).

I've been on the buy and sell side of MBS (and, other loans) and I've bought and sold portfolios to/from Freddie and other players. In any indirect lending environment, the upstream players (buyers, sellers, regulators, credit rating agencies, etc.) are believing the loans are generated according to stated guidelines. A very small percentage of the loans are well audited. Even then, the lender usually knows in advance which loans will be audited and they have time to create paperwork to meet stated guidelines. The game is based on confidence.

So, take away confidence and the game is over. In the final hours, Bear Stearns could not get other banks to accept US Treasuries and Agencies as loan collateral. Guaranteed payment, no thanks!

[Jeffrey]

One person holding several loans secured by several properties and protected by excess collateral that will absorb initial losses (to a point) does hold something less risky.

Exactly; I've benefitted greatly from cross-collateralization.

[77devil]

Are you saying that the shareholders of a corporate wall street investment firm had less incentive to rein in the activities of the firm because they believed that there would be no down side since the government would step in to bail them out? But why wouldn't the partners of a wall street investment firm organized as a partnership have an equal tendency to be reckless since the government would step in to bail them out? Actually, I think that nobody could conceive of the possibility that such a mighty colossus could ever go under.

Shareholders have nothing to do with it. Moral hazard is created when the management and the employees empowered to take risk believe there is a backstop. After Bear Sterns went under in February 2008, the management at Lehman Brothers, for example, did nothing substantive to raise capital or otherwise reduce it's 40 to 1 leverage. Many senior executives believed right to the end that the firm would be bailed out.

When the firms were partnerships, they were much smaller and significantly less concentrated. There was no too big to fail. Going public not only allowed them to pass the risk from employees to shareholders, but it facilitated the mergers into much larger enterprises as did changes in regulations that allowed concentration across the financial services industries. Think Citibank in the 1990s, which evolved from the premier commercial bank serving multinational firms globally into Citigroup, a financial supermarket that included Travelers Insurance, Smith Barney brokerage, Solomon Brothers investment bank, and other smaller pieces.

[swood1000]

There was belief that by geographic distribution of mortgages in securitizations, you did in fact create obligations subject to heterogeneous risks. Save the Great Depression, real estate markets historically did not have identically timed downturns across geographies. For a variety of reasons, that proved not to be the case in 2007-08.

Also, the achievement of the higher credit rating typically was accomplished through structured subordination (or, in rarer instances, insurance). Basically, one person holding one loan secured by one property holds something riskier because there's little cushion if the one borrower defaults. One person holding several loans secured by several properties and protected by excess collateral that will absorb initial losses (to a point) does hold something less risky. The concept of taking low credit rating obligations and turning them into a higher credit rating investment is debt securitization in a nutshell.

But when you're loaning to people known to have a credit rating lower than that which historically had been granted a loan, and when no-doc loans meant that the lender in fact knew nothing about the ability of the borrower to pay back the loan, and when the collateral was actually a bubble in the housing market caused by speculation enabled by no-questions credit, one finds it difficult to understand how rating agencies could conclude that these factors resulted in a risk that could somehow be reduced by packaging a number of people with the same risks together.

I agree with you that Moody's probably used historical criteria in conducting its evaluation. What I don't understand is how they could have ignored the public policy changes that resulted in a type of borrower far different from the historical type. Of course, hindsight is 20/20.