Steve Eisman | Wall Street Debate At Oxford Union 4/3

See the video and an imperfect transcript uploaded below – the video is about ten minutes

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Now to Steve Eisman to continue the case. The opposition it’s been my experience that most people even extremely educated people don’t fully understand what the financial why the financial crisis happened. So rather than throw thunderbolts I mean spend most of my time trying to explain what happened because I think in the explanation the answer to the question will be fairly clear. The financial crisis is due really to four major interlocking factors too much leverage a large asset class known as subprime mortgages that blew up systemically important banks owning the asset class and derivatives tying balance sheets all over the world. Let me start with the leverage. Between 1997 and 2007 leveraging the large banks in both Europe and the United States tripled. That’s only the stated leverage. If you add on top of it the shadow banking system and all the off balance sheet stuff that was really on balance sheet the amount of leverage went up 4 to 5 times. It’s a lot of leverage now. There are a lot of reasons for why this happened. I could probably spend the next two hours discussing why let me discuss just one aspect of it that most people don’t have never really read about and that is psychological. There is an entire generation of Wall Street executives my age and up who had a very strange experience in the 1990s in the early oughts. They made more money every single year.

Now the reason why they made more money every single year was that the firms made more money every single year but their firms made more money every single year because the leverage of the firms was going up every single year. And really what was happening was they mistook leveraged for genius. And the problem that emerged was that if you had gone to any of the executives of these firms and I did and said to them listen the entire paradigm of your career is wrong. The response would have been Listen kid I made 50 million dollars last year. What did you make. It’s very hard to tell someone who thinks he’s God that he’s wrong. Subprime mortgages you know people today not even remember really what a subprime mortgage was all about. It was a mortgage that had a two or three year teaser rate and there was Reise price upward for the next 27 or 28 years. And most mortgages originated between 2002 and August of 2007 had a teaser rate of 3 percent and a go to rate of 9 percent 3 percent 9 percent. The industry and Wall Street underwrote the loans to the teaser rate which is a fancy term that means that the underwriters knew that the consumer could only afford to pay the 3 percent for the 2 to 3 years he or she could not afford to pay the 9 percent. Now why would anyone write a loan a 30 year loan where the customer can only afford to pay the teaser rate for the first two to three years. And here’s the second great lesson of the financial crisis. Incentives trump ethics. Almost every time. The reason why this happened was that the the consumer would take out a loan and would pay three to four points upfront for the privilege of getting the loan.

And because he or she could not afford to go to rates after two to three years the consumer had to refinance and would pay three to four points for the privilege of doing so which meant that the consumer could not afford the loan and would have to refinance and would never be able to pay off his or her principal. From a societal perspective this was a disaster. But from an economic perspective for the people who are writing the loans the subprime mortgage companies and for the Wall Street securitization departments that were buying them packaging them and securitizing them and selling them all over planet earth. It was a boondoggle because it meant they got to make. They got to redo the loans and securitized them every two to three to four years and make their bonuses over and over again. As the underwriting deteriorated and the credits began to get worse as as as was became very obvious in 2006 no one knew the underwriters or Wall Street said there’s something wrong here. Our underwriting is bad. Let’s do less securitise less and tighten our standards. And the reason for that is no one has ever begun to sentence in the English language where they say. I think this year I’ll make less money because it would have meant they would make less money and they didn’t want to make less money. They wanted to make more money so they let the underwriting standards deteriorate with full knowledge that they were deteriorating and that’s the story of subprime third systemically important firms owned the asset class. This is an bit of an irony.

The model of Wall Street is to buy it and sell it not buy it and hold it. And here Wall Street bought it sold some of it and kept some of its somebody they never ever did. Why. Well over the years between 2002 and 2007 it did become more difficult to find investors to buy all of the products because so much was being generated. Now if we lived in a rational ethical world and we don’t but if we did then what would have happened is Wall Street and the underwriters would have tightened standards and underwritten less because that was if there was not enough and users. But instead they convinced their firms to hold the paper and invest in it with the rationale of how bad can it be. It’s rated triple AA and now derivatives. This is one of the more important parts of the story. If I own debt and GDP and I want to mitigate my risk I can buy a credit default swap from Goldman Sachs pay a certain fee for that. And if GM goes bankrupt Goldman Sachs pays me. So I have now mitigated my risk by owning a Credit Default Swap credit default swaps reduce risk for individual transactions. But the problem is that the only works in this example when G goes bankrupt. If Goldman Sachs is not is not bankrupt. And essentially what has happened is my balance sheet has been tied to Goldman Sachs his balance sheet. Multiply that transaction by trillions and you can see balance sheets all over the world were tied together and that’s the crisis.How To Profit From Convertible Preferred Stock The Charlie Munger Way

Wall Street created the leverage it securitized and sold subprime mortgages all over the world and it created the derivatives that tied balance sheets together who should be blamed. Is there anyone else. Well there are two alternatives that people like to propagate. First we should blame the regulators and there there is some blame. From the early 1990s the regulatory apparatus of the United States adopted a position that was different from the position it had adopted before which is we were going to let the large banks manage their own risks because we trust them essentially. In the 1990s in the 2000s the U.S. and European financial systems had the trappings of regulation but in reality they were completely unregulated institutions. Now there are many good books about the financial crisis but there’s one that I think has the best title that captures the essence of the crisis which is the book by Judge Richard Posner. The title of which is a failure of capitalism and that’s what happened in the financial crisis. This shouldn’t be a surprise unregulated banking systems fail all the time. They go boom and bust. The difference this time was the fact that the sheer size of the global banking system and its interconnectedness because of derivatives created a bust that had Planet Earth burned. And the last thesis that is sometimes propagated it’s not Wall Street’s fault. It’s not the regulators fault it’s Fannie Mae’s fault. Fannie Mae and Freddie Mac you know I have a little history with Fannie Mae and Freddie Mac. I began analyzing them in 1994. I think I was probably on the next fifty five conference calls quarterly conference calls. I analyzed them extensively. I didn’t like them. I thought they took too much risk. I thought they made a belated the the political system.

But I’d like to blame people for what they actually did. Fannie Mae and Freddie Mac did not cause the financial crisis. This is a shibboleth that is propagated by ideologues who are unwilling to admit that the financial system crashed because of the people who ran it. Fannie Mae did buy some subprime mortgages. It did cause partially caused the demise of Fannie Mae. But trust me on one thing. If Fannie Mae and Freddie Mac had bought zero subprime mortgages the exact same thing would have happened because there were people lined up all over planet earth to buy them. I thank you for your time and it was a pleasure.

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