Tuesday, September 06, 2011
The Big Short: Inside the Doomsday Machine
This is the second book about the financial crisis of 2008 that I have read this year. What "The Big Short" does that "The Greatest Trade Ever" did not was to expose the greed and corruption behind the scenes that created these toxic loans.
I would recommend this book to anyone who wants a better understanding about what happened during the 2008 financial collapse. The following is my rudimentary understanding of the situation.
A bond is a promise, usually from the government or a corporation, to pay regular payments for a specific amount of time. They are rated by bond rating agencies such as Moody's or Standard and Poor's and given a score: the higher the score (AAA) the better the chance that they will be paid off by the borrower.
In the 1980's the bond market expanded from boring corporate and government bonds to begin to pool mortgage loans together into their own bonds. The problem with that was mortgage holders could refinance loans and pay them off early. To address this, the bonds were broken into "floors". The "bottom floors" got the lowest rating because they are the loans that were paid off early: the higher the floor, the higher rating; and the higher the quality of loan, or so it seems.
Several things happened in the 1990's. First, Wall Street was making piles of money on these bonds which caused the demand to skyrocket. Lenders stop caring who they were giving money to and began offering more and more outrageous deals to entice more and more borrowers. Deals like an Adjustable Rate Mortgage (ARM) which offers a low introductory interest rate that rises quickly to exorbitant rates. These offers got even more ridiculous; no interest loans for a period, no payment loans that would add interest back into the loan. What kept this ponzi scheme afloat was that housing prices were rising and home owners could keep refinancing pulling more and more money out of their homes. As a result, the bonds created from these loans became more and more toxic representing debt that risked default rather than just prepayment if home prices stop rising.
What should have become apparent to investors (poor quality loans) were hidden by the bond rating agencies who used old corporate and governmental bond formulas to rate these sub-prime mortgage loans. Little was done to investigate the quality of loans within these pools. To make matters worse, Wall Street started to bundle the “bottom floor” of hundreds of different mortgage bonds and have them rated. 80% of these bonds were rated AAA, the same ratings at US Treasury Bonds. Crazy!!!
Several people saw the impending doom and began betting against these bonds. They believed that if as few as 8% of the loan began to default the “Bottom Floor” would be worthless. For a small premium (less than 2%), investors could buy insurance on these bonds called Credit Default Swaps (CDS) in essence getting paid if the loans defaulted. They defaulted big time.
This was an excellent read that I would recommend to anyone interested in learning how corrupt Wall Street is.
I would recommend this book to anyone who wants a better understanding about what happened during the 2008 financial collapse. The following is my rudimentary understanding of the situation.
A bond is a promise, usually from the government or a corporation, to pay regular payments for a specific amount of time. They are rated by bond rating agencies such as Moody's or Standard and Poor's and given a score: the higher the score (AAA) the better the chance that they will be paid off by the borrower.
In the 1980's the bond market expanded from boring corporate and government bonds to begin to pool mortgage loans together into their own bonds. The problem with that was mortgage holders could refinance loans and pay them off early. To address this, the bonds were broken into "floors". The "bottom floors" got the lowest rating because they are the loans that were paid off early: the higher the floor, the higher rating; and the higher the quality of loan, or so it seems.
Several things happened in the 1990's. First, Wall Street was making piles of money on these bonds which caused the demand to skyrocket. Lenders stop caring who they were giving money to and began offering more and more outrageous deals to entice more and more borrowers. Deals like an Adjustable Rate Mortgage (ARM) which offers a low introductory interest rate that rises quickly to exorbitant rates. These offers got even more ridiculous; no interest loans for a period, no payment loans that would add interest back into the loan. What kept this ponzi scheme afloat was that housing prices were rising and home owners could keep refinancing pulling more and more money out of their homes. As a result, the bonds created from these loans became more and more toxic representing debt that risked default rather than just prepayment if home prices stop rising.
What should have become apparent to investors (poor quality loans) were hidden by the bond rating agencies who used old corporate and governmental bond formulas to rate these sub-prime mortgage loans. Little was done to investigate the quality of loans within these pools. To make matters worse, Wall Street started to bundle the “bottom floor” of hundreds of different mortgage bonds and have them rated. 80% of these bonds were rated AAA, the same ratings at US Treasury Bonds. Crazy!!!
Several people saw the impending doom and began betting against these bonds. They believed that if as few as 8% of the loan began to default the “Bottom Floor” would be worthless. For a small premium (less than 2%), investors could buy insurance on these bonds called Credit Default Swaps (CDS) in essence getting paid if the loans defaulted. They defaulted big time.
This was an excellent read that I would recommend to anyone interested in learning how corrupt Wall Street is.
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Lewis knows how to turn a phrase and does a good job teasing out the dark humor of the situations. He also does a very good job at explaining the essence of very complicated financial transactions and gives the reader a good understanding of the whys and hows of the financial meltdown. While this book is an important addition to our understanding of what happened, it isn't complete as it doesn't spend any time talking about US government policies that contributed to the crash (specifically, the special legal status given to the three rating agencies, and Fannie and Freddie's role in weakening underwriting standards). Nonetheless, this is still both an important and entertaining book.
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