Financial Crisis 2. The Big Short (as a lens on the psychology of - - PowerPoint PPT Presentation

Understanding the 2008 Financial Crisis

Nicoli Nattrass Centre for Social Science Research University of Cape Town January 2015

• 2. The Big Short (as a lens on

the psychology of finance)

Mortgage bonds made up of pools

• f home loans

Mortgage bonds made up of pools

• f home loans

CDOs CDSs on CDOs CDSs on CDOs CDSs on CDOs

Streams of home loan repayments Streams of income (from the home loan repayments and payments

• n CDSs)

Wall Streets’ newest technique for squeezing profits out of bond markets should have raised a few questions. Why were supposedly sophisticated traders at AIG FP doing this stuff? If credit default swaps were insurance, why weren’t they regulated as insurance? Why, for example, wasn’t AIG required to reserve capital against them? Why for that matter, were Moody’s and Standard & Poor’s willing to bless 80% of a pool of dicey mortgage loans with the same triple-A rating they bestowed on the debts of the US Treasury? Why didn’t someone inside Goldman Sachs stand up and say, “This is

• bscene. The rating agencies, the ultimate pricers of all these

sub-prime mortgage loans, clearly do not understand the risk, and their idiocy is creating a recipe for catastrophe”? Apparently none of these questions popped into the minds of market insiders as quickly as another: How do I do what Goldman Sachs just did?” (The Big Short, page 78).

The Psychology of Finance

• The psychology driving the bubble: greed (linked to

sex, drugs), optimism, ‘type-A personalities’, crooks; faith in the market and the rating agencies (Inside Job)

• Cassidy suggests ‘denial’ was also at play as well as

‘heuristics’ or mental shortcuts, (How Markets Fail, page 19 and Chapter 15).

• The psychology of those shorting the bubble: ability to

go against the grain, preferably backed with money and

• reputation. The Big Short shows how hard this can be

for upstarts. It also suggests that it helps being a paranoid/drop-out type, or someone with Asperger’s syndrome, and definitely not sucked into Wall Street

• culture. (Big Short, page 61-2)

‘The Wall Street Personality’

• The Inside Job: 40.35-45.38
• Conspicuous consumption (6 corporate jets for Lehman

brothers), greed, preparedness to take risks where they get the upside benefit an the company stands to take the fall…

• Disconnected (Richard Fuld)
• Male competition (William Buiter)
• Arrogant, aggressive, accept no criticism (Joe Cassano – see

also The Big Short, pages 86-9)

• Personality: drugs, sex, prostitution
• Blatant disregard for the impact of their behaviour on

society or their families (therapist)

• Fraudulent (see

http://www.rollingstone.com/politics/news/the-9-billion- witness-20141106?page=2)

Gillian Tett’s Fool’s Gold

• Points out that the crisis could have

been foreseen.

• The people who invented the

derivatives in JP Morgan Chase included women, and had no idea that they were creating a monster. It was other banks that misused them.

• They were stunned and chastened

after the crash….

• Reviewers have praised the book for

its inside story (parties, networks), for its discussion of the crash. But some worry that she was too generous in her analysis of JP Morgan Chase.

Charles ‘Chuck’ Prince CEO of Citigroup (was awarded $40 million when he retired in November 2007 after an ‘unexpectedly poor 3rd quarter performance). Named in The Guardian as one

• f the 25 people at the

heart of the meltdown:

http://www.theguardian.com/ business/2009/jan/26/road- ruin-recession-individuals- economy

John Cassidy argues that such people were ‘neither sociopaths, nor idiots, nor felons’ and that they were caught in a ‘prisoner’s dilemma in that ‘the competitive environment they operated in … provided them with no incentive to pull back’ (How Markets Fail, page 12)

Failings of the Human Brain (Kahneman and Tversky in Cassidy chapter 15)

• Representativeness heuristic

(tendency to generalize on the basis of insufficient evidence)

• Availability heuristic (relying too much on own experience

and recent events)

• Confirmation bias (getting ‘anchored’ on a theory and

interpreting even contradictory evidence as supportive

• Disaster myopia (and what Keynes called ‘spontaneous
• ptimism’ or ‘animal spirits’)
• System 1 thinking (fast, short-cuts, responsive to reward

signals) vs System 2 (reasoning, harder work)

The Personalities of The Big Short

• There were many warnings about the housing bubble

(e.g. The Economist warned about it in June 2005). What was unique about the shorters was that they acted on this knowledge….

• Asperger’s syndrome, socially disconnected (Michael

Burry)

• Obsessive, crusading, ‘sincerely rude’ (Steve Eisman)
• Deeply distrustful of Wall Street types and bond

traders (Vincent Daniel)

• Alert to the possibility of disaster in financial markets

and in real life and unimpressed with financial market models (Cornwall Capital)

Bloomberg video (also features Michael Lewis) http://www.bloomberg.com/video/profile-michael-burry- yxFQeBrfTyOqh2T6rYw2UQ.html

Excerpt from The Big Short about Michael Burry reprinted in Vanity Fair. Available here:

http://www.va nityfair.com/bu siness/features /2010/04/wall- street-excerpt- 201004#

Lessons about the market

• The ‘market’ for CDSs had to be made
• With no clear ‘market price’ or easily available

indicators for the performance of the underlying CDOs, the payments on CDSs were contestable until the writing was finally on the wall.

• Michael Burry assumed fraud on the part of the Wall

Street Banks (because they would not sell him CDSs at the price they were claiming his were worth….)

• You may be right, but timing is everything – especially

when your investors do not approve of your short

• position. They were furious when he ‘side-pocketed’

their money, forcing them to stay in the trade….

Greg Lippmann (Deutsche Bank Bond trader): Made the market for CDSs. He wanted to short the market. His bosses said he had to make it bigger (so they could be sure he could

• ffload the position if necessary by

selling his CDSs later) Initially no one but Michael Burry was buying CDS even though there was a large supply of potential sellers (to make synthetic CDOs) So he set about convincing others to bet against the sub-prime derivatives by buying CDSs He sold a billion dollars of CDSs on sub-prime mortgage bonds to John Paulson (who

• f all the shorters had the

most money to play with – eventually pushing his position to $25 billion). Eisman also bought millions

• f dollars in CDSs

Steve Eisman. His wife says he is ‘sincerely rude’ and ‘lives inside his head’. An obsessive crusader. He shorted $600 million…

http://www.binghamton.edu/magazine/index.php/m agazine/feature/the-big-cynic

Vincent Daniel (worked for Eisman) ‘viewed his fellow man with the most intense suspicion’ – especially brokers.

Wolf of Wall Street: 8.15-11.02 (di Caprio and McConaughey)

• January 2007 Lippmann is short $10 billion in

sub-prime mortgage bonds – and it was costing him $100 million a year in premiums

• AIG had stopped selling CDSs (but, inexplicably,

did not reduce their exposure)

• Lippman’s losses were subsidized by people like

Eisman (whose CDS deals he brokered) – but these shorters were losing heart (some worried that the sub-prime mortgage market was rigged by Wall Street to ensure that the CDSs never paid

• ff)
• So Lippmann invited his investors to see who was
• n ‘the other side’ of the bets they were

making……notably Wing Chau…

Wing Chau later sues Michael Lewis and Steve Eisman (unsuccessfully)

• ver his portrayal in The Big Short and

is subsequently found guilty of fraud and his company’s registration is revoked

http://www.reuters.com/article/2015/01/12/us- sec-chau-idUSKBN0KL2AE20150112

The Big Short: Spiderman at the Venetian

‘The engine of doom was

being piloted by Wing Chau and people like him’. He controlled $15 million in funds invested only in CDOs backed by the triple B tranches of mortgage

• bonds. He was buying

after AIG exited the market… Page 142….

Mortgage bonds Mortgage bonds CDOs CDSs on CDOs CDSs on CDOs CDSs on CDOs ‘I love guys like you who short my

• market. Without you

I don’t have anything to buy’ The Big Short, page 143

• Cornwall Capital accumulates $205 million in CDSs

(with a capital base of $30 million). The market shuts down in mid 2007 as even Wachovia stops selling CDSs.

• 70% of their CDSs were from Bear Stearns
• March 2007 they bought $150 million in CDSs from

HSBC betting on Bear Stearns going under (but that transferred the risk to HSBC)

• August 2007 shareholders brought their first lawsuits

against Bear Stearns for the collapse of their sub-prime backed hedge funds).

• Ben Hockett sold $205 million worth of CDSs on AA

tranches of CDOs from a UK pub. They had bought them for $1 million and sold them for $80 million. They had paid $300,000 for the bet against Bear Stearns that netted them $105 million.

• Michael Burry realized profits of $720 million for his

investors but they never thanked him for it…. He now runs his own money.

Further lessons about the market: Size Matters

• Cornwall Capital’s difficulties getting an ISDA

agreement to trade swaps – what they called their ‘hunting license’ – because they only had $30 million to play with (they were perceived as a ‘garage band hedge fund’). They needed $100 million minimum to be credible.

• Bear Sterns refused to post collateral and they

just had to accept that.

• Fortunately networks also mattered and Ben

Hockett (with old connections to Deutshe Bank got them in….