Photo By Dan Menningen

As the housing market went down in 2007, signs like these sprouted throughout Ohio and the country.

 

February 9, 2016

‘Big Short’ explains 2007 housing market crash

I recently saw “The Big Short,” a movie about the fall of the housing market in 2007 and how a group of people saw it coming and were able to profit from it. I thoroughly enjoyed the movie, but there was one problem.

I don’t get it.

I understand the basics of the subprime mortgage crisis, the name of the 2007 recession that the movie details, but I don’t understand the details of what happened and how this group of people were able to predict that the housing bubble was going to pop.

So, I sat down with Russell Raimer, a finance professor at Cleveland State University who worked for years in the private sector, to help me understand the movie. This was essentially trying to teach Finance 304 to someone who would flunk Finance 101 and thanks to him I am going to explain The Big Short and why this is a big deal.

But first, some background.

When people bought a home, they would take a loan out from a lender that required they put down 25 percent of the home’s value and make incremental payments to the lender that were based off their yearly income until they owned the home. These are called home mortgages.

In 1981, Freddie Mac and Fannie Mae, government-based lenders, allowed the local lenders to take a stack of mortgages and sell them to the government-based lenders, which would then take the mortgages and put them into a mortgage-backed security (MBS), essentially a group of loans bundled together into a trust fund and given a grade based upon the average credit score of the loans.

Fannie and Freddie would sell them to banks, who would turn around and sell the principal payment or the interest payments of the mortgages to other investors. The selling of the interest payment or principal payment of the MBS were called selling tranches. According to Raimer, tranche is a French word meaning “slice.”

Here is a simple example: Person A lends Person B $5, with the understanding that B is going to give A back the $5, but with $5 interest later.

Person A makes the same deal with five other people. A takes all of those deals, packages them together and sells them to Person C for $40 because A needs money right away. Person C needs money immediately as well, so he splits up the loans and sells the $25 interest payments to Person D for $20. Now, put this on a grander scale and you have MBS’s and tranches.

Now, these MBS’s were given grades as well depending on the credit score of the loans. AAA is the best and it decreased from there. Keep this in mind.

In the early 2000s, the government wanted everyone to have the American Dream: house in the suburbs, white picket fence, two kids and a dog. The government ordered Fannie Mae and Freddie Mac to give out more loans.

While this was going on realty and loan companies were pressuring realtors and lenders, both working on commission, to sell a bunch of houses with massive mortgages. To meet these quotas, they began giving out loans that had people putting nothing down or differing payments for an extended period of time. So previously, a person had to give a nice amount of money to the lender up front to their mortgage, now if someone had a pulse, they could get a mortgage.

An example of these loans is what is known as a NINJA loan, an acronym for “No Income, No Job, No Assets,” which was an extremely low rated loan that starts off with a low interest payment and after a few payments, the interest rate increases, according to Raimer.

The idea was that the house you were going to buy was going to increase in value so you will be able to afford the larger payments with the newly increased value of your home.

Another example of these loans was an Adjustable Rate Mortgage or ARM, where the interest rate of the loan will go up or down depending on the market. The selling point behind this was the idea that a person was right out of college, with a brand new job and as they work their way up in the world, they would get raises and promotions that would help to subsidize the raising interest cost.

Great idea on paper, but what happens if that person loses his job or the rates go up and someone can’t pay their interest costs because the raise or promotion never came?

What if that person isn’t the only one this happens too?

“The Big Short” happens and Dr. Michael Burry saw it coming.

Burry was a hedge fund manager for the California based fund Scion Capital LLC and the first to see what was happening in the housing market.

Burry crunched the numbers and realized that Fannie Mae and Freddie Mac were taking good stable A-AAA rated loans and bundling them with these NINJA and ARM loans which were BBB or lower rated, and selling them as an MBS to the banks, which were selling tranches to investors.

During all this buying and selling of MBS’s, some of the loans would default and drag the rest of the MBS rating down with it. Home owners with high ratings would also pay off their mortgages, so to balance the MBS, the banks would add other loans that would then default.

Back to our fun example from earlier. Let’s say everything that happened before — took place and after the interest payments were sold, three of the five walk up to A and say “Hey, I can’t pay you back because I don’t have a job.” Person A is in the clear because he sold the loans, but the people holding the package of loans that A sold to them are out a combined $30. Take this simple example and multiply it by millions and you have the Subprime Mortgage Crisis.

Burry saw this coming and went to the banks and told them this was going to happen and they laughed at him, believing the housing market to be extremely stable.

So, he bought millions of dollars in credit default swaps, or CDS. CDS’s were initially insurance policies people could buy if the housing market were ever to crash. The banks sold these thinking that the housing market would never crash so it was just easy money, but Burry used them differently.

Burry saw them as betting slips that said, “Burry says the housing bubble is going to pop and Goldman Sachs does not, so Goldman Sachs will give Burry 100/1 odds the housing bubble is not going crash.” He bought CDS’s with many other banks as well.

Along the way, others saw the housing bubble pop coming as well and also bought CDS’s from banks all over. AIG being one of the biggest seller of these CDS’s.

The others saw this coming because the lenders were selling collateralized debt obligations (CDO), which were horrible loans packaged as AAA-rated loans. CDO’s really sped up the crash because they were essentially empty promises that this loan is bad now, but wait, they will get better. Spoiler alert, they never got better.

In the second quarter of 2007, the mortgages defaulted because people could not pay the increased payments on their loans. The banks also could not give new loans because they did not have enough money in the reserves because they were heavily invested in these failing MBS’s. And people were cashing in their CDS’s because the market failed (again, something the banks never saw coming).

So, what if a business has a handshake deal with a bank before the bubble popped? The business was going to expand its retail space and needed a loan to help fund it. So it expands, and when the bills are due, the bank cannot lend the business the money because they do not have enough in the reserve. So the business has to lay people off to pay for the expansion, which causes the former employees to not be able to pay their mortgages and default, thus making a giant mess of everything that morphed into a recession.

Fixing this required a giant bailout from the US government and a lot of people losing their homes and jobs.

That giant bailout was used by some banks to fix their mistakes and others, such as AIG, used the money exactly how you would expect them to use free money: as bonuses to higher ups, according to the Washington Post in 2009.

The US economy is now starting to bounce back and the banks are paying back the bailout.

Now besides general knowledge for Oscar night, why does this matter?

It matters because the whole thing happening again with Bespoke CDO’s. They are essentially the same thing as the original CDO and yes, they are perfectly legal. Nothing that has been described in this article has been deemed illegal by the government.

Remember what the great 20th century Spanish philosopher George Santayana said,

Those who do not know history are condemned to repeat it.



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