After the introduction of subprime mortgage-backed securities, investors were throwing their money into the U.S. housing market and housing prices began to rise. The newly relaxed lending regulations and low interest rates drove housing prices higher, making the MBS and CDO seem like even better investments. They figured that even if the borrower defaulted on their loan, the bank would still have a really valuable house to put back on the market. However, they were dead wrong.
As the price of houses were increasing, a bubble was beginning to form and it was about to burst. People were unable to pay for their insanely expensive houses or keep up with their ballooning mortgages and started to default. By August of 2008, 9% of all mortgages in the U.S. were in default. Houses were put back onto the market but people were unable to buy them. Supply was increasing but demand went down and housing prices collapsed. The housing bubble had burst. Eventually, even those who were still able to pay their mortgages realized that they were paying way more than what their house was actually worth. This caused even more defaults and prices to further decline.
As housing prices were crashing, big financial firms stopped buying subprime mortgages and the price of MBS and CDOs began to fall. Investors who had thrown tons of money into MBS and CDO were losing huge amounts of money on their investments. Even those in the Senior Tranches of the CDOs, considered the most risk-free, were not safe from the crash.
What Was Lost
Beginning in the fall of 2007, the U.S. stock market began to plummet, losing around $8 trillion in value in a span of a year. Unemployment rose from 5% in December of 2007 to 9.5% in June of 2009, peaking at 10% in October of 2009. Americans lost $9.8 trillion in wealth as their home values plummeted and their retirement accounts vaporized. Real GDP fell 4.3% from its peak in quarter 4 of 2007 to quarter 2 of 2009. Around 10 million Americans were left without homes and 8.8 were left without jobs. Home prices fell approximately 30%, on average, from their mid-2006 peak to mid-2009, while the S&P 500 index fell 57 percent from its October 2007 peak to its low in March 2009.
The Big Shorts
In the years leading to the crisis, some investors realized the risk that was building the housing market and saw that a bubble was forming. These people became known as “The Big Shorts” in Michael Lewis’s book of the same name. They saw the danger in the subprime lending practices and securities like CDOs and MBSs. They also knew that the housing market would inevitably collapse. One such person was the fund manager for Scion Capital, Michael Burry. In 2005 Burry began focusing on the subprime market and realized that the housing market would eventually collapse around 2007.
Michael Burry’s CDS Trade
Through his analysis, he saw that the value of the mortgage bonds would eventually start losing their values when the adjustable-rate mortgages start kicking in. When he saw this, he decided to short the housing market. Michael Burry was able to do so by buying credit default swaps (CDS), a financial swap agreement where the seller of the CDS agrees to pay the buyer in the event that the debt defaults. It’s basically buying insurance on an asset default. This “insurance” can be cheap or expensive based on the market’s perception of the risk of default.
To do this, he convinced large investment banks such as Goldman Sachs to sell him credit default swaps on subprime deals that he saw as vulnerable. Bill Ackman used credit default swaps to short the market in March 2020. Many investment banks like Goldman Sachs and insurance agencies like AIG sold swaps because they had the mindset that the housing market would never fall. In turn, the prices on MBS and CDOs would continue growing so it was basically free money if they sold these.
Michael Burry’s logic was to buy these swaps without owning any MBS or CDOs so when the price of these securities inevitably crashed, he would get money through the CDS payout without suffering any losses by owning the securities. Eventually, his investment paid out and his firm Scion Capital recorded returns around 490%. In a 2010 interview with Michael Burry, he stated that anyone who studied the financial markets carefully from 2003 to 2005 could have recognized the growing risk in the subprime markets. Michael Burry was one of many who did their own analysis and looked carefully into the subprime market rather than assuming that prices would never fall.
Lehman Brothers Falls
In September of 2008, one of America’s largest and oldest financial institutions filed for bankruptcy. Lehman Brothers, an investment bank that was situated in New York, filed for Chapter 11 bankruptcy protection on Monday, September 15, 2008. The reason was due to the fact that they had suffered huge losses from having held onto large positions in subprime and other lower-rated mortgage tranches.
In the second fiscal quarter of 2008, Lehman Brothers reported a loss of $2.8 billion. In the first half of 2008 alone, Lehman stock lost 73% of its value. By August 2008, Lehman reported that it intended to release 6% of its workforce, 1,500 people, just ahead of its third-quarter-reporting deadline in September.
Investor confidence eroded as Lehman’s stock lost roughly half its value and pushed the S&P 500 down 3.4% on September 9, 2008. The fall of Leman Brothers created panic in many investors and investor confidence plummeted. Investors sensed the financial instability in the nation which caused stocks to crash and in turn created global panic and financial instability. To this day, the fall of Lehman Brothers is the largest bankruptcy filing in U.S. history, with Lehman holding over $600 billion in assets. Realizing the panic in America, the government had to take action.