Economics and Change Part Two

In the previous post, I alluded to the financial crisis of 2008, which turned a recession into an economic nightmare and plunged the United States and world economies into a deep recession, the deepest since the Great Depression. A little while back, I read a book on the topic that lends itself very nicely to the subject of this blog. That book was The Big Short, by Michael Lewis.

The Big Short discussed the build-up to the financial crisis and the collapse of the housing bubble, following the story of the people who saw the storm coming and acted to profit from it. In essence, they created the market for credit default swaps on collateralized debt obligations. Essentially, these collateralized debt obligations were debts owed with collateral behind them, which, in this case, were largely mortgage-backed securities. These CDOs would be divided into several levels, or tranches, which would bear varying levels of risk of loss in the event of some of the loans on the CDOs defaulting, and to compensate for the varying levels of default risk, varying interest rates, with riskier tranches being given higher interest rates.

The biggest problem with this was that, due to the easy-credit bubble of this time, many of the loans and mortgages that these CDOs were based on were subprime. They had been given to people who had no or low-paying jobs, few to no other sources of incomes, and no ability to repay. Many of these loans were destined to default. This would have been bad enough, except the rating agencies were essentially deluded into thinking that these loans given to people who could not repay them were safe and not very risky, especially when packaged together. To paraphrase the book, it was as if the rating agencies believed that if a big enough pile of garbage was collected together and wrapped up nicely, it would turn into a pile of gold.

And so, the banks refused to believe that the dynamic of the rating agencies had changed, even in the face of logic. Despite being the ones to put pressure on the rating agencies to give the CDOs higher ratings than they were actually worth, the financial system largely refused to understand the new and changing paradigm and essentially believed their own lies. They put their faith in these ratings, and so, they started betting on these CDOs as a way to make money. 

The story in the The Big Short was one, however, of some people being able to recognize the changing paradigm. They were able to see the bad loans for what they were and bet against them in time to make a killing by establishing a market for credit default swaps -- essentially a bet against the CDOs, where a premium was paid as insurance against a default of the CDO. Because the CDOs were presumed safe, the premiums were very low, meaning that very large quantities of "insurance" could be taken out for very little.

These few people, who saw the changing paradigm in time to act, reacted in the most rational and most beneficial way (at least, to themselves). In refusing to go along with the standard ratings-can-be-taken-to-the-bank (pun absolutely intended) concept and in seeing the change in the rating agencies that helped form such a shaky foundation to the financial system, these people were able to make a boatload of money. Those who chose to act irrationally, get sucked in by their own game, and believe that the rating agencies that they had worked so hard to delude were making good calls ended up getting destroyed in the market and helping cause the financial crisis once the first parts of the recession hit and started causing defaults. Once again, irrationality and resistance to change resulted in chaos.