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The Big Short by Michael Lewis

Reviews:

Seattle Post Intelligencer: http://www2.seattlepi.com/articles/422063.html

Barnes and Nobel Review: http://bnreview.barnesandnoble.com/t5/Reviews-Essays/The-Big-Short/ba-p/2298

The Washington Post: http://www.washingtonpost.com/wp-dyn/content/article/2010/03/12/AR2010031202291.html

The New York Times: http://www.nytimes.com/2010/04/18/books/review/Gross-t.html

Media Coverage:

On the Daily Show with Jon Stewart: http://www.huffingtonpost.com/2010/03/16/michael-lewis-the-big-sho_n_500862.html

On 60 Minutes: http://www.ritholtz.com/blog/2010/03/60-minutes-michael-lewis-the-big-short/

Google video search results

Summary:

Let’s set the stage of the financial industry leading up to the crash (from an English Major’s perspective):

1. The industry began trading mortgage bonds a new form of bond trading.
2. To get more capital for the mortgage bonds, there was an increase in subprime loans being offered and the loans were getting worse (being offered to more people with virtually no income at teaser rates they could only afford for a few years) and getting more prevalent. A mortgage bond used to have 2% in subprime loans by 2005 they were made up of almost 95% subprime loans and thus the bond was more likely to fail.
3. FICO scores that were high only because the person had little to no credit card debt lead to more and more subprime and bad lending.
4. A few investors figured that the mortgage bond business was getting too risky and they bet against it in the form of loan credit default swaps. Essentially creating a way to short the mortgage bond market. “When an investor goes long on an investment, it means that he or she has bought a stock believing its price will rise in the future. Conversely, when an investor goes short, he or she is anticipating a decrease in share price” (from http://www.investopedia.com/university/shortselling/shortselling1.asp). Basically, “You paid a small premium, and, if enough subprime borrowers defaulted on their mortgages, you got rich” (p 125).
5. “Roughly 80 percent of what had been risky triple-B-rated bonds now looked like triple-A-rated bonds” (p 76) by leveraging Credit default swaps into a synthetic CDO. “It used credit default swaps to replicate the very worst of the existing bonds, many times over” (p 76). “Fully 80 percent of the CDO composed of nothing but triple-B bonds…to wipe out any triple-B bond…all that was needed was a 7 percent loss in the underlying pool of home loans” (p 129).
6. The tower of debt: “The first tower was the original subprime loans that had been piled together. At the top of this tower was the triple-A tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche” which were “repackaged into another tower of bonds: a CDO”
7. All that had to happen for these bonds to be worthless was to have house prices stop rising. Prices didn’t even need to fall! That is all it would take for the system to come crashing down.

Author Michael Lewis felt lucky. He had escaped what he saw as a “to good to be true” job as a bonds trader with Salomon Brothers, wrote a book about what he saw as a flawed system thinking it would soon collapse. It took 20 more years to finally do so, just when he thought he had been wrong. He contacted others who spotted the flaws and got a list of investors who bet against the house (the mainstream financial industry and their subprime mortgages) and as he investigated those on the list, the book The Big Short was born. This is the story of those who bet against the system and won.

Steve Eisman: A curious character, Eisman is a man with a talent to offend pretty much everyone, started with a job as an analyst at his parent’s firm. Never hiding what he thought, he was able to spot companies that were in trouble before anyone else and his opinions became more and more influential, his endorsement more and more sought after. He entered the market right around the time that mortgages were being turned into bonds, and right before the mortgage bond “was about to be put to a new use: making loans that did not qualify for government guarantees” (p 8). Vincent Daniel: The man Eisman hired to assist him with getting the truth about the subprime mortgage loans. They found that the delinquency rate did matter because “all retained some small fraction of the loans they originated, and the companies were allowed to book as profit the expected future value of those loans” (p 13-14) they predicted the boom in the late 90s of those making subprime loans at that time. But it never really went away and by the time Eisman had built his own firm, “he needed to learn everything he could about the fixed income world… [because] the fate of stocks depended increasingly on the bonds. As the subprime mortgage market grew, every financial company was, one way or another, exposed to it” (p 25). Eventually he discovered the secret behind synthetic CDOs, met Wing Chau who ‘managed’ them and got a new mission: “buy specifically credit default swaps on Wing Chau’s CDOs” (p 144). Eventually  they added short positions to the credit rating agencies as well (p 172) and then some of the biggest banks like Bank of America, UBS, Citigroup, Lehman Brothers and more (p 174). His bet paid off.

Michael Burry: In 2004 he began looking closely at the subprime mortgage bonds to discover how he might short them (p 26). Why did they keep making these bad loans? “They didn’t keep the loans but sold them to Goldman Sachs and Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds and sold them off” so they were not left with the risk (p 28). His biggest problem was how do you short them when it isn’t allowed (p 29) and after much thought and research he “got an idea: credit default swaps on subprime mortgage bonds” (p 30). When he went into business as a money manager after losing interest in the medical profession, Joel Greenblatt invest 105,000 dollars with him as well as White Mountains who purchased a smaller amount of his fund at 600,000 dollars and gave him 10 million to invest on Scion Capital which was madly successful. In 2005 he began developing a way to buy insurance on the worst loans (those most likely to default) and in a few weeks he had purchased “several hundred million dollars in credit default swaps from half a dozen banks, in chunks of 5 million” (p 52-53) eventually owning $750 million in subprime mortgage bonds. He became the first to create them, then the one most doubted about their wisdom, and finally the one owning the majority of them when loans started to default. He was poised to make a fortune, and so were his investors. But when the subprime loans began to fall and yet this bet didn’t pay off, his investors wanted out and he wouldn’t let them (p 184-191). On August 31, 2007 Michael Burry began to unload his own credit default swaps and made profits of $720 million. While he made a killing in the market, his investors didn’t appreciate how he did it and the lack of recognition for being right killed any desire he had to continue his hedge fund.

Greg Lippmann: worked for Deutsche bank and was instructed to get people to invest in Credit Default Swaps so that more synthetic CDOs could be created and sold. He pitched his proposal with number crunching assistance from  Eugene Xu to Steve Eisman and his company. Once the research was done, Greg Lippmann found he believed the bonds would fail and had very little trouble getting behind the credit default swaps, however his way of presenting the proposition lead to most people including those who worked with Steve Eisman to distrust his motives making it hard to get investors. By the end of 2006 he had about 100 investors trying to hedge their bets by dabbling in the credit default swaps market. He made $47 million dollars in 2007 with Deutsche Bank.

Charlie Ledley: Partnered with Jamie Mai and Ben Hockett and began investing by trying to predict drastic changes in the market. They looked for ways to get themselves “into a position where small changes in states of the world created huge changes in values” (p 129). They would buy low priced stock right before something dramatic happened and then the stock would jump. It was a risky way to invest, hard to predict and hard to be consistent with (p 109-121). Deutsche bank institutional customer enabling them to purchase some of Greg Lippmann’s credit default swaps. They were among the first to spot the problem with CDOs and to buy the brand new and cheaper credit default swaps on them (p 130) and by “January 2007…they owned $110 million in credit default swaps on the double-A tranche of asset-backed CDOs” (p 134). Corn wall capital owned 205 million in credit card swaps by February of 2007 (p 163). On August 6th they sold those to UBS netting $80 million for them (p 221-222).

Howie Hubler: worked for Morgan Stanley and invested in credit default swaps on subprime loans. Now he needed a mark, and he found them. Eventually enticed to run Morgan Stanley’s Global Proprietary Credit Group Huber managed subprime-backed CDOs and had 2 billion in bespoke credit default swaps as well that would eventually pay off. He also bought  about $16 billion dollars of CDOs by 2007. He was cynical, but not cynical enough betting that less than 8% of the subprime mortgages in those CDOs would go bad when it turns out a much higher number than that would default. The risk he had taken was hidden from the Morgan Stanley’s reports (p 200-206). When Huber did an analysis of what would happen if there was a 10% default rate on subprime loans, they found that it would be a loss of 2.7 billion (p 212) but he was still convinced that kind of loss would never happen. They did. Morgan Stanley exited with a loss for about $3.7 billion and total losses were about $9 billion (p 214-215). His hedged bets weren’t hedged enough. “Howie Hubler lost more money than any single trader in the history of wall street- and yet he was permitted to keep the tens of millions of dollars he had made” (p 256).

Then it all started to go south (again, I’m and English major not a numbers girl). In the 1st half of 2007: “the ABX, a publicly traded index of triple-B-rated subprime mortgage bonds…fell more than a point” (p 161). “By early June, the index of triple-B-rated subprime bonds was closing in the high 60s” a loss of more than 30 % of their original value (p 164). However, the CDOs which were created out of these bonds did not collapse even though their collateral was gone (p 165). “The bond market had resumed what would become an uninterrupted decline” (p 172). “The facts on the ground in the housing market diverged further and further from the prices on the bonds and the insurance on the bonds” (p 194) and by July 2007 everything flipped. All of the sudden big names were interested in betting against the market, and by July most could see the writing on the wall that the subprime loans were going bad quickly and the safe bet was the short bet (p 195-199). Then comes the sharp decline in profits that those who spotted the problem early on were expecting. Those companies that had invested heavily or covered the credit default swaps were now facing major losses. In 2008: Lehman Brothers filed for bankruptcy and Merrill Lynch was sold to Bank of America. The stock Market fell by more than it had since 9/11/2001 and the government bailed out AIG to payoff the losses on the subprime credit default swaps they sold to Wall Street banks (p 237). Corporations yanked their money out of Money Market funds, and large Wall Street firms had taken huge losses on the triple-A CDOs. “The CEOs of every major Wall Street firm were also on the wrong end of the gamble. All of them, without exception, either ran their public corporations in to bankruptcy or were saved from bankruptcy by the United States government. They all got rich, too” (p 257). It didn’t stop there, as we know, and the repercussions are still being felt by the the industry and those that the subprime mortgages bonds were built on- the American People.

My opinion on the book:

This book did an excellent job of making the complex and jargon filled world of wall street easy for a layman to understand (at least somewhat!) and the author is such a good storyteller that those featured in the book come alive for the reader.