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The Consequences of Greed

            In Life, many take action and to every action there is a reaction. When someone partakes in an action they must understand that there is a consequence to that action. In Michael Lewis’ book the Big Short, this theme comes into play many times.  However, the actions in the book are far more costly than an action that an average individual like you or me would make. One wrong move and a company could lose everything. Michael Lewis tells of many corporate leaders and how their greed is what led us to the use of Subprime mortgage loans that caused the U.S. Financial Crisis in 2008.

            The Subprime mortgage loan was the beginning of the end. These were loans that tricked lower middle and lower class Americans into signing into these loans in order to get out of their debts from credit cards, or auto loans, by making all of the payments under one payment through refinancing. According to Michael Lewis, in his book The Big Short, they did so by promising them a fixed rate of 7% which lenders called a “teaser rate.” This rate was in place only to get the borrower interested in getting these loans. However, these lenders knew these borrowers could not afford these loans let alone pay them back. They soon began to bet on the loans defaulting (or not being paid back) they would then sell these ‘bets” as bonds to be discussed later.  Steve Eismen was the first to begin to realize what these lenders were doing. He began to see how big time lenders were packaging these subprime loans and making them into a single bond of several hundred loans and selling them to larger lending companies and banks. According to an article by Gerald P. Dwyer, the lending companies developed these things called tranches, in lighter terms they were 3 levels of lending “floors.” The top tranche was to be repaid their loans first with lower risk and interest rate. The buyers of the middle tranche were to get repaid second with a slightly higher risk and interest rate than the first tranche. The bottom tranche was supposed to be repaid last with a much more interest risk and a higher interest rate. All three tranches faced a risk of losing money, if these loans defaulted.

Informational video on Tranches and Financial Crash

             Michael Lewis states that lenders wanted to be repaid when the lender wanted to, not prematurely or when the borrower wanted to pay the loan back. This ensured that they would make a profit of the loans they sent out. So by purchasing the bottom tranche a lender took a tremendous risk due to the fact that they had a high chance of being repaid prematurely. That is why they were offered the higher interest rate to ensure they made a profit. The same goes for the middle tranche. The top tranche however, had a very low risk since they were to be repaid first they knew they could still make a profit. Now for a greedy executive these tranches sounded like a good way to make money. However they did not realize that most of these loans would default, meaning the borrowers were not paying them back. So the bond buyers on the bottom and middle tranches began to start losing money on their investments. The top tranche however had huge gains due to the fact they got repaid first. This is the first time we see that there is consequences to corporate greed, not only did some executives lose money on this deal but so did hundreds of Americans who were tricked into signing these loans.

            Since these types of loans were so new, they were not regulated by any type of Administration. Therefore these Executives felt they could do this without having to answer to anyone. In comes Michael Burry, he was a very greedy individual who was always into investing. Burry began to ask himself how he could make more money off of these bonds. Before developing one of the most diabolical systems and introducing it to the World Trade Market. According to Michael Lewis’ description Burry had worked with credit default swaps (CDS) for the majority of his career. A Credit Default Swap (CDS) is just a policy where if a borrower fails to pay their debt the lender will still receive some sort of compensation from whatever company the lender purchased the CDS from. This would in theory guarantee that his investors would receive money for their investments, thus cheating bigger banks out of money that should have never been lent out in the first place.

 

Diagram of how Credit Default swaps work

 Knowing of how this process works and how often these Subprime mortgage loans defaulted Burry created the Credit Default Swap on Subprime mortgage loans. Burry successfully got his investors to purchase these Credit Default Swaps. However he was not as successful at making sure his investors would stay and continue investing in them. Since he was unable to guarantee a major return on their money his investors wanted out. According to the article Executive Summary, Credit Default Swaps became a tangled web that dragged the financial market down due to sellers purchasing CDS policies on the CDS policies they already had in place. In other words these lenders were purchasing insurance policies on their insurance policies. Michael Burry made millions off of this, by purchasing over 60 million dollars’ worth of these bonds from Deutsche Bank. Again according to the article Executive Summary, the use of CMO’s; which is a version of a Subprime mortgage loan, and the use of CDS’ lead to the collapse to the private credit markets. Again we see a consequence to the actions of greedy individuals. Had the CDS policies had not been purchased on other CDS policies we may not have seen such a collapse.

This collapse had adverse effects on more than just the mortgage market. Due to the fact that these lenders also provided money for non-financial companies, we began to see negative effects within the entire economy. In comes John Paulson, an investor with large amount of money to invest. His sole purpose for investing was to purchase Credit Default swaps on subprime mortgage loans. John was much more successful in bringing in investors than Burry. By guaranteeing his investors would receive compensation on their investments despite the high risk of defaulting loans. John was able to guarantee this  by purchasing the CDS policies on other CDS policies. This was yet another consequence to what seemed to be a small problem in the beginning but led to catastrophe in the lending and mortgage market. With the Economy already spiraling down due to the CDS policies, John Paulson only accelerated the financial collapse.

According to Michael Lewis’ book The Big Short, Howie Hubler was yet another player in the CDS scheme. However his form of Credit Default Swap was far more diabolical than that of Michael Burry or John Paulson. Hubler’s version triggered immediate pay off when the subprime mortgage market dropped 4%. Subprime Mortgage Loans were already lower than that before the stock market began to crash. Hubler sold these bonds to anyone who would buy them, mostly foreign investors. That year Hubler made over 25 million off of the bets that his subprime loans would default. It wasn’t until Deutsche bank saw its loans to start to fail and demanded that their CDS be paid for by Morgan Stanley (a major bank in the stock market, also the bank that Howie Hubler worked for), that Hubler began to see some hardships from his plans. Deutsche demanded 1.2 billion dollars from Morgan Stanley. Since Deutsche Bank had purchased CDS’ through Morgan Stanley, Morgan Stanley was supposed to pay Deutsch back what it had initially lost. Deutsche only received about half the amount. According to The Big Short, Deutsche gave Morgan Stanley an ultimatum, either pay the 1.2 billion, or buy some of their bonds. Morgan Stanley attempted to leave its deal with Deutsche costing them over 3.7 billion dollars and Howie Hubler his job.

Corporate Executives such as Michael Burry, John Paulson, and Howie Hubler made millions on CDS and Subprime mortgage loan schemes. The development of Credit Default Swaps, Subprime Mortgage Loans, and CDS on Subprime Mortgage Loans were what caused the Financial Crash. All three of these developments were developed through sheer greed of corporate executives just looking to fill their pockets. Had these executives been exposed earlier the crash may have never happened. I believe this crash to have been an eye opener not only for corporate executives and the United States government, but for the everyday Americans who faced the hardships of defaulting on a loan.

Art Depicting a Greedy Executive