A Disaster Waiting to Happen – The Story of the Subprime Mortgage Crisis

The Big Short, by Michael Lewis, gives a really neat and eye-opening account of the disaster of the subprime mortgage-lending industry, and how it caused the financial crisis of 2008. I knew little about the workings of Wall Street before reading this book except that it is the pulse of the financial world, where a lot of money can be made through the trading of stock and managing of other people's money. But there is so much more to it. Before giving a summary of the events that led up to the crisis, here are five interesting things to start with.

1. Bond markets are a lot bigger, riskier and dirtier than stock markets. In the subprime mortgage bond market, there was a lot more room to make money by bending the rules of finance, and creating ‘innovative’ – or deceptive – new financial products to delude the investor. This was possible because of the high degree of opacity present in the bond market.

2. The bond market people on Wall Street were out to screw not only the ordinary homeowners and investors, but also other firms on Wall Street and intermediary institutes. 

3. The rating agencies, i.e. S&P and Moody’s, who employ rejects from investment banks and hedge funds, were easily influenced by big Wall Street firms to give a favorable rating to their piece-of-crap subprime mortgage bonds and derivatives.

4. Very few people were smart enough to recognize the disaster that was brewing in the subprime mortgage market between early 2000s to 2007, and fewer were brave enough to bet against it (by some sources, this number was less than 20 people). Most of the people on Wall Street, including those who played a part in creating the market, didn’t fully understand it!

5. You could make money – A LOT of money – on Wall Street without having to make the right decisions. The incentives on Wall Street were all wrong. 

So here is how it all began …

In early 2000s, home mortgage lenders were making home loans to borrowers who could not afford to pay them back. Their primary aim was to bulk up their balance sheets, and so very little attention was paid to the credit worthiness of the borrowers. The home loans were then sold by these subprime mortgage lenders to Wall Street firms like Goldman Sachs, Merrill Lynch, Lehman Brothers, Morgan Stanley, and the like who would subsequently securitize them into bonds and pass them on the investor.  So essentially, neither the originator of the mortgage (i.e. the mortgage lenders), nor the Wall Street firms were exposed to the risk, since they were passing it on to the investor. Soon, many billions of dollars were made out in loans to homeowners, and over a trillion dollars’ worth of bonds were trading on the market, all backed by home mortgages which were going to crash sooner or later. This was now a HUGE market, spiraling out of control and if you were smart, you would bet against it.

What happened in between…

So that the defaults wouldn’t start right off the back, the homeowners were given a ‘teaser-rate’ period of two years, where they paid an interest payment they could afford. After the end of the ‘teaser’ period, the interest rate sky-rocketed and would be too high for the homeowners to honour. By 2007, homeowners across the country began to default on their mortgage payments.

Wall Street did well to cover this! While defaults were slowly, but surely, on the rise, the value of the mortgage-backed bonds kept rising. This was because the rating agencies, influenced by the Wall Street bond market giants, were blessing these crappy bonds with investment grade ratings (i.e. triple A, double A), when in fact, these bonds were made up of some of the worst loans! This kept these bonds attractive to investors.

But….how was anyone going to make money from this?

You could make money by betting against the subprime market.The few analysts who were studying the subprime mortgage crisis very closely, and watching in dismay, included hedge funds FrontPoint Partners, Michael Burry, Cornwall Capital – and they were all betting against the market. 

Because there was no direct and easy way to short a bond, (as there is with a stock) they bet against the stock of all firms involved in the messy business of subprime mortgage lending, including the loan originators, intermediaries and investors. This is until a more direct way to bet against the market was invented by Michael Burry in the form of the Credit Default Swap.  

A Credit Default Swap was essentially like insurance against a bond becoming worthless (you could buy a CDS on a bundle of bonds). The owner of a CDS on a pack of subprime mortgage bonds would be paid the full value of the bonds if the homeowners started defaulting on their payments.  In the book, this situation is likened to buying fire insurance on a house that was only waiting to go up in flames.

Soon firms like Goldman Sachs were selling cheap CDS (and passing this risk on to bigger insurance firms like AIG FP). From their point of view, a CDS was a quick and easy source of money for them because they thought there was no way the bonds were going to crash – at least not anytime soon – or at least, not all at once! The system was big enough to prevent a crash like that – or so they thought. 

Crash boom bang!

When in 2007, the teaser rate period for most home mortgages came to an end, the default rates sky rocketed. Bond prices started to fall rapidly. Wall Street firms who held a long position on the subprime mortgage market (surprisingly!), were now scrambling to get on the other side of the bet by buying up as many CDSs as possible, and at extremely high prices. This is how the few hedge funds, including FrontPoint, Mike Burry's Scion, Cornwall Capital, cashed in their CDSs and made millions within days!

By fall of 2008, all the major Wall Street firms involved in the market were caving. Lehman Brothers filed for bankruptcy, and Merrill Lynch announced a USD. 55B loss on subprime mortgage bonds. There was a big run on banks all over the world, with stock indices going in a free fall. 

In September 2008, the Federal Reserve announced a USD. 85B loan to AIG to pay off its insurance debt to Wall Street’s Goldman Sachs and other firms. This was followed by the USD. 700B TARP program to buy up the subprime backed assets from Wall Street firm, but, mysteriously, was only directed at a select few Wall Street banks.

Some who played the market cleverly, and were rewarded for it (i.e. hedge funds likeFrontPoint, Scion, Cornwall). Others, in select few Wall Street firms responsible for the mess, left unscathed and richer (i.e. Goldman Sachs, Citigroup, etc).  While the innocent investors and homeowners, bore the brunt of the crash (i.e. homeowners, foreign investors, and others who had taken a long position on the market).