Wednesday, February 03, 2016

The big short

Kath and I used Meerkat movies to got and see the big short. A film about the reasons behind the huge financial crash of 2008, and the few voices who predicted it. I though that it is a great film which manages to turn the boring financial subjects into an understandable and interesting backdrop for a film.

In short banks got rich selling bundles of loans off as Collateralized debt obligations, these bundles of loans were sold as containing good mortgages with low default rates. Unfortunately over time the banks got greedy and found ways to bundle increasingly bad loans, until they included loans for NINJAs (Not in a Job Applicants). The ratings agencies kept putting A grade on and the deals went on and on until in 2008 the liabilities started to get called in and the whole system collapsed. 

It brought me back to 2005 when I worked for a broker business in the UK. The government was bringing in the Consumer Credit Act 2006. Among other things made it included requirement for loan documentation to show the total amount that was repayable. I vividly remember one moment during the user acceptance phase, in which we showed the updated documents to some of the end users.

I went to the leader of one of the sales teams, and she asked if the figures were correct. I said of course, the calculation is simple for a fixed rate loan. You multiple the payments by the period and deduct the original borrowing, giving the total amount payable in interest. She then said, she didn't believe it, the amount looked too high. So I asked her to grab a calculator, multiply the payment by the 300 month term and deduct the original borrowing. She was very surprised by the result, bear in mind they specialised in consolidation loans which were in 2006 expensive (between 7 - 12% interest). She did sell them all day long so I was surprised how little grasp of the costs she had. What really surprised me though was as I walked away she said "Well the lenders never expect them to pay it back anyway". At the time I thought what a weird thing to say, but now in the context that these loans would probably have ended up in CDO's the market for this being bigger than the profit on the loan in fact the bank didn't care too much! An insane system no wonder it failed.
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