I just finished reading The Big Short: Inside the Doomsday Machine by Michael Lewis. This book is a fascinating look at the creation and collapse of the subprime mortgage market that subsequently led to the market collapse in 2008 and the demise of Bear Stearns, Lehman Brothers, and Merrill Lynch. If you have spent any time on Wall Street for whatever reason you should read this book. Lewis does a great job in breaking down a very complex situation while weaving individual stories from different perspectives into the mix.
The most fascinating thing about the book was how this debacle ever reached the tipping point. After reading the book I’m still not sure anyone really knows for sure, but there is plenty of blame to go around from the government on down. One thing is for certain though and that was the taxpayers were ultimately left holding the bag.
Essentially it went like this. Easy mortgages with a high risk of default were used as collateral for bonds that were created and traded amongst institutions. Not even the rating agencies understood the quality of the collateral so triple B- morphed into A. A-rated collateral required less capital on bank balance sheets. Credit default swaps (one of the most publicized terms during the crisis) were insurance contracts that paid out in even of default on the bond and represented a hedge against a long bond position.
The collateral cycle went like this. Mortgages (ARMs) were issued with teaser rates that would reset 2-3 years after issuance. As long as real estate continued to climb and interest rates remained low buyers would refinance the ARM into a new mortgage at a new teaser rate, new bonds would be created with even higher risk and the cycle would start over. This continued until the market reached the tipping point and the value of the real estate couldn’t support a new loan.
The banks had become so highly leveraged that when defaults started they rapidly became insolvent. The Feds jumped in trying to save the system and we’ve been digging out ever since.
The American dream for millions had become the American disaster for Wall Street.
A great read.