Scams we are still paying for
Michael Roberts reviews: Adam McKay (director/co-writer) The big short 2015, general release
The big short, based on the best-selling book of the same name by Michael Lewis, is up for an Oscar this month. Like the book, the film satirically outlines how, in the lead-up to the global financial crash in 2008 and the subsequent great recession, American mortgage lenders and investment banks engaged in a huge financial scam. Banks like Goldman Sachs packaged up a bunch of mortgages into a ‘derivative’ security instrument that was sold on to other banks and financial institutions around the world. This security instrument was called a ‘collateralised debt obligation’ (CDO).
CDOs contain a bunch of mortgage-backed securities, which, in turn, are based on different home mortgages - some with very good credit-worthy borrowers and many with sub-prime mortgages (with borrowers who will almost certainly default if the housing market collapses).
The trick with CDOs is that even if they were 90% composed of sub-prime securities, because the likes of Goldman Sachs made them up, they were deemed by the ratings agencies who vet these products for buyers as triple-A (namely hardly any risk at all). So the CDOs were rated very safe, but in fact contained very risky securities. Goldman Sachs and other investment banks could get away with this as long as US home prices kept rising fast, as they did between 2002 and 2006. As soon as they stopped in 2007, sub-prime borrowers started to default and all the securities in these CDOs eventually became worthless.
The big short tries to show how the likes of Goldman Sachs set up these scams. Before 2007, like other investment banks it was selling these CDOs like the blazes and making lots of money for clients who bought them (usually other investment banks and rich individuals, often from Europe). And this scam was fully supported and promoted by the US Federal Reserve and the government authorities. The head of the Federal Reserve at the time, Alan Greenspan, reckoned that the exploding housing market was a boon to American consumption and there was no risk, while mortgage derivatives and CDOs were an exciting new form of financial engineering that would reduce the risk and impact of collapse by diversifying it across the whole financial system.
When Raghuram Rajan, a Harvard economist and now head of India’s central bank, questioned this in a paper presented at a meeting to celebrate Greenspan’s retirement,1 he was attacked by Larry Summers, former US treasury secretary under Bill Clinton and Keynesian guru, as a “Luddite” who failed to recognise the great new financial innovations like CDOs and other derivatives.
But some hedge fund and investment managers realised early the nature of what Warren Buffett later called these “financial instruments of mass destruction”. And that is what the film and Lewis’s book is about. It describes how some small financial speculators recognised that the housing boom was a huge credit bubble and the creation of these new exotic financial instruments were a scam that would eventually pull down the big banks and the American economy like a house of cards. So they speculated on the collapse of the value of mortgage bonds and CDOs and took out (then very cheap) default insurance instruments, called credit default swaps (CDS), in anticipation that CDS prices would rise, as mortgage defaults - starting with ‘sub-prime’ mortgages - started to rocket. Then they would make a killing.
As the film shows, ‘shorting’ the housing market in this way was difficult and risky. First, even when US home prices started to fall and mortgage defaults rose, the big banks bolstered the mortgage bond market with their own money and kept bond prices up and CDS prices down, and so our investment bank heroes (in the film) nearly lost all their money. And, second, the likes of Goldman Sachs at first refused to take our heroes’ bets or would not allow large positions that would really make big money. A big short was not allowed.
But then Goldman Sachs realised what our small investment managers had already grasped. This was a housing bubble and it was all going to end up pear-shaped, big time. Goldman Sachs reckoned that CDOs were going to turn sour in early 2007, as the property bubble started to burst. As Lewis puts in his book, “Goldman Sachs did not leave the house before it began to burn; it was merely the first to dash through the exit - and then it closed the door behind it.”And close the door it did. Goldman Sachs now joined our film heroes and began to bet against these same securities that it was selling as low-risk and bona fide. As one government regulator subsequently said, “It was like selling cars with faulty brakes and then buying an insurance policy on the buyer of those cars.”
The next scam, not outlined in the film, is that Goldman Sachs executives knew CDOs were turning bad, but they still went ahead and set up more. Goldman Sachs called these latest ones Abacus and invited their clients to buy them. Goldman Sachs worked with John Paulson, a top hedge fund manager (a key figure in the book, but renamed in the film), who wanted to ‘go short’ on these CDOs - not only to pick out the bad CDOs, but actually to construct the worst possible CDO, so that ‘shorting’ it would make the most money! Goldman Sachs did not tell potential investors that the Abacus CDO had been constructed with the help of a hedge fund that wanted to short it. Indeed, Goldman Sachs told investors that it had asked a completely independent investment company, ACA, to choose the securities going into the CDO. So the SEC reckons (the US Securities and Exchange Commission) that Goldman Sachs lied to its clients and then ripped them off.
The Abacus CDO was even more exotic (and toxic) than other CDOs. It was a ‘synthetic CDO’, made up not of mortgages, not of mortgage bonds, but of the very insurance premiums or CDSs themselves - a financial derivative of a financial derivative. How exotic can you get! The owner of this synthetic CDO became a huge insurer of mortgage bonds, without knowing the quality of the bonds insured, let alone the quality of the mortgages behind them. If the mortgages turned sour, the CDO owner was liable to almost unlimited liabilities or payouts to those insuring against default (ie, our heroes and GS). In the end, John Paulson, with the help of Goldman Sachs, made $1 billion on just one Abacus CDO going bust - at the expense of buyers like the UK’s Royal Bank of Scotland and Switzerland’s UBS, who were stupid enough to buy it. Goldman Sachs made millions in fees and commissions in setting up the Abacus CDO and getting investors to buy it.
The film entertainingly deals with how the small hedge fund speculators played out their ‘big short’ with the complacency, ignorance, irresponsibility and sheer neglect exhibited by the real estate brokers, banks, monetary authorities, credit agencies and financial regulators. And it makes rather clumsy attempts to explain the nature of CDOs, including ‘synthetic’ CDOs - although, admittedly, they are not easy to explain, especially considering that most bankers and economists at the time did not understand them, but carried on blithely with faith in the system and financial engineering. As Charles Prince, the head of the world’s largest bank, Citigroup, said at the time, “When the music stops, in terms of liquidity, things will be complicated. But, as long as the music is playing, you’ve got to get up and dance. We’re still dancing”.
A much better explanation of how the housing market and the global financial system collapsed and the role of the economists, bankers and official authorities in that disaster is provided by Charles Ferguson’s super documentary, Inside job.2 And the culture of investment banks - the greed, the reckless risk-taking and fraudulent activities - is more dramatically developed in Margin call, an underrated film that came out with much less fanfare.3
The big short makes no attempt to look at the wider picture: why did the housing market become a massive credit bubble that went bust and why did it spread across the globe into the worst economic slump since the 1930s. Sure, no entertainment film can cover everything and it is to the credit of the likes of Brad Pitt and others that money was found to make this particular one. But do not expect to understand why the financial world went down from this film. Michael Moore makes a better and equally entertaining job of covering the wider theme in his Capitalism; a love story, made in 2009.4
The trouble with The big short - both the book and the film, but more so the film - is that the small hedge fund speculators who made a killing by ‘shorting’ the housing market and taking on the big banks are seen as clever, maverick heroes who ‘took on’ the big boys and girls, when they are really just a bunch of speculators that got it right.
None of them wanted to expose the financial system or capitalism: they just wanted to make money - even though the characters in the film on occasion show some concern with those who really paid for this financial disaster with the loss of their homes (millions), their jobs and real incomes (millions) - and not banking jobs. And, on top of this, the financial collapse led to a bailout that cost billions, still being paid for by taxpayers in interest on public-sector debt and loss of public services (austerity).
For example, who sold Goldman Sachs and our hedge fund heroes the credit insurance in the form of these credit default swaps? None other than the biggest insurance company in the world, American International Group. AIG usually sold boring car or buildings insurance, as well as life insurance. But it also set up a division that specialised in selling insurance on ‘financial instruments’.
AIG was prepared to sell CDSs on mortgage-backed bonds to all and sundry - it was money for old rope, it thought. And for a while it made huge profits from its financial credit division. By the end of 2007, AIG had issued $527 billion in CDSs, of which $78 billion was written on just those CDOs that Goldman Sachs and others were selling. So AIG became liable for most of the losses that could happen if the US property market collapsed. And it duly did. As home prices dropped and sub-prime mortgages defaulted, the value of the mortgage-backed securities fell and those who had insured against such an event (Goldman Sachs and others) with CDSs then demanded payouts from AIG. AIG’s huge profits disappeared and soon it found it could not even meet the insurance payouts.
In the great financial crisis of September 2008, when the investment bank, Lehman Brothers, went bankrupt, so did AIG. But there was a difference. The US government decided to bail out AIG with taxpayers’ money to the tune of $85 billion (and more later). Why did it do this?
If you insure your car against a crash and then the insurance company goes bust, you do not get paid. Goldman Sachs and other banks had insured against losses on the very mortgage products and CDOs they were selling to others. When they went bad, they wanted AIG to pay up. But if AIG went bust, they would get next to nothing. So the government bailout - led by people who had worked only a short time before as executives in Goldman Sachs - enabled AIG to secure the funds to pay Goldman Sachs and others. Indeed, Goldman Sachs got paid $14 billion in CDS insurance - or 100c on the dollar. Goldman Sachs did not lose a penny, while everybody else took a hit - particularly small investors and, of course, the taxpayer - you and me.
That was not the end of it. The government then handed more billions to Goldman Sachs and other banks to prop up their balance sheets and allowed them to borrow more in the bond markets with a government guarantee. Goldman Sachs got $29 billion that way, JP Morgan got $38 billion and Bank America another $44 billion.
And where are we now, some eight years since the heroes of The big short made their killing? Nothing much has changed. The never-ending story of banking goes on, with nearly every month another fine on banks or exposure of banking fraud, like the Libor-rigging scandal, the laundering of drug cartel money by HSBC, the ‘big whale’ debacle of JP Morgan that lost billions after the end of the great recession. And, even just last month, the news that Goldman Sachs has finally settled fines and compensation with those banks and mortgage brokers that it scammed back in 2007.
Lloyd Blankfein is still the chief executive officer of Goldman Sachs. Back in 2010, Blankfein was interviewed by The Sunday Times. It went something like this:
So it’s business as usual then, regardless of whether it makes most people howl at the moon with rage? Goldman Sachs, this pillar of the free market, breeder of super-citizens, object of envy and awe, will go on raking it in, getting richer than god? An impish grin spread across Blankfein’s face. Call him a fat cat. Call him wicked. Call him what you will. He is, he says, just a banker “doing god’s work”5.
1. R Rajan, ‘Has financial development made the world riskier?’ National Bureau of Economic Research November 2005.
2. Preview available at www.sonyclassics.com/insidejob.
5. The Sunday Times November 8 2009.