Saturday, October 22, 2016

The Big Short and the Derivatives Market: 2008 Revisited

After watching The Big Short (great movie, by the way) several friends asked me some questions, because I have some background in economics, about what happened. The movie was good about how things came about, but kind of short (no pun intended) on WHY. It was also a bit disingenuous about assessing blame. It is unarguable that the greed of Wall Street and the stupidity/corruption of government were largely to blame, there is ample guilt to go around.

To understand what happened we have to look at the nature of investing. I would caution the reader that if you have a background in econ/investing, you may not want to continue- this is going to be pretty basic stuff. The stock market is basically legalized gambling. In the beginning, if a company wanted to expand, or needed capital for other things, they sold shares of stock. This gave the holder a small piece of the company for which they receive a dividend. Logically, if they sell their shares, if business was good the shares could be sold for a profit and if not, the investor loses- hence, the gambling aspect.

In the 1970's a man named Lewis Ranieri came up with the bright idea of bundling mortgages and selling bonds based on them...they were called Mortgage Backed Securities (MBS's) and they were a GOOD idea. Like they say in the movie "everybody pays their mortgage." The MBS gave birth to what we now know as derivatives- basically betting on things other than the stocks themselves, but associated with them. To digress for a moment: You can "bet" on things like commodities such as coffee, wheat, pork, orange juice and other consumables, as well as precious metals. You can also bet on currencies, for example, that the value of the Euro will be comparably less than the value of the dollar. When you bet against a position this is called "selling short." Hence the title The Big Short. Now back to MBS's  They continued to be a good idea as well as a sound investment until a few things happened.

The first thing occurred in the 1980's. The Wall Street banks say the success of the MBS's and the potential of derivatives and began to hire people with backgrounds in mathematics rather than finance. The wisdom of this would prove questionable as time went on. These mathematical whiz kids were told to "be creative." And they were: the derivative market was off and running. One problem that should be obvious, even to the untrained eye, is when you're dealing with numbers- which have finite but abstract values, it's easy to make numbers on either side of an equation match up by applying simple arithmetic. However, when you're trying to make dollars in an equation match up, they have to come from somewhere. Needless to say, because our lives pretty much depend on dollars, their importance increases exponentially.

The second thing that happened began with a class action discrimination suit brought against Fleet Bank and others in 1995 in which the claimants charged discrimination in lending practices particularly against minorities. The fact is that the "minorities" in question were denied loans/mortgages because they failed to meet the minimum income requirements. Now I may be crazy, but I'm not stupid...if someone comes to me and wants to borrow money and I know that there's absolutely no way they can pay it back, my refusal to make the loan has nothing to do with the fact that they might be a minority. Banks are in the business of making loans. It would be economic suicide to refuse a loan to a customer with the where-with-all to repay it. Conversely, it would be suicide to lend money to someone that cannot repay it...these are called gifts and no bank can stay in business long by gifting money!

The other important development was the deregulation of of banks by the Clinton Administration that practically repealed the Glass-Stegall Act of 1933. In all fairness, this was a bipartisan bill signed by President Clinton- so as I said before there is ample blame to spread around. The upshot of this bill was to remove regulations that differentiated between investment banks and normal banks such as Citibank, or Wells Fargo. In effect what we think of as "regular" banks became the same as investment banks and vice other words the same laws governed both. Our savings were no longer safe.

The banking industry is in business to make money- it goes without saying. When they're painted into a corner and forced to make loans to potentially risky applicants, they're going to look for ways to cut losses and make money. So, they turned to the whiz kids in the derivative "think tanks"...and they proved to be up to the task. They began to bundle riskier and riskier mortgages. These are called Collateralized Debt Obligations (CDO's) what the movie called "dog shit loans." These are made up of a multitude of mortgages which on the surface look ok. For example, if you take 1000 mortgages in a bundle and look at the average- $75,000 average income/$7500 average yearly mortgage...10% of yearly income=good investment. BUT, averages are deceiving. You may have some loans where the homeowner has an income of $100,000 a year and a mortgage payment of $10,000 yearly on a 30 year fixed rate loan which is 10% and a sound investment. In the same bundle, however, you have a $35,000 yearly income with an annual mortgage payment of 30% of income with a variable rate (sub-prime) loan and red lights go off. So like I said, averages are deceiving. This is why Michael Burry, in the movie, was successful. He read the mortgages, not the averages.

In conclusion: Like I said there is plenty of blame to go around. The movie tries to absolve the "immigrants and poor people." If I have an annual income of $25,000 and somebody tries to sell me a house for $300,000...I know I can't afford it. The realtors were in search of quick profits and the higher the housing price, the higher the profit. The investment banks were trying to make the best of being forced to make risky loans and what they did was reprehensible- greed on steroids. CDO's of CDO' was insanity. I have to believe that they did it purposely- tit-for-tat for being forced into a risky situation, knowing all the while that the taxpayers would be stuck with the bill for their irresponsibility. But the profits were great! And, derivatives are here to stay so hold on to your hat (and money), so we can expect more of the same. As far as government goes, they haven't looked out for us since the Federal Reserve was founded, if not before. I hope this has been at least a little helpful.

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