Those Dangled Carrots

 The Big Short is Michael Lewis’s incredible retelling of the meltdown of the American financial system. What happened, who was responsible and what to do now have been major matters since the subprime disaster. Lewis tells the story from the perspective of those who ended up raking in the millions (and millions) by “shorting” the market for subprime mortgage-backed bonds.

The astonishing merit of the book is that I now know much more about the intricacies of what happened but am less sure than ever about exactly what anyone could ever have done about it before the fact. While you would like to point your finger and say that there is the villain, so-and-so was corrupt, this one was dishonest or these people over here ought not to have done what they did, there is none of that at all in the way the story is told.

At every stage in the bringing together of mortgages into “collective debt obligations” (CDOs), and then the further creation of a form of insurance known as “credit default swaps” (CDSs) no one was acting other than in a way intended of course to make themselves money but also while offering a financial product they believed was providing security and additional financial opportunity to others. Greedy, yes, but what’s new? It wasn’t greed that drove the process into the ground so much as an absence of a sense of danger.

In particular, no one seems to have had grand larceny on their mind, or at least that is the way the story is told. It was only that the big picture and the risks involved eluded virtually everyone in the major bond-trading houses and elsewhere. You can say they were incompetent and ought to have known what they were doing, but as with any tragedy you can look back with the kind of clarity you never have looking forward.

If there was incompetence at the helm, it seems to have been in the ratings agencies. The enormous risks and absence of value in the CDOs, these bundled mortgages, were recognised by that tiny handful of bond traders who could see the disaster in the making and made millions from it. But they were the tiniest minority amid all that financial genius that Wall Street is supposedly packed with. The credit rating agencies seem to have been completely out of their depth in calculating risk.

To understand how everything fell apart, you need to know the meaning of some financial terms and how everything meshed. And I offer my apologies in advance for my poor general understanding of any of this. If you are a financial type, just remember that I am equally incapable of explaining nuclear physics. But let me give it the old college try.

We begin with the mortgage, a document that states that in exchange for a sum of money used to buy a house, the borrower will repay certain sums of money at stated intervals for a stated period of time until the whole amount borrowed plus interest is paid off.

Next it is necessary to appreciate what is meant by a “teaser rate”. This is the very low interest rates that were being offered to house buyers for an initial two-year period before the actual interest rate kicked in, with its built-in catch-up.

A subprime mortgage is an offer of housing finance to people with a poor credit history. Offering to lend to people with lousy credit ratings and a much impaired ability to repay a debt was perhaps asking for trouble, but there you have it, especially with a teaser rate off the top.

There is then what is known as a Collateralised Debt Obligation (CDO). This was a bundling together of hundreds of mortgages into a single package that was then sold round the world as a bond. The various mortgages each had a particular cash flow potential so that with all of the embedded mortgages taken together, if everyone kept paying as their payments came due, a potential monthly return of a certain sum of money would result.

So far as the buyers of CDOs were concerned, they would either get the value of the mortgage payment month by month or their owners could sell the house if payments could no longer be made. Since house prices had never fallen in the United States for something like sixty years, there seemed to be no risk whatsoever in buying these bundled mortgages. They would continue to provide a steady income to those who held the bonds.

And the good thing about the CDO was that all kinds of people could be allowed to buy property where they had been unable to do so before. Even if some of the mortgage owners might default, the law of large numbers meant that most would not—why should the future be different from the past?—so that there would continue to be a steady stream of payments. Therefore money could be poured into financing poor people into houses they could not otherwise have been able to afford.

Now we come to the Credit Default Swap, the CDS. This was a form of insurance on the various CDOs, the bundled mortgages. They were thus a form of insurance just in case more people than expected ended up defaulting on their loans. What made this a very unusual form of insurance was that it was insurance on something one did not own, like buying fire insurance on your neighbour’s house.

This is how Lewis describes the process as seen by Michael Burry, the financial innovator who worked out how to make money shorting the subprime market:

‘The various floors, or tranches, of subprime mortgage bonds all had one thing in common: The bonds were impossible to sell short. To sell a stock or bond short, you needed to borrow it, and these tranches of mortgage bonds were tiny and impossible to find. You could buy them or not buy them, but you couldn’t explicitly bet against them; the market for subprime mortgages simply had no place for people in it who took a dim view of them.’

But where there’s a will there’s a way. Lewis explains how Burry solved this problem, having discovered the CDS a few years earlier:

‘[The CDS] was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing.’ [my italics]

So if you thought that subprime bonds would actually default, not just fall in value but actually default, this was how to do it.

The question then was how much should this insurance cost? How much should an issuer of a CDS charge for insuring the holders of the bundled mortgages? That, of course, depends entirely on the size of the risk. If your house has a one in ten probability of burning down, then the insurance will be somewhere above one tenth of the value of your house. Actuarial risk is built around the probability of an event taking place and the payout that would be required if that event should actually occur.

Therefore, the crucial question was making sure that the estimated risk would coincide with the actual risk. That is what insurance companies do, and here the issuers of the CDSs depended on the ratings agencies to estimate the risk correctly. Underestimating the risk would jeopardise the entire process since the CDSs would be priced well below a level needed to compensate for the risks involved.

So the question before the ratings agencies was how much risk there was in large-scale defaults on mortgages. As the ratings agencies saw it, building on their knowledge of the past, the question was how likely it would be that an event that had never happened would happen. To them, it was as close to zero as could be imagined.

Meanwhile, there were a handful of investors in pockets around the USA who could see only trouble ahead for the CDOs, the bundles of mortgages. They recognised that the kinds of people who were buying houses under these new terms were not solid middle-class citizens but were an entirely new segment of the market who had never previously owned homes. Moreover, they took the view that when the teaser rates had finally come to their end after two years, whatever financial stress that had existed before would become unendurable. The rate of default would therefore explode.

So what they did was go around buying as many of the CDSs as they could afford. Since the ratings agencies had examined in their lackadaisical way the various mortgage bundles, and had given them highly inflated credit ratings (Triple-A and all that), the cost of the insurance was miles below the risk, a few cents in the dollar.

In buying such insurance, to use the parlance of the financial world, they had “shorted” the market by betting against their solvency; that is, they bet that the value of all of these CDOs would go up in smoke.

So when the defaults did indeed begin, all those who had bet against the solvency of those holding the mortgages reaped hundreds of millions from the financial system. The insurance companies who had issued the CDSs were suddenly required to cough up immense amounts of capital at short notice, capital they did not have. This is where the insurance giant AIG found itself facing bankruptcy along with others since there was no possibility for any of these insurers to pay off anything like the money owed.

Meanwhile, major historic financial institutions, whose CEOs and directors had had no idea of what was going on in their normally placid bond departments, discovered almost overnight that they had been exposed to risks of which they had no idea. Their CDOs, which existed in the billions of dollars, but which now appeared worthless, would drag them into oblivion.

Moreover, these CDOs had been sold off around the world and were part of the asset portfolio of financial institutions and pension funds everywhere. The more of these “toxic assets” these financial institutions held, the more their asset base disintegrated before their eyes. The entire world financial system therefore froze, since no one could any longer be sure that any single financial firm across the entire globe was actually solvent and could guarantee its debts.

It was at this point that the Bush administration came up with the Troubled Asset Relief Program (TARP) to refinance the losses of these major Wall Street institutions along with the insurance companies who were required to pay out on the CDSs they had issued. And according to Lewis, they did it for free with no strings attached. They just gave them all the money they needed to cover their debts and so here we are. Or so at least I understand.

In reading Lewis and the story he tells, it is hard to know how any of this could have been avoided. If industry professionals cannot work it out ahead when it’s their own money on the line, no one else can either.

What becomes pretty clear is that no regulator would have made the slightest difference. If the risks eluded even those with an enormous financial interest in getting it right, there is next to no probability any regulator would have unscrambled that egg. Anyone with the ability to have understood what was going on would have stood to make his fortune rather than working for a regulatory agency. No such persons exist.

Those who had argued that such CDOs, rather than spreading risk which was what they were designed to do, had actually concentrated risk, were proven right. In an opposite way, those who had thought that CDOs were a good way to provide finance to the less well off were perhaps proven wrong while others who had said that the government should not be trying to foist loans on people on low incomes were perhaps proven right. Starter rates seem to work all right in Australia and elsewhere if they are given to people who don’t need them. Otherwise, forget it. They are a trap for the unwary and can ruin lives.

A market system works only if the costs of production are paid for in the prices received, with bankruptcy the normal way to deal with those who miscalculate. That works for most markets and I cannot think why it should not work in finance just as well.

Therefore, if I found a policy message it was this. In such a high-stakes business, accountability matters. Limited liability in brokerage and other areas of wheeler-dealing is a poor idea. It should be partnerships or nothing. The lazy absence in these major Wall Street firms of real effort to understand what was being done finally had its cost. But those who have paid with the jobs and their homes are not the ones who brought this catastrophe down on our heads. Unlimited liability would make sure they paid attention, and if they messed up that they paid with their wealth.

But in saying any of this I go past my expertise. There are no doubt ways to institutionalise arrangements so that this particular disaster never recurs. But given the nature of the story, other financial geniuses will find some other way to finagle their fortunes out of misperceived and mispriced risk. This observation made by one of the traders who earned tens of millions on the meltdown does appeal to me:

‘If you are going to start a regulatory regime from scratch, you’d design it to protect middle- and lower-middle-income people, because the opportunity for them to get ripped off was so high. Instead what we had was a regime where those were the people who were protected the least.’

Recessions are periods of renewal when an economy rights itself from whatever misdirection there had previously been. The story of the Global Financial Crisis is one more example of a general case. How to prevent such crises no one knows. The business cycle will be with us forever.

What we can stop, however, are the Keynesian methods of dealing with recessions. The TARP and other such emergency arrangements did seem to bring the rot to an end. The problems in the US economy are no longer found in the financial system but in the insane levels of government spending and debt that followed. It is this, rather than the financial panics, that seems to have brought longer-term ruin to the world’s economies.

As for the underlying human nature that drove the subprime crisis, I take you to the last two sentences in the book: “Something for nothing. It never loses its charm.” Yes, as the book tells the story, the fatal attraction of the free lunch is ever present, whether on Wall Street in putting together these bundles of debt or among those who borrowed to buy houses using a low-interest subprime mortgage. Those dangled carrots. Who can ever resist?

Steven Kates teaches economics at RMIT University in Melbourne. He has been invited to speak at the Freedomfest in the United States this month where the topic of his paper is “The Age of Keynes: The Beginning of the End?”