Saw "The Big Short" today.
It's a good movie.
I saw it and lived it...worked for the data network that belongs to the 4,000 banks that do international business. The movie explains how "a few bad mortgages" (Jim Cramer, CNBC) knocked down the US financial system. I heard a banker call it "taking bank deposits to that big casino". The movie has a great scene in Las Vegas in which Selena Gomez explains -- with some help from a University of Chicago economist.
You can read the first version of Michael Lewis's book in his article "The End of Wall Street as We Know It":
http://upstart.bizjournals.com/news-markets/national-news/portfolio/2008/11/11/the-end-of-wall-streets-boom.html?page=allEssentially?
- The financial industry created pools of mortgages so that each pool could be traded, like a stock or a bond
- Each pool had a mix of a few AAA credit mortgages and loads of BBB, meaning garbage credit, mortgages. The two rating agencies -- Moody's and Standard & Poor -- gave each pool the rating of the most credit-worthy mortgage. Moody's and S&P did this partly because they are lazy -- don;t want to check the credit of a hundred mortgages within a pool -- and partly because the pool initiators could take their business to the competitor.
- Banks made money trading the pools, but needed more and more pools
- All the smart guys convinced each other that the housing market would always improve. They KNEW...because they had computer models. When a hedge fund manager asked what would happen if housing prices ever declined...if, for instance, people began to lose jobs and miss mortgage payments...the ratings agency said "our model does not allow for a drop in prices".
- So far, I've described stupidity and greed, qualities that a market always corrects eventually. This was different: stupidity and greed multiplied.
- As Selena and the Prof explain, bright lads began to create instruments based on the velocity that prices would increase...not the mortgages themselves, but a calculation derived from the direction of the market. Then the bright lads created instruments based on the instruments based on the velocity that prices would increase.
- That's a derivative. I met derivatives around 1994, when Wall Street (which was still clustered around the corner of Wall and Broad Streets, NYC) was stunned because a firm had fleeced Orange County, CA, the Pension Fund of West Virginia, and one of the toothpaste / shampoo companies. Their derivatives had been very profitable until suddenly they weren't. Orange County went bankrupt. The toothpaste company sued and got -- eureka -- tapes and internal email from traders and managers. One tape caught a trader boasting that "we've got this deal so tangled that they'll never get out". In an email exchange, a new kid asked his manager about a deal sheet: "What's this 'ROF'?" Answer: "Oh, that's the Rip Off Factor.
(Those were the innocent days, the just getting started days of the International SWAPS and Derivatives Association.)
By 2004 or 2005, Chase Manhattan and a dim-witted insurance company called American Insurance Group (AIG) had created a "don't worry about it" insurance package to protect mortgage pool owners. The insurance packages could be traded, as well.
Create mortgage pools full of garbage mortgages, takes side bets on side bets, then trade instruments derived from the AIG packages: result was an atom bomb in the financial system.
Unfortunately, nothing was done. People are still inventing "innovative financial instruments" that amount to side bets three-times-removed from any underlying value.
See the movie. Read the original article. Read the book. Ignore the explanations from CNBC and FOX Business.
