During the financial crisis of 2007-08, the US stock market lost more than half of its value and unemployment in America roughly doubled, to more than 10%. This was, to put it mildly, a rough time. According to a class I took on American Economic Policy this past Spring, the primary causes of the crisis were a huge increase in leverage (ie. people and companies borrowing too much money) and an under-pricing of risk (with high risk assets, including houses, stocks, loans, real estate and bonds all being bid up in price in a search for returns). One of the most significant  parts – possibly the most significant part of this economic disaster was the eventual collapse in housing prices and how this spiraled outward into the financial system.

Michael Lewis, a former Wall Street bond trader, renowned financial journalist, and author of the seminal study of 1980’s finance, Liar’s Poker, captures the history of the housing disaster in his recent book, The Big Short: Inside the Doomsday Machine. Interestingly, he does not simply relate the facts and figures and causes of everything that happened – rather he explores the events that led up to the crisis through the frame of those that saw the bubble forming and found ways to bet against it. In short (pun intended), he profiles the folks who figured out that the housing market was built on a house of cards (again, pun intended), and then made boatloads (aka billions and billions) of money by betting that the housing market and the American economy would collapse.

The financial crisis was immensely complicated. Huge sums of money were flying around at lightning-fast speeds. Lewis does an admirable job of breaking down the complexity of how many of these trades work and slipping past the Wall Street jargon and acronyms so that, for the most part, a layman can follow the narrative and understand what happened. This is probably one of the best reasons to read the book – it really helped me grasp the housing crisis in a much more nuanced manner.*

Quick primer on what happened here (for a better and deeper understanding, reading the book will definitely help**): In the late 1990’s and the early 2000’s, housing prices skyrocketed and lending standards decreased (American housing prices jumped almost 125% from 1998 to 2006). People were able to buy homes with far less money down, or even to take a second loan out to cover their down-payments. Lending companies further decreased their lending standards and began to target potential home-buyers who typically did not have the credit history or income that made them eligible for a home loan – these loans are known as sub-prime loans (sub-prime lending rose from $30 billion/yr in the 1990’s to $625 billion/yr in 2005). At the same time, there was a massive amount of liquidity in the market that led to available money that could be lent out to buyers, especially as institutions reached for returns (this was potentially caused by both extremely low interest rates in the 2000’s and a large current account deficit). Basically, institutions had a lot of money that they wanted to invest in safe assets that gave out a good return. They were willing to invest in the American housing market. This drove mortgage lenders to make more and more loans.

The loans that were being made became increasingly complex. Lenders would create adjustable rate mortgages (ARMs) that would have a low fixed initial rate for the first year or three, and then the interest rate on these loans would dramatically change to a standard index measure of interest (such as the FED Funds rate – the interest rate at which banks borrow from the Federal Reserve) plus a fixed margin set by the lender (because the initial rate was so low, after the adjustment period, the new combined rate from the index and the margin was often much larger). As the FED Funds rate rose during 2004 through 2006, the amounts mortgage borrowers had to pay each month rose dramatically. As Lewis puts it, “Even more shocking was that the terms of the loans were changing, in ways that increased the likelihood that they would go bad. Back in 1996, 65% of sub-prime loans had been fixed rate, meaning that typical subprime borrowers might be getting screwed, but at least they knew for sure how much they owed each month until they paid off the loan. By 2005, 75% of loans were some form of floating rate.” Furthermore, buyers of sub-prime ARMs often did not understand that their rates would sky rocket, and had no way to pay off the new interest levels due to their low incomes. Lewis cites a multitude of cases as examples, such as the Mexican immigrant who picked strawberries as a day laborer, and received a $750,000 loan with just $15,000 in annual income.

Some people were able to buy multiple properties, such as the Las Vegas adult entertainer that Lewis interviews, who owned five different investment properties. The people were betting on the property values to rise and being able to sell them off before the ARMs came into effect, thus making profits along the way. This worked out really well, so long as the property could be sold while the buyer was still paying the initial low rate and not after he started paying the much higher rate of the index plus the margin. (Side note: I remember a few of my friends in the military in the 2000’s, moving into a new location, buying houses, and selling them two or three years later when they moved on to a new duty station. Many of my friends made huge profits – if they timed the market right. But if they didn’t sell before the crisis hit – well, many of them are still paying off those homes). The combination of people buying more investment properties, an increase in lending to sub-prime borrowers, and low interest rates all drove the rise in housing prices.

Investment banks (like Goldman Sachs) would then buy up a slew of mortgages from lenders. What they were really buying “was a claim on the cash flows from a pool of thousands of individual home mortgages.” These mortgages would be bundled together and then sliced up and sold as mortgage backed securities (MBSs). A buyer of an MBS would then receive interest on this bond – a little tiny piece of the amount that hundreds or thousands of homeowners would be paying to the holders of their mortgages. As long as they considered these MBSs safe assets and places to store their money, numerous companies, banks, and other institutions would buy them up and use them to hold excess liquidity while earning a decent return along the way. The MBS market grew rapidly – by 2005, of the $625 billion of sub-prime loans made, $507 billion were packaged and sold as MBSs.

However, sub-prime owners had mortgages that were far riskier to own than regular prime home owners. So investment banks would ‘tranche’ out the sub-prime MBSs. These sub-prime MBSs had very low credit ratings due to their high risk, and thus companies did not want to buy them as a place to store their extra liquidity. Imagine you have an MBS made up of 100 sub-prime loans. If you can rank these loans by riskiness, you can then re-divide the pile into new a new type of MBS, based upon which loans are riskiest. The new MBS is now called a Collateralized Debt Obligation (CDO) – but it is simply a repackaged pools of assets (in this case mortgages, but CDOs can be made on other assets), with various tranches based upon differing risk levels. You can then sell off this CDO in chunks based upon risk. So you divide the CDO into five tranches, and sell each tranche as a bond with a different rate of return.*** You tell the institutional buyers that the bottom tranche (the worst of the new CDO) will pay far higher returns because it contains the first 20 loans that will go bad. But the next four tranches of the CDO will pay far lower returns as they are safer, because you feel there is a very low risk that more than 20 out of the 100 original sub-prime loans will default.

This is exactly how investment banks divided up CDOs into various tranches of risk, and then sent them to rating agencies, such as Moody’s or Standard & Poor’s. The Rating Agencies would obviously give the bottom tranche of the CDO a low rating, but eagerly gave much higher ratings to the upper tranches, despite them containing sub-prime mortgages that were likely to default. And they did default. Companies who had purchased the upper tranches based upon their safe ratings (often AAA ratings) saw them as an easy and safe way to store money, and also earn a better return than other safe investments. But they were not safe. Despite the inherent diversification of the CDO tranches (they might contain mortgages from all over America), they were still correlated in that a downward turn in the economy would cause many, many subprime borrowers to default. It was an “illusion of security.”

The illusion eventually shattered. As housing prices stopped rising, home buyers could no longer sell their houses for a profit and ended up being stuck with huge bills and rising interest rates. They often had to default. Companies that had bought CDO tranches, thinking they were safe, where dumbstruck when they realized their investment dollars were disappearing as home buyers across the country defaulted. But no one really seemed to know how exposed they were to the risk, because institutions were not exactly sure what was in their CDOs, leading to massive panic on Wall Street and huge fire-sales and other dramatic economic swings. The entire system seemed to fall apart as giant behemoths like Bear Sterns, Lehman Brothers, and others collapsed.

Throughout the book, Lewis explains that “the problem was the system of incentives that channeled the greed” of Wall Street bankers and investors. Lenders were incentivized to lend to everyone, but not to worry about if borrowers could pay them back because they would sell off the mortgage. Raters were incentivized to rate as many CDOs as possible as safe (with a AAA rating) because they were paid by the bond sellers to rate them, and they wanted the CDOs to be considered safe. Investment banks were incentivized to bundle together as many mortgages as possible and create incredibly complicated instruments with them – because they collected large fees at every step of the process and the more complicated the instrument, the larger the fee.

Lewis dryly notes that “the catastrophe was foreseeable, yet only a handful noticed.” By setting his book through the eyes of those that did see the disaster coming – who realized that the entire housing market seemed to be based upon a simple “bet that home prices would never fall,” he adds a human element and personality to this complicated story. He tells the stories of David Eisman who realized there were big problems in the sub-prime market in the mid-1990s; Michael Burry, who came to grips with his own Asperger’s syndrome by reading sub-prime contracts and seeing the market holes through his glass eye; and Charlie Ledley with Cornwall Capital, who seems to just fall into the trade of a lifetime by happenstance. All three men were able to buy Credit Default Swaps (CDSs) – basically insurance on a CDO. If the CDO went belly up, the owners of the CDS would get paid. But they were not buying insurance on their own property; instead they were buying insurance on something they knew would collapse. Lewis compares it to buying fire insurance on a house that you do not own, that is already on fire.

There is a lot more complication in explaining how the housing crisis took place and how a few people made a ton of money off of it. Lewis even seems to realize this difficulty in his conclusion, when he writes that the crisis is “hard to explain. How do you explain to an innocent citizen of the free world the importance of a credit default swap on the AA tranche of a subprime backed collateralized debt obligation?” But this review is already approaching 2000 words, so I am going to try and stop here and leave further explanation to Wikipedia and a strong endorsement of this and other books.

The Big Short is a good book about an important topic – about how one of the greatest financial disasters in history was caused, how our system allowed it to happen, and how only a few saw it coming. Lewis really does break it down into plain English in a way that most of us can understand. I wish he had more thoroughly analyzed how the government responded to the crisis and new innovative ways to fix the market and prevent future disasters, but the book was written as the Dodd-Frank Wall Street Reform and Consumer Protection Act was still being drafted, and it really does not delve into how to create potential solutions. Overall – definitely worth a read. Score: 8.0.****

* An even better and more comprehensive book I read that really helped me understand the great recession (ie. the financial crisis of 07/08 and the ensuing recession) was After the Music Stopped by Alan Blinder, a Princeton economic professor.

** I apologize for the over-generalization and simplification – and if I get any of the nuance here wrong.

*** I love this diagram the IMF put together on how a subprime mortgage system works.

**** Also I apologize for not writing anything for almost 2.5 months. I moved to a new job and have been getting adjusted to the Washington DC area, and life has kept me rather busy.