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Sunday, January 30, 2011

Book Review: "The Big Short: Inside the Doomsday Machine"

by Richard F. O’Boyle, Jr., LUTCF, MBA

In Michael Lewis’ expose of the origins of the 2008-2009 credit meltdown, “The Big Short: Inside the Doomsday Machine,” we see how greed and ignorance created the perfect storm that brought on the worst financial crisis since the Great Depression. As a financial professional who helps families and businesses plan for their retirements, I help implement insurance and planning strategies. When we put in place these plans we are often relying on third party ratings of insurance companies and products to give us the confidence that the plans can be fulfilled.

If anything, the experience of the last three years must give us pause when taking for granted the ratings of companies such as Moody’s and Standard and Poor’s. I’m not saying that we should jettison these ratings altogether – instead we should consider them carefully as a piece of the overall picture of financial strength. These agencies went wrong when they got involved in rating very complex derivative products while relying almost entirely on the data supplied by the companies that created those same products.

Lewis’ account of the development mortgage bonds and the evolution of derivative financial products such as credit default swaps is a readable insider’s view of Wall Street’s money machine. Things went awry when rating agencies gave their stamp of approval on these products for sophisticated investors such as hedge funds and institutions. Shockingly, the creators of these products – Citigroup, Goldman Sachs, Merrill Lynch and other banks – often weren’t so sure of the value of the home loans that were the foundation of the underlying bonds.

The basic problems were that the mortgages that formed the foundation of the bonds after 2005 were increasingly low-quality subprime loans and the rating models of the agencies did not take into account that property values might decline. Furthermore, the banks creating the products tailored their submissions to the agencies so that the credit risks of the underlying bonds were not truly diversified and thus riskier than they appeared. In effect, very risky bonds were given super-safe AAA ratings.

Here’s how the products were constructed and what went wrong:
1. Individual mortgages are lumped together into mortgage bonds. Investors in these asset-backed bonds get paid off as the individual mortgages are paid off.
2. Mortgage bonds are rated for financial stability by rating agencies based on their assumptions about default rates by individual mortgagees. The underlying home values and FICO scores are two key measures that they look at.
3. Investors in the bonds buy insurance called “credit default swaps” against the risk that these mortgage bonds will not pay off as expected (that they will default). The price of this insurance is based on the rating that the mortgage bonds received.
4. Big banks package thousands of these bonds and savvy investors trade in the swaps. Some banks generated so many of the bonds that they couldn’t sell them all right away so they held onto them in their own accounts.
5. When adjustable rate mortgages began to reset in 2007 and 2008, the new higher rates forced many individual mortgagees to default. The cascade effect of high defaults and sinking home values triggered the credit default swap insurance plans.
6. Banks were forced to pay out on the insurance and devalue the bonds held on their own books. Ultimately, the banks were forced to come up with more cash to shore up their finances or go bankrupt.

While I walked away after reading this book with a clearer understanding of how Wall Street works, I’m not sure that this knowledge makes me any more confident with the abilities of the various players. Lesson learned: be careful of the herd mentality in all forms of investing. Even the most sophisticated investors can get into trouble when they get greedy and rely too heavily on someone else to do their own homework.

“The Big Short: Inside the Doomsday Machine” is available from Amazon.com

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