A Quick Graphic Overview of The Big Short

I presented my synopsis of The Big Short, by Michael Lewis, for a private client this past week.  It was quite an experience.  These were highly educated, quite successful folks.  Many had read the book.  Two had seats at a table the week before with former President George W. Bush, and he had said:  “I’ve got a book you’ve got to read:  The Big Short.”  The day that I presented it, there was an article on the Huffington Post, ‘The Big Short,’ By Michael Lewis: Why Politicians Love This Bestseller (taken from Politico) describing how the book is the most quoted book on Capitol Hill.  (yes, Republican George W. Bush and Democrats on Capitol Hill are both recommending this book.  Amazing!).

So many have tried to wrap their arms around the issues that led to the financial meltdown of the last couple of years.  The effects are far-reaching, and sadly, nowhere near finished.  Lewis’ book is so valuable because, 1) he is a great story-teller, and 2) he comes close to making the incomprehensible comprehensible.

Consider these two quotes from the book to help understand the difficulty of the comprehensibility problem:

“There was so much confusion about the different terms,” said Charlie Ledley.  In the course of trying to figure it out, we realized that there’s a reason why it doesn’t quite make sense to us.  It’s because it doesn’t quite make sense.”  …  “The Wall Street firms just got the ratings agencies to accept different names for it so they could make it seem like a diversified pool of investments.”

It’s too much to expect the people who run big Wall Street firms to speak in plain English, since so much of their livelihood depends on people believing that what they do cannot be translated into plain English…

I have created a graphic (with a little corrective help from a financial advisor friend) to give a summary of the issues in The Big Short, the issues that led to this crisis.  Take a look.

Click on image for larger view

Some brief explanations:

• Top left – in the old days, people put 20% down (of their own money) and the lender financed 80%.  That % down kept decreasing, so that in the worst days of the looming mortgage crisis, lenders were literally loaning more than the house was valued at.

• Bottom left – in the old days, the loan was paid off, in its entirety, over the long haul (30 years), to the original lender; frequently a Savings & Loan. – In the mortgage crisis days, the loans were immediately sold (“originate and sell”), thus, mortgage makers/lenders got their fee up-front, and for too many, getting the loan approved was the only goal.  The loan was sold, immediately, to another entity to service (collect!) the loan payments.

{By the way, one reason all of this collapsed was the false believe that if loans were defaulted on, it would not matter so much – because the value of a house would only/could only go up.  So, after a default, the value would be higher anyway}.

{And, by the way, part 2 – many; way too many!; up to 75% in the craziest period – of these loans were adjustable rate mortgages, with loans that began with 2-year teaser rates, which meant that it was inevitable that there would be plenty (lots!) of folks who could not make their “new” payments after the two year teaser rate period was completed}.

• Bottom middle – these mortgages were bundled into bonds, sold through Wall Street Firms.

A quote from the book:

In short order, the Salomon Brothers trading floor gave birth to small markets in bonds funded by all sorts of strange stuff:  credit card receivables, aircraft leases, auto loans, health club dues.  To invent a new market was only a matter of finding a new asset to hock.  The most obvious untapped asset in America was still the home.  People with first mortgages have vast amounts of equity locked up in their houses; why shouldn’t this untapped equity, too, be securitized?

• Top Middle, and Right – Now it gets really complicated.  There were additional investment instruments, with portions of mortgages kind of “sliced up” and interspersed throughout, and then “synthetic” investments that had less and less connection to actual mortgages, all of which were made to look like “good investments” by the ratings agences, which were under staffed, and certainly faced a conflict of interest in that they were paid for by the Wall Street firms to begin with. (In just the last week, or so, hearings have revealed the depth of these problems).  And, there were other “instruments” that were taking the opposite approach — while everyone was long on the sub-prime mortgages and the ever-more-divorced-from-actual-money investment instruments, a handful found a way to go short…

A quote from the book, (with a rather graphic metaphor):

More amazing was their circularity:  CDO “A” would contain a piece of CDO “B”; CDO “B” would contain a piece of CDO “C”; and CDO “C” would contain a piece of CDO “A”!  Looking for bad bonds inside a CDO was like fishing for crap in a Port-O-Let:  The question wasn’t whether you’d catch some but how quickly you’d be satisfied you’d caught enough.

And another quote from the book, from Steve Eisman (one of the two key players who “got it right” – my apology for the language.  It is a direct quote):

Eisman:  “The credit default swaps, filtered through the CDO’s, were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product.  Wall Street needed his bets in order to synthesize more of them.  They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford.  They were creating them out of whole cloth.  One hundred times over!  That’s why the losses in the financial system are so much greater than just the subprime loans.  That’s when I realized they needed us to keep the machine running.  I was like, “This is allowed?”

I think the graphic partially captures the environment that led to the collapse.  The story is a lot longer than this, and I have left much out.  But I took my best shot at the bare essence of the story.

———————-
Disclaimer:  I am trained in communication.  I am not a financial expert.  So I welcome corrective comments.  If I’m completely wrong, or mis-read The Big Short, please let me know.