¶ Intro
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Teaming up with non-profits to serve its communities and do good for dogs. Make your next cocktail with Tito's. Distilled and bottled by 5th Generation Inc. Austin, Texas. 40% alcohol by volume. Savor responsibly. Today, I'm going to discuss a very complicated but crucial topic, the financial crisis and how it created today's financial system. Its causes are multifaceted and complicated, and we're going to explore it all.
Its importance can't be overstated. It brought the global financial system to its knees. The world almost entered a massive global depression. By 2006 underwriting standards had deteriorated so that virtually anyone could get a loan. problem was that everyone involved in the process was paid on the basis of volume and not loan quality. The more volume, the more everyone got paid. So no one had an economic incentive to slow the gravy train. And here's where I come into the story.
Hi, this is Steve Eisman, and welcome to another episode of The Real Eisman Playbook. Today, I'm going to discuss a very complicated but crucial topic, the financial crisis and how it created today's financial system.
¶ Causes of the Financial Crisis
Because of the length of this lecture, I'm going to break it up into two parts. The topics I'm going to explore are the causes of the financial crisis, regulatory changes that occurred afterwards that have permanently changed the industry, Why did Silicon Valley Bank fail, and was it ever a threat to the financial system? And finally, the regulatory changes I think the Trump administration will be making. It's a lot, so let's get started.
The financial crisis of 2008 is now history. Its causes are multifaceted and complicated and we're going to explore it all. Its importance can't be overstated. The crisis was not just a U.S. event. but global. It brought the global financial system to its knees. The world almost entered a massive global depression. And the actual recession that occurred, as horrible as it was, was by far not the worst case scenario. That...
thankfully, was avoided. The regulatory changes imposed in the financial sector afterwards changed the financial sector and system forever, making it much safer, but with unforeseen consequences as well. And because of those unforeseen consequences, I believe the new Trump administration will make changes that we will also explore. But first, an overview. The financial crisis had four interlocking causes. One...
Too much leverage in every financial institution, but most importantly, in globally systemic institutions, which is just a fancy term for very large banks and investment banks. Number two. a large asset class subprime mortgages that blew up. Number three, systemically important financial institutions owned a lot of that asset class. And four,
Derivatives tied the balance sheets of large institutions together in a web of such complexity that no one knew where it started and where it ended. So let's start with topic one, too much leverage. The leverage story is long, and I'm going to talk about it for a while. To understand the leverage story, you need to understand that the business model of banks is different from other business models. Unlike other businesses.
Banks require leverage to generate an adequate profit. And a bank's cost of goods sold are unknown at point of sale. Now, a bank's cost of goods sold are the losses that occur. from the loans that it makes. And when a bank makes loans, it can only make an educated guess as to what those losses will eventually be. Before I explore the too much leverage problem,
I actually first need to explain how a bank works. What does it do? And I'm going to spend a long time on this because you can't understand the financial crisis without understanding these crucial fundamentals. The traditional bank makes loans. Conceptually, I like to say that a bank sells you access to its balance sheet for a price. And the access is via a loan, and the price is the interest rate that it charges.
I'm going to spend a lot of time here because once you get this, you are 90% of the way to understanding how the financial crisis unfolded. And to understand why a bank needs leverage to function, let's do a thought experiment. and start a new bank. Let's say Bank A, a new bank, raises $1 billion in equity, and the marching instructions are for the bank to use zero leverage, meaning no deposits.
I'm going to oversimplify here. So let's say that the bank makes $1 billion in loans with the money that it raised, the $1 billion in equity. Now that would never happen. Every financial institution needs some level of liquidity or cash for a rainy day. But let's just go with my example. Our Bank A has $1 billion in equity and $1 billion in loans. For a bank,
The loans it makes are its assets. From a mathematical perspective, there is no leverage. But that means that the leverage ratio is 1. Here, leverage is defined... as assets divided by equity. And here, the equity and the assets are the same. Now, how profitable can this bank be by making loans to good customers at today's normal interest rates?
Since the bank is selling access to its balance sheet for a price, the key measurement of profitability is return on total assets, the ROA, which is net income divided by total assets. Here the bank charges interest on loans, and that is its only source of revenue. Then it has operating expenses. It has to pay its employees and its executives. It has office space, computers, etc.
It also has to estimate future losses on its loans, which is called the loan loss provision. And then it pays taxes to the government. What's left is net income. Take that net income and divide it by total assets. and you get the ROA. So let's assume our bank A has an ROA of 1%. Now 1% of $1 billion equals $10 million. Trust me. in that a 1% ROA in bank world is not bad. It's not stellar, but it's not bad. JP Morgan has more than a 1% ROA, and Citigroup has had less than 1% for decades. Bank?
managements are compensated not on the ROA of the company, but the return equity, the ROE. And here's the key formula, and this is crucial. ROE equals ROA. times leverage so here the roe is one percent since assets and equity are the same the leverage is one times and so the roe is one percent times one equals one percent So the ROE is 1%. Now, 1% return on equity is a terrible number. So let's try the thought experiment again, but with some leverage.
By the way, we're going to put a table up to show each of the examples so you can more clearly see the numbers. So in our second example, our bank A starts with the same $1 billion in equity. And now let's open a branch and bring in depositors. And let's say Bank A brings in 9 billion of deposits, some checking and some savings. The bank is now transformed. It has 1 billion in equity and 9 billion in deposits. The deposits are a form of debt.
Because if a depositor shows up and wants his or her money, the bank has to give it to them. Bank A now has $10 billion of total money with which it can make loans. And let's say it does make $10 billion in loans. First... Notice that the leverage ratio was now 10 times, $10 billion in assets divided by $1 billion in equity. Still, the only revenue the bank has is the interest it charges on this $10 billion in loans.
But now it has an added expense. The interest, it pays to its depositors. It still has operating expenses. It still has to set aside its estimate for future losses on its loans. And it still has to pay taxes. Let's assume... that this version of Bank A makes the same 1% ROA. But here, it's 1% times 10 billion, not 1 billion, and that equals $100 million. The ROE is now...
10%, which is the 1% ROA times leverage of 10. So from an economic perspective, this more levered bank is no more profitable than our original non-levered bank. They both have an ROE of 1%. But because version 2 is 10 times levered, it has an ROE of 10%, which is not terrible, versus the earlier terrible 1%. ROE. Leverage turbo charges the bank's profitability. Now let's make the example even more extreme.
Instead of gathering $9 billion in deposits, let's take in $99 billion in deposits. Now the bank makes $100 billion in loans from the $99 billion in deposits plus the $1 billion in equity. The leverage is now 100 times. Assuming the same 1% ROA, this high-octane bank makes 1% ROA times 100 billion, which is a billion dollars. The ROE is 100%, which is 1% ROE times 100. So that's how a bank works. As long as it's profitable, then the more leverage, the higher the ROE. I'm going to say that again.
As long as a bank is profitable, then the more leverage it employs, the higher the return on equity. There are a lot of lessons to be taken from this thought experiment. Lesson one. Bank executives are compensated largely on a combination of net income and return on equity. The higher the net income and return on equity, the more they are paid.
Since a bank's net income and return on equity tends to go higher with more and more leverage, the temptation for leverage to increase in all banks can be overwhelming, and often only regulators can stop it. Lesson two, in our thought experiment, Bank A keeps getting more profitable as the leverage goes up. In all three examples, the return on assets was 1%.
and the return on equity increased solely because of leverage. But banks can lose money. How? When they underestimate the level of future losses. Suppose that because of higher losses, our bank loses money. And instead of generating a 1% ROA, it has a negative 1% ROA. To see how too much leverage can be dangerous. Let's look at our highly 100 times levered $100 billion bank. Negative 1% times 100 billion equals negative 1 billion.
Since our bank only started with $1 billion in equity, it is now wiped out. So more and more leverage is great so long as the bank makes money. But if it is too levered and loses money... It can be wiped out quickly. Lesson three, and I can't emphasize this enough. Do not take away from this thought experiment that all leverage in banks is bad. Quite the opposite. We want banks to be levered.
That is their social purpose. Banks take deposits that their customers give them and recycle that money as loans to other customers. We want banks to do that. If we did not allow banks to recycle deposits or restrain their leverage to very low levels. Banks would have to charge very, very, very high levels of interest to generate an adequate return. It's because banks employ leverage.
that they can make a decent return on equity with only a one-ish return on assets. For most businesses, a 1% ROA is awful. For a bank, it is adequate so long as it can have at least 10 times leverage. We want banks to recycle money, and therefore we want them to have leverage. The difficult question is, how much leverage is too much? We don't want banks to have too little.
And we don't want them to have too much. It's kind of like Little Bear's porridge. It has to be just right. And we explore this later on. So now that I've explained how a bank employs leverage... and why it needs to have leverage to generate an adequate return, let's begin to look at the crisis. There is no question that by the time the crisis began, large banks had way too much leverage. How did that happen?
Between 1997 and 2007, leverage in large financial institutions tripled. In Europe, for example, the average bank leverage ratio climbed from 11 times to 33 times. In 2007, Citibank's leverage ratio was 33 times. If you included all the off-balance sheet stuff that Citibank had risk for, which was not on its balance sheet,
the leverage ratio was probably over 40 times. And the same is true for all the large investment banks of that era, like Goldman Sachs and Lehman. And now we have to turn to an intellectual concept. whose importance I cannot overstate, called risk-weighted assets, or RWA. This one concept might be the most important reason for the crisis, and its origin is completely honorable. In our three bank examples,
I calculated leverage as assets divided by common equity. It was just simple math. But imagine two banks, each with 10 times leverage and each with the same amount of assets and equity. Both are levered the same. And both are the same size, but one bank makes only very high-risk loans and the other only low-risk loans. How does a regulator deal with that? So, sometime in the late 1980s...
the banking system began to marry two concepts, leverage and risk. And the concept of risk-weighted assets, or RWA, was born. Every bank asset is given a risk score. And that score is multiplied by the size of the asset so that the bank can calculate not only its assets, but its risk-weighted assets as well.
So two banks might have the same level of assets and equity, and both, on a simple math basis, are levered 10 to 1. But the risky bank might have much higher risk-weighted assets than its assets. and the less risky bank might have less RWA than assets. It all depends on how much risk each bank is taking. So our two banks might both be levered 10 to 1, but on an RWA basis,
the risky bank might be levered 20 to 1, and the less risky bank might be levered only 5 to 1. By the way, up till now, I have spoken about leverage. But when banks discuss this concept, they talk about bank capital ratios. This is the same thing as leverage, only the numerator and denominator are reversed. So leverage is assets divided by equity.
or RWA divided by equity. And bank capital ratios are equity divided by assets or equity divided by RWA. Just a point. Conceptually, the risk-weighted asset idea makes a lot of sense. but its acceptance through banking on a global scale had several implications and unforeseen consequences. Hi, Steve Eisman here. On my weekly wrap, I try to both teach and convey information as objectively as possible.
I try to make clear what are the facts and what are my opinions. But in today's media, it's increasingly hard to figure out what are the facts and where the facts are being shaded by opinion. That's why when I look into news events... I first go to Ground News. Ground News is my solution for getting to the facts of important stories, but also to see how left, right, and center are seeking to convey the same exact story.
Take, for example, the recent Senate rejection of dueling health care bills as the Obamacare deadline nears. To understand the story, I went to GroundNews.com and clicked on that particular story headline. There, I immediately saw four tabs, left, center, right, and bias comparison. When I clicked on the center tab, a series of headlines appeared, all from center-leaning sources. I could then click on any of those headlines.
and read the story at the source. The same happened when I clicked on the left tab and on the right tab. The bias comparison tab showed Ground News' own analysis of how all three political leanings conveyed the same exact story. I find the ground news system enormously helpful because it allows me to easily separate the facts from opinions. I use ground news.
And I recommend you try it out. Go to groundnews.com slash REAL to get 40% off their unlimited access Vantage subscription. That's groundnews.com slash REAL. groundnews.com slash R-E-A-L. And if you don't mind, use this link to get the discount so they know I sent you. So you're about to make a trade based on a friend's text. But which you do you listen to? Is it, we could buy a house in Tulum. Get optioning those options. We could lose everything. Or let's do a little research.
Get your head in the trade and make the investment decision that's right for you. Learn more at FINRA.org slash trade smart. Regulators and bank CEOs look at their leverage or capital ratios on an RWA basis and not on a simple math basis. How is an asset scored to generate its RWA? That is mostly delegated to the ratings agencies. Something rated AAA has a very low RWA score, maybe as low as a single digit percentage. Something not rated...
might have a very high RWA score or something rated very low might have a very high RWA score. The score is generated by the historic level of losses that the asset class generates combined with how volatile that loss range can be. So an asset class with an historically low level of losses and a narrow range of losses will have a low RWA. Here are some unforeseen consequences. First, as we've learned,
Banks have a built-in incentive to increase their leverage so that their return on equity goes up, so that the CEO can make more money. So banks have an incentive to load up their balance sheets with low-risk weighted assets. Mathematically, you can have a bank with an ever-increasing absolute leverage ratio, but because it keeps adding on low risk-weighted assets, the RWA capital ratio might be largely unchanged.
The RWA score depends on history. What is the historic level and range of losses? That level and range are not a law of physics. Loans are made by human beings and institutions. They have underwriting standards, and these standards can change. They can loosen, and they can tighten. If for some reason, underwriting standards loosen continuously over several years,
losses will gradually climb to levels above their historic range. I emphasize, eventually, because losses don't happen overnight, and this can be dangerous. Suppose there is an asset class, say, mortgages that has a historic low level of losses and therefore a low RWA score. And suppose underwriting standards loosen. It takes time for losses to eventually show up.
So banks could be making mortgage loans, assuming the old level of losses still apply. They could load up their balance sheets with these mortgages, and their leverage on a simple math basis could explode. while their leverage on an RWA basis stays the same. If losses started to climb to high levels and the absolute leverage ratio was too high, it could turn into a disaster. Another one, psychology.
I can't overstate this point. By loading up a balance sheet with low-risk weighted assets, a bank can kind of game the system. It can increase its leverage and increase its return on equity. And since all bank capital and leverage ratios from a regulatory perspective are calculated via risk-weighted assets, a bank could have a higher leverage ratio on a simple math basis.
but a decent leverage ratio on a risk-weighted basis. And this is in fact what happened from 1997 to 2007. Because of this increasing leverage on an absolute basis, bank ROEs kept going up. Remember when I said that in Europe, leverage on an absolute basis went up from 11 times to 33 times? Guess what? Return on equities tripled as well. This meant that the return on assets stayed the same.
Banks were no better run than before. Their return on equity or profitability improved because of more and more leverage, and that was it. Ironically, leverage during this period on a risk-weighted asset basis was flattish. So bank CEOs developed a sense of being godlike because their return on equities kept going higher. In fact, they really were not any more profitable than they had been. It was just...
They used more and more leverage. And you don't need to be a genius to increase leverage. You just borrow more. And as these bank return on equities kept climbing, bank CEOs kept getting paid more money. And here is the psychology part. An entire generation of bank CEOs mistook leverage for genius. Suppose you went to a bank CEO in 2006 and predicted the coming crisis and told the CEO,
that the entire basis of his business model was wrong, and that the use of more and more leverage was going to cause a disaster. How do you think that CEO would respond? He might not say this, but this is what he would have thought. I made $50 million last year. I can't be wrong. Again, an entire generation of bank CEOs mistook leverage for genius. Now, before we move on to the second cause of the financial crisis, I want to pause here to discuss a related issue. After the crisis...
Some commentators argued that deregulation of the banking industry caused the financial crisis, specifically the elimination of Glass-Steagall. And I think that's just wrong. Glass-Steagall was a law passed during the Depression. that separated banks from investment banks. It died during the 1990s. I believe quite strongly that even if Glass-Steagall had been strictly enforced, the great financial crisis would still have happened.
The entire risk-weighted asset concept was created independently of anything related to Glass-Steagall. It's the leverage that was created because of the RWA concept that was the problem. And the same subprime loans would have been made regardless of Glass-Steagall. So let's now discuss that. Cause number two, subprime mortgages as a dangerous asset class. Subprime mortgages blew up the world.
But because almost no subprime mortgages are made today, few people even remember what this asset class was about. Now, I have a long history with the subprime mortgage sector. In the 1990s, I was a sell-side analyst at Oppenheimer. where I covered the financial services sector. I covered everything that was not a bank or an insurance company. My coverage was quite broad
I followed investment banks, asset managers, Fannie Mae, Freddie Mac, credit cards, and several specially financed companies. And I also covered the subprime mortgage sector. Back then, it was a small sector. making mostly home equity loans to subprime borrowers who use the money to pay bills and or to pay off other forms of debt. Now, who is a subprime borrower? Technically, a borrower with a credit score below 650.
But that's just a number. The potential subprime borrower was the entire lower middle class of the United States and parts of the middle class as well. Starting in the early 1990s, household income growth... on an inflation-adjusted basis in the United States stopped increasing. It's a problem that continues to this day. The reasons for it are beyond the scope of this podcast. Hopefully, we will explore it sometime in the future. But statistically, it's a fact.
the real incomes of most Americans stopped growing. So the only way for many Americans to increase their spending was to borrow. As a society, the lack of middle class income growth was and is a serious problem. It's one major reason why President Trump is president again. And as a country, we've never really tackled it. And there was no political will to tackle it back in the 90s at all.
It was far easier to let people borrow to increase their spending rather than finding ways to improve their incomes. Anyway, lending to this growing subprime population became a gross sector. But prior to the 1990s, there was an inherent problem. Companies that lent to subprime borrowers were small and were looked down upon. They had poor...
rating agency credit ratings, and so had a hard time getting funding to make the loans they knew they could make. And then securitization was invented, and that changed everything. Now, I don't want to go into a lot of detail here. Because in the future, I will be doing a lecture on fixed income where I will explore securitization in depth. In the pre-securitization world, the subprime lender would raise debt and use those proceeds to make loans.
The interest on its loans was higher than the interest on its debt, and it made a spread or net interest margin. But because of bad ratings, a subprime lender's ability to raise debt was limited. In a securitization, however, a company might originate $1 billion in subprime loans, package the loans, and put them into a securitization. The ratings agencies would give the securitization...
and not the company a credit rating, and the interest on the loans in the securitization would be higher than the interest paid on the securitizations. So the subprime mortgage company would make a spread or a net interest margin. through the securitization. Generally the credit ratings on the securitizations created a market for these companies to raise funding that was far bigger and more liquid than their old method of raising debt on their balance sheets.
Suddenly, funding was no longer a constraint on growth, and these companies began to really grow. And it wasn't just subprime mortgages that grew. It was also subprime credit cards and subprime auto loans as well. Now, the first pure subprime mortgage company went public in 1992, and others soon followed. Some names from back then were The Money Store and Ames Financial. In 1993...
the subprime mortgage industry generated only $20 billion in loans. By 1998, the industry was producing about $150 billion per year. Growth had been explosive. But in 1998, the industry blew up. It blew up because of bad accounting methodology, and it's a long story, and I'm not going to go into it here. Suffice to say that by the end of 1999, many companies were bankrupt or retrenching rapidly.
And that was the end of the subprime mortgage sector 1.0. There was a recession in the United States in 2000. And when it ended, the Fed, led by Alan Greenspan, had cut the Fed funds rate to 1%, which back then... was revolutionary, but today seems kind of quaint. Back then, this low Fed funds rate created a problem for bond investors. Bond investors need yield, but it was hard to find.
in a 1% rate world, and Wall Street wanted to supply it. So one potential supply would be subprime mortgage loans, because they charged high rates. But the industry barely existed anymore. So Wall Street brought new companies public. Companies like New Century went public, but not all subprime mortgage companies went public. Some of the largest, like AmeriQuest, remained private. This industry was a goldmine for Wall Street. They brought the companies public.
then the mortgage companies would originate subprime mortgage loans and sell those loans in bulk to a Wall Street investment bank or to a bank. The investment bank or bank would package those loans into all different kinds of securitizations and sell those loans to investors throughout the world. The lender, the subprime mortgage company, made money.
Three to four points it charged the consumer and then made another two or three points when it sold those loans to Wall Street. So five or so total points on $1 billion in loans equals $50 million in revenue. Wall Street would sell those loans via securitization at a markup as well to investors all over the world. Everyone made money. It was quite the gravy trade. Funny thing was that many of the managements of subprime 2.0
were the same people who managed 1.0. That's why I began to think that one day this industry would blow up again, because it had blown up in 1998, and the players were most of the same. Normally, people don't change. So as early as 2003, I was looking for signs of problems. What I did not imagine was that the subprime mortgage sector would get as big as it did. In 2002, the industry started to go public.
and growth took off. And every year, industry originations grew. Why? Remember when we discussed earlier that banks don't know their cost of goods sold at point of sale. And what that means is that cost of goods sold in lending is future losses on loans. Emphasis here is future. All a lender can do is estimate future losses. It won't know if that estimate is right for a few years.
So a lender lends to what is called a risk adjusted yield. It charges an interest rate to a borrower, subtracts its own interest expense, and then subtracts the estimate of future losses. Again, it subtracts its estimate of future losses. That's the risk-adjusted yield. Think of it as profitability before operating expenses. Suppose it turns out that delinquencies and losses are much lower than anticipated.
The lender is not really happy here because they conclude that their lending standards were too tight. They could have had looser standards, originated far more loans. Sure, they might have higher losses. but they would still achieve their risk-adjusted yield, and they would be much, much, much more profitable because of the extra volume. And that is what happened to the subprime sector in the early 2000s.
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On the one hand, the economy was good. On the other hand, middle-class household income was stagnant. But because of low rates, the housing sector was doing well and home prices kept increasing. People tend not to default on their mortgages when they are building equity in their homes because of rising prices. So from 2002 through 2006, subprime lenders kept loosening their underwriting standards. And every year...
Delinquencies kept coming in below expectations. So the industry loosened more. By 2006, growth had exploded. Around $600 billion was being generated annually in loan volume. which was around 20% of the annual mortgage market of the entire United States. A once cottage industry had become big business. But, and here's the big but, underwriting quality had collapsed.
I remember when I began to do a deep dive on the subprime securitization market in 2006 that I discovered something that I found astonishing. At least 50% of all loans in the securitizations were originated via a method called low-doc, no-doc. And what do I mean by that? A subprime borrower has a credit score below 650. Credit scores start to lose their efficacy below the 650 level. So a subprime loan needs more careful underwriting.
Not less. But because of low delinquencies, the industry went in the opposite direction. So that by 2006, at least 50% of all loans were underwritten with very little underwriting. The borrower was asked what his or her income was, and that income was barely verified or not verified at all. The borrower was taken at his or her word. I like to say that by 2006...
Mortgage underwriting standards were so low that if you could breathe, you could get a mortgage loan. And I don't even think I'm exaggerating there. And now I'm going to get on my soapbox. There were massive social implications resulting from the growth explosion in subprime mortgage lending, and this was because of the structure of the subprime mortgage loan. It was typically a teaser with a go-to rate adjustment.
That's a fancy way of saying that the borrower got a low fixed rate for two or three years, and afterwards the rate went up to LIBOR plus 600. Essentially, people got a 3% rate for two to three years. And after that period, they got repriced to around 9% for the next 27 to 28 years. And here's the crazy thing. The lender underwrote the loan to the teaser rate. Meaning that the lender knew...
at the outset that the borrower could only pay the 3% rate and that when the rate climbed to 9%, the borrower would eventually default. Now, was this just a scheme to take people's houses? I don't think so, because it is expensive to repossess someone's home. The design was actually different. In a typical subprime loan, the originator charges three to four points as a fee.
That compares to one point or less for a prime loan. Now, most borrowers and subprime land were unsophisticated. They really did not understand that their loan would be repriced from 3% to 9%. in two or three years. And when that deadline approached, the lender would then contact the borrower and remind them. The borrower would freak out because there was no way they could pay 9%. So the lender offered to refinance.
¶ Where I Come Into the Story
under the same terms of 3% for two to three years, and then the same go-to rate. Of course, this was not free. The lender would charge the same three to four points for refinancing. And the borrower, however, would not actually pay out of pocket those three to four points. Instead, that amount was added to the principal amount of the new loan. So borrowers were forced to refinance every few years.
and pay the enormous three to four points for the privilege. And rolling those points into the principal amount of the loan meant that the subprime borrower never paid down any principal on their mortgage. Subprime bar was replaced on a treadmill from which they could never get off. Now, socially, this was a disaster for the middle and lower middle classes of the United States. But from the mortgage industry's perspective and Wall Street's perspective, this was a goldmine.
Every three years or so, the borrower would refinance and the lender would make another three to four points. And when Wall Street would get to repackage the same loans in a new securitization and then sell those securitizations to clients all over the world at a markup. Everybody made money and everybody was paid on volume. Yet.
This gravy train functioned only as long as borrowers could refinance. If something happened to stop refinancing, then all borrowers would get repriced to 9% and defaults would soar. As I said earlier, By 2006, underwriting standards had deteriorated so that virtually anyone could get a loan. And here's where I come into the story. Having seen the industry blow up in 1998, I was waiting for years for the industry to do it again.
And that's where securitization actually was an enormous help to me. The subprime mortgage industry securitized 100% of its loan volume. The securities were rated by the ratings agencies. And every month, the agencies put out data. on each securitization every month. Each securitization to close its 30-day, 60-day, 90-day delinquencies for the month, as well as repossessions and losses per month. This was a treasure trove of information.
The data was sort of public. Not public to everyone. But if you paid a subscription fee to the ratings agencies, which we did, you got it. And this data are incredibly granular because it comes out every month on every securitization. For analytical purposes, the key was to see if there was any deterioration of credit quality over time. In other words, my partners and I would compare the delinquency numbers for multiple securitization for, let's say, month 10
of each securitization. We wanted to see if the 2006 securitizations had higher delinquencies in the same month than earlier securitizations. And what we found was that for the 2006 securitizations, the early stage delinquencies were far, far, far higher than securitizations of any prior year. This confirmed what we had heard anecdotally. that underwriting standards had deteriorated terribly. And by the summer of 2006, it was pretty clear that something was wrong.
Now, if the mortgage industry and Wall Street had appropriate incentives, they would have tightened underwriting standards immediately, and the problem would have largely been contained. The problem was that everyone involved in the process was paid on the basis of volume and not loan quality. The more volume, the more everyone got paid. So no one had an economic incentive to slow the gravy train.
The industry kept originating and securitizing, and delinquencies kept climbing. The book, The Big Short, and the movie starts in the spring of 2006. Now, I'm not going to go through the book, but here are a few highlights. We were short the equity of a whole bunch of public subprime mortgage companies. The stocks. We were very convinced that the industry was going to suffer enormous losses. But...
The public subprime mortgage companies like New Century were not large cap stocks and trading was illiquid. And the cost of borrow to short these stocks was huge, in some cases as high as 20% annually. We simply could not safely allocate sufficient capital to shorting these stocks, especially given that they were highly shorted. And as depicted in the movie, that's when we started to learn how to short subprime securitizations,
and more liquid market. How do you short a subprime securitization? This is something I'll talk about when I get to the topic of derivatives. So let's pause on that one. Anyway. We began shorting subprime securitizations in the fall of 2006 and kept shorting till around July 2007. People sometimes ask me, how did I have the guts to remain short when the hold was telling me that everything was fine?
Timing is everything in life, and here my timing was kind of perfect. From the fall of 2006 till the summer of 2007, the subprime credit data kept getting mostly worse. Every month we would check the data and feel good.
¶ Outro
The one period that might have given us pause was in March and April of 2007, when the data looked a little better. But my partners and I had a long history of research in consumer lending companies. We knew... that in March and April of every year, consumers get tax refunds and pay down some debt. So of course the credit data looked better. So the securitization market experienced a rally, but we just used that as an opportunity to put on more positions.
By the summer of 2007, credit data was so bad that no one could remain in denial. Investors all over the world decided universally that they would no longer buy any kind of subprime securitization, a buyer's strike. And that's when it all began to really unravel. With an investor-buyer strike in place, Wall Street could no longer sell subprime securitizations to anyone.
If Wall Street could not sell to investors, then it had to stop buying loans from subprime originators. And if subprime originators could not sell their loans, then they had to stop making them. And if subprime originators stopped making loans, then consumers could no longer refinance. And when consumers could no longer refinance, their loans started to reprice to the go-to rate of around 9%, which they could not afford.
And then the credit picture got even worse. All this happened by late summer 2007, which meant that the financial crisis was now inevitable. Why? And on that cliffhanger, I end part one of this lecture. If you want to learn the rest, wait for next time when I drop the second half of this lecture. See you next time.
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