“The Big Short” and Incentives

The film adaptation of Michael Lewis’ The Big Short is due in theaters this week. The release presents an opportunity to reflect on how and why the US mortgage industry almost drove the global economy off a cliff. Chief among these was the behavior of the various parties involved, from borrowers to investors. As a friend of mine once told me: if you really want to understand the behavior of people or institutions pay close attention to the incentives that are available to them. Here’s a few examples of how the incentives available to multiple parties helped create a massive economic calamity.

Borrowers
Borrowers had the incentive to take on debt in an environment of incredibly low interest rates courtesy of the Federal Reserve. The Fed had cut rates in 2003 after the dot-com bubble burst sent the economy into recession. Lower interest rates were intended to encourage borrowing and spending thus stimulating economic activity. Peter Fisher, former Under Secretary of the Treasury, summed up the situation nicely in the documentary Money For Nothing

“Now, there are a lot of people who want to criticize the American household for being dumb…
…I think that’s mistaken. I think, I would never short the intelligence of the American consumer. Sort of the collective wisdom I think is usually pretty good. We gave them really good interest rates in 2003 and 2004 and guess what? They borrowed a lot of money.”
[1]

Lenders and Originators
Broadly speaking mortgages can be divided into two categories: agency and non-agency. Agency loans meet a set of underwriting standards established by Government Sponsored Enterprises (GSEs like Fannie Mae and Freddie Mac). Non-agency loans on the other hand fail to meet these standards for a number of reasons: the loan value is too large, there is limited documentation of the borrowers income, the borrower has poor credit history, etc.

Despite these risks originators were able to profit from non-agency loans in two ways. Initially they were compensated through fees and points paid by the borrower. Second, and more importantly, the loans they created were sold off in packages to institutions such as investment banks–at a profit–where they were bundled into Mortgage Backed Securities and sold to investors.

The desire to increase profits and limited safeguards to protect institutions created the incentive for originators to misrepresent certain aspects of the loan application–either through predatory lending or predatory borrowing. [2] The result was relaxed and in some circumstances irrational loan terms including the Interest-Only Negative-Amortizing Adjustable-Rate Subprime Mortgage and the No Income No Job or Assets (N.I.N.J.A.) loan. As a consequence, a large pool of borrowers took on home loans that they couldn’t afford, eventually defaulting.

Investment Banks
Credit Default Swaps (CDSs) are an insurance contract of sorts that enables someone to “insure” or bet on the movement of an asset without actually owning or having any exposure to that asset. It was through this instrument that investors like Mike Burry were able to inexpensively bet against the subprime housing market without ever directly shorting a subprime mortgage bond. Burry and the few other individuals that were conducting such trades purchased CDSs from investment banks like Goldman Sachs. However, the actual CDSs weren’t coming from Goldman but another source. Lewis writes of Burry

Now he couldn’t help but wonder who exactly was on the other side of his trades–what madman would be selling him so much insurance on bonds he had handpicked to explode? If Mike Burry made $100 million when the subprime mortgage bonds he had handpicked defaulted, someone else must have lost $100 million. Goldman Sachs made it clear that the ultimate seller wasn’t Goldman Sachs. Goldman Sachs was simply standing between insurance buyer and insurance seller and taking a cut. [3a]

Goldman Sachs was just a middleman, purchasing CDSs from insurance giant AIG for 0.12% (12 basis points) then turning around and selling the CDSs to investors like Mike Burry at 2% and profiting off the difference. In doing so Goldman was essentially taking advantage of lax oversight on the part of AIG

“In a matter of months, AIG FP, in effect, bought $50 billion in triple-B-rated subprime mortgage bonds by insuring them against default. And yet no one said anything about it–not AIG CEO Martin Sullivan, not the head of AIG FP, Joe Cassano, not the guy in AIG FP’s Connecticut office in charge of selling his firm’s credit default swap services to the big Wall Street firms, Al Frost. The deals, by all accounts, were simply rubber-stamped inside AIG FP, and then again by AIG brass. Everyone concerned apparently assumed they were being paid insurance premiums to take basically the same sort of risk they had been taking for nearly a decade. They weren’t. They were now, in effect, the world’s biggest owners of subprime mortgage bonds.” [3b]

Goldman not only had the means but the incentive (profit) to sell CDSs at the expense of AIG. While Goldman was generating profits it was concurrently redistributing the risk of default on subprime mortgages back to AIG. Lewis puts it in a rather simple way

“It was incredible: In exchange for a few million bucks a year, this insurance company was taking the very real risk that $20 billion would go poof” [3c]

In hindsight we know the $20 billion, and much more, did go poof. There are of course other examples of incentives at work, but I don’t want to give everything away. I thoroughly enjoyed the book and can’t wait to see the movie.

References
1. Money For Nothing: Inside the Federal Reserve. Liberty Street Films. 2013.
2. Ashcraft, Adam B. and Til Schuermann. Understanding the Securitization of Subprime Mortgage Credit. Federal Reserve Bank of New York Staff Reports. Staff Report no. 318. March 2008. https://www.newyorkfed.org/medialibrary/media/research/staff_reports/sr318.pdf
3. Lewis, Michael. The Big Short. W. W. Norton & Company, Inc. New York, NY. 2010.
(a) p. 53
(b) pp. 71-72
(c) p. 72