Understanding the 2008 Financial Crisis

Nicoli NattrassCentre for Social Science Research

University of Cape Town

January 2015

2. The Big Short (as a lens on

the psychology of finance)

Mortgage bonds made up of pools of home loans

Mortgage bonds made up of pools of home loans

CDOsCDSs on CDOs

CDSs on CDOs

CDSs on CDOs

Streams of home loan repayments

Streams of income (from the home loan repayments and payments on CDSs)

Wall Streets’ newest technique for squeezing profits out of bond markets should have raised a few questions. Why were supposedly sophisticated traders at AIG FP doing this stuff? If credit default swaps were insurance, why weren’t they regulated as insurance? Why, for example, wasn’t AIG required to reserve capital against them? Why for that matter, were Moody’s and Standard & Poor’s willing to bless 80% of a pool of dicey mortgage loans with the same triple-A rating they bestowed on the debts of the US Treasury? Why didn’t someone inside Goldman Sachs stand up and say, “This is obscene. The rating agencies, the ultimate pricers of all these sub-prime mortgage loans, clearly do not understand the risk, and their idiocy is creating a recipe for catastrophe”? Apparently none of these questions popped into the minds of market insiders as quickly as another: How do I do what Goldman Sachs just did?” (The Big Short, page 78).

The Psychology of Finance

• The psychology driving the bubble: greed (linked to sex, drugs), optimism, ‘type-A personalities’, crooks; faith in the market and the rating agencies (Inside Job)

• Cassidy suggests ‘denial’ was also at play as well as ‘heuristics’ or mental shortcuts, (How Markets Fail, page 19 and Chapter 15).

• The psychology of those shorting the bubble: ability to go against the grain, preferably backed with money and reputation. The Big Short shows how hard this can be for upstarts. It also suggests that it helps being a paranoid/drop-out type, or someone with Asperger’s syndrome, and definitely not sucked into Wall Street culture. (Big Short, page 61-2)

‘The Wall Street Personality’• The Inside Job: 40.35-45.38• Conspicuous consumption (6 corporate jets for Lehman

brothers), greed, preparedness to take risks where they get the upside benefit an the company stands to take the fall…

• Disconnected (Richard Fuld)• Male competition (William Buiter)• Arrogant, aggressive, accept no criticism (Joe Cassano – see

also The Big Short, pages 86-9)• Personality: drugs, sex, prostitution• Blatant disregard for the impact of their behaviour on

society or their families (therapist)• Fraudulent (see

http://www.rollingstone.com/politics/news/the-9-billion-witness-20141106?page=2)

Gillian Tett’s Fool’s Gold• Points out that the crisis could have

been foreseen.• The people who invented the

derivatives in JP Morgan Chase included women, and had no idea that they were creating a monster. It was other banks that misused them.

• They were stunned and chastened after the crash….

• Reviewers have praised the book for its inside story (parties, networks), for its discussion of the crash. But some worry that she was too generous in her analysis of JP Morgan Chase.

Charles ‘Chuck’ Prince CEO of Citigroup (was awarded $40 million when he retired in November 2007 after an ‘unexpectedly poor 3rd quarter performance). Named in The Guardian as one of the 25 people at the heart of the meltdown:

http://www.theguardian.com/business/2009/jan/26/road-ruin-recession-individuals-economy

John Cassidy argues that such people were ‘neither sociopaths, nor idiots, nor felons’ and that they were caught in a ‘prisoner’s dilemma in that ‘the competitive environment they operated in … provided them with no incentive to pull back’ (How Markets Fail, page 12)

Failings of the Human Brain (Kahneman and

Tversky in Cassidy chapter 15)

• Representativeness heuristic (tendency to generalize on the basis of insufficient evidence)

• Availability heuristic (relying too much on own experience and recent events)

• Confirmation bias (getting ‘anchored’ on a theory and interpreting even contradictory evidence as supportive

• Disaster myopia (and what Keynes called ‘spontaneous optimism’ or ‘animal spirits’)

• System 1 thinking (fast, short-cuts, responsive to reward signals) vs System 2 (reasoning, harder work)

The Personalities of The Big Short

• There were many warnings about the housing bubble (e.g. The Economist warned about it in June 2005). What was unique about the shorters was that they acted on this knowledge….

• Asperger’s syndrome, socially disconnected (Michael Burry)

• Obsessive, crusading, ‘sincerely rude’ (Steve Eisman)• Deeply distrustful of Wall Street types and bond

traders (Vincent Daniel)• Alert to the possibility of disaster in financial markets

and in real life and unimpressed with financial market models (Cornwall Capital)

Bloomberg video (also features Michael Lewis)

http://www.bloomberg.com/video/profile-michael-burry-

yxFQeBrfTyOqh2T6rYw2UQ.html

Excerpt from The Big Shortabout Michael Burry reprinted in Vanity Fair.

Available here: http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004#

Lessons about the market

• The ‘market’ for CDSs had to be made• With no clear ‘market price’ or easily available

indicators for the performance of the underlying CDOs, the payments on CDSs were contestable until the writing was finally on the wall.

• Michael Burry assumed fraud on the part of the Wall Street Banks (because they would not sell him CDSs at the price they were claiming his were worth….)

• You may be right, but timing is everything – especially when your investors do not approve of your short position. They were furious when he ‘side-pocketed’ their money, forcing them to stay in the trade….

Greg Lippmann (Deutsche Bank Bond trader): Made the market for CDSs.

He wanted to short the market. His bosses said he had to make it bigger (so they could be sure he could offload the position if necessary by selling his CDSs later)

Initially no one but Michael Burry was buying CDS even though there was a large supply of potential sellers (to make synthetic CDOs)

So he set about convincing others to bet against the sub-prime derivatives by buying CDSs

He sold a billion dollars of CDSs on sub-prime mortgage bonds to John Paulson (who of all the shorters had the most money to play with –eventually pushing his position to $25 billion).

Eisman also bought millions of dollars in CDSs

Steve Eisman. His wife says he is ‘sincerely rude’ and ‘lives inside his head’. An obsessive crusader.

He shorted $600 million…

http://www.binghamton.edu/magazine/index.php/magazine/feature/the-big-cynic

Vincent Daniel (worked for Eisman) ‘viewed his fellow man with the most intense suspicion’ – especially brokers.

Wolf of Wall Street: 8.15-11.02 (di Caprio and McConaughey)

• January 2007 Lippmann is short $10 billion in sub-prime mortgage bonds – and it was costing him $100 million a year in premiums

• AIG had stopped selling CDSs (but, inexplicably, did not reduce their exposure)

• Lippman’s losses were subsidized by people like Eisman (whose CDS deals he brokered) – but these shorters were losing heart (some worried that the sub-prime mortgage market was rigged by Wall Street to ensure that the CDSs never paid off)

• So Lippmann invited his investors to see who was on ‘the other side’ of the bets they were making……notably Wing Chau…

Wing Chau later sues Michael Lewis and Steve Eisman (unsuccessfully) over his portrayal in The Big Short and is subsequently found guilty of fraud and his company’s registration is revoked

http://www.reuters.com/article/2015/01/12/us-sec-chau-idUSKBN0KL2AE20150112

The Big Short: Spiderman at the Venetian

‘The engine of doom was being piloted by Wing Chau and people like him’. He controlled $15 million in funds invested only in CDOs backed by the triple B tranches of mortgage bonds. He was buying after AIG exited the market…

Page 142….

Mortgage bonds Mortgage bonds

CDOs CDSs on CDOs

CDSs on CDOs

CDSs on CDOs

‘I love guys like you who short my market. Without you I don’t have anything to buy’ The Big Short, page 143

• Cornwall Capital accumulates $205 million in CDSs (with a capital base of $30 million). The market shuts down in mid 2007 as even Wachovia stops selling CDSs.

• 70% of their CDSs were from Bear Stearns• March 2007 they bought $150 million in CDSs from

HSBC betting on Bear Stearns going under (but that transferred the risk to HSBC)

• August 2007 shareholders brought their first lawsuits against Bear Stearns for the collapse of their sub-prime backed hedge funds).

• Ben Hockett sold $205 million worth of CDSs on AA tranches of CDOs from a UK pub. They had bought them for $1 million and sold them for $80 million. They had paid $300,000 for the bet against Bear Stearns that netted them $105 million.

• Michael Burry realized profits of $720 million for his investors but they never thanked him for it…. He now runs his own money.

Further lessons about the market: Size Matters

• Cornwall Capital’s difficulties getting an ISDA agreement to trade swaps – what they called their ‘hunting license’ – because they only had $30 million to play with (they were perceived as a ‘garage band hedge fund’). They needed $100 million minimum to be credible.

• Bear Sterns refused to post collateral and they just had to accept that.

• Fortunately networks also mattered and Ben Hockett (with old connections to Deutshe Bank got them in….