W.W. Norton & Company
It finally happened last week. I came home from work and found it waiting in the mailbox.
The good folks at Capital One want to lend me up to $30,000. Seems I’m one of the lucky Canadians with excellent credit who’s been approved for Capital One’s SmartLine Platinum MasterCard. For three years, I’ll get a low fixed interest rate, perfect for consolidating all of my higher interest debt.
Not so long ago, I was getting one or two of these offers every day. And Joe and Karen from The Bank I’ve Never Heard Of would cold-call and pitch six-month interest free loans.
But the letters and calls stopped around the same time as the subprime mortgage mess set off the meltdown of the world financial system, brought on the Great Recession and triggered raid-the-cupboard government bailouts that my grandkids will be paying off.
Now you and I would never lend $100 to a deadbeat coworker or the black sheep of our family. Yet banks happily lent hundreds of billions of dollars to folks who, in the words of Bruce Springsteen, had debts that no honest man could pay.
Best-selling author Michael Lewis explains how it all went wrong. Only he tells the tale from the perspective of the handful of outsiders and misfits who saw the future and doubled down on disaster.
People like Michael Burry, a 32-year-old, one-eyed reclusive investor and hedge fund manager suffering from undiagnosed Asperger’s. Burry was one of the first to spot the huge bubble in the subprime-mortgage bond market and figure out how to profit from it.
Burry figured out that a lot of subprime-mortgage bonds were loaded with truly lousy loans made to poor, debt-burdened Americans who were living way beyond their means. Exhibit A was the Mexican strawberry worker who, with an annual salary of $14,000, got approved for a $724,000 subprime mortgage loan.
These loans typically carried introductory interest rates that were artificially low. The teaser rates then reset to much higher floating interest rates. Burry believed that the higher rates would set off a wave of defaults and hundreds of thousands of loans would go bad all at once.
“As early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards,” says Lewis.
“In Burry’s view, standards had not just fallen but hit rock bottom.” Burry believed that borrowers had lost restraint by 2003. Lenders lost it by early 2005. And Burry estimated that all those loans made in 2005 would go bust sometime around 2007.
So Burry came up with a way to bet against the subprime-mortgage bond market, which pretty much resembled a giant Ponzi scheme. He convinced a Wall Street firm to sell him credit-default swaps on subprime-mortgage bonds.
As Lewis explains it, a credit-default swap is basically an insurance policy on a bond, where you make periodic premium payments for a fixed term. For example, you could pay $200,000 a year to buy a 10-year credit-default swap on $100 million worth of bonds. The most you stood to lose was $2 million ($200,000 a year for 10 years). But you could gain $100 million if the bond went into default any time over that 10 years.
The price of the insurance premium was driven by ratings placed on bonds. And the rating agencies appeared pretty much clueless when it came to assessing the true risk of subprime-mortgage bonds. So premiums were low and credit-default swaps were a relative bargain. “It was as if you could buy flood insurance in the valley for the same price as flood insurance on the house on the mountaintop,” says Lewis.
In short order, Burry cherry-picked the worst subprime-mortgage bonds and owned credit-default swaps on a billion dollars worth of bonds. As the market started unravelling, Wall Street firms began offering to buy back Burry’s swaps at a profit. And when the subprime-mortgage bond market went bust, Burry pocketed $100 million for himself and $725 million for his investors who were smart enough to bet against the house.
But the recklessness on Wall Street hurt a whole lot of people on Main Street. Folks lost their life savings, their homes and their jobs in the Great Recession. So why did Wall Street firms and big banks lend so much money to people who’d never repay their debts?
In the final chapter of his book, Lewis says the seeds were sown when Wall Street firms went from conservative private partnerships to risk-taking public corporations.
“From that moment, the Wall Street firm became a black box. The shareholders who financed the risk taking had no real understanding of what the risk takers were doing, and, as the risk taking grew ever more complex, their understanding diminished. The psychological foundations of Wall Street firms shifted, from trust to blind faith.”
The Big Short is a must read and it just may convince you that the underside of your mattress is the safest and smartest investment vehicle if you can’t find a one-eyed, reclusive money manager with the foresight to spot the next bond market bubble.