Will We Ever Learn? The Scary Similarities Of The Subprime Mortgage And Junk Bond Crises
In this article, Cameron Hight highlights the similarities between the Subprime and Junk Bond crises and summarizes his research from Sorkin’s “Too Big to Fail”, Lewis’s “The Big Short”, and Klarman’s “Margin of Safety”.
I have never claimed to be a market historian, but the obvious similarities of the Subprime and Junk Bond crises are staggering even to the casual observer. Maybe it is a confluence of my recent reading of Sorkin’s “Too Big to Fail”, Lewis’s “The Big Short”, and Klarman’s “Margin of Safety” that brings the parallels into clear focus, but I am floored by our ability to have two vastly identical crises in the course of two decades.
While reading chapter 4 of “Margin of Safety” I turned to my disinterested wife after each page and proclaimed, “this junk bond thing is almost identical to the subprime crisis.” The narrative is plagiarism of the same financial horror story (see the chart below). In the search for higher yields, investors relax standards and issue debt to people (subprime) / companies (junk bond) that have no ability to pay back their obligations. Diversification and low correlation amongst low-quality borrowers was used as a justification for reducing the risk inherent in individual risky loans. Due to the demand for higher yielding assets, investment banks concentrated human and financial capital at staggering rates into packaging and selling subprime / junk bonds.
Capital available to finance these shaky deals increased with the ability to resell structured products like mortgage-backed securities and collateralized debt obligations (subprime) / collateralized bond obligations (junk bond). Retail banks and institutional investors (subprime) / thrifts and savings and loans (junk bond) created ready capital sources to soak up the buy side of any high yielding deals. CDO-focused funds (subprime) and high yield mutual funds (junk bond) added additional fuel to growing capital being given to undeserving borrowers.
An escalation of creative financing was needed to allow lower and lower quality standards including Pick-a-Pay, Alt-A, No Doc, Interest-Only (subprime) / zero-coupon and pay-in-kind (junk bond). The ratings agencies had to play dumb or be dumb to allow packaged subprime mortgages and packaged junk bonds to be magically rated investment grade. To justify these ratings they used historical models that assumed house prices could not fall (subprime) or historical junk bond default rates and no refinancing issues (junk bond). Finally, all of these lending machines were picking up speed as the empirical evidence was flying in the face of all that were willing to look as illustrated by subprime defaults growing from 2005 on and MBS, CDO, and CDS prices staying stable (subprime) / junk defaults rising in the late 80s at the same time the pace of new junk deals was accelerating.
Is our memory so short that we cannot remember the financial chaos created by the junk bond market in the 1980s? Some remembered because there were many smart investors that made the connection and made substantial bets on how the subprime story was going to end. Many issues coalesced to allow both bubbles to form and I certainly do not have the prescription to prevent it from happening again, but the first place I would focus my attention is the flawed incentive structure that paid the participants of the junk bond market to make foolish bets. The incentive to take outsized risk for short-term gain has not changed substantially in the past 20 years and has probably even become more acute with the increase of financial engineering and the repeal of Glass-Steagall in 1999. As my friend Dr. Art Laffer says, “Incentives are the key to understanding economic behavior.” Maybe we should stop paying bonuses on this year’s returns and instead pay a three or five-year rolling percentage of returns. That could discourage some of the short-termism that manifests financial crises.
We are just fortunate the Credit Default Swap market was nascent in the 80s or the Junk Bond crisis would have been compounded like the Subprime Crisis of this decade. Will we ever learn?
Similarities of the Subprime and Junk Bond Crises