Dispute Resolution

The Big Short

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Posted in:Banking and Finance|January 28, 2016 | Join the mailing list

In 2010 a book by Michael Lewis was issued and few people outside of the banking and finance industries took much notice.  The book has now been made in to a film which has been released in the UK.  It is US based and very true outline of what happened when the world’s economy collapsed.

Between about 2000 and 2006 banks on both sides of the Atlantic undertook an activity that led in large part to the collapse of the world’s banking systems, and few people know about it and even fewer understand it.

A bank’s principal income creation for decades was from interest received on consumer mortgages.  That has been the banking industry’s principal consumer income for decades.  In the late 1990s, after the last collapse, banks started to realise that debt was their friend.  The more debt they created the greater their income.  “Leveraging” became big business. This activity was brought to the UK in about 2000 or 2001.

The people that shorted banks and finance companies made hundreds of millions in just one morning.

New rules were created in 2001 in the UK.  They did little to alter to any great extent the rules that banks played by in terms of loans to consumers.  At the same time banks in the US brought to the UK the sub-prime, heavily leveraged mortgage business.  Since time immemorial there has always been a market for lending money to people who have bad credit, but naturally that had always been a small market.  It was a very niche market.  However, a mortgage or loan or credit card for someone with bad credit has a substantial mark up on its interest rate and the US based banking model created a way of making huge profits from bad credit (subprime) mortgages, loans and credit cards.

The sub-prime market created a book of mortgages that had interest rates that were substantially greater than interest rates for “normal” good-credit mortgages.  If those loans had a fixed interest rate (which mostly they did) then the bank had a fixed interest rate (ie its income profit) that was very profitable and the amount of profit was known many years in advance.

With this fixed interest rate producing a lot of money, banks then packaged them up into collatorised bonds.  That is, they took a book of, say, 100,000 mortgages and chopped the income up into groups known as bonds.  The bonds would then be sold to investors, who bought the future income.  Unfortunately, to increase profits the banks began to mix up good mortgages with the sub-prime mortgages and additionally moved more and more mortgages into being securitised by way of these bonds.  By 2007 most mortgages were turned into bonds by the banks providing the mortgages on both sides of the Atlantic.  The income generated increased drastically, because it was a mix of good but low interest mortgages (and thus little chance of defaulting) and larger income generating but not so good mortgages (and thus a higher rate of defaulting).

The only group who were losing out were the consumers.

Banks bought these bonds in large quantities, because they created a great income.  The banks selling them generated a huge profit on the mortgages many years before they would have done had they not sold them (ie. An immediate income versus 25 years’ of interest being paid).

People who ought never to have been sold a mortgage, because they had little or no chance of ever repaying it, were offered sub-prime mortgages, sub-prime credit cards and sub-prime loans.  The banks made money from this with virtually no initial risk.  That is because the property market was only going in one direction plus the profits generated in a year may often outweigh the loss in year two when the loan is defaulted.  Property prices climbed massively.  So, the banks made money setting up the mortgages and made more money selling off the securitised bonds.  If the consumer defaulted, the banks took possession of the property and sold it, with the number of properties not making more than they were bought for being minimal.  Out of the back of these defaulted loans debt collection in the UK boomed.  The only group who were losing out were the consumers.

The Big Short is a film and book about a US fund manager who realised how dangerous these securitised mortgage bonds were, and how severe the eventual collapse of the property prices would be.  The increase in property prices was fuelled by the non-stop lending of money into both the prime and sub-prime mortgages as banks ate up more and more debt.  Then one day people realised what was happening and alarm bells went off and mayhem ensued – this is what is central to the book/film.

The fund manager realised that banks, financiers and mortgage companies had leveraged too much and the property price was artificially high, so they shorted the banks and made billions.  The book/film is about a fund that “shorted” banks.  “Shorting” is simply a clever way of betting that a share price will go down rather than up.  Shorting banks in the UK led to Northern Rock and Bradford & Bingley being nationalised and HBOS being sold to Lloyds.

The people that shorted banks and finance companies made hundreds of millions in just one morning.  Over the period of a year some of the most distinguished banks and mortgage companies in the world had collapsed.  Countries around the world had to inject Trillions into their banking systems to stop the world’s economy falling further.

At the end of the collapse, bankers retained their bonuses every year even when their banks were posting double digits billion losses.  A lot lost their jobs, but were eventually employed in other banks.  Some financiers and hedge fund managers who knew what was going to happen simply made millions as others lost billions.  Pensioners lost the value of their pensions.  Investors lost the value of their investments.  The bankers got richer.

If you read the book The Big Short, we also recommend reading Shredded: Inside RBS by Ian Fraser.

To find out more about the issues raised in this post, or to discuss any queries regarding Banking & Finance get in touch with our expert team on 0161 829 2599.
The information and opinions contained in this article are not intended to be comprehensive, nor to provide legal advice. No responsibility for its accuracy or correctness is assumed by berg or any of its partners or employees. Professional legal advice should be obtained before taking, or refraining from taking, any action as a result of this article.

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