Jim White Examines The Big Short

After being asked several times my opinion on The Big Short (“Short” for short in this writing), a few days ago I went to see the movie. Short is based on the book of the same name by Michael Lewis, a leading critic of Wall Street who once worked with some of the characters depicted on the screen. I viewed the movie from the perspective of an observer of the interaction between major Wall Street institutions and Jefferson County, Alabama and the disastrous impact on Jefferson County of the toxic mortgage securities described in the film.

Short tells the story of how investment bankers created mortgage securities by assembling pools of home mortgages and using the pools as collateral for mortgage notes. The securities were divided into different series or “tranches,” each having different rights to cash flow from the payments of interest and principal being made on the mortgages in the pool. Tranches with first call on the stream of payments were thought to be highly secure (home mortgages were regarded as low risk to begin with) and carried relatively low interest payments. Tranches with second or third call on mortgage payments were acknowledged to be less secure and paid higher rates of interest. Overall, the interest rates on the mortgage securities were materially less than the rates on the underlying mortgages, providing large profits to the banks and bankers involved in the securitization process. The process seemed to fulfill the medieval dream of turning lead into gold through alchemy.

The pools were put together and analyzed with complex software programs using assumptions regarding default rates, prepayments, changes in interest rates and other factors. In 2007 and later these assumptions turned out to be false. As Short makes clear, the bankers doing the securitization were not interested in the complexities of the computer programs they were using or the actual facts about the boring home loan mortgages. They dealt in dreams not reality. The rating agencies, who were supposed to be the referees of the securitization games, were looking to make more money by officiating at as many securitization games as possible and failed to examine the underlying assumptions and their consistency with actual experience, and failed to blow the whistle on bad plays.

Financial risk increased when banks and other institutions began to enter into “credit default swaps,” a fancy name for a financial guarantee otherwise unauthorized for many of those entering into them (financial guarantees have long been disfavored by old line insurers such as Lloyds of London). Bond insurance companies, which had started out 40 years earlier guaranteeing only investment grade municipal bonds with very low default rates historically, began to insure mortgage securities with much higher risk (commanding higher premiums) and then compounded their mistake by investing in the same types of mortgage securities they were guaranteeing. When the hammer came down, the bond insurers found that the mortgage securities they had insured defaulted and those that they had invested in defaulted too. So the bond insurance companies were rendered manifestly unable to meet their obligations, and here is where Short connects to Jefferson County.

In late 2007 and early 2008, the rating agencies woke up to the fact that the bond insurers were dramatically under reserved for losses and that their assets were overvalued due to the decline in value of the mortgage securities they held. This led to reductions in the ratings of the bond insurers (from AAA to far lower), and shortly thereafter to default on all the outstanding revenue bonds of Jefferson County.

From 1997 to 2006 Jefferson County entered into a series of complex financings that depended on bond insurance to provide comfort to the tax exempt bond market that Jefferson County would pay when obligated to do so. A downgrade of the bond insurers was agreed to as an event of default on Jefferson County’s securities, an event of default regardless of the financial condition of Jefferson County. A principal motivation for the complexity of the financings that made this covenant necessary was the ability, as in the case of mortgage securitization, of the Wall Street players to make an unusual amount of money from interest rate swap spreads, underwriting spreads, bond insurance premiums, letter of credit fees, standby purchase agreement fees, financial advisory fees and legal fees. When the bond insurers failed, Jefferson County failed, but the fees were not refunded (although some of the principals suffered losses in other ways).

An important insight of Short is that a lot of people knew what was going on but chose to ignore it. The same was true in Jefferson County. On the few occasions when knowledgeable people challenged transactions they were criticized and even threatened.

Will the events described in Short happen again? History teaches that every now and then greed gets out of hand and man’s sinful nature takes over. The lesson of Short is, “Watch out for greed,” or, alternatively, “Hire someone competent and trustworthy to check out complex deals and explain them to you.” The lesson for all of us is, “Do not look the other way.”