Sorting out the Big Short

Tonight I watched the Big Short for the second time. I highly recommend it to anyone. It does a remarkable job explaining some pretty complex financial topics in a way that is clear and understandable. If you want to understand why the economy collapsed in 2008, watch this movie.

The director typically does comedies, and that worked out really well, because it's a very enjoyable movie. Great acting, great dialogue. I've read the book twice, and the movie is very true to it. (The book's well worth a read too.)

It is just breathtaking the level of stupidity and outright fraud on Wall Street that this movie depicts. I don't use the term fraud lightly either.

I've been sorting out what I learned from the movie and the book and wanted to try to summarize what I think I learned, and what that means going forward. In particular, how this affects my take on Bernie vs Hillary, and what this might mean for Silicon Valley.

So here is my understanding of the events leading up to Great Recession. This is pretty complex financial stuff, so I may not have all of it exactly right, but this is how I understand what went on. For an even better explanation of this of course, see The Big Short.

Mortgage fees and bonds

The big banks made a fee each time a mortgage was sold, so they had an incentive to sell mortgages. But originally they were on the hook if those mortgages failed, so it was in their best interest to sell mortgages that would be paid back, and thus mortgages needed to be sold to those who could afford to pay.

Enter the mortgage bond in the '80s. Because mortgages were assumed to be a safe bet that would always be paid back, mortgages would be a safe place for investors to put their money, right? Thousands of mortgages were bundled together into a bond. People with houses pay their mortgages each month, and the people who own a bond on those bundled mortgages get a chunk of that money each month. Money in, money out.

A bond could have riskier mortgages rated say BBB, and because it's riskier, that would result in a higher payout. The safer mortgages, AAA, are less likely to fail, so give a smaller rate of return. A mortgage bond gets divided up into sections or tranches, and investors can choose which tranche matches the level of risk and reward they are most comfortable with.

Based on the percentage of safe mortgages in a bond, the ratings agencies (S&P, Moody's, Finch) give an overall rating to the mortgage bond as a whole. So an institutional investor like a pension can look for safe mortgage bonds with a low overall risk of failure. Because if enough of the lower tranches fail, then the mortgage bond as a whole fails.

Expanding home ownership through ARM wrestling

For a while this is all fine and dandy. Normal fixed rate mortgages are going into mortgage bonds, banks are getting a nice fee each time a mortgage is sold, only now since the mortgage is in a bond, they are not as responsible if the mortgage goes bad. Investors get steady paythrough from the underlying mortgages.

However the problem is that there are only so many people in this country who have good credit that are likely to solidly pay their mortgages on time. The banks need more people to buy mortgages, because they get a fee each time a mortgage is sold, and the brokers get a fee each time a mortgage bond is sold.

So you need more people to get mortgages that are less credit worthy. Enter the Adjustable Rate Mortgage. This has the advantage of being initially cheaper than it eventually will be, making more expensive homes affordable to people who may not be able to afford the eventual payments once the rate resets in two years. So more people can buy more homes. But don't worry, houses keep increasing in value, so you can refinance in two years into a new more affordable mortgage, and your increase in equity can fund the closing costs. And guess what? The banks get another nice fee with that refinance.

And here's the kicker. The ratings agencies decide that ARM loans are actually more valuable than fixed rate loans, because they assume that there won't be refinancing. They assume that the paythrough investors get will actually increase over time because when the ARM rate goes up, home owners will just pay that higher rate.

So now brokers have a serious incentive to sell mortgage bonds with more ARMs in them, and they give higher bonuses to mortgage brokers to do so. So more and more people buy loans with ARMs, but even then banks need more people to buy loans so they can get their fees. So they start reducing the requirements to get loans.

Need a second loan to eliminate the need for a down payment? Sure. More loan fees.

You don't have enough documented income to qualify for a mortgage? No worries, we'll waive those requirements. More loan fees.

Can't make your payments? No worries, just pay the interest for now. Or defer your payments for however long you like. More loan fees.

This got to the point where mortgages were being sold to low-income workers paid in cash, without verifiable incomes, just so banks could get more fees, brokers could get more fees.

The Ratings Game

But who would buy bonds based on mortgages this terrible? Well, the banks went to the ratings agencies and got mortgage bonds rated as AAA, even if most of the mortgages in them were terrible, and the ratings agencies went along with this, because if agency A didn't give a mortgage bond a good rating, then agency B would. And since the ratings agencies depended on the fees they get from the banks, they had a big incentive to give ratings that were not exactly as deserved.

Even still, some mortgages were so rotten they couldn't make it into a mortgage bond that could get a good rating. So the banks piled mortgage bonds that were poorly rated into Collateral Debt Obligations or CDOs, which were a bunch of bad mortgage bonds bundled all together. And somehow since there was a variety of terrible mortgage bonds, the ratings agencies were convinced to label the CDOs with good ratings, even though the underlying mortgages were awful. Because again, if agency A didn't, then presumably agency B would, and the ratings agencies needed their fees.

So investors are being sold mortgage bonds they are being told are a solid way to get ongoing paythrough of homeowner mortgage payments that are solid and reliable, but that's totally not the case.

Swap meet

Eventually some investors figure out that this whole thing is a sham, so they decide to bet against the housing market. They buy credit default swaps, which are essentially insurance. If mortgage bonds fail, then the purchaser of the credit default swap gets a payout. With home insurance, you are insuring against your own home's potential loss. But with a credit default swap, you don't need to own the home. So it is essentially a casino bet. And there is no limit to the number of people who can make such a bet.

The banks are willing to sell credit default swaps, because how could the housing mortgage fail? And it solves another problem for them. Because credit default swaps look remarkably like mortgages. Those who buy credit default swaps have to pay premiums like insurance. So there are monthly payments coming in... that could also go out to investors.

So credit default swaps get bundled together into Synthetic Collateral Debt Obligations, made up not of mortgage bonds but credit default swaps. So once Wall Street runs out of mortgages they can sell to get their fees, they can instead sell credit default swaps.


Until of course the whole house of cards starts to fall apart. ARM loans reset with higher payments at a point when home prices are no longer increasing. Home owners can't get refinanced loans and can't afford the higher payments, so they start defaulting on their loans.

As default rates increase, investors who bought higher risk tranches of mortgage bonds lose their shirts. But eventually enough loans fail that the mortgage bond as a whole fails.

Initially the banks pretend that mortgage bonds are still worth money, and so they refuse to pay out on credit default swaps. Because once they admit mortgage bonds are going bad, the market collapses, and they still have mortgage bonds on their books.

Eventually it's impossible to ignore reality, though, and the credit default swaps need to be paid out. And that is a ton of money, far more than what even the mortgages themselves are worth.

What makes this particularly dangerous is that in the late 90s the Glass-Steagall act was repealed. That act—put in place in the wake of the huge housing crisis during the Great Depression—prevented investment banks that made bets on the economy from being the same banks that held savings accounts. So not only were investment banks in trouble, not only were supposedly safe bond investments at risk, but everybody's life savings and daily abilities to pay bills was put at risk.

Enough history

This is all may seem esoteric, but I think it's hugely relevant today.

I'm supporting Bernie Sanders because I think he better gets the level of fraudulence going on in Wall Street. Will Hillary try to move regulations in the right direction? I certainly hope so. She seems unwilling to deal with the problems of the Glass-Steagall repeal, which concerns me. Mixing investment banking with life savings increases systemic risk. She's also getting a lot of campaign funding from Wall Street, and it's hard not to think that will have an effect on the policies she pushes for, even if she has personally progressive views. If she counts on those funds for a re-election campaign, will she really risk offending people funding her? Will she do better than the Republicans at aiming to rein in Wall Street? Sure. But I think Bernie is willing to go further.

Beyond the immediacy of this primary, though, the more I think about what went wrong, I wonder about what else in our economy could go bad.

It was an unassailable truth that the housing market would always go up. It is disturbing to wonder about what else that we believe without question may be false. I suspect that the next shoe to drop is another Dot Com bust.

A lot of money is going into Silicon Valley, and I suspect that's another house of cards. A lot of the big Silicon Valley companies like Facebook itself are based on the premise that they shouldn't charge users for their services in order to get slews of users, and eventually magically that will make money. Most often on the premise that with lots of user data, advertisers will be able better target users with just the right ad, and presumably people will buy more things. But I don't think I'm alone in thinking that the more targeted the ad, the more creeped out I am, and the less likely I am to buy something.

Silicon Valley may not have the same force multiplier that the housing market did in credit default sweeps, but it feels like much of Silicon Valley is also premised on a belief that tech will always create value. But... maybe not.

Investors expect a return on their investments. If those do not materialize, the investments are not as attractive, and once values start to collapse, not only do stocks tumble, but the entire investment thesis that profitless companies will eventually be worth a fortune... crumbles.

I started to learn to work with the web just as the last Dot Com bubble burst. I don't want to live through another one.

An alternative

Imagine if our economy was not based on false premises.

So much of our economy has become service based. What if more people in our country made living wages, and had more money to spend?

  • Imagine if we had a more educated workforce that wasn't saddled with debt and could afford to take risks.
  • Imagine if our spirit of entrepreneurship was fully unlocked when companies big or small didn't have to worry about the intricacies of health insurance plans.
  • Imagine families that could spend paid time with their children when they were born.
  • Imagine if an engaged workforce that felt they were getting their fair share, that didn't have to worry about college debt or high deductibles or ridiculous prescription drug costs could fully focus on key tasks our country needs: rebuilding our crumbling infrastructure, building a green economy that keeps our climate from collapsing.

Yes, we might not keep as much take home pay to make that happen, but we'd get good value for those dollars, and we'd have a more sustainable way of life. And maybe, just maybe, we'd have less risk of our economy falling apart due to the latest fraud.

I don't think that vision is pie in the sky. It would take work to make it happen. It would mean electing a new Congress, and that won't happen easily. But building a society where we all work together, no matter our gender, our race, no matter who we love, that's something I think is worth fighting for.

I don't find it inspiring to hear candidates say it's just not practical to have goals that are difficult. We have to settle for crumbs. I don't think that a smaller vision gets people to the polls. I think solutions that aren't big enough to solve our real problems are the opposite of practical.

I will gladly support Hillary if she is the nominee. Right now though I am going to vote for the vision I hold true, and that means supporting Bernie Sanders for President.