“The Big Short” by Richard Sale

Richard Sale headshot (2)

My wife and watched the film, “The Big Short” recently. I did not think the screen play too incoherent, too hasty, and too hurried nor did it make clear where the subprime mortgage scandal began.

I am now reading, The Big Short, by Michael Lewis, and it makes for blood-curdling reading.

The whole scam had its source in income inequality. Its am was to defraud the middle class and the poor. Income distribution was skewed and was becoming more skewed in favor of the rich. That’s what started to whole subprime mortgage crisis. The pitch for subprime mortgage bonds was that you were helping consumers get free of high interest rate credit card debt and putting him into lower interest rate mortgage debt.

The subprime mortgage industry was at first seen as a useful addition to the U.S. economy. It soon turned into a doomsday machine.

The concept was based on turning home mortgages into bonds. One man’s liability was another man’s asset, but now liabilities would be turned into little bits of paper that anyone could sell to anyone. The small market in mortgage bonds was funded by all sorts of strange stuff: credit card receivables, aircraft leases, auto loans, health club dues. The most obvious untapped asset in America was the American home. People with first mortgages held vast amounts of equity in their homes. There was a stigma in going to own a second mortgage borrower, but the reasoning was that if we mass market the bonds, the cost of borrowing will go down. The lower middle class would replace high interest rate credit card debt with lower interest rate mortgage debt. Of course the target of the bonds was the “less credit worthy Americans.” The mortgage bond wasn’t a single giant loan for an explicit fixed term; instead, a mortgage bond was a claim on the cash flows of thousands of individual home mortgages.

The bond sellers took giant pools of home loans and carved them up to pay debts made to homeowners into pieces called tranches. Such loans carried government guarantees. The holders of such bonds could resell them to other investors. It was a fast buck business.

During the 1990s, the subprime business was only a small fraction of US credit markets. A few tens of billions. As income inequality grew, so did the subprime mortgage market. The accounting for subprime mortgages was increasingly arcane. Moody’s did an account that made clear that underlying the bonds were pools of underlying the individual mortgage bonds – how many were floating rate and how many of the houses borrowed against the owner occupier. The most important question was how many were delinquent? Wall St Firms were not disclosing the delinquency rate of the home loans they were making. The operator sold all the loans to people who packed them into mortgage bonds. “How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.

To maintain the fiction that they were profitable enterprises, the sellers needed more and more capital to create more and more subprime loans. Sellers manipulated interest rate buyers who were told they were paying 7 percent on there loans when were actually paying 12.5 percent. They were tricking their customers. It was usual practice to make sure that the middle lower income people received the most protection. This system gave them the least protection against such schemes. Eisman said the goal of the mortgage subprime market was “fuck the poor.”

Credit Default Swaps


From Wikipedia

A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer (usually the creditor of the reference loan) in the event of a loan default (by the debtor) or other credit event. This is to say that the seller of the CDS insures the buyer against some reference loan defaulting. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. It was invented by Blythe Masters from JP Morgan in 1994.

In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.[1] However, anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDS contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan.[2]

Credit default swaps have existed since 1994, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion,[3] falling to $26.3 trillion by mid-year 2010[4] and reportedly $25.5[5] trillion in early 2012. CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency.[6] During the 2007-2010 financial crisis the lack of transparency in this large market became a concern to regulators as it could pose a systemic risk.[7][8][9][10] In March 2010, the Depository Trust & Clearing Corporation (see Sources of Market Data) announced it would give regulators greater access to its credit default swaps database.[11]

CDS data can be used by financial professionals, regulators, and the media to monitor how the market views credit risk of any entity on which a CDS is available, which can be compared to that provided by the Credit Rating Agencies. U.S. Courts may soon be following suit.[1]

Mike Burry, a genius who was the first to detect the upcoming crash of the subprime mortgage market fraud, said that his strategy was not to get the best loans, but the worst loans and then bet that they would fail. The price of a loan was rated by bond rating agencies who usually gave a triple A rating on loans. Burry he had collected a lot of triple B-rated loans. They were risky, and the riskier they were, the greater the chance that they would default. Soon, he owned $750 million in credit default swaps in subprime mortgage bonds. These were bonds he had handpicked to explode. He said that the beauty of credit fault swaps was that they enabled him to make a fortune if only a tiny fraction of the dubious pools of mortgages went bad.

A final word on Burry from Wikipedia

In 2005, Burry started to focus on the subprime market. Through his analysis of mortgage lending practices in 2003 and 2004, he correctly forecasted the real estate bubble would collapse as early as 2007. Burry's research on the values of residential real estate convinced him that subprime mortgages, especially those with "teaser" rates, and the bonds based on these mortgages would begin losing value when the original rates reset, often in as little as two years after initiation. This conclusion led Burry to short the market by persuading Goldman Sachs to sell him credit default swaps against subprime deals he saw as vulnerable. This analysis proved correct, and Burry profited accordingly.[7][8][9] Burry has since said, "I don't go out looking for good shorts. I'm spending my time looking for good longs. I shorted mortgages because I had to. Every bit of logic I had led me to this trade and I had to do it".[2]

Though he suffered an investor revolt before his predictions came true, Burry earned a personal profit of $100 million and a profit for his remaining investors of more than $700 million

No one ever went to jail for this fraud that almost destroyed the U.S. economy.

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70 Responses to “The Big Short” by Richard Sale

  1. Babak Makkinejad says:

    Richard Sale:
    Surely you cannot be faulting Burry.
    He acted like Rhett Butler, profiting where he could “when a civilization is being destroyed”.

  2. alba etie says:

    That was a good brief synopsis of the Big Short. Any thoughts as to why there were never criminal charges come out of the 2008 meltdown ?

  3. Fred says:

    “No one ever went to jail for this fraud that almost destroyed the U.S. economy.”
    Yes. Which is one of the reasons Trump is so popular.

  4. Fred says:

    But then Rhett didn’t contribute to the collapse of a civilization being destroyed.

  5. doug says:

    One of the things I’ve been following closely is the re-creation of the credit bubble. The “recovery” we have had, as one sided as it is, is based on asset re-inflation. To do this interest rates have been pushed down to historical lows. The current risk associated with this is not factored in the traditional sense and, IMO, exceeds significantly the current interest rates. The Fed, and all of us actually, are now trapped. It is impossible to inflate our way out and that leaves only one option. Restructuring. This goes by various names. Bankruptcy, bail-ins, negative interest rates. But this is constrained. People won’t accept easily the notion that savings can decrease in value. They will prefer saving cash stuffed in the mattress to bank accounts. Controlling this will require increased restrictions on cash v electronic (bank) accounts.
    This is a financialization of economies is a pervasive problem in the entire developed world. No idea how it will play out but it looks like an unstoppable force encountering an immovable object. One of which will prove wrong.

  6. doug says:

    Bubbles are created when too few Michael Burrys counter bubbles. There is always a lot of political pressure to limit or outlaw short selling. Mostly from the investors who are riding the bubble up and don’t want anyone peeing in the punchbowl.
    Lots of people participated in the fiasco. People that knew better. It wasn’t just the fools that got suckered into “pick-a-payment” seconds. Like this guy, an economics reporter for the New York Times.

  7. Valissa says:

    And here’s another one…
    What Republicans did 15 years ago to help create Donald Trump today https://www.washingtonpost.com/news/wonk/wp/2016/03/21/how-republicans-helped-create-donald-trump-more-than-15-years-ago/
    The Republican establishment began losing its party to Donald Trump on May 24, 2000, at 5:41 p.m., on the floor of the House of Representatives.
    Urged on by their presidential standard-bearer, Texas Gov. George W. Bush, and by nearly all of the business lobbyists who represented the core of the party’s donor class, three-quarters of House Republicans voted to extend the status of permanent normal trade relations to China. They were more than enough, when added to a minority of Democrats, to secure passage of a bill that would sail through the Senate and be signed into law by President Bill Clinton.
    The legislation, a top Republican priority, held the promise of greater economic prosperity for Americans. But few could predict that it would cause a series of economic and political earthquakes that has helped put the GOP in the difficult spot it is in today: with the most anti-trade Republican candidate in modern history, Trump, moving closer to clinching the party’s nomination.
    … The 2000 vote effectively unleashed a flood of outsourcing to China, which in turn exported trillions of dollars of cheap goods back to the United States. Over the next 10 years, economists have concluded, the expanded trade with China cost the United States at least 2 million jobs. It was the strongest force in an overall manufacturing decline that cost 5 million jobs. Those workers were typically men whose education stopped after high school, a group that has seen its wages fall by 15 percent after adjusting for inflation.

  8. cynic says:

    Things would improve if many of those ‘too big to jail’ were shortened by a head.

  9. Cvillereader says:

    If I recall correctly, there were plenty of rank and file conservatives who warned about the dire consequences of both NAFTA and MFN trade status for China. The problem was that they were tarred and feathered by the “conservative” political class as isolationists who supported protectionism.
    It’s not surprising that the Washington Post fails to address the real problem– a political class that no longer thinks it is required to represent the American people, and a cosmopolitan elite class that prefers to think of themselves as citizens of the world.

  10. shepherd says:

    Just to clarify the bonds a moment. There are two different securities discussed here. The subprime mortgages were compiled into something called a collateralized debt obligation (CDO). The credit default swap (CDS) is insurance against the failure of a security.
    The way a so-called subprime CDO works actually makes sense on paper. Essentially, let’s say you want to extend credit to people with bad credit ratings. Actuarially, people of a certain credit rating are likely to fail to pay a certain percentage of the time. But that won’t usually be 100%, more like 50%. So the way a CDO works is that you take a bunch of loans and pool them together. Then you cut them into what are called tranches. The tranches basically say in what order people get paid. So Tranche A is always paid first, and if there’s any money left over, that goes to Tranche B. Once Tranche B gets his full share of interest and principal, and if there’s any left over, it goes to Tranche C. So if you’re first in line, voila, what had been a risky set of loans becomes much less so. Not everyone will default so at least you’ll get paid.
    Then the banks faced the problem of the middle tranches, which are known in the biz as “mezzanine” tranches. What to do with them, since they were risky. Again, not all of those B and C tranches are going to go unpaid, so you model the risk and create still more CDOs. With enough of them, you can recycle truly bad stuff, again into a first rate security.
    Suddenly a lot can go wrong. In this case, the credit ratings of the people and the loans extended to them grossly overestimated their ability to pay. Instead of a 50% failure rate, it went to more like 90. The mezzanine securities were wiped out. And by the way, nobody read these documents. Each one is hundreds of pages long, filled with impenetrable stuff. Investors had no idea what they were buying and simply trusted ratings agencies to do their homework, which they didn’t.
    Still, as loony as this seems, you’re not at a mammoth disaster yet. Next comes the CDS, or insurance policy. Let’s suppose you’re a big holder of these securities and you want to make sure nothing goes wrong. You take out insurance on it. Again the person issuing the CDS doesn’t read the CDO or have any idea what’s in it. He simply looks at what rating it has. Where it gets crazy is that you can even take out insurance on something you don’t own as a way of betting on a default. That way if a CDO fails, you get paid, even if you don’t own it. Banks issued tons of these, and way more than they could pay for in a systemic collapse. Now you have a huge bubble in the making. Only a few CDOs have to fail before the CDS system goes haywire, and banks can’t make payments.

  11. Richard Sale says:

    I agree.

  12. Fred says:

    “But few could predict…” You mean like Ross Perot and plenty of others, especially union leaders?
    I think the last series of posts by Richard have laid the groundwork for understanding the discontent. What to do about it is another thing entirely. The political leadership seems to be doubling down instead of actually trying to learn anything from the past.

  13. Walrus says:

    I too enjoyed “The Big Short” and I thank Mr. Sale for his comments.
    There are a number of other enabling factors that have brought us to where we are now; which is up the creek in the proverbial barbed wire canoe.
    The prime cause, which is ultimately going to destroy the country, is the relationship between money and political power, unless Trump can slay the beast.
    The repeal of the Glass- Steagalll act that prevented banks from also speculating in markets was another cause.
    Then of course there was the move to a fee based financial system such that the originator of financial vehicles like CDO’s always on sold them and had no interest in the quality of the goods.
    That no one has gone to jail is a direct result of the aforesaid relationship between political power and money.
    The next target for Wall Street, assuming Clinton becomes President, is social security, private pension funds and any remaining pools of capital like insurance businesses.

  14. SmoothieX12 says:

    “… The 2000 vote effectively unleashed a flood of outsourcing to China, which in turn exported trillions of dollars of cheap goods back to the United States. Over the next 10 years, economists have concluded, the expanded trade with China cost the United States at least 2 million jobs.”
    This may be, and most likely is, very true but that is just one of many factors. American DE-industrialization started way earlier than that. Actually, in 1980s.

  15. HankP says:

    doug –
    This is absolutely correct, and the result of Congress refusing to do what it has done since the 1930s – stimulate demand with government spending. If that’s not available, asset reinflation is the only thing left, and it’s like trying to push a wet noodle. The problem is lack of demand, not lack of supply. The problem is also deflationary pressure, as we can see with lower and lower interest rates.
    Believe it or not, the US is actually doing better than Europe since they’ve been overcome with a push for austerity – the exact opposite of what’s called for in this situation. Not to mention their other major problem, which is countries not being in charge of their own monetary policy.

  16. Origin says:

    An amusing explanation of how the subprime debacle really worked and what caused it–a simple question.

  17. johnf says:

    Three times between 2009 and 2014 I tried to sell Michael Lewis’s original and lengthy article on the subject, and then his book “The Big Short” based on the article, as a drama adaptation to the BBC. The rights were available.
    Three times they turned it down.
    Their reason each time was that by the time the adaptation was broadcast, everyone would have forgotten about the financial crisis. Their sheer ignorance of the reality of the crisis amazed me.
    I went to see the film with mixed feelings. I thought it was superb. Thank God someone’s done it.

  18. MRW says:

    @Mr. Sale,
    Michael Lewis doesn’t get it exactly right, but then he does not have a white-collar criminology education nor the experience with its intricacies to get it right. For a much clearer (and deadlier) explanation which will open your eyes, AND a highly entertaining 45 minutes, I *urge* you to listen to this:
    “Bill Black Interview with Harry Shearer” May 1, 2011.
    You won’t regret it. Sit back and listen with a cigar and a brandy, if you imbibe. 😉

  19. Valissa says:

    IIRC it goes back to the 1970’s. While searching for a good link for that I found this short slideshow presentation that gives a simple overview of US industrialization starting in the ’70s. [note: there are no arrows, just click on the page to move to next slide]

  20. Bill Herschel says:

    I thought the movie was great. Having comedy writers script it was a stroke of genius. Yes, reading the book is the way to get the best understanding of the crime, but the movie conveys a lot of it. The movie is very funny which I know is a lot like making Thénardier a comic character, but it works.

  21. MRW says:

    @Mr. Sale,
    After Black, listen to this:
    I heard this on OCT 3, 2008, three weeks after the crisis hit. Still germane. You’ll understand credit default swaps ‘crystal-clear’.

  22. SmoothieX12 says:

    Really appreciate this link. Thank you.

  23. Ante says:

    Richard Sale
    The Big Short is a good story, but it’s fundamentally misleading. I’ll paraphrase Yves Smith to spare you block quotes.
    The ‘big short’ wasn’t a heroic trade, it was a series of actions that turned what would have been a serious problem echoing the savings and loan scandal into a global crisis that nearly killed several of the most important capital markets.
    Her book about the crisis and the economics that led to it, Econned, is very good.
    I think it’s important, when considering these things, to step back and see that these pieces are all part of a larger puzzle. Outsourcing, cutting wages, stealing pensions, races to the bottom over tax breaks, pushing debt on everyone, are all part of a strategy of accumulation. Once there, we can reject these dogmas and do what needs to be done for the betterment of the nation and all its citizens.

  24. HankP says:

    shepard –
    That covers half of the problem. The other half, which I witnessed personally, was mortgage companies blatantly lying on mortgage applications as to the financial situation of their applicants. And the reason why they lied? They made more (much more) in commissions from high risk mortgages than they did from conforming mortgages.

  25. VietnamVet says:

    This isn’t over by any means. All the bad debt from the 2008 crash has never been written down. Financialization is still going strong. The current push is to take a stream of public money and sell financial products on the monies. The higher the churn the greater the financiers’ cut. This is the basis for the push for Lexus Lanes, Charter Schools, or the forever wars: Private – Public Partnerships. A recent example is Maryland’s Purple Line Light Rail Plan.
    The contract is too complex to understand. CAF, the Spanish manufacturer’s DC Metro rail cars are the least reliable and their contract with Amtrak for Viewliner cars has run into major problems. When there is no direct public control and if the goal is to get the connected rich (not to provide affordable, safe and convenient transportation) what could go wrong?

  26. HDL says:

    “the expanded trade with China cost the United States at least 2 million jobs. ”
    True, a flood of Chinese imports over the past 15 years has cost hordes of U.S. jobs. In a recent paper, three respected economists — David Autor of the Massachusetts Institute of Technology, David Dorn of the University of Zurich and Gordon Hanson of the University of California at San Diego — estimated the loss of manufacturing jobs at 985,000 from 1999 to 2011.
    But this large number needs context. Over the same period, all U.S. manufacturing jobs dropped 5.8 million; the share caused by China was a bit less than one-fifth. When the economists added China’s impact on non-manufacturing firms, the job decline more than doubled to 2.4 million. Still, that’s less than 2 percent of total payroll employment of 131 million in 2011 and 143 million now. A more powerful job destroyer was the Great Recession (8.7 million jobs lost over two years).
    In addition, there are export jobs. With U.S. exports about 80 percent of imports, they offset most — though not all — of trade-related job loss. In 2014, exports supported 11.7 million jobs, says the Commerce Department: 7.1 million for goods (aircraft, medical equipment) and 4.6 million for services (software, films).
    Robert Samuelson, today’s WAPO.

  27. Mark Logan says:

    Mr Sale,
    I will suggest that a full understanding of the situation must include the part of who benefited the most. Although the traders wetted their beaks beyond all dreams of avarice they barely pecked at the fire hose stream of defrauded, stolen money spewed at the American public. All that money fed an economy which could not be sustained, yet we feel entitled to still. We still largely set the bar of recovery where it was when people could use their unpaid for houses as practically bottomless ATMs.
    There was nothing altruistic in the motive, certainly. Please don’t get me wrong there. I hold the actions if the traders in the same contempt and agree with everything you’ve reported about them. Embellishing, not arguing, but let’s not make the mistake of scapegoating. The enabling factors of piracy must be embraced.
    A humorous metaphor….they were nowhere near as ethical as this guy…but….

  28. Mark Gaughan says:

    This is from Moon of Alabama’s archives. b was on top of the CDS issue back then.

  29. Some facts might be of interest!
    Disclosure: Employed in the GC office of HUD from July 1, 1974, to September 10, 1979 as an attorney adviser.
    1. Mortgage bankers and mortgage originators largely unregulated.
    2. Most housing policy set by the IRC not by HUD.
    3. HUD has little direct regulatory and FHA still the guts of HUD.
    4. Housing is a roof over your head not an investment.
    5. The HUD legislative charter is the provision of decent, safe, sanitary housing for all Americans. IMO it has not accomplished this mission.
    6. The Federal Reserve officers and staff do not understand housing or energy sectors.
    7. Buying a home [almost never paid off] is an emotional event.
    8. An unlimited mortgage deduction completely distorts governmental and private capital to a largely unregulated market.
    9. FDI [Foreign Direct Investment] in real estate, commercial and residential, largely untracked.
    10. Building codes at all levels of government while often well-intentioned are largely unenforced. The federal government and States largely exempt their construction from building codes which are managed by local governments. Of the almost 100,000 units of local government most do not have even one full-time building inspector.
    IMO over 1/3 of residential real estate even now overvalued due to depreciation of the improved real estate, lack of compliance with local building codes, rising sea levels, obsolete mechanical systems, such as HVAC, and lack of insulation. And constructive or actual fraud often perpetrated on innocent homeowners, in particular the elderly.

  30. doug says:

    Ah, the Procrustean solution. Not too big to fail either.

  31. crf says:

    Richard Sale writes: “The bond sellers took giant pools of home loans and carved them up to pay debts made to homeowners into pieces called tranches. Such loans carried government guarantees.”
    Subprime mortgage loans usually didn’t come with Government guarantees (Fanny Mae and Freddy Mac.)
    There was a successful effort by banks, before the bubble burst, to lobby these corporations to lower their standards somewhat in approving mortgages. But their bankruptcy was caused not mainly by subprime loans gone bad, but by ordinary mortgages going bad due to the housing value crash, financial crisis and the recession.

  32. Ed says:

    I too watched “The Big Short” several days ago, Then this antidote arrived via Cryptogon:
    It’s 45 minutes long and deserves your avid attention.
    “The Big Short” was produced by Arnon Milchan, an Israeli intel guy who was deeply involved in arms trade, especially things nuclear. Arnon also produced the movie “JFK” with Kevin Costner. He is revered and rewarded by Israeli power.
    All hail AIPAC. All hail the Rothshcildian octopus.

  33. elaine says:

    If one is a graduate of Harvard or Yale & of the political class look right
    into the camera & tell your loyal subjects, “Wall Street & the banks have paid
    back all of the money with interest.” No harm no foul.

  34. Jack says:

    The mortgage credit crisis and the Big Short are just vignettes to the larger credit story. I think to get the full picture one has to cover the role of Fannie & Freddie how they went to gargantuan balance sheets and to future generations holding the bag and the role of legislation in creating the NRSROs. One cannot overlook the role of the Fed who played a central role in the blowing of the bubble.
    Many on the left claim it was capitalism gone amuck without for a moment considering the outsized role of government in inflating credit. Just to understand the scale total system debt doubled in the 90s to around $25 trillion. The GSEs securities grew from $1.2 trillion to end the decade at $4 trillion. So there was already tremendous momentum in GSE credit inflation as we entered the 21st century. By the time the tech bubble went bust, the lefts favorite economist Paul Krugman who only promotes unlimited government spending in both good and bad times had this to say in a NYT oped.
    “The basic point is that the recession of 2001 wasn’t a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance.To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.”
    Greenspan took that advice to heart. You should know the rest of the story with the GSEs and how they inflated their on and off balance sheet exposure to stupendous proportions in the first decade of the new century.
    Similarly, prior to goverment interference, ratings organizations made their living by selling research to the buyside. Those that actually purchased securities. If they did a lousy job and buyers lost money they had to look for another job. Then government ostensibly to regulate and insure quality deemed that a cartel would be perfect and sellside issuers would pay a fee to rate their security. We know how that worked out as corruption ran away.
    This story is worth pursuing if you would like to understand the financialization of our economy and insider dealing of using the power of the state to curb competition and create a fee based and speculation based financial system where profits are privatized and losses socialized. I urge you to investigate this as it is not what many think.The days of the Wall St partnership where partner’s capital was always at risk is long gone. Wall St & government and the politicians that run it are in a symbiotic relationship where regulation is called for each time the working folks are screwed but such regulation only entrenched the oligarchy further.

  35. rjj says:

    Their reason = their stated reason. What was their reason for canceling The Hour?
    I think BBC was “transitioning” into the Borg during that time – and emerged as Banality Buggery Cant.

  36. jonst says:

    Yes, the criminals–indirectly, in most cases, a bit more heavy handed in others…control the justice system. And know how to play it, for the most part. Its like being a very, very, good test taker, with a very, very, friendly and sympathetic Professor grading the test.
    And the prime *mechanics* of this–not great minds behind this, i.e. “this” being financial deregulation, but grunt workers for it, a necessary prerequisite for all to follow, were/are the Clintons. One of whom I believe Richard will be voting for.

  37. Actually manufacturing segment of American economy began to drop in late Fifties. Now down to about 11%!

  38. Thanks for this great insight!

  39. And no regulation of CDOs and/or CDSs? And no taxation? Or of Derivatives?

  40. Lochearn says:

    If you read the comments that follow the article by Yves Smith you will see that a lot of people disagree with her. The fact is that Michael Lewis is an extremely good writer and Yves Smith is an extremely boring and turgid writer. She also has a nasty side to her. I have her book and I found it unreadable. Thanks to Lewis’ book and the film many people are getting a basic understanding of the subprime crisis and that can only be a good thing.

  41. wisedupearly says:

    those that benefited the most?
    would they be the poor souls who were told that teaser loans were a safe bet and that the interest rates would never be reset and even if they did, they could sell the house for double the price — it was a”no-brainer”? Lots of reasonable people were conned.

  42. Richard Sale says:

    very droll. thank you.
    Richard Sale

  43. Richard Sale says:

    Will do.

  44. LeaNder says:

    That was my impression when I looked into matters. Way too many may have been involved in the end.
    On the other hand, when the disaster finally happened it reminded me of stunning return offers in the US real estate fonds market surfaced over here too, many, many years before the final crash. Was this an attempt at loss dilution?
    When I looked into Enron and comparative matters, I stumbled across arguments that feel similar to your argument in the first passage. They too to the extend I recall, outsourced their losses to other firms, an elaborate branch network?
    Are you suggesting, the different market/speculation tools kind of balance each other out, and thus should prevent this type of disaster? But do they? Did they historically?
    i looked into some type of organized crime business network over here around the same time frame. A rather exquisite business scheme that used the European market “to bury” firms in Spain. The player, who had drawn my attention sold his firm twice. I have studied not only his business records, but also a series of shady connections that surfaced there or elsewhere. … He wound up in one of two central court cases here in Cologne.
    Case matters, or the overall network apparently was way too big to handle by authorities. … I could have given them some hints concerning this special actor. But he went away free apart from a little “community service” he had to do. From what surfaced in his business papers, including history, everyone over here can look into, it seemed clearly and very, very easy to see was a criminal case of bankruptcy. Never mind, the authorities did not know, what I could have told them.
    As you may imagine, in his specific case a lot of artisans that did work for him, paid heavily. So yes, one can ask is there something like a system?

  45. tensegrity says:

    Lots of issues here just ignored by the article and the movie. From my perspective as a person who’s 25+ year career has been in the institutional investment mgmt:
    – stupid institutional investors were happily buying up as much structured product as Wall St. could generate even as spreads they would earn for owning this stuff over plain vanilla alternatives successively compressed to silly low levels;
    – stupid banks like Citi and AIG sold as much CDS as they could even as they pushed premiums down on CDS to silly low levels in 2005/2006 (meaning they were increasingly selling insurance on bonds and getting paid terribly little for such);
    – stupid homeowners increasingly became ridiculous in thinking that everyone could be a real estate magnate;
    – leverage in the system was huge by 2008 — many proprietary trading desks and big hedge funds owned structured product on a highly levered basis (borrowing in the repo market to finance their owning far more than was their capital)
    – when things started to go sideways in latter 2008 and risk managers took control of the investment banks, leverage was cut very suddenly and repo markets stopped functioning due to concerns of repo lenders over collateral. This led to all leveraged investors (i.e., prop desks and hedge funds) suddenly having to dump their positions of structured product on to the market or see their capital wiped out to zero.
    – when levered investors dumped positions on the market, there were no natural buyers, which caused MASSIVE price destructure
    – credit worthiness of subprime, Alt-A, etc. loans were certainly overestimated by ratings agencies and stupid investors (as was the possibility that they all become bad credits at the same time), the price destruction in much of the structured space was vastly over done. Proof of this is that eventual default rates were no where near what they were implied by prices in early 2009. Further, opportunistic investment strategies that sprung up in order to buy some of this stuff at huge discounts to part tended to be HUGE homeruns.
    – I buy the market monitarists’ argument that the Fed made things FAR worse by still being worried about non-existant inflation even as markets were melting down. By letting nominal GDP go negative the Fed made the situation far, far worse than it would have been had they been resolved to prevent this. A world with negative nominal GDP growth, is a real killer for financials and any other levered entities.

  46. Realtors also not exempt from blame.

  47. shepherd says:

    Hank P,
    There were a lot of bad actors, and a lot of people got burned. I watched the crisis from the corporate side. No one cares, but ordinary companies got hurt by this too.
    CDOs and CDS’s are both “derivatives.” Neither is regulated. The income from a CDO is taxable. The issuer, however, is usually offshore (in a mailbox somewhere), so they don’t pay taxes from selling them. I don’t know much about the tax structure of CDS’s. I’m not as familiar with them.

  48. Richard Sale says:

    I thank you for this. I was simply attempting a brief review of Lewis’ book. I am still gathering data.
    But this helps me to understand more.
    Richard Sale

  49. zth says:

    Cart, horse. Advocacy vs Analysis. Beating the messenger.
    It was very clear at the time to anyone listening to McCulley (and Krugmans coverage of it) that he was describing what Greenspan was doing.
    You really believe they were advocating a bubble and calling it a bubble? When they called the dot-com a bubble, they were advocating it?

  50. Jack says:

    You are missing the point!
    They were and have always advocated credit inflation. That is the central tenet. The response to any economic or financial downturn has been more of the hair of the dog that bit you. And government has been at the core of this as they have provided the backstop and socialized the losses.

  51. Fred says:

    Thank you for this post and the prior ones. I have quite a bit to learn and am grateful to the excellent teachers here.

  52. Landis says:

    I’m a long time lurker and appreciator of this site, I’m also a former mortgage bond and interest rate derivative trader, although I was not there during the crisis. I just wanted to offer to try and answer any questions you all may have.

  53. Mark Logan says:

    Obviously not. It was the public in general, which benefited from the money injection. I believe that key to they mystery of no appreciable effort to investigate what was causing the boom.

  54. tensegrity says:

    Happy to have been of even a tiny bit of help! Unfortunately, the whole episode has many dimensions and facets with, in my view, a great deal of fuzziness even after the fact. In that sense, it doesn’t lend itself well to a 2hr movie script. It’s also worth mentioning that, while people in the finance/investment industry are often demonized for causing the whole thing, the after effects of the financial crisis on those in the finance/investment industry have been truly devastating, as the combination of massively increased investor risk aversion and Dodd Frank has created a brutal environment for most anyone who doesn’t happen to already be employed by one of a handful of already largest investment managers or banks, as most all other firms have struggled just to survive and the creation of new businesses in the industry has been made almost impossible.

  55. drpuck says:

    Your additions here are very critical to lining up the entire story.
    Except, pardon me, I don’t understand this: “stupid homeowners increasingly became ridiculous in thinking that everyone could be a real estate magnate.”
    Does this have to do with mortgage market makers seeking out both ripe new customers in the crap cash flow/balance sheet realms, and, also, in the second home and flipping realms?
    Am I correct that lots of defaults took place in the second home market–as borrowers jumped out of interest-only and teaser mortgages?

  56. Blaker says:

    In regards to regulation and Wall Street, my favorite comment of all time came from a high school friend who lied all the way through a series of interviews at a Wall Street firm to obtain a job as a stock Trader. His comment on regulation after 30 years in the trenches trading stocks “Regulation, I hate it with all my heart. But it provides the structure of rules that we (Wall Street) work to get around and make our profits.” Thus the financial industry which is the most powerful lobbying group in our political system crafts the regulations through which, and around which, they continuously make their profits.

  57. Thomas says:

    How about a short analysis on what you thought went wrong?
    It is interesting how the Treasury Secretary was full of delight the morning he burst the bubble. It seems he only wanted to make an example for all the firms by coming down hard on one. That the select example was his former commercial rival never brings up the question of abuse of authority.

  58. MRW says:

    You don’t understand the difference between federal government accounting and non-federal government accounting.

  59. Jack says:

    MRW, the government spending uber alles quack heard from again!
    Your faith-based theory of infinite government spending = nirvana, demonstrates with no shadow of doubt how much accounting, finance or common sense knowledge you have. Zero.
    Are you sure you’re not a former failed Soviet central planning commissar?

  60. Jack says:

    Take one simple example. They said that Citi, Morgan Stanley, Goldman, et al had to be bailed out because they were too big to fail. Then they shout from the ramparts that never shall that happen again. So they create this gigantic regulatory obfuscation in Graham-Dodd. End result these banks are even bigger and have an even larger share of total assets. If they are in reality wards of the state then they should be nationalized. At least there will not be any pretense and Blankfien and Dimon will get a government salary.
    There are thousands of small and regional banks. Most had healthy balance sheets and would have loved to pick up assets from a bankruptcy court. But no capitalism must not be allowed to work instead government must interfere and favor the implicit cartel of the politically well connected.

  61. Landis says:

    I think first its important to understand that a lot of things, in several different areas, had to go wrong in order to experience a crisis of the magnitude that we did. I tend to think about the crisis in two different pieces, the first being mortgage related and the second being credit related.
    To start, its important to realize that there are two fundamentally different mortgage markets in the United States, an Agency mortgage market and a Non-Agency (or private label) mortgage market. The agency mortgage market, which is a much larger share of the market, are mortgage bonds that have their principal and interest insured by a GSE (Fannie Mae, Freddie Mac, Ginnie Mae). While non-agency bonds are underwritten by financial institutions and have no insurance against loss of principal (unless its built into the bond structure, but that is an aside).
    The beginnings of the crisis occured in the Non-Agency area, where all of subprime is located. I think there was at first a fundamental disconnect between the poeple making the loans, many of which were predatory on unqualified borrowers (NINJA and no doc loans etc), and the people who traded/invested in the bonds created by those loans. Investors do not typically analyze individual loan data (remember there can be thousands of loans, this is why burry’s analyst was so aghast when asked to pull the data in the movie) but rather look at aggregates and trends. Then to tie it all up and really make it all worse, through functionally alchemy the street created very complex financial instruments, and asked very non-complex (traders) people to trade them. The issue was that the pricing of these instruments is extremely sensitive to a small number of key assumptions that where based on a very small and limited data set. Without getting into the real nitty gritty the fundamental error in the assumptions was that a default in one part of the country would not be related to a default in another part of the country, which obviously turned out the be scarily false in the wake of a broader economic recession. Greed and other incentives led traders and investors to both take for granted the quality of the underlying loans and to make aggressive assumptions in their models that led to a drastic bubble.
    However, I do not think the mortgage crisis alone would have created the financial crisis on the scale that we experienced, the real issue was the system risk inherent in the financial system. There are two not very well understood aspects of the financial system that I think led primarily to what ultimately happened. The first is the reliance on overnight and very short term funding Banks and other financial institutions fund themselves by borrowing overnight on a secured basis vs securities that they place on hold with the lender as collateral. Naturally, as more and more of these non-agency bonds where made, they were used more and more as collateral, which was fine when the prices where going up since a higher price could justify more borrowing (see the vicious circle?), but when prices are going down that collateral all of a sudden doesn’t look as good, and if for one day (JUST ONE DAY) your counterparties are too scared to lend to you becuase they are worried about your solvency, you fail. This is exactly what happened to Bear Stearns, a firm that had been profitable since the civil war, but which funded a quarter of its balance sheet overnight.
    The other issue, that is probably even less understood, is the interconnectedness of the street via derivative contracts. This is complicated but essentially imagine a loan you take out from the bank, and imagine you repay that loan, but instead of you just giving the bank cash, you actually keep the old loan, and create and offsetting loan with the bank. The net exposure is 0, in that neither you nor the bank owes each other money, but instead of one legal document saying you owe the bank money that is then cancelled, there will be two offsetting legal documents that say you two owe each other the same money. If we expand this concept to the real world, there are millions (im guessing, maybe tens of millions?) of legal contracts kind of just out there in the ether that all net to 0. BUT they only net to 0 if you and the bank continue to be going concerns, if one of you fails, then what was then a hedged position is now a massively naked risk position. Magnify this by the trillions and you begin to understand why these banks are too big too fail, since a domino effect of one bank dropping out of their derivative commitments leading other banks to default on their commitments and so on and so forth until the whole system collapses.
    To this end, a lot of the post crisis regulation has looked to solve these two issues (and by virtue create new ones, but so it goes) through the requirement of more stable funding sources and derivative clearing, but we are not nearly out of the woods yet.
    I hope this was helpful, there are many many aspects to the crisis and many good books about it, but I tried to highlight what I thought were the main drivers.

  62. Patrick D says:

    Mark Logan,
    Obviously not. It was the public in general, which benefited from the money injection. I believe that key to they mystery of no appreciable effort to investigate what was causing the boom.
    Exactly! I watched the housing bubble grow, was not surprised to see it pop but underestimated the reach of the damage. I wrote the item below on Oct 2, 2008 to capture my thoughts at the time. Note that they are laced with a good deal of bitter sarcasm.

    I was thinking through this the other day to “follow the money” and remember what was going on at the time. It highlighted a number of issues that demonstrate how much of what is being said today is BS.
    As I recall, the circumstances that prevailed for roughly the previous 10 years were as follows:
    Money is cheap. Lenders have cash they need to move. Lenders and borrowers get reckless. Lenders and borrowers agree to mortgages the borrowers can barely manage to buy houses they cannot really afford. Risk? Most borrowers don’t know the meaning of the word… nor, apparently, the meaning of the word “variable” or “adjustable”… nor are they capable of comparing that initial mortgage payment to their monthly income, nor calculating what that payment could be in a few years when the rate adjusts. For the shrewd borrower with little to lose, they just got a juicy option on a house for little or nothing. If the value goes up, sweet! If it drops, they can just walk away. For the lenders, they’re selling this loan eventually and, besides, there’s a piece of land with a house standing there. That’s worth something.
    All these new buyers drive up prices for existing inventory and demand for new inventory. Transactions take place and money moves. For existing inventory, sellers take most of it with a nice profit. If they go back into the market and upgrade most of the money moves on. Mortgage brokers and real estate agents get a percentage of the inflated sales prices and are making some serious coin.
    For new inventory, builders and developers take most of the money to pay their suppliers, employees and subcontractors and take a profit if they’re competent. Times are great for equipment and materials suppliers and distributors, carpenters, electricians, plumbers, painters, etc.
    Homeowners who don’t sell love it too. Their home equity inflates so they are eligible for bigger lines of credit at those lower interest rates to buy stuff. It is better than a credit card because mortgage interest is lower and has tax benefits. Let’s not forget the ego factor either. An appreciating house makes one feel good about one’s investment decisions and optimistic about retirement.
    All these new real estate transactions at higher prices are great for property tax revenue. Local gov’t may get a bit stretched supplying new infrastructure for the new homes (these are good problems to have) but school districts are bringing in more. Seems like a lot of Main Streeters are doing pretty well, no?
    At the macro level, the construction industry is a major driver in the U.S. economy generating income tax revenue for the states and the feds when they are running deficits and juggling debt. Politically, those construction jobs are important for keeping the unemployment numbers down as well. Many of those jobs are Union too. YES! Geographically, a lot of that construction takes place and creates jobs well outside the major metros, for a change, and in areas with stagnant economies (a.k.a. Small Town America… and why are real estate values jumping in Detroit??).
    So, now the banks have loans but they want to make more and, besides, those potatoes are HOT. That’s what Fannie and Freddie are for. It is why they exist. They enjoy privileged regulatory status and lobby Congress hard to maintain it. They make all sorts of guarantees and everyone from the Bank of China to my father-in-law “knows” they are backed by the Federal Government so they are confident lending them money or investing in them. Risk? Don’t you have faith in the government’s money?
    Fannie and Freddie take most of the conforming loans but the rest of the conforming and all of the “jumbos” have to go somewhere. American real estate is the biggest game around and everyone wants a piece of the action. New players like investment banks are game now. They’ll take whatever is left. Money is no object when you play the game leveraged (30-40/1 debt to equity range I’ve heard?). Everyone from the original lender up the financial services ladder takes a cut. Nice business. A little bit of many mortgages adds up. Risk? Portfolio management will take care of that and, besides, we can buy insurance. Insurance companies know all about risk.
    Now that things have started to collapse everyone wants to know why someone didn’t stop it. I don’t see that anyone had an interest in doing so. I guess the Federal Reserve could have raised interest rates but it is embarrassing to blame a handful of individuals for not “protecting us from ourselves”.
    The government proposes “bailing out Wall Street” according to the common view. That cut (commissions, bonuses, salaries) for each level of the secondary “Wall Street” market is a small percentage of the money those mortgages represent. It’s not like Wall Street is working with a private pool of money consisting of their personal savings. The bulk of the money lent belongs to other people. Who? Wall Street? Main Street? Asia? Europe? Hard to say who the ultimate lender is. Shareholders and bondholders of the firms involved would be comprised of all of the above.
    Now that things have started to collapse, whose money is at risk on the lenders’ side? Who is really getting bailed out? Who is losing their house? If its value is less than the mortgage is it really their house or are they just renters? If someone bought and borrowed with little or nothing down aren’t they as much a high-risk speculator as any Wall Streeter?

  63. Patrick D says:

    Mr. Sale,
    Thank you for writing this piece. I hope you explore the crisis further and continue to share your thoughts as you do.
    My $.02:
    – While I have no doubt there was criminal activity it would be a mistake to approach the topic with the idea that that is all it was. Just like bogus political science and international relations theories are at the core of many of the U.S. foreign policy issues regularly discussed here, bogus economics and finance theories are at the core of U.S. and global economic issues.
    – Little fish engage in activity that breaks the law. Big fish change the law before they engage in that activity or have friends who make sure the law is not enforced. The collapse of MF Global is a good example. Jon Stewart did a pretty good job with explaining that one although I believe Corzine’s easy manipulation of government went beyond getting the regulators called off to lobbying Congress to change the regulations that would have prevented MF Global from investing in European government debt in the first place.

  64. Thomas says:

    Thank you for sharing your insight.

  65. Babak Makkinejad says:

    You might like to read the Isaac Beshiver Singer’s story: “The Gentleman from Krakow”.

  66. turcopolier says:

    From Richard Sale “I want to apologize to the readers of this site. I completely botched the opening to my article on “The Big Short.” I was taking notes on Lewis’ book and typing them out, my head turning from one to the other, and at times I wrote sheer nonsense. My wife, an excellent proofreader and editor, usually takes out my stupidities, but she had not read it, and the stupidities remained.
    Everyone was very polite about it, and it was a very poor performance, so please be patient.” pl

  67. different clue says:

    The American jobs lost during the Free Trade Bonfire of the Industries were mainly well-paid-with-benefits shinola jobs in manufacturing. The jobs gained during that same “Bonfire of the Industries” period were mainly low-paid McSh*t jobs in the service-sector.

  68. different clue says:

    Obama certainly telegraphed that punch with his effort to degrade and attrit Social Security in order to weaken it for eventual Yeltsinization. Obamacare provides for stealth defunding of Medicare over time time in order to privatize it and voucherize it to recipients to flush all the money down the Wall Street and down Big Insura. We could call it the “Ryan-Obama” plan. Hopefully enough bitter opposition can stop it.
    I expect the Tea Party Republicans will become defenders of Medicare and Social Security. Some legacy New Deal Democrats will join them in that effort. The Wall Street Republicans and the Wall Street Clintonite Obamacrats will join forces to privatise Social Security and Medicare . . . or at least begin sliding them that way.
    A President Clinton poses a greater threat to Social Security, Medicare, the VA Hospital System, etc. than a President Trump would. Clintonistas can tell us what a President Trump would pose a greater threat to. And we can all decide which “greater threat” really is the Greater Threat. I hope Sanders stays in the nominaton race to a bitter end on the convention floor . . . to put the Democratic Party through excruciating changes and tortures in front of God and C-SPAN.
    Of course if the Rs nominate one of their name-brand figures instead of Trump, then I will vote for Clinton.

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