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‘The Big Short”s Eisman Explains How He Beat the Global Economy

Steve Eisman, the basis for Mark Baum, Steve Carell’s character in the 2015 film The Big Short, spoke to a standing-room-only crowd at Boston College on Wednesday, describing the 2008 financial crisis as a perfect storm of fraud and incompetence.

Eisman was one of the first investors to foresee the burst of the housing bubble, and the subsequent near-implosion of the entire financial industry. He and others “shorted”—or bet against—the market, making millions of dollars off of financial firms in the process.

“I wasn’t worried that I’d be wrong—I was always worried that the government would bail the [biggest banks] out before I could make money,” Eisman said.

Eisman is now a managing director and portfolio manager at Neuberger Berman, a private investment management firm. The event was sponsored by the BC Economics Association with the support of the economics department, Omicron Delta Epsilon, the Winston Center for Leadership and Ethics, and the Woods College of Advancing Studies.

Some have criticized investors like Eisman, who, by shorting the U.S. housing market, made millions of dollars due to the incompetence of the biggest banks and financial firms while the economy plunged into a deep recession.

Eisman, however, compared his actions to that of a hypothetical investor shorting Enron, an energy firm which collapsed due to corruption and corporate fraud in 2001.

“It’s not my fault that [the housing market] was a fraud,” Eisman said. “I just recognized it.”

Eisman said that three elements were necessary for the financial cataclysm of 2008 to occur:too much leverage, a massive asset class primed to explode, and the ownership of that asset class by “too-big-to-fail” firms.

“Unfortunately for Planet Earth, we had all three,” Eisman said.

Leverage—a financial firm’s debt-to-asset ratio—skyrocketed in the United States in the early years of the new millennium. Wall Street’s spectacular successes in the ’90s caused investors to discount the possibility of even a slight decline in profits, Eisman said.

“Between 1997 and 2007, leverage in the financial system more than tripled. In 2002, Citigroup’s assets reached $1 trillion, and the bank was leveraged 22:1,” Eisman said. “Five years later, [assets] had grown to $2 trillion and 22:1 became 35:1.”

Eisman said that this pattern was closely replicated by every other large financial institution in the U.S. and Europe as the industry made more money every year, while increasing their leverage, without experiencing any noticeable decline in profits—or any notice of the potential risk.

“They mistook leverage for genius,” Eisman said.

By 2006, leverage at the biggest banks was at the highest point in history. Most financial firms were enjoying debt-to-asset ratios ranging from 35:1 to a staggering 50:1. At the same time, unbeknownst to most in the industry, an entire class of critical assets—subprime housing loans—was nearing implosion, Eisman said.

Eisman explained that, at the time, the subprime mortgage industry was based on a continuous debt cycle. Prospective homeowners signed mortgage papers that promised a “teaser rate” of around 3 percent interest, and after 2 or 3 years their rates would be increased to around 9 percent.

Banks, however, only underwrote the loans based on the teaser rate, because lenders knew that since borrowers could only afford to pay 3 percent, they would have to refinance their mortgages, to retain a low interest rate, every 3 to 5 years—paying a fee for the privilege, Eisman said.

“This works only as long as people can refinance [their mortgages], but if something were to happen—to stop the refinancing [cycle]—it would be a disaster,” Eisman said.

Throughout the early 2000s, mortgage delinquency rates had been exceptionally low, causing the losses built into risk calculations to be lower than anticipated. Loan underwriters began loosening their lending standards to increase revenue—by 2006, every consumer who was able to “breathe” was given a housing loan, Eisman said.

Few realized that the reason default rates were so low was large part due to the expansion of the housing bubble itself—homeowners are very unlikely to default on their mortgages when the values of their homes keep increasing, Eisman said.

“In 2006, you had maximum deterioration of underwriting standards and maximum housing prices—obviously a recipe for disaster,” Eisman said.

By the time the housing loans originated in early 2006 and had been securitized and sold to financial firms, Eisman began to notice that the loans backing those securities were defaulting in increasing numbers. He began shorting them—betting against the health of those ailing securities—in the fall of 2006.

In 2007, the the meltdown now known as the Great Recession began in earnest. Investors quit buying mortgage-backed securities, securitizers stopped buying loans, and loan originators ended the refinancing of mortgage rates that kept the industry afloat, Eisman said.

“It was a freak show—by the fall of 2008, the [U.S. financial] system was on the verge of collapse,” Eisman said.

Mortgage defaults skyrocketed. Deeply leveraged financial institutions across the U.S. suffered catastrophic—and increasing—losses. Not only did individual banks face oblivion, but the entire economy faced collapse. Eventually, biggest banks and investment firms were “bailed out” by the U.S. Treasury and Federal Reserve—which was a necessary step, Eisman argued.

“Any industrial company with a commercial paper program would have had to file for bankruptcy, and 10 percent unemployment would have become 30 percent unemployment,” Eisman said. “As distasteful as it was, we did have to bail [the biggest banks] out.”

Featured Image by Keith Carroll / Heights Staff

April 5, 2017