Michael Lewis
Wall Street transformed the American housing market into a speculative casino by repackaging high-risk subprime mortgages into complex financial instruments. Banks extended loans to unqualified borrowers using teaser rates that would inevitably reset to unaffordable levels. These loans were then bundled together into mortgage bonds and further packaged into collateralized debt obligations. By pooling these risky assets, financial institutions exploited flawed models to convince rating agencies to assign top tier investment ratings to debt that was statistically guaranteed to fail. The entire system relied on the false premise that housing prices would rise indefinitely and that nationwide mortgage defaults were impossible.
A small group of outsiders recognized the fragility of the housing market and sought a mechanism to bet against it. Since they could not short houses directly, they utilized credit default swaps. A credit default swap functioned as an insurance policy on a specific mortgage bond. The buyer paid regular premiums and received a massive payout if the underlying bond defaulted. This created an asymmetric bet where the potential losses were capped at the cost of the premiums while the potential gains were exponentially larger.
Michael Burry left his career in neurology to start Scion Capital and became one of the first investors to short the subprime mortgage market. Burry possessed a relentless focus that drove him to read the obscure prospectuses of individual mortgage bonds. He discovered that the underlying loans were designed to default as soon as their initial teaser rates expired. By May 2005, Burry began purchasing hundreds of millions of dollars in credit default swaps. His investors revolted and threatened lawsuits as he continued to pay premiums while the housing market temporarily remained solvent.
Steve Eisman operated the FrontPoint hedge fund under Morgan Stanley and recognized that the consumer finance industry was actively exploiting the poor. He understood that the fixed income departments of major investment banks drove Wall Street profits by originating and selling bad loans. After meeting with rating agencies, Eisman realized that the agencies were either incompetent or willfully blind to the risk in the mortgage pools. He concluded that the entire rating system was fraudulent and aggressively shorted the financial companies exposed to the subprime market.
Greg Lippmann worked as a bond trader at Deutsche Bank and acted as the primary evangelist for shorting the housing market. He analyzed data showing that home prices did not even need to decrease for a wave of defaults to occur; they only needed to stop rising at rapid rates. Lippmann created a presentation to pitch the short trade to hedge funds across the country. His efforts spread the idea to a select group of institutional investors who purchased the credit default swaps that Deutsche Bank and others were brokering.
Jamie Mai and Charlie Ledley started Cornwall Capital in a garage with just over one hundred thousand dollars. They specialized in event driven investing by purchasing cheap options on highly improbable events. When they investigated the subprime market, they discovered that collateralized debt obligations were inherently flawed because a minor loss in the underlying mortgage pool would wipe out the entire structure. They realized the market severely underpriced insurance on the highly rated double-A tranches of these obligations. Their strategy allowed them to secure massive leverage, ultimately turning their small initial capital into over one hundred million dollars.
Moody's and Standard and Poor's provided the critical validation that kept the mortgage machine running. Wall Street trading desks learned exactly how to game the rating agency models to secure pristine ratings for toxic debt. The agencies relied on average credit scores for loan pools rather than evaluating individual borrower risk. This allowed banks to mix loans from reliable borrowers with completely undocumented loans from individuals with no ability to repay. The rating agencies failed to evaluate the actual contents of the collateralized debt obligations, effectively rubber stamping systemic risk.
For every investor betting against the housing market, someone had to take the other side of the trade. A unit called AIG Financial Products assumed the majority of this catastrophic risk. Operating with a flawless corporate credit rating, AIG sold billions of dollars in credit default swaps to Wall Street firms. The executives at AIG believed they were insuring diversified consumer loans and failed to realize they were holding the concentrated risk of the American subprime mortgage market. This monumental miscalculation forced the United States government to issue a massive bailout to prevent the collapse of the global financial system.
While some individuals profited from the collapse, traditional Wall Street insiders suffered historic losses due to their overconfidence. Howie Hubler ran a bond trading desk at Morgan Stanley and initially recognized some of the risk in the subprime market. However, to fund his own bets against certain mortgages, he sold insurance on highly rated collateralized debt obligations, assuming they were perfectly safe. When the market crashed, those seemingly safe obligations collapsed. His actions left Morgan Stanley with a loss of over nine billion dollars, marking the largest single trading loss in Wall Street history.
The financial crisis was ultimately driven by a systemic misalignment of incentives. Loan originators were paid to close mortgages regardless of their quality because they immediately sold the debt to investment banks. Investment banks earned massive fees for packaging the loans into bonds and passing the risk to global investors. Rating agencies were compensated by the very banks whose products they were evaluating. Because individuals and institutions were rewarded for taking catastrophic risks with other people's money, the market completely detached from economic reality until its inevitable collapse.