By Brian Summerfield, Online Editor, REALTOR® Magazine
Following the subprime mortgage meltdown in 2007 and subsequent housing crisis, the line from most commentators was that no one saw it coming. The near-collapse of finance and credit in this country was like a bolt from the blue. Who could have possibly predicted it?
Another bit of post-meltdown conventional wisdom was that all the parties involved — Fannie and Freddie, government regulators and policy makers, Wall Street’s biggest banks, investment ratings agencies, mortgage brokers, borrowers, and even real estate practitioners — played some part in the collapse. The overall system was more or less healthy, but the selfish and shortsighted decisions of some “bad actors” from all of these groups led to market failure.
Michael Lewis, acclaimed author of Liar’s Poker, Moneyball, and The Blind Side, offers a contrarian perspective on both of these phenomena in his most recent book, The Big Short: Inside the Doomsday Machine (W.W. Norton & Co. Inc., 2010). Regarding the first point, there were at least a few people who figured out what was going on in the financial markets. For them, it was never a matter of whether there would be a day of reckoning or not — it was just a question of when. They invested accordingly, and their bets paid off big as the economic edifice came crashing down.
That part of the book is interesting, but the more important issue for readers is the second one. Lewis, who once worked on Wall Street, says the origins of the collapse were not in the rapacious greed of a few scoundrels from various groups, but rather in systemic problems — some of which have been in place for several decades — that create reckless investments and obfuscate risk. To that end, Lewis discusses the following details to make a very compelling case.
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FROM THE BOOK: 5 LESSONS FOR THE REAL ESTATE INDUSTRY
1. Mortgage bonds are different by nature. In general, when someone is talking about a bond investment, they’re referring to buying a piece of debt from a specific institution, such as a corporation or government, in exchange for greater repayment at a later date. Mortgage bonds, though, are giant pools made up of thousands of borrowers who can pay off their debts whenever they want to and are able to (or not pay them off at all). Home loan investors (obviously) want to be paid, but not right away, all at once. To make mortgage bonds more attractive, Wall Street divvied up borrower payments into various levels, called “tranches,” that mixed prepayments with higher interest rates. So the lowest tranche — that is, the first group of investors to receive prepayments — gets the highest interest rate, while the highest tranche gets the lowest interest rate, but a longer payment period.
2. The first subprime mortgage meltdown was not in 2007-2008. Subprime lending, which arose in the early 1990s, was initially viewed favorably in financial circles. It was seen as a way give lower-middle-class borrowers who had decent — but not great — income and credit access to cheaper home loans by packaging them in bonds and selling them to larger and larger numbers of investors. However, the lending companies attracted some fairly unscrupulous characters, due largely to the fact that it was a “fast-buck business,” according to Sy Jacobs, one of the few Wall Street analysts who studied the subprime market during that decade. “Any business where you can sell a product and make money without having to worry about how the product performs is going to attract sleazy people.” When Russia defaulted on its loans and Long-Term Capital Management went bust in 1997, all of the capital that had fueled the boom in subprime lending moved to safer investments, and those companies immediately went bankrupt. Their failure to hold up on their own was later explained as being caused by faulty accounting instead of bad lending practices, which allowed the whole process to begin anew in the next decade.
3. The investment world is incomprehensible by design. Remember when we covered “tranches” a couple of paragraphs ago? If you’re anything like me, you may have wondered why those working in the financial sector would want to call a level of investment a “tranche” instead of a more common, clear term — like, say, a “level”? According to Lewis, the reasoning behind this arcane vocabulary is simple: It confuses people who don’t work in the financial sector. In one humorous part of the book, he describes how members of the small investment firm Cornwall Capital tried to determine what a “collateralized debt obligation” (CDO) was. (Essentially, this is a multi-layered pool of debt that’s packaged for investment.) “Eventually, they figured out that language served a different purpose inside the bond market than it did in the outside world,” Lewis writes. “Bond market terminology was designed less to convey meaning than to bewilder outsiders. Overpriced bonds were not ‘expensive’; overpriced bonds were ‘rich,’ which almost made them sound like something you should buy.”
4. Most people on Wall Street don’t understand these investments either. Continuing on that point of impenetrable language, Lewis quotes Charlie Ledley, principal of Cornwall Capital, who explains why this confusion is so fundamentally problematic. “In the course of trying to figure it out, we realize that there’s a reason why it doesn’t quite make sense to us. It’s because it doesn’t quite make sense.” Throughout Lewis’ book, he describes how CEOs at some of Wall Street’s biggest banks openly admit that they don’t comprehend the level of risk their bond traders have undertaken; how hot-shot traders focus much more on bringing in new money than on understanding what they’re actually investing in; and how underpaid and demoralized employees at ratings agencies gave their highest marks to junk investments.
5. Perception is NOT reality. With this kind of endemic dishonesty and incompetence in the system, it’s not surprising that something eventually went catastrophically wrong. In this case, the catalyst for collapse was poorly designed CDOs — largely composed of mortgages, many of them bad — and the multiple bets that were made for or against these bonds. But it could have been something else. Perhaps the most astounding thing about all of this was Wall Street’s capacity for self-delusion: It wasn’t just that the system had no safeguards against failure; the system was barely even able to acknowledge that failure when it came. Throughout late 2006 and early 2007, it became clear to the handful of investors Lewis describes in his book that these CDOs were going bad (which meant their bets would be paying off), but the banks that were selling and holding these CDOs simply refused to admit they were declining in value. When these investments finally started to fall apart in June 2007, Goldman Sachs, Morgan Stanley, and Bank of America did not respond to any inquiries for more than a week. When they finally did reply, all three institutions said they’d had some kind of technical difficulties and wanted to make sure that they had accurate marks for the investors’ bets — the reason being that the banks were now beginning to make the same bets they were. This was a private prelude to the beginning of the public collapse in subprime loans that would begin just a couple of months later.
“In the second quarter of 2005, credit card delinquencies hit an all-time high — even though housing prices had boomed. That is, even with this asset to borrow against, Americans were struggling more than ever to meet their obligations. The Federal Reserve had raised interest rates, but mortgage rates were still effectively falling — because Wall Street was finding ever more clever ways to enable people to borrow money. [Scion Capital Principal Mike] Burry now had more than a billion-dollar bet on the table and couldn’t grow it much more unless he attracted a lot more money. So he just laid it out for investors: The U.S. mortgage bond market was huge, bigger than the market for U.S. Treasury notes and bonds. The entire economy was premised on its stability, and its stability in turn depended on house prices continuing to rise. ‘It is ludicrous to believe that asset bubbles can only be recognized in hindsight,’ he wrote. ‘There are specific identifiers that are entirely recognizable during the bubble’s inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud … The FBI reports that mortgage-related fraud is up fivefold since 2000.’ Bad behavior was no longer on the fringes of an otherwise sound economy; it was its central feature. ‘The salient point about the modern vintage of housing-related fraud is its integral place within our nation’s institutions,’ he added.”
ABOUT THE AUTHOR
Michael Lewis is an author and financial journalist. He has written numerous books, including Liar’s Poker, Moneyball, The Blind Side, and Home Game. He lives in Berkeley, Calif., with his wife and three children.