Today’s topic covers the 2008 financial crisis so we can discuss how some risky assets have evolved in future posts. In essence, we are looking at 2008 Revisited in our current financial markets and we are primed for another downturn.
For those that haven’t seen it, The Big Short is a mainstream movie that attempts to identify the root cause of why the 2008 financial crisis occurred.
The linkage between Wall Street and Main Street was, for the most part, established when the finance industry created securitization in the 1970s and was mass-commercialized in the 1980s by the now defunct Salomon Brothers. Today, almost 75% of mortgages issued are securitized.
Securitization works like this. Large financial institutions like investment banks or quasi-government agencies like Fannie Mae first pool together several hundred mortgages. Once these mortgages are pooled, they then issue bonds to investors using those assets as backing. Each month when families pay down their mortgages, that incoming cash is sent to investors who purchased bonds. As homeowners pay down mortgage principal early, refinance their mortgages, or default on their loans, the payments to bondholders fluctuate. The name given to these bonds that investors buy is mortgage-backed securities, or MBS for short.
Two concepts central to The Big Short are short selling and collateralized debt obligations (CDOs).
Money is generally made in the market when the value of an asset goes up. But there are ways for sophisticated investors to make money when the value of assets declines, and that’s where short selling comes in. We’ve discussed short selling in several prior posts so we won’t rehash that concept here. Click here for a link to prior blog post on short selling.
A key instrument of this complex short was a collateralized debt obligation, or CDO. A CDO is a sort of mortgage-backed security on steroids. Whereas, MBS are only made up of mortgages, CDOs can be made up of a diverse set of assets—from corporate bonds to mortgage bonds to bank loans to car loans to credit card loans. These loans, from different sources, are then bundled together and then sent back out into the marketplace as new bonds. And like some MBS, investors in CDOs can buy into different tiers, ranging from low-risk to high-risk.
Leading up to the crisis, certain investment banks started creating CDOs that included just the lowest rated tiers of mortgage-backed securities. Ratings agencies, nonetheless, rated those CDOs Triple-A. The thought was that while one high risk mortgage may be a bad gamble, thousands of high risk mortgages are a good bet because there’s safety in numbers. They can’t all go south at once, right?
The main characters of The Big Short rejected this herd mentality and began shorting these products. They used derivative contracts called credit default swaps (CDS) issued by companies like AIG to bet against these CDOs. CDS is a fancy term for insurance contracts that allow banks and hedge funds to protect against the risk of a CDO default. For a small fee paid to AIG, hedge fund managers would receive a guarantee that in the “unlikely” event of a CDO collapse, they would still receive a certain return. And in the case of The Big Short, these savvy investors bought just the insurance contract (the CDS) without owning the flawed CDOs they were meant to insure against. In other words, they bought only the insurance that the mortgages would fail without ever owning the mortgage securities or the CDOs themselves. Some have compared this to owning theft insurance on someone else’s home in which you only get paid if they get robbed.
The dominoes eventually fell: homeowners with adjustable-rate mortgages saw their rates skyrocket, they then defaulted on their loans, cash flows to CDOs dried up, CDO managers couldn’t pay their bondholders, and the owners of the insurance contracts (the credit default swaps) got their big payouts.
This has been a post to attempt to refresh your memory. In 2008 Revisited, we set the groundwork for future posts where we will discuss what institutions have done in today’s market to set us all up for another massive crash.
If you would prefer a Youtube explanation, check out this clip, starring Selena Gomez, breaking down the components that we discussed in this post.