The Big Short: Inside the Doomsday Machine

I made the comment to my husband a few weeks ago that the housing market looked like it might be stabilizing locally. Houses seemed like they were more reasonably priced for our area, which prompted me to add this week’s book to my immediate read pile, The Big Short: Inside the Doomsday Machine, by Michael Lewis.

Most people, when they hear The Big Short, will think of the movie which was released in 2015. Which is fair, the movie is based on the book, and won an academy award for best adapted screenplay, which, now that I’ve read the book, makes perfect sense. The screenplay was a masterful adaptation of some pretty dense stuff, which ultimately led to the global financial crises. Having seen the movie, which I love, and now having read the book, I can easily say the movie is an accurate, cliffs note’s version, of the book, and I would be hard pressed to say that the movie missed any of the big picture drama that was encapsulated in the book.

But what was left out of the movie, both for brevity and clarity, is just exactly how screwed the public was as a result of this. See, the biggest thing to come out of this, is that the only people to actually understand what was happening in the moment are Steve Eisman (Mark Baum in the movie, played by Steve Carrell), Michael Burry (played by Christian Bale), Greg Lippman (Jared Vennett in the movie, played by Ryan Gosling), Charlie Ledley (Charlie Geller in the movie, played by John Magaro), Jamie Mai (Jamie Shipley in the movie, played by Finn Wittrock), and Ben Hockett (Ben Rickert in the movie, played by Brad Pitt). Literally no one else, including the banks who were fronting the money for the bad mortgages, knew what was going on. Many of them, even a decade plus later, STILL have no idea what happened. So let me see if I can break this down for you, using the book, not the movie. Although the movie is an excellent reference, this is not a movie review channel, so let’s dig into the book.

Everything that happened does go all the way back to the 1970’s, when Lewie Ranieri started packaging mortgages not as stand-alone products, but as packaged bonds. Hmm…that is not where to start this recap. Let’s start with some basic terminology.

What is a stock? A stock is a share of a company, basically a small ownership interest in a company. A stock is a piece of paper that says you believe in a company so much, you want to own a portion of it, relative to the amount of stocks you own. For simplicity, lets say Mouse Company releases 10,000 shares of its company. Only 10,000 shares ever, my math is not so awesome I can use real world numbers. You think Mouse is going to do pretty well, so you buy 100 shares. You now own 1% of Mouse Company. But, being a smart investor, you don’t put all our eggs in one basket. Cat Company is also releasing 10,000 shares. You like Cat Company better, so you buy 1,000 shares, meaning you now own 10% of Cat Company. The stock market is HEAVILY regulated. Owing, I believe, to stock market shenanigans which are not discussed in this book, but are discussed in Lewis’s previous book, Liar’s Poker, which I have not yet read, but kind of want to now. So you own 11% total, of two separate companies, 10% in Cat, and 1% in Mouse. That’s the stock market.

BONDS…are an entirely different kettle of fish. A bond, from Investopedia, is “a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental).”

Now, assuming my reading comprehension is up to par and not pickled by cocktail juice, what Lewie Ranieri did, is repackage mortgage loans, which are typically private affairs between individuals, i.e. the mortgage holder, and the banks who provided the money for the mortgage, into larger bonds, which are then traded like stocks, but are not stocks, and so are not regulated. Basically, multiple mortgages go into a bond.

Well, Ranieri started taking these individual loans from banks, and packaging them into corporate bonds. So, if you got a loan from Bank of America, then other loans made by BofA to other mortgage holders, might all get packaged into one big bond. Those bonds could then be traded, similarly to stocks. But because they represent liabilities (money owed) rather than assets (ownership in a company), they are not regulated in the same what that stocks are. You know what, that’s not quite right either. They do represent assets. Because your house is an asset. And for a long time, home equity line of credit, aka HELOC loans, were a thing, because you would use your house, your asset, to open a line of credit that would let you pay off bills.

Understand the confusion? Because a bond is typically between an investor and a corporation or government, not between an investor and a single individual, it was like the wild west out there.
What the central characters of The Big Short recognized, well before the rest of the world woke up, is that mortgages were being paid off at an alarmingly fast rate. This sounds, on the surface, like a good thing, right? Someone takes out an enormous loan for a house, then pays it off in short order. The problem is, the mortgages weren’t being paid off by the homeowner. I can use my own house as reference. When we bought our house, Bank of America initially loaned us the money. Within three months, BofA sold our mortgage to a different mortgage company. This results in BofA’s books showing that the mortgage was paid in full. Not because I paid off the balance of the mortgage. But because Carrington Mortgage purchased the mortgage from BofA. I still owed on the mortgage, I just now owed the money to Carrington, not to BofA.

This raised multiple flags for the Big Short crowd. My example used individual banks. What was happening in reality, is that individual money managers running bonds desks at various large financial institutions, were buying these mortgages wholesale from banks, and packing them into things called Collateralized Debt Obligations or CDO’s. These were not entirely new. In financial markets, these were a spin off of something called an Asset Backed Security or ABS, which means almost exactly that. It’s an investment backed by a pool of debt, like an auto loan or even a HELOC. If you default on an auto-loan, they will repossess your car, sell it at auction, and recoup their losses. If you default on a HELOC, they’ll put a lien against your property, meaning if you don’t repay, they can come in and seize your house. A CDO specifically includes mortgages, not just HELOC’s.

The Big Short crowd realized that the reason all these mortgages were being sold off almost immediately after the ink was dry on the contract, is because the mortgages themselves were bad. And they were being packaged into these CDO’s to clear them off the banks books and transfer the liability to the even bigger banks, i.e. the Morgan Stanley’s, the Bear Stearns, the Lehman Brothers.

And these were some phenomenally bad loans. Lewis points out one where a migrant strawberry picker making $14,000 per year was approved for a $750,000 home loan. And it is really easy to blame the migrant worker for this. Except, and this is really important to understand, the people submitting the mortgage loan paperwork were by and large lying to the banks. So why would they do that? Because they get paid big bonuses for originating these mortgages.

And not mentioned in the book, but just as important, is congressional complicity. All of this was perfectly legal, and not just because Congress didn’t understand what was going on anymore than the bankers did. It was legal because of the creation of Freddie Mac, which was a government backed housing initiative which bought up mortgage loans from lenders, which then freed up cash  from those lenders to be able to loan more money. Freddie Mac then offered those loans they had purchased to investors…like Morgan Stanley.

All of this led to the banks, with congressional approval, seeking ways to get more people into homes. Why wouldn’t they? The government was guaranteeing the money would be good. None of the legalities are mentioned in the book. I’m just sort of riffing here.

Now, the banks, while they didn’t really understand the monster they were creating, did understand basic risk assessment. They new that someone with a FICO score of 500 and no real income would never be able to qualify for a 30 year fixed, low interest rate, mortgage. AAA rated mortgages, with high FICO and great income, was a finite resource. Basically, not everyone could qualify for a mortgage. But the government was leaning towards housing as a right, and the banks, sensing government money behind it, took that ball and ran with it. How did they overcome the limited supply of people with good income AND good credit?

The adjustable rate mortgage. This allowed the migrant worker with a $14,000 annual income to purchase a house worth $750,000, but giving him a low teaser rater…say 2% or even 0%...then in two years, that teaser rate would expire, and the interest rate would balloon to 11% or more. This caused the mortgage payment to skyrocket. And mortgage defaults rose. A large portion of these bad loans…and understand, the migrant workers story stands out because who the fuck gives someone only making $14k per year three quarters of a million dollars? But there were loans with no documentation. And I don’t mean to undocumented immigrants. I mean, they didn’t check the buyers income. They didn’t even verify the person buying the house was employed before handing them the keys to a house. The four states which were designated as The Sand States for this little fiasco were California, Florida, Arizona, and my own state of Nevada. Las Vegas would eventually become a major nexus of default mortgages.

The Big Short crew saw the writing on the wall and, starting with Michael Burry, created a market called Credit Default Swaps or CDS. Basically, they were buying insurance on the bad loans, betting the owners of the CDO’s that those loans were going to go bad. Insurance was incredibly cheap. $100,000 in CDS would net $5 million when the loans went bust. Just, for example. So basically, to bastardize the example from the book, they were buying fire insurance on the CDO’s, waiting to sell that insurance back to the banks who owned the CDO’s, once the CDO’s actually caught fire.

And none of the owners of the CDO’s believed this would ever happen. How? How is it that the owner of the CDO didn’t see what the Big Short crew saw?

Averages. Each CDO was comprised of a tranche. What the fuck is a tranche? A tranche just means a slice of something. In this case, a slice of the mortgage market. Tranches that were rated AAA were composed almost exclusively of BBB mortgages. They did this by packaging mortgages wherein the owners had a FICO score of 500 with mortgages wherein the owners had a FICO score of like 700. As long as the AVERAGE FICO score of the mortgage holder in that tranche was around like 618, it would be rated as AAA, even though the underlying loans were ALL BBB rated.

This was called the Mezzanine Level in the book. And all it took for the house of cards to collapse was for 7% of mortgages to fail. And all it took for the failure was for home prices to stop rising. As long as the prices were rising, there was a chance the owner might be able to refinance into a fixed mortgage loan, or even to sell to someone else. But as soon as the housing market stabilized, the loans became defunct. Because if you try to sell a house for less than you still owe on it, you still owe the balance. So if you owe $250k on a house, and you are only able to sell it for $200k, the holder of your mortgage, still wants the remaining $50k. After all, they loaned you $250k, not $200k. So when housing prices stopped rising, the market collapsed. Spectacularly. Horrifyingly.

To the tune of over 5 trillion dollars in assets. Several banks did go under, most notably Bear Stearns and Lehman Brothers. And of course, as we all know, the US government stepped in and starting picking winners and losers, determining who should sell to who, and guaranteeing bad assets owned by the losers, to incentivize the winners to make the buy. All on taxpayer dollars. Every time the government gives money away, whether it’s to the Ukraine or to JP Morgan Chase, they do so using money we the people gave them, in the form of our tax dollars.

The true horror of this though, is that the ONLY losers of the whole sorry story are the common taxpayers, not just in America, but globally. The common people. As Lewis says in the book “What are the odds that people will make smart decisions about money if they don’t need to make smart decisions—if they can get rich making dumb decisions?”

By September 2008, the US Government had stepped in and created TARP, the Troubled Asset Relief Program. This was the bailout they used to save the bankers, giving them millions of dollars while the Americans who were completely screwed in these fraudulent deals got nothing, and were left homeless.

Why am I so sure that they were, in fact, screwed, and that it was the corrupt as fuck bankers who did the screwing, and that it was not the migrant worker making $14,000 per year who willfully and blindly walked in to a deal he had no business making? Well lets look at incentives. The bankers got enormous bonuses, all backed by Freddie Mac and Fannie Mae and their own corporations, for making these loans. The migrant worker had no earthly reason to lie. Yes he gets a home, but it’s unlikely he was homeless before. He was just paying rent or living at the trailers on site. True, it could be argued that your own home is better than migrant trailers. But the fact remains that the balance of power in this case is with the mortgage brokers. They had no business making such preposterous loans and should absolutely have been jailed for their complicity in the fraud. Instead, the government rewarded them.

One of Morgan Stanley’s bonds traders, who was in this up to his eyeballs, lost Morgan Stanley $9 billion dollars…and was able to keep his $26 million dollar bonus.

And congress, rather than interviewing the people who saw it coming, the Big Short holders, called on author Michael Lewis to explain it to them. He kept saying no, interview Burry, interview Eisman. And congress wanted him…the author of the book, who learned what he could from Burry and Eisman and Hockett. And to this day, no one on Wall Street, no one in Congress, can really explain how all this happened.

The easiest explanation is corporate greed. And that is a wholly justified explanation. It certainly explains why the generation that were children when all this happened grew up to be staunch socialists. It’s easy to point the finger at the school and say well yes, the schools are only teaching socialism, of course they’re all socialists. And there is some truth to that. But the other side of that truth is they watched their parents struggle out from under this shit show that Wall Street dropped on America, and determined that the government, who stepped in and rescued everyone, was the only one who could stop it. Except, the government only rescued the banks. And that is NEVER discussed when talking about the events of 2007/2008. It’s never mentioned that the only reason the banks that survived managed to do so, is because the government handed them even more tax payer dollars and said here you go….don’t get caught again. While leaving the average American holding the bill for governmental largesse.

A chilling line at the end of the movie says that “In 2015, several large banks began selling billions in something called a “bespoke tranche opportunity.” Which, according to Bloomberg News, is just another name for a CDO.”

And this is sadly true. Which is why I’m watching housing prices in Nevada stabilize with bated breath. Like…. on one hand, this means my opportunity to buy a house with the dream library is just around the corner. But at what cost?

So, the movie was phenomenal. For my money, Steve Carrell stole the show and should have won several awards for his role as Mark Baum. Just phenomenal. The book goes into a deeper dive, providing more background as to how this all happened, and was quite readable. But as Lewis says in his afterword, his challenge with this book, is that he’s used to writing books with a comedic undertone. And there was nothing funny about the collapse of the global economy. This book is not funny. It’s infuriating. And well worth the read.

This review is also available on YouTube, Rumble, and PodBean.