This is what caused The Financial Crash of 2007-08

A small number of people made a fortune out of the financial crash of 2007-08.

Among those who made money were Mike Burry and Steve Eisman. They weren’t working together. They each used their own approach to conclude that the system was going to fail.

After the crash, the Government set up the Financial Crisis Inquiry Commission. The Commission interviewed more than 700 witnesses and concluded that there were

…widespread failures in financial regulation; dramatic breakdowns in corporate governance; excessive borrowing and risk-taking by households and Wall Street; policy makers who were ill prepared for the crisis; and systemic breaches in accountability and ethics at all levels.

Michael Lewis in The Big Short explains how Mike Burry and Steve Eisman saw it. It was simple: Mortgage companies lent money to people to buy homes on mortgages they couldn’t afford. They lent at low interest rates that would skyrocket after a honeymoon period.

They either didn’t ask for or they fiddled the income information to support the mortgage payments. And the borrowers didn’t need to put down a deposit so they had no financial stake in the properties.

And if things got out of hand, the borrowers could remortgage because prices were always going up, weren’t they?

Why The Mortgage Companies Didn’t Care

So why didn’t the mortgage companies care that the mortgages were going to go bad on them?

First, they made their money out of the deal in commissions and fees.

And if the borrowers wanted to remortgage, the mortgage companies were happy to oblige because they got a whole new set of commissions and fees.

Second, they mixed some good mortgages with risky mortgages, bundled them up and sold them on to investors as a basket of mortgages.

The only time they held the risk was in the short time between lending the money and selling on the basket of mortgages.

Of course, some didn’t handle that very well and got caught at the wrong time holding the mortgages, but mostly they just passed on the risk.

So why didn’t everyone see that it couldn’t go on and that a tsunami was coming?

Who’s Got The Sandwiches

The answer is that it was a bit like the picnic where everyone thinks someone else brought the sandwiches. I haven’t got them – I thought you had them.

The investors just couldn’t conceive of more than a small percentage of the loans going bad.

They figured someone else would pick up the risk and it would all go on forever.

What they didn’t do, which they should have, was to examine the baskets of mortgages they were holding.

Some had a mix of good and bad mortgages, but a lot had a mixture of bad and even worse mortgages.

What Mike Burry, Steven Eisman and a couple of others did was to do the analysis.

Shorting The Market

They saw things couldn’t go on and they shorted the market.

Short selling works with three parties – a short seller, a broker, and the owner of the shares. The short seller borrows shares from a broker against a promise to complete the sale later. The short seller is credited with the value of the sale.

If the price of the shares drops when he completes the sale, he keeps the difference between the price he borrowed at and the current price.

The broker is happy because he makes a commission on the transaction. The original holder of the shares is not happy if the share value drops because he has to make up the shortfall so the broker can pay the short seller.

Of course, the short seller is not going to make any profit if the original owner of the shares goes bust when the shares fall in value.

So Mike Bury and Steve Eisman took out insurance against the mortgages going bad. The beauty of it was that they could take out insurance at low rates against an event they were certain would happen.

If the companies who ultimately carried the risk had analysed the risk they would never have offered the insurance at such low rates.

The insurers saw mortgages that were set up to run thirty years. So they figured they were going to get thirty years of insurance premiums. That’s how they set the premiums. And they listened to the rating agencies who said the baskets of mortgages were safe.

But mortgages don’t run that long. People sell within a few years. And if the house was foreclosed then the mortgage wouldn’t even run that long.

If the ratings agencies had understood the risks, they would never have rated the mortgages companies so highly.

What Mike Burry And Steve Eisman Saw

What Mike Burry and Steve Eisman saw was that the people who carried the risk didn’t understand it and that neither did the rating agencies.

What they wanted to know was – where did the buck stop? They needed to know that because if the ultimate institution that would have to pay them out went bust itself, then they would not get the payouts they were due.

Eisman shorted everyone he could until he knew who had the risk. He shorted Bank Of America, UBS, Citigroup, Lehman Brothers, and Merrill Lynch.

When asked why the shorted Merrill Lynch, Eisman said he had a simple thesis. Goldman Sachs was the big kid who ran the games in the neighborhood. Merrill Lynch was the little fat kid assigned to take the less pleasant roles, just happy to be part of things.

And it paid off. Merrill Lynch went bust and got taken over by Bank Of America. But they paid out.

Of course the aftermath was that Eisman and the other winners were unhappy with what happened. The system fell apart and everyone in the country and beyond suffered.

It wasn’t something you could walk away from and laugh about how Wall Street had screwed itself.

Dissenting Views

I read the dissenting views to the conclusions of the Financial Crisis Inquiry Commission.

One view was that the root of the problem was easy access to cheap capital coming into the country. The majority view as per the quote at the top of this article is that the crash was because of a failure of regulation, and a prevelance of unethical behaviour.

I favour giving the minority view some credit. When the cat’s away, the mice will always play. So giving the mice a big piece of cheese to play with was bound to cause problems. And regulation will only catch some of the bad behaviour.

That said, it was a loosening up of regulation that allowed the system to operate at all.The moment that investment banks were allowed to risk capital on ventures like baskets of sub-prime mortgages, the doors were open to abuse.