The Big Short is a shocking narrative on the events and players of what will undoubtedly be one of the greatest financial disasters of mankind. It gives the reader, whether financial expert or novice, a brutal understanding of the markets from homebuyer to fund manager, and the instruments of trade. It is the financial equivalent of reading a synopsis of Dr. Frankenstein’s inventive creations beyond the explicable, manipulations of the unassuming, and leveraging of enough electricity to power a monstrous doomsday machine.
To narrow the selection of most interesting aspects of The Big Short is no easy task. The moments of amusement coupled with utter disgust were certainly higher than anticipated. One of the most interesting, and disturbing, was the role of the credit rating agencies. There are various points in the market food chain where the reader can’t help but think, ‘here is where the virus could have been neutralized or impeded.’ The rating agencies of Moody’s and Standard & Poor’s are certainly such a juncture. The lack of understanding of the risk involved in CMO and CDO tranches and the underlying assets should have minimized the market for these. Instead of giving higher risk ratings because of their opaque nature, or simply refusing to rate something they don’t understand or for which they can’t adequately model, the agencies fold to the pressures of their peers, clients, bosses, and inadequacies of understanding. The ratings agencies wanted to appease their Wall Street counterparts. These wise ‘clients’ were reassuring them of their low risk status, and there was the fear they would simply go to another agency. The mere unawareness or disregard for the lax nature of the residential lending environment that was the foundation of these securities also add to the agencies complicity in fraud. In mu opinion, these understated ratings were gross misrepresentation, negligence, and borderline criminal.
There are numerous lessons to learn from the catalysts of this financial crash with the probability of only a few being adequately addressed. There is a large degree of personal and moral responsibility involved, both of which are very hard to mandate. Though companies, such as banks, brokers, investors, and so on, can have ethical policies, morality is only instituted personally. Since morality is subjective, this example is better discussed ethically. The borrower of a loan should take personal responsibility in managing its finances. The lender should operate ethically, only lending to those most probable to repay, regardless of whether the lender sells the paper to another investor. In general, adequate underwriting should be required via regulation, both of which were absent during the subprime mortgage madness. The originator was driven by fees and was able to pool the loans for sale. Also, when the teaser rate expired, the struggling borrower might only refinance leading to more fees. But if the borrower and lender are like two basketball teams saying ‘we don’t have to keep the score, and we don’t have to call every foul,’ then the government was a cheerleader and a referee dressed as one. Governmental policy starting in the mid-1980’s began to push home lending which went as far as to threaten banks that didn’t adequately lend to its submarket even if the borrower was less qualified (to pay back). The Borrower certainly hears the message of ‘everyone deserves the opportunity to own its own home,’ hence the Lender and the Borrower come closer to the table whether their best reasoning says otherwise. Greed will always exist. It is the selfish desire for something, and the lender, borrower, politician, rating agencies, and regulators cannot defeat its subtleexistence. We just tend to think of greed as something big with a capital ‘G.’ Because of this, regulation must be present and, most importantly, monitored and enforced. There can certainly be overregulation, and we are currently in a period where the pendulum swung too far in the other direction. Credit is loosening and some markets are recovering better than others.
Secondary markets for home mortgage loans play an important role for the liquidity and speed of the markets. I do believe the private sector (eventually) performs better than governmental agencies based solely on the free markets nature of ‘survival of the fittest’ – provide a good or service that people want, operate efficiently or go out of business. Freddie and Fannie certainly do not operate efficiently, and a quasi-government guarantee allowed them to operate irresponsibly and gave investors a false security. The residential real estate market is just too fragile at this time. A ‘wind down’ would cause a slowdown in the primary mortgage market likely stalling the economy even more. I believe that there is a need for the private sector to dominate the secondary market, but I don’t believe there are enough willing participants to make the transition seamless and worthy at this time.
If the egregious subprime lending practices are corrected and the credit ratings act with integrity, some of these existing derivatives should be allowed as long as they are better regulated and simplified. There must be adequate paper trails, and there has to be true underlying assets, not fraud or the same asset used in a pool 100x over. There should be a limit to the amount of pooled assets or tranches and to the number of repackaging pools within pools which is how Wall Street gamed the rating agencies. This would at minimum make a paper trail easier to trace, and therefore easier to rate. I believe that if at any point the true underlying assets, its borrower, underwriting, and the location of its remaining ‘share’ (which may be split and held in another pool), then the instrument has become too complicated to rate and therefore should be banned. The idea of the issuer holding a percentage of the instruments they create is worthy of thought, but it all comes back to the riskiness of the underlying debt.
Written by Josh Lowder, CCIM MRED, 2013