Wise Startup Blog

I just got done with the book, The Big Short, by Michael Lewis, and it was one of the best books I’ve read (well listened to on audiobook) in the past 5 years. It explained to me exactly why the economy had such a gigantic meltdown in specific financial language. So why did we have this meltdown? Here is a quick summary.

What is a Sub-prime Mortgage?

The root of the entire collapse is a sub-prime mortgage. A sub-prime mortgage is a mortgage given to people with credit scores of 650 or so below. The highest credit score is 850 and most people with average credit have ~700.

So these people have low credit scores because 1) they don’t pay their bills 2) they have very little credit history, mainly because they are young or don’t make any money.

A bunch of companies started giving away mortgages to these sub-prime lenders around 2005. Everybody was getting approved, so it was easy to approve people with bad credit. The key to these mortgages was that they typically had a teaser rate for the first 2-3 years that was really low, like 2%, and then after that the rate would jump up to like 7% and then to maybe 10, 12% etc.

So these people would get the mortgages, be paying them fine, and then after a couple years, they would either have to refinance or default.

Asset Backed Security

SOOO… that whole concept isn’t that catastrophic, worst case scenario a bunch of people have foreclosed homes and lenders are out of money.

So where it got interesting stems back to the 80s with the bond market. Trading or debts, mainly corporate debts. GE wanted to raise money, so they sold bonds to the public. They would pay 5% every year, and since GE is a stable company, people would buy their bonds and earn a nice return.

From these corporate bonds, people started financing all kinds of things. You could and this original bond then evolved into an asset backed security (ABS), which was a combination of any type of monthly/yearly payment.

There are auto loan backed securities where people pay a monthly/yearly car payment (gym membership, cell phone plan, etc.), and those payments can be treated as bond payments. These ABS were then sold to investors who could trade them.

The thinking was, if you bundle up 10,000 gym memberships across the entire country, there is very little risk of all of these people defaulting (not paying) all at once, so just as GE has very little risk of going bankrupt, so too do these gym memberships.

This spread of risk is diversified, but from the ABS came the mortgage-backed security (MBS).

Bond Ratings Explained

So a bond has a rating just like a car has an estimated MPG. An independent body runs some tests and says the new Mustang gets a 36MPG (when driving appropriately), and we use this to measure how much this car may cost us to own.

A bond is the same thing. To determine how much to pay for a bond, you have to look at 1) how much it’s going to pay you and 2) how likely you won’t get paid back. #1 is a factor of #2.

Bonds that are very likely to pay you back are rated AAA, and for this little risk, you are paid very little. AA is more risk, slightly higher payment, and this continues to A, Aa, BBB, B, etc.

Mortgage Backed Security

So, the trouble with ABS, as investors were concerned, is the dollar amounts were so small. People are only paying $50/month for their gym memberships, and auto loans are tiny payments too. What’s the biggest payment consumers are making now?

Home loans. The banks realized that if they could lend more people money, faster, that they could then take all these mortgages, bundle them up, and sell them as investment bonds.

You can imagine the bonds like this: If you combine 100 mortgage bonds into a tower, consisting of 100 different owners, each paying a monthly mortgage payment, then you start to form an investment device that would pay an investor money every month/year.

There was a small change they had to make to the MBS to make it act like a typical ABS, in that with a gym membership, you will pay $50/month forever. If your contract is 2 years, you will pay $50 for 24 months. You can’t pre-pay.

With a mortgage, there was a risk that people would pre-pay your mortgage, and if they did that, you would not be able to earn the maximum rate of interest.

So the banks realized that they could create mortgage towers that looked like this:

AAA
AAA
AAA
AAA
AAA
AA
A
BBB
BB
B

Now, for a mortgage itself to be AAA or BBB rated is determined by a couple of factors:

Outstanding Mortgage Balance
Mortgage Rate
Remaining Months to Maturity
Likeliness of the Borrower to Default

So mortgages that have just begun have the least likely chance of default, since most homeowners pay their first mortgage payment, and loans that are almost completed also have the least likely chance of default, since most people who have paid their house down to year 29, will pay it down to year 30.

So using this structure, we can create a product, the MBS that will give you consistent payments every single year by taking slices of different mortgages.

This can also be explained like this for an MBS:

month 1
month 1
month 1
month 340
month 340
month 10
month 50
month 100

(assuming 360 months total, 30 years)

Originate and Sell

So hopefully that wasn’t thoroughly confusing. Basically, these MBS were very complicated instruments created by multiple mortgage loans from both sub-prime and regular mortgages, which was supposed to be the intention, but in reality some MBS had 70% of sub-prime mortgages in them (the highest chance of default).

So what is originate and sell? It’s a process that mortgage companies went about where they would originate or issue loans to consumers, and then they would sell these loans to banks like Goldman Sachs would would package them up into an MBS, and then Goldman would sell them to somebody else.

For these originators, since they were selling the loans to Goldman once they were issued, they didn’t really care how likely the loans were to default since they weren’t their problem anymore.

So originators did whatever they could to sell as many mortgages as possible. They did home equity lines of credit, offered teaser rates, and even one issuer created an interest only loan that offered payment leniency.

Upon request, you could amortize your payment or not pay your monthly payment, and put the payment back into the mortgage.

So there were a ton of crappy mortgages being issued.

Making a Shitload of Money

Now investment banks like Goldman Sachs were taking these MBS products and selling them to big time pensions, investment banks, etc. who were earning a great return on these diversified collections of loans.

They were making a ton of money, and they wanted to make more. So they used HELOCs, refinancing, 2nd mortgages, allowing people to buy investment properties, etc to give the same consumers multiple different loans.

The only way to make more money was to issue more loans, but the problem was, there were only so many people to loan money to.

What if there was a way to make more loans out of thin air?

Collateralized Debt Obligations

A mortgage backed security, MBS, is a collection of 100 different loans. All the loans are from different parts of the country, from people in different stages of their mortgage.

What if you took 10 different MBS, a total of now 1,000 different loans, and bundled these up and sold them? You would be diversified by spreading the risk.

These CDOs were a combination of different MBSs. The MBSs were a collection of assets that were earning a 5% return for their owner, if you bundle these assets up, there is value in that, because the underlying loans have value, so you could conceivably make 5% from these CDOs as well.

Now, you could take all of the MBSs that were in the market, package them up and start selling these, instantly doubling your profits you were making from MBSs.

You can see why there is a huge catastrophe that could happen if the underlying mortgages were worthless.

The owners of the MBSs would have nothing. And the owners of the CDOs would own nothing.

Credit Default Swaps (CDS)

So with all of this risk, you want to reduce it or hedge it. So if you are worried that you may die early, and leave your family with no money, you buy life insurance to protect your family against calamity.

If you fear that your investment goes bad, you can buy insurance. Since these CDOs were so new, no insurance was in existent yet, so the bankers invented a credit default swap.

If your MBS/ABS went bad, you could buy an insurance policy to protect against loss, the cost was based on how likely it was for your MBS to go bad.

Let’s take this example:

Our investment is worth $100 in 30 years, and it’s a AAA MBS, so we only have to pay $.20 per year for 30 years, and if our investment goes bad before the 30 years, we get $100.

If the investment never goes bad, we have paid ($.20 x 30 = $6) $6 for this protection.

CDS Were Very Profitable

So in the scenario above, you could buy insurance on an investment for very cheap, and get a huge payout if your investment went bankrupt.

But what were the chances of a AAA MBS going bad? There is almost no chance of people not paying their gym memberships nationwide all at once. So if you’re a bank or insurance company, you will gladly sell people insurance on these gym memberships.

Your company will make a ton of money, and most likely never have to pay anything out.

Well, just like these gym membership based Asset Backed Securities, our Mortgage Backed Securities had a AAA rating.

Companies like AIG, Bear Sterns, etc. were selling TONS of insurance on these CDOs and MBSs and booking HUGE profits. These products were AAA rated, so you were stupid not to issue tons of insurance contracts on them.

Gaming The Ratings Agencies

So anybody that looked at these MBS, CDOs, etc. could see that there were teaser rates, that these sub-prime people had shitty credit scores, no credit history, that a majority of the homes were not owner-occupied.

Nobody did their research.

The insurance companies issued trillions of dollars in insurance on bonds they thought were AAA rated. These loans weren’t actually AAA rated.

The companies in charge of rating these bonds were Standard & Poors, Moodys, etc.

They got paid everytime they rated a CDO, so their incentive was to rate as many as possible. If they rated a CDO negatively, the banks wouldn’t give them as much business.

Also, the guys at Moodys were getting paid $100k. The guys at Goldman were getting paid $100 MILLION.

They outsmarted Moodys, and gamed the system to create CDOs that passed the AAA rating scale, but were in reality BBB or lower.

So the insurance they sold was priced too low for the risk, and people bought all the insurance they could.

When the mortgages backing all these MBSs and CDOs went bad, the MBSs and CDOs were worthless, so those investors lost their money. Then, it also meant AIG owed trillions in insurance contracts, and since every company bet more money than they had, the banks FAILED.

Greed

The main message from this whole mess is greed was behind all of this. People making $20,000 owned a $500,000 house, and people making $100 Million wanted to make $500 million.

Everyone was at fault, but the people creating these CDOs and MBSs should be held responsible. They created shitty products, gamed the system, and screwed over the entire public.

The banks should have been allowed to fail, but it would have punished too many people. The bankers themselves should be barred from working on Wall Street after this whole mess, hopefully that will happen, most likely not.

For me, this is a great look into how this all happened, and should prepare me better for the next crazy bubble.