The Global Financial Crisis (GFC) has
been as much a mystery to public in general as to the ones responsible for it. The
cost of GFC to the world economy is estimated to be around USD 15.0 trillion and affected lives
of millions.
There were people who could
understand the folly of the markets as early as 2003 and put bets in favor of
doomsday. These contrarians earned millions eventually, but were as perturbed
by the possible destruction of the whole financial system as all of us.
Michael Lewis in The Big Short: Inside the Doomsday Machine shares three stories where contrarians shorted the
sub-prime mortgage bonds market and bought CDS (a type of insurance) betting
that the sub-prime borrowers wouldn’t be able to repay the mortgage loans.
Before venturing in these amazing
stories lets understand what exactly a Mortgage Bond is. A typical bond is a
form of large debt – the mortgage bond basically is a pool of mortgages. Innovative
Salomon Brothers further divided mortgage bonds into pieces of tranches which
could be traded in the market. These mortgages were extended to credit worthy
borrowers and guaranteed by government agencies.
Everything was hunky dory till the
time mortgage bonds were put to new use – making loans to the borrowers who
didn’t qualify for the government guarantee a.k.a sub prime borrowers. Wait,
why would anyone lend to low quality borrowers? It doesn’t make any sense. The
answer lies in social justice – income inequality was increasing and
institutions took over the great task of social justice by lending to sub-prime
borrowers.
Now is the time to meet characters
of the story and unfolding of unbelievable turn of events.
Steve Eisman was a great proponent
of subprime lending during initial years but was shocked by the malicious
accounting practices of subprime lending firms. Eisman was brazen man and
always looked for big kill. He became crusader against Household Finance
Corporation – largest subprime borrower at the time for its corrupt practices
which was later acquired by HSBC!
Next in line is Dr. Michael Burry,
a blue blood value investor who could garner USD 1.0 million from Gotham
Capital as his first investable capital. He was a recluse and rational fanatic
who let go residency in neurology at Stanford University for money management. This
was year 2000 and by year 2004 Dr. Burry was managing USD 600.0 million! Dr. Burry
found subprime lending unsustainable and side pocketed his clients’ money to buy
CDS of mortgage bonds.
The third is about accidental
capitalists by the name of Cornwall Capital Management – a company floated by
two amateur investors aged 30 with no reason to claim investing talent.
One most important character who
single handedly made pitches to hundreds of investors to bet against the
mortgage market was Greg Lippiman. Greg strengthened Eisman’s beliefs and
motivated Cornwell Capital to bet against subprime mortgage bonds. On other
hand, Greg gave headaches to Dr. Burry by his strenuous and noisy talks against
subprime bonds. Dr. Burry didn’t want the world to know this once in lifetime
idea to make tonnes of money.
Michael Lewis had intriguingly explained
the roles of financial institutions in creation of CDS market for mortgage
bonds.
AIG FP was the first seller of subprime
bond’s CDS in the market & took short positions of USD 50.0 billion. AIG
bosses couldn’t fathom how someone can buy CDS and bet for defaults by sub-prime
borrowers!
Moody’s and S&P models to rate
the mortgage bonds were riddled with errors. These agencies were rating these
subprime loans as AAA bringing capital to this crystal sheen market. No due
diligence was being done on loans under mortgage bonds and system was throwing
out AAA ratings basis ridiculous data points.
Most of the Wall Street firms
looked out and out stupid to Eisman. Many of these firms earlier acted as
intermediary between AIG and CDS buyers. Later they started housing the risk in
their balance sheets rather than offloading it. Morgan Stanley, Goldman Sachs,
Bear Sterns, Meryl Lynch valorously sold billions of dollars of CDS in the
market. HSBC took huge losses in subprime lending business through Household
finance which they had bought. Eisman, Dr. Burry, Cornwell and few others kept
buying CDS from these sellers.
Eisman saw another opportunity –
he started shorting shares of institutions like UBS, Citigroup, Lehman brother
and few others.
All three protagonists were deep in
the money in 2007 when borrowers started defaulting. The biggies of Wall Street
took losses of billions of dollars by 2008 nudging many of them close to insolvency.
GFC left indelible mark for the
world economy. What lessons did India take from the crises? We experienced a
mini-storm in micro-financing sector a few years back when institutions pushed
loans to people at bottom of pyramid without doing proper due diligence. Indian
banking system is now at an inflection point. The rapid credit growth of
previous years has led to tonnes of bad loans for banking system. Financial Institutions has now shifted
their focus to retail lending by towing inline with government’s push for
financial inclusion. I hope Indian institutions don’t repeat the past mistakes
and lend with great sense of responsibility.
This beauty from Michael Lewis is
a good read for all who believe there are opportunities even in adversity.
Read it, devour it!
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