The Big Short:The Dunning-Kruger Effect Part IV

The Big Short

Christian Bale as Dr. Michael Burry in The Big Short 


In the first three parts of the Dunning-Kruger effect, we’ve explored the cognitive landscape of individuals who are unable to recognize their own ineptitude; and a corollary of the effect, those who wrongly assume that their competence comes as easy to others as it does to themselves. Both can be considered metacognitive deficiencies:  a lack of awareness of self on the one hand;  and a lack of awareness of others, on the other.  In Part IV, we look at an example of the consequences to society as a whole of these deficiencies by focusing on the systemic meltdown of the world economy in 2008, through the lens of the film, The Big Short.

The Big Short: A Wicked Dramedy for our Times

While there’s been no shortage of post-mortems on the cause of the Great Recession, the most entertaining has to be the new movie The Big Short, a Golden Globe and Oscar nominee for best film, based on Michael Lewis‘s book of the same name. The film follows three sometimes inter-related investment entities as they uncover the massive fraud that had taken over the real estate industry, and their efforts to profit from that knowledge. That a morality tale emerges in the wake of their pursuit of “price discovery,” a traditional goal of the free (unmanipulated) market, is just icing on the cake.

The protagonists include Michael Burry, M.D., played by Christian Bale, the only character identified by his real name; Brad Pitt, whose character is based on Ben Hockett, an arbitrage analyst for Deutsche Bank who advises a couple of his young neighbors working out of their garage in Berkeley, CA. doing business as Cornwall Capital  (in the film, they’re located in the much more photogenic Boulder, CO;  Ryan Gosling, whose character is based on Greg Lippmann, a subprime loan trader who worked at Deutsche Bank; and Steve Carell, who plays a character based on Steve Eisman, the managing partner of FrontPoint Partners, a private hedge fund working under the umbrella of Morgan Stanley.

Collectively, they pulled back the curtain of illusion that shrouded the rotten foundations of the mortgage bond industry. In so doing, they helped expose the systemic effects of greed, stupidity, denial, and fraud among the self-proclaimed masters of the universe who run the Wall Street casino. When the dust finally settled from the 2007-2008 crash,  the damage to the U.S. economy, according to a study by Congress’s General Accounting Office, was $22 trillion.  By comparison, an entire year’s GDP is roughly $13 trillion.

The Mortgage Bond Industry

The modern mortgage bond industry has been around since at least the creation of Fannie Mae in 1938 during the Great Depression. (In the 19th century, the collapse of railroad mortgage bonds contributed to the financial panic of 1857;  and mortgage back securities (MBS) contributed to the Great Depression that began in 1929.)  For thirty years, the modern MBS was considered to be a bullet proof investment, and a very lucrative one at that, helping to double Wall Street’s share of the nation’s GDP from 20% to 40% during that time.

By packaging individual mortgage loans into bonds, lenders can more easily replace money they’ve lent to individual borrowers.  It also has the effect of expanding the number and type of lenders beyond the traditional neighborhood savings and loans (which had its own industry-wide collapse in the 1980s, requiring a $124 billion bailout from the US taxpayer).  And most importantly to Wall Street, they generate huge fees and bonuses.

Mortgage bonds are comprised of thousands of individual loans of varying quality and credit worthiness.  They are stratified into so-called “tranches,” and then sold in a secondary market. In return, buyers receive regular interest payments, basically pass-throughs from borrowers’ monthly payments. Traditionally, an MBS consisted of 65% A to triple-A graded loans, and the remaining number various categories ranging all the way down to triple-B rated, aka “subprime loans,” which traditionally made up 5% of an individual bond. Those ratios would change drastically as the credit bubble expanded, with subprime accounting for 25% of the total.  Yet somehow, those bonds were still being rated triple-A from Standard and Poors and Moodys, Wall Street’s major bond ratings agencies. (More on their key role in the Great Fraud in Part V.)

Dr. Michael Burry

Burry started out as neurologist who just happened to have an affinity for numbers. An asocial loaner with a glass eye and Asperger’s syndrome, he spent his time poring over corporate 10k filings and other sources of investing information, relieved by periodic poundings on his drum set to heavy metal music pumping through his headphones.  He began making stock market trades during the long, wee hours of his internship, and posting them on a tech stock message board during the heyday of the dot-com bubble.

Bored with medicine, Burry started Scion Capital in 2001, a one-man firm located in San Jose, CA.  Using a modest amount of family money, he quickly racked up a highly successful stock picking and trading record. He created his own blog, where he wrote about his theories of investing.  By checking the server domains that his anonymous readers were logging in from, he realized that a lot of his followers were big Wall Street firms.  One regular visitor was Joel Greenblatt, author of You Can Be a Stock Market Genius.  Greenblatt called him up one day and told him that his firm, Gotham Capital, would like to buy a quarter of his company for a million dollars.

Other money came pouring in.  Three years later, Burry was managing $600 million, and turning new money away.  Instead of taking the usual 2% off the top as other hedge fund managers did, he charged actual expenses only, usually well below 1%.  In return, he required that individual investors give him complete autonomy, meaning that they couldn’t withdraw any of their money for at least a year, or as many as five.  This latter provision would prove crucial when the shit hit the fan in 2007-2008, when the financial firms whom he had bet against delayed paying up by manipulating the markets long enough to recover some of their losses.

In his capacity as a private fund manager, Burry dared to go where no one had gone before. He actually bothered to look inside individual mortgage bonds and analyzed their thousands of individual loan components. (Something that the bond ratings agencies were supposed to do, but didn’t.)  What he found stunned him— the credit quality of a large percentage of the individual borrowers was atrocious;  and was no way reflected in their parent bonds’ ratings.

So he decided to bet against the conventional wisdom that had suffused the mortgage bond industry for decades, whose major players were as oblivious to the accumulating risk as fish are to water.  That is, until they find themselves flopping around on a fishing boat deck wearing a barbed hook lip ring.

While his detailed research turned up traditional indicators of value— court rulings, deals with other companies, government regulatory actions, etc.— it was a macro indicator that really got Burry’s attention. Living in Silicon Valley, the heart of the high tech/internet industry, he couldn’t account for the fact that despite the bursting of dot-com bubble in the spring of 2000, which resulted in the loss 0f tens of thousands of high paying jobs, home sales seemed unaffected.  In fact, houses in his area continued to appreciate. Intrigued, he started looking under the hood at the engine that was then driving the real estate juggernaut.  He concluded that rising prices were being fueled by bogus loans. When the bubble finally burst, home prices fell some 50%, leaving the mortgage bond industry in tatters.

The Great Vampire Squid

In his analysis of the Great Recession, Rolling Stone investigative reporter Matt Taibii famously branded Goldman Sachs as:

the great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money.”

The Big Short' Vampire Squid

Shorting a stock involves borrowing and then selling it, with the expectation that you can repurchase and replace it later at a cheaper price, pocketing the difference.  No such mechanism existed for shorting subprime loans.  Tranches of these “dog shit” loans (as Steve Carell’s character so artfully describes them) were hiding in plain sight. But they were protected by their consolidation into large triple-A rated mortgage bonds, which never, ever failed.

So Burry approached Goldman Sachs in early 2005 and asked them to create him a specialized financial instrument that would allow him to bet against the subprime industry.  They just about laughed him out of the room.  In the film, they initially try to talk him out of his plan, but he remained unmoved. Given that the equivalent cost of a swap on a triple-B subprime loan was about ten times the cost of insuring a triple-A tranche;  and the odds of a triple-A loan defaulting in the first year was about one in 10,000, they were only too happy to separate this fool from his money.  So they opened their gigantic maw, whipped out their blood funnel, and set out to suck him dry.

Credit Default Swaps

After months of legal wrangling, Goldman created  “credit default swap” targeting the subprime market. While credit default swaps existed to insure whole bonds, no such policy existed to insure just their subprime components, at least any that had the specificity that Burry required. Without that specificity, his whole investment thesis would be for naught if he was proven right in the market but unable to collect from the financial entities underwriting his swaps.  Additionally, a lack of standardization would make it more difficult to sell them to other investors as the market for these novel products matured;  that is, when the rest of the Street removed their blinders and jumped in with both feet.

A key difference between Burry’s new, limited swaps and those used to insure whole bonds was that his were “naked swaps.”  This meant that he had no ownership interest in the underlying collateral used to secure the loans comprising the mortgage bond;  i.e., borrowers’ homes. If a whole mortgage bond fails, its collateral has to be liquidated, usually through a tedious and costly foreclosure process. (Different states have different foreclosure laws, which added immensely to the complexity of sorting out the fubar post-crash wreckage.)

Without (ahem) exposure to the collateral underlying the loans, Burry’s naked swaps were guaranteed 100% of their face value.  In contrast, liquidated mortgage bonds might only recover 50% of their value, and take years to unwind, generating significant legal fees along the way. (Okay, now that we’ve opened that metaphoric door, we might as well quote legendary Wall Street investor Warren Buffet: “Only when the tide goes out do you discover who’s been swimming naked.“)

Just as important, Burry’s swaps were to be paid off incrementally as given tranches of subprime loans defaulted— no messy foreclosure process required. Under normal circumstances, the top-rated tranches of a bond are settled first, leaving whatever crumbs are left for the triple-B cellar dwellers to scrabble over.  This pecking order would prevail in the Great Liquidation to follow.  But that was of no concern to Burry.  He had already successfully whistled himself past the chilly Wall Street graveyard and into the warm, loving embrace of Scion’s bank.  Fending off lawsuits threatened by his own investors to return their munny during the nadir of the Great Unraveling, Burry eventually returned to them an astounding 489% on their investment.

With his novel credit default swaps, a new instrument for betting against the real estate industry was born.  In effect, Burry had created a completely new market.  How many people in history can lay claim to that?

Herewith ends Part IV.  In Part V, we continue with our exploration of the events that precipitated in the Great Recession, and try to answer the question:  To what extent was the biggest economic collapse in 78 years a product of simple greed and  fraud;  and how much a product of the Dunning-Kruger effect― a cognitive brain fart of massive proportions, characterized by incompetence and denial.

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