The original cast of subprime financiers had been sunk by the small fraction of the loans they made that they had kept on their books. The market might have learned a simple lesson: Don’t make loans to people who can’t repay them. Instead it learned a complicated one: You can keep on making these loans, just don’t keep them on your books. Make the loans, then sell them off to the fixed income departments of big Wall Street investment banks, which will in turn package them into bonds and sell them to investors. Long Beach Savings was the first existing bank to adopt what was called the “originate and sell” model. This proved such a hit—Wall Street would buy your loans, even if you would not!--that a new company, called B&C mortgage, was founded to do nothing but originate and sell. Lehman Brothers thought that was such a great idea that they bought B&C mortgage. By early 2005 all the big Wall Street investment banks were deep into the subprime game.
And:
Even in life or death situations, doctors, nurses, and patients all responded to bad incentives. In hospitals in which the reimbursement rates for appendectomies ran higher, for instance, the surgeons removed more appendixes. The evolution of eye surgery was another great example. In the 1990s, the ophthalmologists were building careers on performing cataract procedures. They’d take half an hour or less, and yet Medicare would reimburse them $1,700 a pop. In the late 1990s, Medicare slashed reimbursement levels to around $450 per procedure, and the incomes of the surgically minded ophthalmologists fell. Across America, ophthalmologists rediscovered an obscure and risky procedure called radial keratotomy, and there was a boom in surgery to correct small impairments of vision. The inadequately studied procedure was marketed as a cure for the suffering of contact lens wearers. “In reality,” says Burry, “the incentive was to maintain their high, often one-to two-million-dollar incomes, and the justification followed. The industry rushed to come up with something less dangerous than radial keratotomy, and Lasik was eventually born.”
And:
In October 2001, [Mike Barry] explained the concept in his letter to investors: “Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’”
The alarmingly named Avant! Corporation was a good example. He’d found it searching for the word “accepted” in news stories. He knew that, standing on the edge of the playing field, he needed to find unorthodox ways to tilt it to his advantage, and that usually meant finding unusual situations the world might not be fully aware of. “I wasn’t searching for a news report of a scam or fraud per se,” he said. “That would have been too backward-looking, and I was looking to get in front of something. I was looking for something happening in the courts that might lead to an investment thesis. An argument being accepted, a plea being accepted, a settlement being accepted by the court.” A court had accepted a plea from a software company called the Avant! Corporation. Avant! had been accused of stealing from a competitor the software code that was the whole foundation of Avant!‘s business. The company had $100 million in cash in the bank, was still generating $100 million a year of free cash flow—and had a market value of only $250 million! Michael Burry started digging; by the time he was done, he knew more about the Avant! Corporation than any man on earth. He was able to see that even if the executives went to jail (as they did) and the fines were paid (as they were), Avant! would be worth a lot more than the market then assumed. Most of its engineers were Chinese nationals on work visas, and thus trapped—there was no risk that anyone would quit before the lights were out. To make money on Avant!’s stock, however, he’d probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.
And:
[Mike Barry] analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans. It surprised him that Deutsche Bank didn’t seem to care which bonds he picked to bet against. From their point of view, so far as he could tell, all subprime mortgage bonds were the same. The price of insurance was driven not by any independent analysis but by the ratings placed on the bond by the rating agencies, Moody’s and Standard & Poor’s.* If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier A-rated tranches, he might pay 50 basis points (0.50 percent); and, on the even less safe triple-B-rated tranches, 200 basis points—that is, 2 percent. (A basis point is one-hundredth of one percentage point.) The triple-B-rated tranches—the ones that would be worth zero if the underlying mortgage pool experienced a loss of just 7 percent—were what he was after. He felt this to be a very conservative bet, which he was able, through analysis, to turn into even more of a sure thing. Anyone who even glanced at the prospectuses could see that there were many critical differences between one triple-B bond and the next—the percentage of interest-only loans contained in their underlying pool of mortgages, for example. He set out to cherry-pick the absolute worst ones, and was a bit worried that the investment banks would catch on to just how much he knew about specific mortgage bonds, and adjust their prices.
Once again they shocked and delighted him: Goldman Sachs e-mailed him a great long list of crappy mortgage bonds to choose from. “This was shocking to me, actually,” he says. “They were all priced according to the lowest rating from one of the big three ratings agencies.” He could pick from the list without alerting them to the depth of his knowledge. It was as if you could buy flood insurance on the house in the valley for the same price as flood insurance on the house on the mountaintop.
More (#3) from The Big Short:
And:
And:
And: