The Big Short - Circumstances
This article is part of the Writing to Mary and Jack series.
Dear Mary and Jack,
Today I present you with the first of three articles on analyzing your situation, the heart of a leader's job. Each situation is made of three specific parts, the first of which is Circumstances. Using recent history, I invite you to contemplate how your understanding of Circumstances, or lack thereof, can have drastic effects on the success of your team or organisation.
A July 2013 paper [i] of the Federal Reserve Bank of Dallas, studying the impact of the 2008 financial crisis, suggests that it could have wiped out in value the equivalent of an entire year of the American economy output. The numbers range the measurable impact between $50,000 and $120,000 per US households, which places the cost of the financial crisis between $6 and $14 trillion (For the US). The range is wide, but it doesn’t matter, it credibly suggests that the impact of the crisis is at least measurable in thousands of billions, an unprecedented financial and societal cost.
At the heart of this crisis was most probably a very unhealthy banking regulation environment, one for example that allows commercial banks to speculate with their own money [ii]. But there were also two fundamental beliefs that altered how people perceived the Circumstances.
Written as simple statements these would look like this:
“Large Banks cannot go bust” and “The real estate market will grow forever”.
You probably think this is dumb… How so many people in the US adhered to these two beliefs, is a story for another day, but suffice it to say that it made everybody’s business much more profitable… Let us take a closer look at each one of these beliefs:
First, many of the large investment banks involved in turning a real estate market bubble into a global financial meltdown were deemed to be too big to fail [iii]. What that meant in people’s heads, is that they were so big and so rich that they could not really go bust, and even admitting that they could, the regulator (The government, that is) could not afford to let them fail and would then come to their rescue. The reality however, is that there had never been a crisis so big in history that their solvency would be questioned. It is not the banks that were too big, it is the crisis that so far had been too small.
The second one effectively assumes that the real estate market was a well-functioning market, meaning that housing prices were accurately representing housing value. This was also not true. During the early 2000, speculation in US real estate was widespread so the market was very dysfunctional [iv]. Using houses as investment vehicles fuelled artificial price inflation. It was then ok to sign ridiculously risky mortgages (The infamous subprimes) for people who had no way to pay. Since housing prices were constantly rising they could resell the house at a profit and do it again, even with no income… That worked for as long as prices continued to rise. Which they did, until they did not anymore. The process in fact defeated itself. As people bought more and more houses with riskier and riskier mortgages, more houses were being built. As the number of houses on the market started to progressively equal then exceed the demand, prices started to level.
As housing sales started to level in 2007, millions of house owners in the US experienced the double-edged effect of owning a leveraged asset in a downturn [v], the so-called credit crunch, and defaulted on their mortgages. The situation was then amplified up to twenty times by voluminous speculation on financial markets.
This speculation used investment vehicles based on the real estate market such as Collateral Debt Obligations (CDOs), synthetic CDOs and Credit Default Swaps (CDS). The system was so constructed that a real estate market recession was not even needed to trigger the crisis. Just a levelling of the growth rate was enough to create a tipping point.
With default rates going sharply up and the value of real estate financial instruments collapsing, the fall-out of the subprime crisis was then further amplified by the leverage of investors, accelerating it into a systemic crisis.
In September 2008, when Lehman Brothers went bust, the whole situation unravelled, and for many it felt as if they had suddenly been dealt a whole new hand of cards.
But Circumstances did not change in 2007 or 2008. The crisis itself was only the very predictable result of Circumstances that had pre-existed it for years, maybe decades. So how come nobody saw it coming?
Well a few did.
Michael Lewis, one of my favourite authors on all matters financial, found these people and narrated their quest for understanding Circumstances in The Big Short [vi]. If reading financial literature is not your thing, try watching the movie version of it. Very faithful to the book, and highly entertaining, the movie would be funny if it was describing anything else than a financial collapse which by 2011 had caused 4 million families to lose their homes, and another 4.5 million to fall significantly behind their mortgage payments (Still only in the US...).
The handful of investors portrayed in the The Big Short, shorted [vii] the real estate market, when everyone else was betting on it. The only difference between them and everyone else was: they did the research. For example:
Dr Michael Burry actually went through thousands of mortgages neatly packed in Collateral Debt Obligations (CDOs), something that nobody had done, and realised that the whole engine of the US economy was in fact a ticking bomb. It drove him to bet big and this epic scene of the movie shows well how he was perceived as a lunatic for doing it.
Mark Baum and his team at FrontPoint Partners went to Florida to see first hand how the crisis was taking shape. They were only asking very simple questions. But these questions had been asked by nobody else… And these questions made all the difference between the short sellers, who won big on the crisis (Hence The Big Short), and everybody else, who lost big.
Well leadership has a way of working that resembles investment. As a leader, your strategy is a course of action decided in a specific set of Circumstances. Get the Circumstances wrong, your strategy is wrong, and you can lose big. But get them right, especially if everybody else is wrong, and you will win big.
Circumstances are the sum of all elements affecting your situation, and on which you have no control. To start with, in any situation, you cannot change the past. The weather, how fast time passes, seasons and many other things around you, like market trends or regulations (Unless you are a member of parliament), are part of Circumstances.
Understanding what you can and cannot control is not as easy as it seems. Well for example the past, the weather or the time are obvious ones. But the culture of a company or organisation, even a big one, can be influenced, or not, it is a matter of judgment. If you are a head of state, or the head of the FED, there are many other things you can influence. What really matters in the end is to form an accurate picture of Circumstances. And for this, The Big Short suggests, a good way is to do the research, particularly the painstaking homework that nobody else wants to do because it’s boring or mundane, and ask questions.
Once you have done the research and received answers, you still need to exert your judgement to decide something can be influenced or not. If you cannot influence it, it is part of your Circumstances. If you can, it is part of your Challenge. And the Challenge dear Mary and Jack, is what I will write to you about next time.
In the meantime, keep well!
[i] Atkinson, T., Luttrell, D. and Rosenblum, H. 2013, How Bad Was It? The Costs and Consequences of the 2007-09 Financial Crisis, Staff Papers, Federal Reserve Bank of Dallas (US). http://bit.ly/2E1f6OF
[ii] Banks trading with their own money and for their own gain engage in proprietary trading. Proprietary trading implies that banks can take enormous risks, without necessarily booking these risks on their balance sheet, and cash in huge profits. For large banks, it implicitly assumes that central banks will step in if they incur enormous losses, to shore up their debt and help them stay afloat, to prevent the systemic ripple effect of a large bank going bust. This effectively happened in the 2008 crisis. Proprietary trading is problematic because it amounts to banks cashing enormous benefits from activities that do not benefit their customers and being shielded from losses by taxpayers.
[iii] See on this subject the fascinating account of the crisis as it unfolded on a day by day, conversation by conversation: Ross Sorkin, Andrew 2009, Too big to fail, Inside the battle to save Wall Street, Penguin Books, 618 pp.
[iv] These two articles show how sharp housing prices went up in the period preceding the crisis, the simplest sign of a speculative bubble. http://bit.ly/2s2iHKJ / - http://bit.ly/2FGiTRY
[v] Leverage means debt, used to amplify a financial bet. Leverage increases the gains when all goes well, and the losses in a downturn. Imagine you invest €1 of your own money in a sandwich. The value of the sandwich doubles! Fantastic, you now have €2. In percentage it looks like you win, in absolute value you have not made any measurable gain… Imagine that you then use your credibility to persuade a bank to lend you €99 that you will use to amplify your investment. You invest €100 in a truckload of sandwiches, of which you own only €1, the rest is debt. You have leveraged yourself 99 times, meaning that your investment contains € 99 of debt for € 1 of your own capital. The value doubles: great! You earn € 200, you keep € 101, and reimburse the debt: you win €100 for an initial investment of €1. Genius!!! But if the value of the sandwiches goes down 50%, you then are stuck with an investment now worth €50, and you still have a €99 debt to reimburse! You default on your debt, and you lose pretty much everything. Banks do this too… with billions.
[vi] Lewis, Michael 2010, The Big Short, Inside the Doomsday Machine, W. W. Norton & Company, 320 pp.
[vii] To short something, say a given stock, in investment lingo means taking an investment position predicting that the value of this stock will go down. Because short sellers make the largest profit by betting against commonly accepted trends, they usually do a lot of research before taking an investment position.