Steve Eisman's Masterclass on the 2008 Financial Crisis (Part One) | The Real Eisman Playbook Ep 38

Summary

Steve Eisman explains how excessive leverage, deteriorating subprime-mortgage underwriting, concentrated exposure to those mortgages, and derivatives linking major financial institutions helped set up the 2008 financial crisis. He argues that incentives based on loan volume—not loan quality—allowed the risks to build. This first part focuses on bank leverage and the growth of subprime lending, ending as the market for subprime securities seizes up in 2007.

Main Causes and Bank Leverage

Eisman identifies four interlocking causes of the crisis:

1. Excessive leverage across financial institutions, especially large, globally systemic banks and investment banks.
2. The collapse of subprime mortgages as an asset class.
3. Systemically important financial institutions holding large amounts of those assets.
4. Derivatives that connected institutions’ balance sheets in a complex web.

He explains bank profitability using ROE = ROA × leverage, where ROA is net income divided by total assets and leverage is assets divided by equity. In his simplified examples, a bank earning a 1% ROA would generate:

• 1% ROE at 1× leverage: $1 billion of assets funded by $1 billion of equity produces $10 million of income.
• 10% ROE at 10× leverage: $10 billion of assets funded by $1 billion of equity and $9 billion of deposits produces $100 million of income.
• 100% ROE at 100× leverage: $100 billion of assets funded by $1 billion of equity and $99 billion of deposits produces $1 billion of income.

Deposits are a form of debt because the bank must repay depositors. Leverage can improve returns when a bank is profitable, but it also magnifies losses: at 100× leverage, a −1% ROA would produce a $1 billion loss—enough to wipe out the bank’s $1 billion in equity.

Eisman stresses that leverage itself is necessary for banks to perform their role of recycling deposits into loans; the challenge is determining how much is safe.

He says bank executives are often rewarded based on net income and ROE, encouraging greater leverage. In his account, banks’ increasing ROE during the pre-crisis period reflected more leverage rather than improved underlying performance, and some executives mistook leverage-driven returns for managerial skill.

Risk-Weighted Assets and Regulatory Incentives

Banks and regulators commonly assess capital against risk-weighted assets (RWA) rather than simply comparing total assets with equity. Assets are assigned risk scores—largely based on rating-agency assessments of historical losses and loss volatility—and those scores determine how much they count toward RWA. Eisman notes that highly rated AAA assets could receive very low, potentially single-digit, RWA weightings.

This framework can create incentives to accumulate assets that appear low-risk under the model. If underwriting standards loosen, however, future losses may exceed the historical data used to assign those low risk weights. A bank’s simple, absolute leverage can then rise substantially even while its RWA-based capital ratio appears stable.

Key figures cited:

• From 1997 to 2007, leverage at large financial institutions tripled.
• Average European bank leverage rose from 11× to 33×.
• Citibank’s leverage in 2007 was about 33×, or likely over 40× including off-balance-sheet exposures.
• Eisman says return on equity also roughly tripled, while leverage measured against RWA was broadly flat.

He rejects the view that repeal of Glass-Steagall was the primary cause of the crisis. In his opinion, excessive leverage enabled by the RWA framework and the growth of subprime lending would have caused a crisis even if Glass-Steagall had remained in force.

Growth and Structure of Subprime Lending

Eisman describes subprime borrowers as technically having credit scores below 650, while emphasizing that the category included many lower-middle-class and some middle-class households. He links demand for borrowing to stagnant inflation-adjusted household incomes and says securitization enabled lenders to expand by creating a broader funding market.

In securitization, lenders originated loans, pooled them into securities, and sold them to investors. This allowed subprime lenders to raise funds beyond what they could borrow on their own balance sheets. He says the sector also expanded into subprime credit cards and auto loans.

Timeline and Scale

• The first pure-play subprime mortgage company went public in 1992.
• Subprime mortgage originations were about $20 billion in 1993 and approximately $150 billion annually by 1998.
• The first wave of the industry collapsed in 1998, which Eisman attributes to accounting problems; by the end of 1999, many firms had failed or retrenched.
• After the 2000 U.S. recession, the Federal Reserve, led by Alan Greenspan, cut the federal funds rate to 1%. Eisman says the low-rate environment increased demand among bond investors for higher-yielding assets.
• A second wave of subprime lending expanded from 2002 onward.
• By 2006, subprime originations had reached about $600 billion per year, roughly 20% of the U.S. mortgage market.

Eisman says lenders’ profits depended partly on their estimates of future loan losses. When actual delinquencies came in below expectations during the early 2000s, lenders concluded they could loosen standards and originate more loans while still meeting their targeted risk-adjusted yields. Rising home prices also helped keep mortgage defaults low for a time.

By 2006, Eisman found that at least 50% of loans in the securitizations he examined were made using low-doc or no-doc underwriting, with income little or not verified. He says standards had deteriorated to the point where “virtually anyone” could obtain a mortgage.

Loan Terms and Incentives

Eisman describes many subprime mortgages as having a low initial “teaser” rate followed by a large reset:

• Approximately 3% for the first 2–3 years.
• Then a rate around LIBOR + 600 basis points, which he estimates at roughly 9%, for the remaining 27–28 years.

He says lenders often qualified borrowers based on the teaser payment, despite the later payment increase. When borrowers could not afford the reset, lenders could offer a refinance at similar introductory terms. The refinance typically involved fees of 3–4 points, often added to the new loan’s principal rather than paid out of pocket. Eisman argues that this could leave borrowers repeatedly refinancing without reducing principal.

He contrasts subprime fees of 3–4 points with 1 point or less for prime loans. Lenders could also earn roughly 2–3 additional points when selling loans to Wall Street. In his example, around 5 points on $1 billion of loans equaled $50 million in revenue. Investment banks then packaged and sold the loans to investors, earning markups as well.

Eisman characterizes the arrangement as a “gravy train” because lenders, Wall Street firms, and others benefited from volume.

Eisman’s Research and Short Positions

Eisman says he began looking for renewed problems in the sector as early as 2003, partly because many managers of the second wave had also been involved in the first. His main monitoring approach was to use monthly securitization data, including 30-, 60-, and 90-day delinquencies, repossessions, and losses.

His analytical framework included:

• Comparing securitizations from different origination years at the same point in their lives—for example, delinquency rates in month 10.
• Looking for deterioration in newer loan vintages relative to earlier ones.
• Treating improving data cautiously if there was a seasonal explanation; Eisman says March and April data often improved because consumers used tax refunds to pay down debt.
• Using temporary market rallies as opportunities to add positions if the underlying credit data continued to worsen.

Eisman says the 2006 securitizations showed substantially higher early delinquencies than prior-year deals, supporting his view that underwriting quality had deteriorated. By the summer of 2006, he believed there were clear warning signs.

Eisman and his partners initially shorted the equity of publicly traded subprime mortgage companies, including New Century. He says these stocks were relatively illiquid, highly shorted, and expensive to borrow—with borrow costs reaching as high as 20% annually in some cases. They therefore shifted toward shorting subprime mortgage securitizations, a larger and more liquid market:

• They began shorting securitizations in fall 2006 and continued until around July 2007.
• By summer 2007, investors broadly stopped buying subprime securitizations.
• The resulting buyer strike prevented Wall Street from selling securities, then from buying new loans from originators. Originations and refinancing contracted; borrowers faced resets toward roughly 9%, increasing defaults and worsening credit performance.

Eisman says the incentives to keep originating and securitizing loans remained strong even as delinquencies rose, because participants were paid on volume rather than loan quality. He concludes that by late summer 2007, the chain reaction had made a broader financial crisis inevitable. The lecture stops before explaining the full crisis and the roles of derivatives and other institutions in detail.

Assets, Instruments, Companies, and Sectors Mentioned

• Assets and instruments: Subprime and prime mortgages; mortgage-backed securitizations; bank loans and deposits; bank equity; derivatives; credit cards; auto loans; bonds; LIBOR-linked adjustable-rate mortgages; short positions in subprime lenders and securitizations.
• Companies and institutions: Citibank/Citigroup, JPMorgan, Goldman Sachs, Lehman Brothers, New Century, Ameriquest, The Money Store, Ames Financial, Fannie Mae, and Freddie Mac.
• Ticker symbols: No stock ticker symbols are stated in the subtitles.

Disclosures and Cautions

Eisman warns against interpreting the bank examples as proof that all leverage is bad; he says banks need leverage but must avoid excessive levels. He also emphasizes the danger of relying on historical loss data when lending standards are changing.

The closing disclaimer says the podcast is for informational purposes only and does not constitute investment advice. Hosts and guests may hold positions in stocks discussed; opinions are their own and are not recommendations. Viewers are urged to do their own due diligence and consult a licensed financial adviser. Eisman also says his views are opinions and distinguishes them from facts.

Presenter and Sources Mentioned

• Presenter: Steve Eisman.
• Sources and institutions referenced: Eisman’s own research and partners; rating agencies and their monthly securitization data; the Federal Reserve under Alan Greenspan; and The Big Short (book and film). The lecture also references the banks and financial companies listed above.