This is the final and follow-up to our last post: The Big Short: Primary Sources (2) – Draw Your Own Conclusions. Below is an excerpt from a lengthy 639-page report titled “WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse”, an investigatory study published by the U.S. Senate on April 13, 2011. The Appendix to this report consists of 1,037 pages of supporting footnotes and exhibits – it’s a gold mine of internal company documents, emails, presentations, etc.
The report and its appendix are long, but quickly skimming through them, you will see a detailed summary and artifacts surrounding the critical events that took place in The Big Short, book and movie. Interestingly enough, Lewis’ book was published on March 15, 2010, a year before the government report was published; the latter thus potentially provides new and additional color. Interpretations – that of Lewis in 2010, the U.S. government in 2011 and you in 2016 – of the same events may be different.
Gregg Lippmann of Deutsche Bank presented the case for shorting the RMBS market via credit default swaps in a presentation dated September 2005, shown on pages 875-912 in the Appendix. The highlights from this presentation are summarized in the excerpt below from the U.S. Senate report. The most interesting thing to us was the prescient observation that regional slow-downs in the rise of housing prices was correlated with rapidly increasing defaults in subprime mortgages. This may not sound that revelatory, but to us it’s pretty cool – subprime mortgage defaults didn’t start to snowball when overall home prices started to decline – they started to occur in higher percentages, before, when overall home prices didn’t rise as much. To use a physics analogy, it wasn’t a reversal in the direction of velocity that precipitated the first cracks in the financial crisis but a reversal (negative) in acceleration. Things were still going up when doo-doo started to hit the fan.
Excerpt from pp. 341-343 of the Report:
Initiating the Short Position. In 2005, Deutsche Bank was heavily invested in the U.S. mortgage market and, by 2007, had accumulated a long position in mortgage related assets that, according to Deutsche Bank, had a notional or face value of $128 billion and a market value of more than $25 billion. 1294
These positions had been accumulated and were held primarily by the Deutsche Bank mortgage department, the ABS Trading Desk, and a Deutsche Bank affiliated hedge fund, Winchester Capital, which was based in London. 1295
Mr. Lippmann told the Subcommittee that, despite the bank’s positive view of the mortgage market, in the fall of 2005, he requested permission to establish a proprietary trading position that would short RMBS securities.1296 He explained that he made this request after reviewing data he received from a Deutsche Bank quantitative analyst, Eugene Xu. He said that this data showed that, in regions of the United States where housing prices had increased by 13%, the default rates for subprime mortgages had increased to 7%.1297 At the same time, he said, in other regions where housing prices had increased only 4%, the subprime mortgage default rates had quadrupled to 28%.1298 Mr. Lippmann explained that he had concluded that even a moderate slow down in rising housing prices would result in significant subprime mortgage defaults, that there was considerable correlation among these subprime mortgages, and that the defaults would affect BBB rated RMBS securities. Mr. Lippmann stressed that his negative view of RMBS securities was based primarily on his view that moderating home prices would cause subprime mortgage defaults and was not dependent upon the quality of the subprime loans. 1299
In the fall of 2005, Mr. Lippmann said that he approached his supervisor Richard D’Albert, Global Head of the Structured Products Group, for permission to enter into CDS agreements to short RMBS securities totaling $1 billion.1300 He said that he explained at the time that a cost benefit analysis favored a short RMBS position, because the bank would pay a relatively small amount of CDS premiums per year in exchange for a potentially huge payout.
Mr. Lippmann said that he estimated at the time that, when the costs were compared to the potential payout if the BBB securities defaulted, the proposed short position offered a potential payout ratio of 8 to 1.
Mr. Lippmann also developed a presentation supporting his position entitled, “Shorting Home Equity Mezzanine Tranches.” It made the following points:
- “Over 50% of outstanding subprime mortgages are located in MSAs [metropolitan statistical areas] with double digit 5 year average of annual home price growth rates.
- There is a strong negative correlation between home price appreciation and loss severity.
- Default of subprime mortgages are also strongly negatively correlated with home price growth rates.
- Nearly $440 billion subprime mortgages will experience payment shocks in the next 3 years.
- Products that may be riskier than traditional home equity/subprime mortgages have become popular.” 1301
Finishing Ryan Gosling*, excuse me, Gregg Lippmann’s testimony to the FCIC, here is Part 3: FCIC STAFF AUDIOTAPE OF INTERVIEW WITH GREG LIPPMANN, DEUTSCHE BANK (PART 3 of 3).
*Ryan Gosling plays Jared Vennett in the movie who is supposed to be Gregg Lippmann of Deutsche Bank.
And here is Christian Bale’s character in real life, Michael Burry, in his testimony to the FCIC: FCIC STAFF AUDIOTAPE INTERVIEW WITH MICHAEL BURRY, SCION CAPITAL.