A Wall Street Whodathunkit
Michael Lewis was certainly not the first Wall Street insider to wake up with a conscience one morning and write a kiss-and-tell book to get a mind-bending revelation off his chest: Banks collude with the government and financial “experts” to rip you off. Whodathunkit, huh?
But The Big Short, the 2015 Hollywood feature based on Lewis’s best-selling 2010 non-fiction novel of the same title, accomplishes a truly wondrous feat that no other been-there, done-that former banker has approached in illustrating the mechanics of financial Darwinism. This dark comedy is the most Herculean effort since the global financial crisis of 2008 to deploy powerful metaphors that so vivid, tangible, and odoriferous that any cognizant viewer with a high school education can easily picture the nuts and bolts of the great big screwing machine that continues to screw us all, no matter how far we think we live from Wall Street. The screenplay, which won a well-deserved Oscar for Best Adapted Screenplay by Adam McKay and Charles Randolph last February, succeeds in translating some of the most pungent of Lewis’ twists of figurative speech and financial jargon into simple, accessible images on the silver screen, where real people – not just actors – explain them in Standard American English right in front of you.
In an example of this brilliant tactic, the film cuts to the kitchen of, Anthony Bourdain, the award-winning chef, who patiently explains what a collateralized debt obligation (CDO) is with pots, pans and a few pieces of fish that a restaurant couldn’t sell that day. The unwanted pieces of fish represent subprime mortgage-backed securities, or bonds that are backed by “ninja loans” that banks made to people with “no income, no job” for brokers to rake in $10,000 commissions. Instead of throwing the old fish away, Bourdain explains, he’ll just recycle it as fish stew and serve it to unsuspecting customers over the next three days. “That’s a CDO,” Bourdain says, adding an indisputable layer of gravitas to hours of jargon-riddled explanations by Christian Bale, Steve Carell and Brad Pitt as hedge fund managers, that a CDO trades on Wall Street as a credit-worthy bond even though the “liar loans” that serve as the collateral for the bond are just about worthless. As unappetizing as it sounds, Bourdain’s demonstration is easier to digest than the metaphor Lewis drops on the page: “Looking for bad bonds inside a CDO was like fishing for crap in a Port-O-Let.”
So how did these CDOs get rated high enough for anyone to think they were worth buying until borrowers predictably defaulted in 2007? To answer to that question, the film takes you inside the New York office of Standard & Poor’s, a rating agency that judges bonds as credit-worthy (with labels like AAA) or likely to default (with labels like BB). Actors explain that S&P, like its competitors, Moody’s and Fitch, earns its revenue by charging fees to companies that issue bonds for the very service of rating those bonds.
Of course, this is a classic conflict of interest. People who buy these bonds assume that that the ratings are objective, and that the ratings analysts who interviewed the managers of the companies that issued the bonds were acting in the interests of the buyer. In the interests of full disclosure, this is why I resigned from a lucrative job at S&P as an editor of reports written by ratings analysts in August 2005, two years before the subprime mortgage implosion, after just twelve months on staff. When I came to understand the company’s revenue model, I could not overlook the fact that the analysts – decried as as “whores” in the film -- had signed non-disclosure agreements with the companies that issued the bonds they rated. These legally binding documents prevented them from talking about anything they learned about these issuers that the issuers themselves had not already made public in press releases or reports to the Securities Exchange and Commission. They really believed it was their sworn duty to ignore streams of information that swirled through their minds when they took turns around a conference table table voting on how to rate a bond.
The victim of this conflict of interest is you – even if you don't know it. If you’re still lucky enough to be employed, your employer has a mixture of stocks and bonds in your pension plan, you would have to plow through monthly or quarterly reports to find out what’s in it. But you’re unlikely to recognize a particular bond by name or serial number – much less understand the collateral that backs the bond, or the assumptions that the ratings analysts were operating on. If you’re self-employed, or unemployed, you could face the same risk by investing in a mutual fund that owns bonds.
The film doesn’t yank you this deep into the innards of ratings agencies, but the book does mention the Japanese farmers’ unions and European pension funds bought the CDOs because of their high ratings. Instead, the film puts a Hollywood actress in the shoes of an S&P employee who explains to Steve Carell, portraying an anger-fueled hedge fund manager, that S&P has a competitive motive to assign investment-grade ratings for subprime CDOs. If S&P, the world’s largest ratings agency, refuses, the issuers will just walk down the street and pay Moody’s, the world’s second-largest ratings agency, for an investment-grade rating, she explains.
Eleven years ago, I heard this assertion debated around my cubicle at S&P, where I worked directly with analysts who rated bonds issued by insurance companies, just as they were starting to question the risk of subprime mortgage-backed CDOs aloud. A couple of these insurance companies sold legitimate insurance policies to investors against the risk that these bonds would default. The S&P analysts explained to me that the issuers really had no choice but to pay S&P to rate their bonds, even if they also paid Moody’s to do it, because the absence of an S&P rating would make investors suspicious. But, if the issuers were unhappy with the ratings, they had the legal right to tell S&P to keep quiet about them. Then they would go to Moody’s, which loved to take business away from S&P, in the hope of a higher rating. Sometimes the issuers went public with both ratings – for “a second opinion,” they would say.
When I asked the analysts why S&P wasn’t calling the housing bubble a bubble – one of them actually drew a horizontal line through that word when I used it in a report that he was supposed to sign off on – they said they didn’t want to lead the market. Besides, they said at the time, housing prices had never fallen more than 40% in America. If default rates went up, they said, they would not rush to downgrade subprime CDOs. Instead, they would wait for traders to decide the level the bonds should trade at, and then they would follow with an appropriate downgradein the bonds’ ratings. S&P’s motives get glossed over in both the book and the movie. All we’re told is that there’s a vast conspiracy between the CDO issuers, the ratings agencies, and the government.
As The Big Short illustrates, there were not enough ninja loans on the market to satisfy Wall Street’s insatiable demand for subprime CDOs. So issuers used financial derivatives, such as put and call options, which are contracts to buy or sell bonds at pre-agreed prices, respectively, to create synthetic CDOs that were essentially clones of the original CDOs. Then they used derivatives to clone the clones. What amazed me 11 years ago was that the synthetic CDOs had exactly the same credit ratings as the CDOs that they replicated. If this sounds too confusing to be true, The Big Short illustrates it clearly in a scene where Richard Thaler, a behavioral economist at the University of Chicago, playing himself, sits at the blackjack table in a casino with the actress Selena Gomez, who also plays herself. He explains that a synthetic CDO is nothing more than a bet that another CDO will pay investors what it promises to – that is, a bet on a bet – and that it’s no better a bet than the first one was. When Gomez places her blackjack bet, someone in the crowd around the table places a bet that Gomez will win. Then a second face in the crowd places a bet that the first person who bet on Gomez will win. Then a third face in the crowd bets in favor of the second bet, and fourth face bets in favor of the third bet, and so on. In just a few seconds, a classic domino theory takes shape.
Where The Big Short could have been a bit more informative, however, was the short position that the hedge fund managers played by Bale, Carell, and Pitt took against subprime CDOs. The viewer is left to assume they portrayed took an enormous risk. Usually, when an investor shorts a a bond, he buys a put option to sell the bond when it falls below a certain price, or a call option to buy the bond when it rises to a particular price. If the investor miscalculates, the loss is theoretically infinite.
But Michael Lewis’s real-life hedge fund managers were careful to protect themselves from this risk. They used a structure called credit default swap (CDS), which is more more like an insurance policy than a short trade. The investor buys a bond and pays a monthly premium to a third party (usually a bank) who promises to pay the investor the full value of the bond if the issuer of the bond defaults. If the bond does not default, the investor has only lost the value of the monthly premiums, which the third party gets to keep. But if the bond defaults, the investor can reap a windfall. The third party pays the investor both a refund of the premiums and the face value of the bond. Then the investor stands to make even more money by selling the bond – for less than the face value -- on the open market. So Lewis’s hedge fund managers had the advantage all along.
The book closes a loop that the film seems to leave untied: These swaps created a demand for synthetic CDOs. The more swaps the hedge funds bought, the more CDOs they had to buy. There were not enough CDOs to go around, so the CDO managers created synthetic ones. “That’s when I realized they needed us to keep the machine running,” Lewis quotes hedge fund manager Steve Eisman, who is not portrayed in the film, as saying after a meeting with Wing Chau, a CDO manager played by the actor Byron Mann.
Another area where the The Big Short could have been a bit more informative was on the fate of ratings agencies and investment banks and other parties to what it describes as a corrupt conspiracy with the government. The epilogue, voiced by Ryan Gosling, says the banks bailed out and a lone trader got busted. In fact, S&P agreed to pay $1.5 billion to the Department of Justice in February last year to settle charges that it had colluded with bond issuers to rate worthless CDOs as investment-grade. The settlement played a decision by S&P’s parent company, McGraw-Hill, to restructure itself from a publishing company that used the ratings agency as a cash cow into two separate entities, one focusing on publishing and the other isolating S&P as a liability. In April this year, Goldman Sachs & Co. agreed to a $5.1 billion settlement with the DOJ for its role in subprime CDOs.
Knowing the story behind the story, watching The Big Short made me glad to have left S&P before sinking into this morass along with the analysts. I’m even happier that Lewis’s seminal book landed in the hands of scriptwriters with the talent to crystalize it clearly enough for anyone to see what went wrong – and to help them detect telltale signs of the next crash.