I just finished reading Michael Lewis’s well researched and wonderfully written book, ‘The Big Short: Inside the Doomsday Machine’, on the 2007 collapse of the US housing industry and the corresponding collapse of the US investment banking system. And while I thought I was pretty well informed on the former – which it turns out I wasn’t – I also found out that I really knew nothing about the latter. Looking at it now from the perspective of an informed present, my ignorance was not surprising; as investment banking – at least from the bond side – is unregulated (even to this day) and as such is highly opaque.

In summary, there were three principal ingredients that created the two closely coupled financial disasters: Policy and the out of hand proliferation of subprime mortgages. The creation and unregulated spread of complex financial instruments called Collateralized Debt Obligations (CDOs). And lastly, the lack of oversight by the government, the banking industries and the rating agencies (Standard and Poor’s and Moody’s).

Subprime mortgages, for those of you that weren’t following along, were housing loans made to those people that were essentially credit unworthy. They started out as an intended implementation of government policy to extend home ownership to more people. The banks and mortgage institutions were more than willing to play along because more loans meant more revenue. The institutions got very crafty by creating the loans in the form of Adjustable Rate Mortgages (ARMs) that were front ended by 2 year teaser rates that had little or no interest before ballooning into payments that carried interest rates that exceeded normal (prime) mortgages.
The underlying assumption was that these subprime mortgages would be refinanced at the end of year 2 for another mortgage that carried better terms for the borrower. The lending institutions loved this because refinancing meant more fees, revenues and profit.
Oh, and it is also important to note that the problem at this level – by using an untested lending model to uncredit worthy Americans – was that everything was further predicated on the assumptions that house prices would keep rising and as such the subprime home loan defaults would be contained in the sub-five percent range. Both assumptions as it turned out were not just wrong but damned wrong.

Like other debt, these subprime mortgages were packaged into bonds to be sold and later traded. This is where the big investment banks on Wall St. came in. Earlier on, one of these banks had developed a new financial instrument called a CDO into which these bonds were then bundled, ostensibly to distribute the risk. Wall Street loves bonds because those big chunks of debt are worth lots of money and buying and selling them creates lots of revenue. Packaging the bonds into CDOs made for even bigger chunks of debt money which were as yet another revenue stream that was even more ridiculously profitable.

As unbelievable as it seems, no one was watching what was happening. The lending institutions making the subprime loans to the consumers didn’t care what was happening upstream because they had hedged their risk to any bad loans that they had made when the debt was packaged and sold off as bonds. Wall St. didn’t care because everyone was getting filthy rich from both the bonds and the CDO trading.
The rating agencies – Moody’s and Standard and Poor’s – were conned partially by Wall St. and largely by their ignorance into rating those triple-B- rated bonds as triple-A-rated after they were packaged into CDOs. So, as the author pointed out, ‘the CDO in effect was a credit laundering service for the residents of lower class America. For Wall Street it was a machine that turned lead into gold.’

It came to be that the lending institutions and lower class America were not generating enough triple-B-rated product so Wall St. got creative again and the Credit Default Swap (CDS) was born. The CDS was in effect a way to ‘short’ the CDO and were sold to traders much in the same way generating yet another profit stream. And where Wall St. got really creative was by then taking the CDSs and packaging them into what were to be called synthetic CDOs; another Wall St. product with yet another gigantic profit stream.

The people that were on the other side of the CDSs was a company called the AIG (American International Group) who were in the beginning nearly the only buyer of the CDOs (actually triple-B-rated subprime mortgage bonds repackaged into triple-A-rated CDOs) and as an insurance company they also effectively insured hundreds of billions of dollars of more subprime loaded CDOs against default.

So for all appearances Wall St. was selling products that were both triple-A-rated and insured against default. And the CDOs were so complicated – each individual CDO carried with it a prospectus that was over 100 pages long (which no one could ever really read because they were so complicated in themselves, using financial jargon that was know only by a few insiders) – so it was that even 98% of the  insiders selling them didn’t understand the contents, let alone the risk.

Things really began to unravel in early 2007 when many lower class Americans began defaulting on the subprime loans once the teaser rate expired and they found themselves in a position of not being able to refinance when the housing market stalled and the unexpected happened and American housing prices quit rising. The defaults at the subprime consumer level set off a chain reaction that brought housing prices down nationwide. And like defying gravity, the proverbial shit ran uphill and anyone holding CDOs soon discovered that they were in possession of nothing but valueless crap.

The book was a great read and almost impossible to put down. Michael Lewis puts the names to faces in what was one of the greatest financial fiascos of modern times. I heartily recommend it.