Real Estate Research

In the first part of our discussion of The Big Short, we argued that the bet against subprime mortgages that the book title refers to was not a sure thing, as the book's protagonists claimed, but a highly risky bet that just happened to turn out well. In this post, we focus on the logic of the "sure thing" claim, which is that the subprime bears were exploiting the ignorance of the subprime bulls. The idea that subprime bulls were ignorant is central to the thesis of the book, because it explains both why investors made such huge errors and why it was possible for the subprime bears to exploit, with little risk, the collapse of the mortgage market.

Lewis argues that the ignorance of the subprime bulls resulted from a combination of laziness and obfuscation by issuers of the securities they were buying. We argue, however, that the evidence, including some in the book itself, shows this claim to be patently incorrect. Issuers provided staggering amounts of information about mortgage securities and there was a whole industry of analysts on Wall Street who pored over that data and published literally thousands of reports.

The question, then, is this: if there was so much research going on and so much information available, why did so few investors get it right? The answer comes back to the same issue we discussed in the previous post: house prices. Investors bought subprime bonds not because they were too stupid or lazy to do research, or because issuers prevented them from getting relevant information, or because the securities were so complex that they couldn't figure out that a subprime borrower was a risky proposition. Subprime bulls bought the bonds because careful research based on vast amounts of loan-level data using state-of-the-art models (which, as we will show, was and still is largely correct) showed that if house prices continued to behave as they had for the previous ten years, the bonds would perform well. The research also showed that if house prices collapsed, investors would lose big, but, after ten years of solid appreciation in house prices, researchers viewed a big fall as unlikely.

Lewis's portrayal of those who lost money on subprime as bumbling and ignorant and those who made money as prescient is wrong and it is not a mere detail, it is the heart of the book. Lewis writes:

…a smaller number of people—more than ten, fewer than twenty—made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market and, by extension, the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed. (p. 105)

What we argue here is that to "foresee" the crisis, one had to explore something to which the subprime bears paid little attention: the evolution of house prices. Whether the fall in house prices that ultimately caused all subprime bonds to default was itself foreseeable is a question that we will return to in subsequent posts, but even the most outspoken subprime bear, Michael Burry, would have a hard time explaining how the main focus of his research—"reading dozens of prospectuses [of subprime mortgage bonds] and scour[ing] hundreds more"—gave any special insight into the dynamics of house prices.

Was the market opaque?
Lewis argues that the issuers of mortgage-related securities "had a special talent for obscuring what needed to be clarified." But to outsiders, specialist terminology often sounds deliberately obscure: why do doctors say the results are "negative" when an X-ray shows good news? The typical buyer in the mortgage marketplace was a specialist, and those who weren't specialists were spending hundreds of millions of dollars and could afford to, and usually did, hire experts to explain to them what was going on.

In the end, Lewis's examples mostly demonstrate his ignorance of the market, not anybody's deliberate attempts to deceive investors. For example, he claims that "a bond backed entirely by subprime mortgages, for example, wasn't called a subprime mortgage bond. It was called an ABS, or asset-backed security" (p. 127). As Lewis himself says, ABS is a class of securities that included "bonds backed by credit card loans, auto loans and other, wackier collateral…" (p. 95n). As such, these securities historically had been characterized by default rates that were literally orders of magnitude bigger than those on mortgage-backed securities (MBS), which were composed of prime residential mortgages. Thus, to the typical buyer of securities, the ABS designation did precisely the opposite of what Lewis claims—it actually drew attention to the credit risk inherent in subprime mortgages.

Another major error along these lines concerns Lewis's discussion of the Alt-A market. Lewis writes that:

Alt-A was just what they called crappy mortgage loans for which they hadn't even bothered to acquire the proper documents—to verify the borrower's income, say. "A" was the designation attached to the most creditworthy borrowers; Alt-A, which stood for "Alternative A-paper," meant an alternative to the most creditworthy, which of course sounds a lot more fishy once it is put that way. (p. 127)

This is just wrong. Alt-A loans were made to borrowers with impeccable credit who, for various and perfectly valid reasons (self-employment being the most common one) could not document income in the standard way. If a borrower had several years' worth of income in the bank, no other debt, and a credit score that indicated that he or she had not missed a payment on anything for years, lenders would rationally overlook his or her inability to provide a letter from an employer documenting income. By calling the loans Alt-A and not A, the lender drew attention to the fact that the loan did not have traditional documentation. The historical credit performance of Alt-A loans was very, very close to that of prime loans and vastly better than that of subprime, so to call Alt-A loans subprime would be completely misleading. As far as investors were concerned, the main difference between Alt-A and A paper involved prepayment risk: Alt-A loans prepaid less and thus were more valuable to investors.¹

Were the "shorters" the only people to do serious research on subprime mortgages?
Another central claim of the book is that Wall Street analysts did not seriously research the market. The following passage suggests that until March of 2007, researchers on Wall Street did not pay attention to the details of the pools of loans they were trading.

On March 19 his salesman at Citigroup sent [Michael Burry], for the first time, serious analysis on a pool of mortgages. The mortgages were not subprime but Alt-A.* Still, the guy was trying to explain how much of the pool consisted of interest-only loans, what percentage was owner-occupied, and so on—the way a person might do who actually was thinking about the creditworthiness of the borrowers. "When I was analyzing these back in 2005," Burry wrote in an e-mail, sounding like Stanley watching tourists march through the jungle on a path he had himself hacked, "there was nothing even remotely close to this sort of analysis coming out of brokerage houses. I glommed onto ‘silent seconds'* as an indicator of a stretched buyer and made it a high-value criterion in my selection process, but at the time no one trading derivatives had any idea what I was talking about and no one thought they mattered." (p. 194)

In fact, researchers had done exactly that sort of detailed analysis for years. This paper provides a detailed discussion of the state of mortgage research in the years 2003–2006, reviewing a relatively small sample of the contemporary literature, which still amounts to dozens of reports. Burry's claim to be the only person doing standard credit analysis–"In doing so, [Burry] likely also became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made (p. 50)"—is fatuous.

In fact, some of the quotes in the book suggest that the subprime bears, and not the bulls, were the ones who had little understanding of the details. Lewis writes:

As early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry's view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. (p. 28)

A loan cannot simultaneously be "interest only" and "negative amortizing." Interest only means you pay only the interest every month and "negative amortizing" means you pay less than the interest so that the principal balance of the loan actually increases over time. Unlike the distinction between ABS and MBS, the distinction between these two terms is easy to understand, even for a nonspecialist, and a self-proclaimed expert like Michael Burry should have understood it. But a careful student of prospectuses like Michael Burry should also have a hard time digging up a subprime negatively amortizing loan. "Option-ARMs," largely the only loans that allowed negative amortization in the United States, rarely ever appeared in subprime deals; they were generally considered Alt-A or prime and most were held in the portfolios of banks and never securitized.

In fact, Lewis erodes his own case by providing compelling evidence that other investors were trying to exploit subtle differences between pools and must have done exactly the sort of detailed loan-level analysis that Burry claims was not going on:

A smaller group used credit default swaps to make what often turned out to be spectacularly disastrous gambles on the relative value of subprime mortgage bonds—buying one subprime mortgage bond while simultaneously selling another. They would bet, for instance, that bonds with large numbers of loans made in California would underperform bonds with very little of California in them. Or that the upper triple-A-rated floor of some subprime mortgage bond would outperform the lower, triple-B-rated, floor. Or that bonds issued by Lehman Brothers or Goldman Sachs (both notorious for packaging America's worst home loans) would underperform bonds packaged by J.P. Morgan or Wells Fargo (which actually seemed to care a bit about which loans it packaged into bonds). (p. 105)

The fact that investors who had done such detailed research made "spectacularly disastrous gambles" refutes the idea that the success of the subprime bulls reflected their willingness to do research.

Why did the subprime bulls believe in the market?
If so many investors did so much research, why didn't they bet against subprime? Lewis hears and reports the right answer over and over again. They didn't believe that house prices were going to fall. On page 89, he quotes one participant: "For the bonds to default, he now said, U.S. house prices had to fall, and Joe Cassano didn't believe house prices could ever fall everywhere in the country at once."

On page 157, he quotes another:

"We asked everyone the same two questions," said Vinny. "What is your assumption about home prices, and what is your assumption about loan losses." Both rating agencies said they expected home prices to rise and loan losses to be around 5 percent—which, if true, meant that even the lowest-rated, triple-B, subprime mortgage bonds crafted from them were money-good.

To me, the most compelling piece of evidence about what the subprime bulls got wrong, the smoking gun that makes sense of what happened, is the following table from a Lehman Brothers report from August of 2005 titled "HEL Bond Profile across HPA Scenarios."

Lehman Brothers analysts used a default model to predict losses for deals made up of mortgages originated in the second half of 2005 under different scenarios for house prices.

There are two key things to notice in the table. The first is the researchers predict catastrophic losses for the "meltdown" scenario of 5 percent annual house price declines. A 17 percent loss means that anything below a AAA-rated bond was essentially wiped out. Because the collateralized debt obligations (CDO) were composed of BBB-rated bonds from these deals, the meltdown scenario implies complete default on the CDOs. The actual price fall that took place was roughly twice as bad as the meltdown—annual declines of 10 percent rather than 5 percent—but the predictions of the model were largely correct: the deals based on these loans should rack up losses of about 23 percent. Thus, this table completely and utterly invalidates the argument that researchers at the top investment banks did no research and were completely ignorant of what they were buying or selling and had no idea that there was any possible scenario in which the bonds might lose.

The second thing to notice about the table is in the last column. The researchers assigned the meltdown scenario a 5 percent probability—a better outcome than the one that actually obtained. More importantly, they assigned 80 percent probability to house price appreciation of 5 percent or more, scenarios where the losses were sufficiently small that even the BBB-rated bonds were "money-good," scenarios in which the heroes of The Big Short would have seen their bets expire worthless.

In a sense, the subprime bears, the heroes of The Big Short, profited from their own ignorance. Their basic thesis was that making loans to people with poor credit histories was dumb and massive losses were inevitable under any circumstances. But what subprime bears failed to understand was that making unsecured loans to borrowers with poor credit histories generally leads to large credit losses—it's called payday lending—but making loans secured by an asset with a rising price is a low-risk business. The subprime bear logic that making mortgages to borrowers with problematic credit histories was guaranteed to fail would have generated massive losses between 1995 and 2004, as actual outcomes resembled scenarios 1, 2, and 3 from the Lehman Brothers' report chart year in and year out. It was their good fortune, not their astuteness, to make the bets in 2006.

By Paul Willen, research economist and policy adviser at the Boston Fed (with Boston Fed economist Christopher Foote and Atlanta Fed economist Kris Gerardi)