The 2008 financial crisis was a complex event driven by excessive leverage, the proliferation of subprime mortgages, and interconnected financial institutions, ultimately leading to a near-global depression and fundamentally reshaping the financial system.
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Today I'm going to discuss a very
complicated but crucial topic. The
financial crisis and how it created
today's financial system. Its causes are
multifaceted and complicated and we're
going to explore it all. Its importance
can't be overstated. It brought the
global financial system to its knees.
The world almost entered a massive
global depression. By 2006, underwriting
standards had deteriorated so that
virtually anyone could get a loan. The
problem was that everyone involved in
the process was paid on the basis of
volume and not loan quality. The more
volume, the more everyone got paid. So,
no one had an economic incentive to slow
the gravy train. And here's where I come
Hi, this is Steve Eisman and welcome to
another episode of The Real Eyesman
Playbook. Today I'm going to discuss a
very complicated but crucial topic, the
financial crisis and how it created
today's financial system. Because of the
length of this lecture, I'm going to
break it up into two parts. The topics
I'm going to explore are the causes of
the financial crisis, regulatory changes
that occurred afterwards that have
permanently changed the industry, why
did Silicon Valley Bank fail, and was it
ever a threat to the financial system,
and finally, the regulatory changes I
think the Trump administration will be
making. It's a lot, so let's get
started. The financial crisis of 2008 is
now history. Its causes are multifaceted
and complicated and we're going to
explore it all. Its importance can't be
overstated. The crisis was not just a US
event but global. It brought the global
financial system to its knees. The world
almost entered a massive global
depression. And the actual recession
that occurred as horrible as it was was
by far not the worst case scenario. That
thankfully was avoided. The regulatory
changes imposed in the financial sector
afterwards change the financial sector
and system forever, making it much
safer, but with unforeseen consequences
as well. And because of those unforeseen
consequences, I believe the new Trump
administration will make changes that we
will also explore. But first, an
overview. The financial crisis had four
interlocking causes. One, too much
leverage in every financial institution,
but most importantly in globally
systemic institutions, which is just a
fancy term for very large banks and
investment banks. Number two, a large
asset class, subprime mortgages that
blew up. Number three, systemically
important financial institutions owned a
lot of that asset class. and four
derivatives tied the balance sheets of
large institutions together in a web of
such complexity that no one knew where
it started and where it ended. So let's
start with topic one too much leverage.
The leverage story is long and I'm going
to talk about it for a while. To
understand the leverage story, you need
to understand that the business model of
banks is different from other business
models. Unlike other businesses, banks
require leverage to generate an adequate
profit. And a bank's cost of goods sold
are unknown at point of sale. Now, a
bank's cost of goods sold are the losses
that occur from the loans that it makes.
And when a bank makes loans, it can only
make an educated guess as to what those
losses will eventually be. Before I
explore the too much leverage problem, I
actually first need to explain how a
bank works. What does it do? And I'm
going to spend a long time on this
because you can't understand the
financial crisis without understanding
these crucial fundamentals. The
traditional bank makes loans.
Conceptually, I like to say that a bank
sells you access to its balance sheet
for a price. And the access is via a
loan. And the price is the interest rate
that it charges. I'm going to spend a
lot of time here because once you get
this, you are 90% of the way to
understanding how the financial crisis
unfolded. And to understand why a bank
needs leverage to function, let's do a
thought experiment and start a new bank.
Let's say bank A, a new bank, raises 1
billion in equity and the marching
instructions are for the bank to use
zero leverage, meaning no deposits. I'm
going to oversimplify here. So, let's
say that the bank makes 1 billion in
loans with the money that it raised, the
1 billion in equity. Now, that would
never happen. Every financial
institution needs some level of
liquidity or cash for a rainy day. But
let's just go with my example. Our bank
A has 1 billion in equity and 1 billion
in loans. For a bank, the loans it makes
are its assets. From a mathematical
perspective, there is no leverage. But
that means that the leverage ratio is
one. Here leverage is defined as assets
divided by equity. And here the equity
and the assets are the same. Now, how
profitable can this bank be by making
loans to good customers at today's
normal interest rates? Since the bank is
selling access to its balance sheet for
a price, the key measurement of
profitability is return on total assets,
the ROA, which is net income divided by
total assets. Here the bank charges
interest on loans and that is its only
source of revenue. Then it has operating
expenses. It has to pay its employees
and its executives. It has office space,
computers, etc. It also has to estimate
future losses on its loans, which is
called the loan loss provision. And then
it pays taxes to the government. What's
left is net income. Take that net income
and divide it by total assets and you
get the ROA. So let's assume our bank A
has an ROA of 1%. Now 1% of 1 billion
equals $10 million. Trust me in that a
1% ROA in Bank World is not bad. It's
not stellar, but it's not bad. JP Morgan
has more than a 1% ROA, and Cityroup has
had less than 1% for decades. Bank
managements are compensated not on the
ROA of the company, but the return on
equity, the ROE. And here's the key
formula, and this is crucial. ROE equals
ROA time leverage. So here the ROA is
1%. Since assets and equity are the
same, the leverage is one times. And so
the ROE is 1% * 1 equals 1%. So the ROE
is 1%. Now 1% return on equity is a
terrible number. So let's try the
thought experiment again, but with some
leverage. By the way, we're going to put
a table up to show each of the examples
so you can more clearly see the numbers.
So, in our second example, our bank A
starts with the same 1 billion in
equity. And now, let's open a branch and
bring in depositors. And let's say bank
A brings in 9 billion of deposits, some
checking and some savings. The bank is
now transformed. It has 1 billion in
equity and 9 billion in deposits. The
deposits are a form of debt because if a
depositor shows up and wants his or her
money, the bank has to give it to them.
Bank A now has 10 billion of total money
with which it can make loans. And let's
say it does make 10 billion in loans.
First, notice that the leverage ratio
was now 10 times 10 billion in assets
divided by 1 billion in equity. Still,
the only revenue the bank has is the
interest it charges on this 10 billion
in loans. But now it has an added
expense. The interest it pays to its
depositors. It still has operating
expenses. It still has to set aside its
estimate for future losses on its loans.
And it still has to pay taxes. Let's
assume that this version of bank A makes
the same 1% ROA. But here it's 1% * 10
billion, not 1 billion and that equals
$100 million. The ROE is now 10%.
Which is the 1% ROA times leverage of
10. So from an economic perspective,
this more levered bank is no more
profitable than our original non-levered
bank. They both have an ROA of 1%. But
because version two is 10 times levered,
it has an ROE of 10%. Which is not
terrible versus the earlier terrible 1%
ROE. Leverage turbocharges the bank's
profitability. Now let's make the
example even more extreme. Instead of
gathering 9 billion in deposits, let's
take in 99 billion in deposits. Now the
bank makes 100 billion in loans from the
99 billion in deposits plus the 1
billion in equity. The leverage is now a
100 times. Assuming the same 1% ROA,
this high octane bank makes 1% ROA times
100 billion which is a billion dollar.
The ROE is 100% which is 1% ROA times
100. So that's how a bank works. As long
as it's profitable, then the more
leverage, the higher the ROE. I'm going
to say that again. As long as a bank is
profitable, then the more leverage it
employs, the higher the return on
equity. There are a lot of lessons to be
taken from this thought experiment.
Lesson one, bank executives are
compensated largely on a combination of
net income and return on equity. The
higher the net income and return on
equity, the more they are paid. Since a
bank's net income and return on equity
tends to go higher with more and more
leverage, the temptation for leverage to
increase in all banks can be
overwhelming and often only regulators
can stop it. Lesson two. In our thought
experiment, bank A keeps getting more
profitable as leverage goes up. In all
three examples, the return on assets was
1% and the return on equity increased
solely because of leverage. But banks
can lose money. How? When they
underestimate the level of future
losses. Suppose that because of higher
losses, our bank loses money and instead
of generating a 1% ROA, it has a
negative 1% ROA. To see how too much
leverage can be dangerous, let's look at
our highly 100 times levered 100 billion
bank. -1%
* 100 billion equals -1 billion. Since
our bank only started with 1 billion in
equity, it is now wiped out. So more and
more leverage is great so long as the
bank makes money. But if it is too
levered and loses money, it can be wiped
out quickly. Lesson three, and I can't
emphasize this enough, do not take away
from this thought experiment that all
leverage in banks is bad. Quite the
opposite. We want banks to be levered.
That is their social purpose. Banks take
deposits that their customers give them
and recycle that money as loans to other
customers. We want banks to do that. If
we did not allow banks to recycle
deposits or restrain their leverage to
very low levels, banks would have to
charge very, very, very high levels of
interest to generate an adequate return.
It's because banks employ leverage that
they can make a decent return on equity
with only a one-ish return on assets.
For most businesses, a 1% ROA is awful.
For a bank, it is adequate so long as it
can have at least 10 times leverage. We
want banks to recycle money and
therefore we want them to have leverage.
The difficult question is how much
leverage is too much. We don't want
banks to have too little and we don't
want them to have too much. It's kind of
like little bears porridge. It has to be
just right. And we explore this later
on. So, now that I've explained how a
bank employs leverage and why it needs
to have leverage to generate an adequate
return, let's begin to look at the
crisis. There is no question that by the
time the crisis began, large banks had
way too much leverage. How did that
happen? Between 1997 and 2007, leverage
in large financial institutions tripled.
In Europe, for example, the average bank
leverage ratio climbed from 11 times to
33 times. In 2007,
City Bank's leverage ratio was 33 times.
If you included all the offbalance sheet
stuff that City Bank had risk for, which
was not on its balance sheet, the
leverage ratio was probably over 40
times. And the same is true for all the
large investment banks of that era like
Goldman Sachs and Lehman. And now we
have to turn to an intellectual concept
whose importance I cannot overstate
called risk weighted assets or RWA. This
one concept might be the most important
reason for the crisis and its origin is
completely honorable. In our three bank
examples, I calculated leverage as
assets divided by common equity. It was
just simple math. But imagine two banks,
each with 10 times leverage and each
with the same amount of assets and
equity. Both are levered the same and
both are the same size, but one bank
makes only very high risk loans and the
other only lowrisk loans. How does a
regulator deal with that? So sometime in
the late 1980s, the banking system began
to marry two concepts, leverage and
risk. And the concept of risk weighted
assets or RWA was born. Every bank asset
is given a risk score and that score is
multiplied by the size of the asset so
that a bank can calculate not only its
assets but its risk weighted assets as
well. So two banks might have the same
level of assets and equity and both on a
simple math basis are levered 10 to one.
But the risky bank might have much
higher risk weighted assets than its
assets. And the less risky bank might
have less RWA than assets. It all
depends on how much risk each bank is
taking. So our two banks might both be
levered 10 to one, but on an RWA basis,
the risky bank might be levered 20 to1
and the less risky bank might be levered
only 5 to one. By the way, up till now I
have spoken about leverage. But when
banks discuss this concept, they talk
about bank capital ratios. This is the
same thing as leverage. Only the
numerator and denominator are reversed.
So leverage is assets divided by equity
or RWA divided by equity. And bank
capital ratios are equity divided by
assets or equity divided by RWA. Just a
point. Conceptually, the risk weighted
asset idea makes a lot of sense, but its
acceptance through banking on a global
scale had several implications and
unforeseen consequences.
Hi, Steve Eisman here. On my weekly rap,
I try to both teach and convey
information as objectively as possible.
I try to make clear what are the facts
and what are my opinions. But in today's
media, it's increasingly hard to figure
out what are the facts and where the
facts are being shaded by opinion.
That's why when I look into news events,
I first go to ground news. Ground News
is my solution for getting to the facts
of important stories, but also to see
how left, right, and center are seeking
to convey the same exact story. Take for
example the recent Senate rejection of
dueling health care bills as the
Obamacare deadline near. To understand
the story, I went to groundnews.com and
clicked on that particular story
headline. There I immediately saw four
tabs, left, center, right, and bias
comparison. When I clicked on the center
tab, a series of headlines appeared, all
from centerleaning sources. I could then
click on any of those headlines and read
the story at the source. The same
happened when I clicked on the left tab
and on the right tab. The bias
comparison tab showed Ground News's own
analysis of how all three political
leanings conveyed the same exact story.
I find the ground news system enormously
helpful because it allows me to easily
separate the facts from opinions. I use
Groundnews and I recommend you try it
to get 40% off their unlimited access
Vantage subscription. That's groundnews.com/real.
groundnews.com/real.
And if you don't mind, use this link to
get the discount so they know I sent
you. Regulators and bank CEOs look at
their leverage or capital ratios on an
RWA basis and not on a simple math
basis. How is an asset scored to
generate its RWA? That is mostly
delegated to the ratings agencies.
Something rated AAA has a very low RWA
score, maybe as low as a singledigit
percentage. Something not rated might
have a very high RWA score. or something
rated very low might have a very high
RWA score. The score is generated by the
historic level of losses that the asset
class generates combined with how
volatile that loss range can be. So an
asset class with an historically low
level of losses and a narrow range of
losses will have a low RWA. Here are
some unforeseen consequences. First, as
we've learned, banks have a built-in
incentive to increase their leverage so
that their return on equity goes up so
that the CEO can make more money. So,
banks have an incentive to load up their
balance sheets with lowrisisk weighted
assets. Mathematically, you can have a
bank with an everinccreasing absolute
leverage ratio, but because it keeps
adding on lowrisisk weighted assets, the
RWA capital ratio might be largely
unchanged. Number two, the RWA score
depends on history. What is the historic
level and range of losses? That level
and range are not a law of physics.
Loans are made by human beings and
institutions. They have underwriting
standards. And these standards can
change. They can loosen and they can
tighten. If for some reason underwriting
standards loosen continuously over
several years, losses will gradually
climb to levels above their historic
range. I emphasize eventually because
losses don't happen overnight and this
can be dangerous. Suppose there is an
asset class say mortgages that has a
historic low level of losses and
therefore a low RWA score. And suppose
underwriting standards loosen. It takes
time for losses to eventually show up.
So banks could be making mortgage loans,
assuming the old level of losses still
apply. They could load up their balance
sheets with these mortgages and their
leverage on a simple math basis could
explode while their leverage on an RWA
basis stays the same. If losses started
to climb to high levels and the absolute
leverage ratio was too high, it could
turn into a disaster. Another one,
psychology. I can't overstate this
point. By loading up a balance sheet
with low risk weighted assets, a bank
can kind of game the system. It can
increase its leverage and increase its
return on equity. And since all bank
capital and leverage ratios from a
regulatory perspective are calculated
via risk- weighted assets, a bank could
have a higher leverage ratio on a simple
math basis but a decent leverage ratio
on a risk weighted basis. And this is in
fact what happened from 1997 to 2007.
Because of this increasing leverage on
an absolute basis, bank roe kept going
up. Remember when I said that in Europe
leverage on an absolute basis went up
from 11 times to 33 times? Guess what?
Return on equities tripled as well. This
meant that the return on assets stayed
the same. Banks were no better run than
before. Their return on equity or
profitability improve because of more
and more leverage and that was it.
Ironically, leverage during this period
on a risk weighted asset basis was
flattish. So bank CEOs developed a sense
of being godlike because their return on
equities kept going higher. In fact,
they really were not any more profitable
than they had been. It was just they
used more and more leverage. And you
don't need to be a genius to increase
leverage. You just borrow more. And as
these bank return on equities kept
climbing, bank CEOs kept getting paid
more money. And here is the psychology
part. An entire generation of bank CEOs
mistook leverage for genius. Suppose you
went to a bank CEO in 2006 and predicted
the coming crisis and told the CEO that
the entire basis of his business model
was wrong and that the use of more and
more leverage was going to cause a
disaster. How do you think that CEO
would respond? He might not say this,
but this is what he would have thought.
I made $50 million last year. I can't be
wrong. Again, an entire generation of
bank CEOs mistook leverage for genius.
Now, before we move on to the second
cause of the financial crisis, I want to
pause here to discuss a related issue.
After the crisis, some commentators
argued that deregulation of the banking
industry caused the financial crisis,
specifically the elimination of
GlassSteagall. And I think that's just
wrong. Glass Eagle was a law passed
during the depression that separated
banks from investment banks. It died
during the 1990s. I believe quite
strongly that even if GlassSteagall had
been strictly enforced, the great
financial crisis would still have
happened. The entire risk weighted asset
concept was created independently of
anything related to GlassSteagall. It's
the leverage that was created because of
the RWA concept that was the problem.
and the same subprime loans would have
been made regardless of glass steagel.
So let's now discuss that cause number
two subprime mortgages as a dangerous
asset class. Subprime mortgages blew up
the world. But because almost no
subprime mortgages are made today, few
people even remember what this asset
class was about. Now I have a long
history with the subprime mortgage
sector. In the 1990s, I was a sellite
analyst at Oppenheimer where I covered
the financial services sector. I covered
everything that was not a bank or an
insurance company. My coverage was quite
broad. I followed investment banks,
asset managers, Fanny May, Freddy Mack,
credit cards, and several specially
finance companies. And I also covered
the subprime mortgage sector. Back then,
it was a small sector making mostly home
equity loans to subprime borrowers who
use the money to pay bills and or to pay
off other forms of debt. Now, who is a
subprime borrower? technically a
borrower with a credit score below 650,
but that's just a number. The potential
subprime borrower was the entire lower
middle class of the United States and
parts of the middle class as well.
Starting in the early 1990s, household
income growth on an inflationadjusted
basis in the United States stopped
increasing. It's a problem that
continues to this day. The reason for it
are beyond the scope of this podcast.
Hopefully, we will explore it sometime
in the future. But statistically, it's a
fact. The real incomes of most Americans
stopped growing. So, the only way for
many Americans to increase their
spending was to borrow. As a society,
the lack of middle class income growth
was and is a serious problem. It's one
major reason why President Trump is
president again. And as a country, we've
never really tackled it. And there was
no political will to tackle it back in
the '9s at all. It was far easier to let
people borrow to increase their spending
rather than finding ways to improve
their incomes. Anyway, lending to this
growing subprime population became a
gross sector. But prior to the 1990s,
there was an inherent problem. Companies
that lent to subprime borrowers were
small and were looked down upon. They
had poor rating agency credit ratings
and so had a hard time getting funding
to make the loans they knew they could
make and then securization was invented
and that changed everything. Now I don't
want to go into a lot of detail here
because in the future I will be doing a
lecture on fixed income where I will
explore securization in depth. In the
pre-securization world, the subprime
lender would raise debt and use those
proceeds to make loans. The interest on
its loans was higher than the interest
on its debt, and it made a spread or net
interest margin. But because of bad
ratings, a subprime lender's ability to
raise debt was limited. In a
securization, however, a company might
originate $1 billion in subprime loans,
package the loans, and put them into a
securization. The ratings agencies would
give the securization and not the
company a credit rating, and the
interest on the loans in the
securization would be higher than the
interest paid on the securizations. So,
the subprime mortgage company would make
a spread or a net interest margin
through the securization. Generally, the
credit ratings on the securizations
created a market for these companies to
raise funding that was far bigger and
more liquid than their old method of
raising debt on their balance sheets.
Suddenly, funding was no longer a
constraint on growth. And these
companies began to really grow. And it
wasn't just subprime mortgages that
grew. It was also subprime credit cards
and subprime auto loans as well. Now,
the first pure subprime mortgage company
went public in 1992 and others soon
followed. Some names from back then were
the Money Store and Ames Financial. In
1993, the subprime mortgage industry
generated only 20 billion in loans. By
1998, the industry was producing about
150 billion per year. Growth had been
explosive. But in 1998, the industry
blew up. It blew up because of bad
accounting methodology. And it's a long
story and I'm not going to go into it
here. Suffice to say that by the end of
1999, many companies were bankrupt or
retrenching rapidly and that was the end
of the subprime mortgage sector 1.0.
There was a recession in the United
States in 2000 and when it ended, the
Fed led by Alan Greenspan had cut the
Fed funds rate to 1% which back then was
revolutionary but today seems kind of
quaint. Back then, this low Fed funds
rate created a problem for bond
investors. Bond investors need yield,
but it was hard to find in a 1% rate
world, and Wall Street wanted to supply
it. So, one potential supply would be
subprime mortgage loans because they
charged high rates. But the industry
barely existed anymore. So, Wall Street
brought new companies public. Companies
like New Century went public, but not
all subprime mortgage companies went
public. Some of the largest like
Americaest remained private. This
industry was a gold mine for Wall
Street. They brought the companies
public. Then the mortgage companies
would originate subprime mortgage loans
and sell those loans in bulk to a Wall
Street investment bank or to a bank. The
investment bank or bank would package
those loans into all different kinds of
securizations and sell those loans to
investors throughout the world. The
lender, the Subprime Mortgage Company,
made money three to four points it
charged the consumer and then made
another two or three points when it sold
those loans to Wall Street. So five or
so total points on 1 billion in loans
equals 50 million in revenue. Wall
Street would sell those loans via
securization at a markup as well to
investors all over the world. Everyone
made money. It was quite the gravy
trade. Funny thing was that many of the
managements of Subprime 2.0 were the
same people who managed 1.0. That's why
I began to think that one day this
industry would blow up again because it
had blown up in 1998 and the players
were mostly the same. Normally people
don't change. So as early as 2003 I was
looking for signs of problems. What I
did not imagine was that the subprime
mortgage sector would get as big as it
did. In 2002, the industry started to go
public and growth took off and every
year industry originations grew. Why?
Remember when we discussed earlier that
banks don't know their cost of goods
sold at point of sale and what that
means is that cost of goods sold in
lending is future losses on loans.
Emphasis here is future. All a lender
can do is estimate future losses. It
won't know if that estimate is right for
a few years. So a lender lends to what
is called a risk adjusted yield. It
charges an interest rate to a borrower,
subtracts its own interest expense, and
then subtracts the estimate of future
losses. Again, it subtracts its estimate
of future losses. That's the risk
adjusted yield. Think of it as
profitability before operating expenses.
Suppose it turns out that delinquencies
and losses are much lower than
anticipated. The lender is not really
happy here because they conclude that
their lending standards were too tight.
They could have had looser standards,
originated far more loans. Sure, they
might have higher losses, but they would
still achieve their risk adjusted yield
and they would be much much much more
profitable because of the extra volume.
And that is what happened to the
subprime sector in the early 2000s. On
the one hand, the economy was good. On
the other hand, middle class household
income was stagnant. But because of low
rates, the housing sector was doing well
and home prices kept increasing. People
tend not to default on their mortgages
when they are building equity in their
homes because of rising prices. So from
2002 through 2006,
subprime lenders kept loosening their
underwriting standards. And every year
delinquencies kept coming in below
expectations. So the industry loosened
more. By 2006, growth had exploded.
Around 600 billion was being generated
annually in loan volume, which was
around 20% of the annual mortgage market
of the entire United States. A once
cottage industry had become big
business. But, and here's the big butt,
underwriting quality had collapsed. I
remember when I began to do a deep dive
on the subprime securization market in
2006 that I discovered something that I
found astonishing. At least 50% of all
loans in the securizations
were originated via a method called low
dock no dock. And what do I mean by
that? A subprime borrower has a credit
score below 650. Credit scores start to
lose their efficacy below the 650 level.
So, a subprime loan needs more careful
underwriting, not less. But because of
low delinquencies, the industry went in
the opposite direction, so that by 2006,
at least 50% of all loans were
underwritten with very little
underwriting. The borrower was asked
what his or her income was, and that
income was barely verified or not
verified at all. The borrower was taken
at his or her word. I like to say that
by 2006, mortgage underwriting standards
were so low that if you could breathe,
you could get a mortgage loan. And I
don't even think I'm exaggerating there.
And now I'm going to get on my soap box.
There were massive social implications
resulting from the growth explosion in
subprime mortgage lending. And this was
because of the structure of the subprime
mortgage loan. It was typically a teaser
with a go-to rate adjustment. That's a
fancy way of saying that the borrower
got a low fixed rate for two or three
years and afterwards the rate went up to
LIBOR plus 600. Essentially, people got
a 3% rate for 2 to 3 years and after
that period they got repriced to around
9% for the next 27 to 28 years. And
here's the crazy thing. The lender
underwrote the loan to the teaser rate.
Meaning that the lender knew at the
outset that the borrower could only pay
the 3% rate and that when the rate
climbed to 9%, the borrower would
eventually default. Now, was this just a
scheme to take people's houses? I don't
think so, because it is expensive to
repossess someone's home. The design was
actually different. In a typical
subprime loan, the originator charges
three to four points as a fee. That
compares to one point or less for a
prime loan. Now, most borrowers and
subprime land were unsophisticated. They
really did not understand that their
loan would be repriced from 3% to 9% in
2 or 3 years. And when that deadline
approached, the lender would then
contact the borrower and remind them.
the borrower would freak out because
there was no way they could pay 9%. So,
the lender offered to refinance under
the same terms of 3% for 2 to 3 years
and then the same go-to rate. Of course,
this was not free. The lender would
charge the same three to four points for
refinancing. And the borrower, however,
would not actually pay out of pocket
those three to four points. Instead,
that amount was added to the principal
amount of the new loan. So borrowers
were forced to refinance every few years
and pay the enormous 3 to four points
for the privilege and rolling those
points into the principal amount of the
loan meant that the subprime borrower
never paid down any principle on their
mortgage. Subprime borrowers were placed
on a treadmill from which they could
never get off. Now socially this was a
disaster for the middle and lower middle
classes of the United States. But from
the mortgage industry's perspective and
Wall Street's perspective, this was a
gold mine. Every three years or so, the
borrower would refinance and the lender
would make another three to four points.
And when Wall Street would get to
repackage the same loans in a new
securization and they sell those
securizations to clients all over the
world at a markup, everybody made money
and everybody was paid on volume. Yet,
this gravy train functioned only as long
as borrowers could refinance. If
something happened to stop refinancing,
then all borrowers would get repriced to
9% and defaults would soar. As I said
earlier, by 2006, underwriting standards
had deteriorated so that virtually
anyone could get a loan. And here's
where I come into the story. Having seen
the industry blow up in 1998, I was
waiting for years for the industry to do
it again. And that's where securization
actually was an enormous help to me. The
subprime mortgage industry securitized
100% of its loan volume. The securities
were rated by the ratings agencies and
every month the agencies put out data on
each securization.
Every month. Each securization disclosed
its 30-day, 60-day, 90-day delinquencies
for the month as well as repossessions
and losses per month. This was a
treasure trove of information. The data
was sort of public, not public to
everyone, but if you paid a subscription
fee to the ratings agencies, which we
did, you got it. And this data are
incredibly granular because it comes out
every month on every securization. For
analytical purposes, the key was to see
if there was any deterioration of credit
quality over time. In other words, my
partners and I would compare the
delinquency numbers for multiple
securization for let's say month 10 of
each securization. We wanted to see if
the 2006 securizations had higher
delinquencies in the same month than
earlier securizations. And what we found
was that for the 2006 securizations, the
early stage delinquencies were far far
far higher than securizations of any
prior year. This confirmed what we had
heard anecdotally that underwriting
standards had deteriorated terribly and
by the summer of 2006 it was pretty
clear that something was wrong. Now if
the mortgage industry and Wall Street
had appropriate incentives they would
have tightened underwriting standards
immediately and the problem would have
largely been contained. The problem was
that everyone involved in the process
was paid on the basis of volume and not
loan quality. The more volume, the more
everyone got paid. So no one had an
economic incentive to slow the gravy
train. The industry kept originating and
securitizing and delinquencies kept
climbing. The book The Big Short and the
movie starts in the spring of 2006. Now,
I'm not going to go through the book,
but here are a few highlights. We were
short the equity of a whole bunch of
public subprime mortgage companies. the
stocks. We were very convinced that the
industry was going to suffer enormous
losses, but the public subprime mortgage
companies like New Century were not
large cap stocks and trading was illquid
and the cost of borrow to short these
stocks was huge in some quick cases as
high as 20% annually. We simply could
not safely allocate sufficient capital
to shorting these stocks, especially
given that they were highly shorted. And
as depicted in the movie, that's when we
started to learn how to short subprime
securizations, which was a far bigger
and more liquid market. How do you short
a subprime securization? This is
something I'll talk about when I get to
the topic of derivatives. So, let's
pause on that one. Anyway, we began
shorting subprime securizations in the
fall of 2006 and kept shorting till
around July 2007. People sometimes ask
me how did I have the guts to remain
short when the hold was telling me that
everything was fine. Timing is
everything in life and here my timing
was kind of perfect. From the fall of
2006 till the summer of 2007 the
subprime credit data kept getting mostly
worse. Every month we would check the
data and feel good. The one period that
might have given us pause was in March
and April of 2007 when the data looked a
little better. But my partners and I had
a long history of researching consumer
lending companies. We knew that in March
and April of every year, consumers get
tax refunds and pay down some debt. So,
of course, the credit data looked
better. So, the securization market
experienced a rally, but we just use
that as an opportunity to put on more
positions. By the summer of 2007, credit
data was so bad that no one could be
remain in denial. investors all over the
world decided universally that they
would no longer buy any kind of subprime
securization, a buyer strike. And that's
when it all began to really unravel.
With an investor buyer strike in place,
Wall Street could no longer sell
subprime securizations to anyone. And if
Wall Street could not sell to investors,
then it had to stop buying loans from
subprime originators. And if subprime
origs could not sell their loans and
they had to stop making them. And if
subprime originators stopped making
loans, then consumers could no longer
refinance. And when consumers could no
longer refinance, their loans started to
repric to the go-to rate of around 9%,
which they could not afford. And then
the credit picture got even worse. All
this happened by late summer 2007, which
meant that the financial crisis was now
inevitable. Why?
And on that cliffhanger, I end part one
of this lecture. If you want to learn
the rest, wait for next time when I drop
the second half of this lecture. See you
This podcast is forformational purposes
only and does not constitute investment
advice. The hosts and guests may hold
positions in stocks discussed. Opinions
expressed are their own and not
recommendations. Please do your own due
diligence and consult a licensed
financial adviser before making any
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