Michael Lewis, author of Liar's Poker which is an insider's account of the bond market in the mid- to late-1980s, has written an article neatly describing the fundamental causes of the sub-prime buildup and subsequent meltdown. No one emerges unscathed. Subprime lenders are "scumbags". The CEO of Moody's is "delusional". The CEO of Option One, the mortgage originator owned by H&R Block, was a "liar". The rating agencies are "morally bankrupt".
Most of us know that subprime debt was packaged and then sliced into tranches. What I never really understood was that the BBB tranche was sliced up again and part of it resold as AAA. To me, this is the smoking gun.
The article focuses on Steve Eisman of FrontPoint Partners, one of the first to say that the emperor had no clothes, and then to act on it by agressively shorting subprime bonds.
In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasnt clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up? (It turned out they didnÂt have to fall; they merely needed to stay flat.)
(Eisman) draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB trancheÂthe bonds Eisman had shorted. But Wall Street had used these BBB tranchesÂthe worst of the worstÂto build yet another tower of bonds: a "particularly egregious" C.D.O. (collateralized debt obligations) The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investorsÂpension funds, insurance companiesÂwho were allowed to invest only in highly rated securities. "I cannot f***ing believe this is allowedÂI must have said that a thousand times in the past two years," Eisman says.
But he couldnÂt figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. "I didnÂt understand how they were turning all this garbage into gold," he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. "We always asked the same question," says Eisman. "Where are the rating agencies in all of this? And IÂd always get the same reaction. It was a smirk." He called Standard & PoorÂs and asked what would happen to default rates if real estate prices fell. The man at S&P couldnÂt say; its model for home prices had no ability to accept a negative number. "They were just assuming home prices would keep going up," Eisman says.
As it turned out, the side bets that Eisman and others were making against the subprime bonds were in turn part of a huge secondary market in credit default swaps that ultimately magnified the losses when the house of cards finally came tumbling down, since these swaps weren't backed by anything. This fantasy market (the author compares it to NFL Fantasy football) wiped out hundreds of billions of dollars when the market melted down.
When Enron and Worldcom imploded, heads rolled. Who is now being held accountable, other than a few regional subprime lenders?
A very sobering read.
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