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The Big Short: Film Tie-In Paperback – 10 Dec 2015
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It's time to throw another tank of petrol on the Wall Street pyre, as only Lewis can (Financial Times)
He is so good everyone else may as well pack up (Evening Standard)
No one writes with more narrative panache about money and finance than Mr. Lewis (Michiko Kakutani New York Times)
Probably the single best piece of financial journalism ever written (Reuters)
Hugely entertaining (Economist)
Terrifying and superbly told (Daily Telegraph)
Genius (Sunday Times)
Compelling and horrifying (GQ)
A more than worthy successor to Liar's Poker ... if you want to know about the origins of the credit crunch, and the extraordinary cast of misfits, visionaries and chancers who made money from the crash, there's no more readable account (Daily Telegraph)
A triumph ... riveting ... a genuine page-turner (Times)
About the Author
Michael Lewis was born in New Orleans and educated at Princeton University and the London School of Economics. He has written several books including the New York Times bestsellers Liar's Poker, widely considered the book that defined Wall Street during the 1980s, The Big Short, 'probably the single best piece of financial journalism ever written' (Reuters), the breakneck tour of Europe's post-crunch economy, Boomerang, and the bestselling exposé of high-speed financial scams, Flash Boys. He writes for Vanity Fair magazine.
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We all know, some years after the event, that a great many people saw the 2007 crash coming. Michael Lewis’s book, however, focuses on the handful of people who really saw it coming and left proof that they’d done so by staking large amounts of money betting that it would.
Take Michael Burry. This is a man we get to know better and better through 'The Big Short', which is appropriate because the events it describes include his own awakening self-awareness (one of the charms of this book). He was perhaps the first to see that the US mortgage industry was lending increasing amounts of money to people who had not the slightest chance of being able to keep up the repayments.
Those mortgages were being sold on to other financial institutions, and then being collected together into bonds which could be sold as packages to yet others. A market quickly developed in those bonds, which developed their own prices quite independent of any value the initial mortgages themselves might have.
In fact, the process went still further, with collateralised debt obligations (CDOs) which contained bits of many bonds and could themselves be sold on.
The explanation I’ve just given is almost certainly inadequate, but I don’t pretend to understand how individual mortgages got packaged into bonds and bonds into CDOs. But that’s the book’s essential point: very few people did understand. These were opaque instruments, not understood by the people who traded in them or by the executives of the Wall Street firms which employed the traders.
They didn’t understand, but they knew that it was in their interest that they keep being created, that their price keep increasing and that the market stay buoyant. So they did all it took to maintain the flow of the instruments – which meant making more and more loans to people less and less able to afford them – and to keep the price high.
In one of his most damning revelations, Lewis explains how Wall Street maintained pressure on the ratings agencies, whose staff were simply not of a calibre to withstand it. So the agencies continued to award to rate these essentially rubbish bonds triple-A. That allowed their prices to be kept floating ever more ludicrously higher.
What the few people like Burry (Steve Eisman, Greg Lippmann and the founders of Cornwall Capital also play major roles in the book) had understood was that this whole structure was ultimately built on lousy loans. It couldn’t be sustained in the long term – the whole tower eventually had to crash. So the trick was to find a way to bet against it. That’s the process known as “selling short.”
Normally, it involves borrowing. You might borrow pounds today to buy dollars, in the belief that the pound will fall, so when you come to buy pounds to pay the loan back, it will take fewer dollars than you’ve realised today; or you might borrow shares to sell today, believing that when you come to buy them again to reimburse the lender, they will cost you less. Large amounts of money can be made that way, but the risk is colossal: if the shares rise instead of falling, or the pound increases in value against the dollar instead of devaluing, your losses can be immense. In fact, they are unlimited.
As it happens there was no mechanism to borrow mortgage-backed bonds in the years leading up to 2007. What there was, however, was a way of insuring against them defaulting. The so-called credit default swap (CDS) meant paying a quarterly premium, against the insurer paying out the full value of any default on the bond – if the bond became worthless, the insurer paid out the face value at which it had been sold.
One can imagine that this was initially a legitimate form of insurance (though it wasn’t regulated as ordinary insurance is). If you’ve lent $100m to someone whose credit you believe is good, you might nonetheless want to take out some insurance against his being unable to pay you back; if someone is prepared to insure the full value for, say, two or three hundred thousand a year then the chances are that you will only be out of pocket by a small percentage of the interest you make on the loan, and usually the insurer will not have to pay out anything (just as in insurance generally: most houses don’t burn down, so the insurers turn the premiums into pure profit). You’ll have made a small reduction in your profit for peace of mind.
Until nearly the end, the Wall Street firms were so convinced of the solidity of the sub-prime mortgage market, that they were more than happy to issue large quantities of CDSs. They were happy to insure the bonds. Interestingly, the men who bet against them didn’t even have to own the bonds they were insuring: they could take out CDSs against the bonds without buying them – in other words, they were making pure bets.
This was the Big Short. They were taking out fire insurance on houses belonging to other people, which they were convinced were already burning. And they made a packet.
The main lesson for us? They did it because they were alone in understanding what the people paid huge salaries to manage the industry failed to grasp.
And the saddest lesson? No lessons have been learned. The finance sector was bailed out by the taxpayer. It goes on paying its senior players wildly excessive salaries. And it continues to pursue huge profits from financial instruments they don’t understand.
P.S. The film (same title) is not at all bad, either.
But it didn’t end there. Those that failed to get the desired rating were simply repackaged, so that all these dubious products were eventually classed as ‘risk free’. This was the second part of the conspiracy and a huge failure by the rating agencies (who were paid by the banks). They failed to examine in detail the structure of a given CDO, but simply accepted the bank’s assessment. The situation rapidly spiraled out of control. A CDO-A might contain some of the mortgages in CDO-B that in turn might contain some of the mortgages in CDO-C, and the latter might even contain some mortgages that were in CDO-A. This was an Alice in Wonderland world where it was impossible to give a true value of any CDO, and its worth was what the bank said it was worth. Even the senior staff at the banks that were selling the CDOs didn’t have a full understanding of what was happening.
This is where the outsiders entered. First they realized that the original loans were often being made to people without asking for proof of income (‘liars’ loans’) and that the home owner was offered a low interest rate (the ‘teaser’ rate) initially, typically for the first two or three years. They argued that after this period expired there would be a high probability that the owner would default and, crucially, that this would happen to the vast majority of loans within any given CDO, because they would all be unable to pay for the same social reasons. The banks, however, had risk models that only considered a worse case scenario of just a few percent failures. If they could take out insurance, via what were called ‘credit default swaps’ (CDSs), against a failure of a CDO, they argued that they would only have to wait a couple of years or so before the low-rate period expired and the insurance would have to pay out. Throughout they remained worried that they had missed something, because the logic seemed so obvious, they couldn’t understand why the banks themselves had not seen it. Eventually they did of course, and much later started to cynically (even corruptly?) bet that the very bonds that they had issued would fail.
Initially, the outsiders had hurdles to overcome. They had difficulty finding any bank that would sell CDSs to them because they were mere minnows with only small funds. However, these hurdles were overcome and to some amusement of the banks they started to accumulate substantial positions in ‘bets’ that the CDOs would fail, and at only a small cost in premiums. It was a nail-biting time because the price of CDOs continued to be stable, even sometimes rise, despite the increasing rate of defaults on the underlying loans. But the end, when it came, was very rapid, just as the outsiders had predicted. Indeed the losses were so great that they feared the big banks would themselves fail and so be unable to pay out on the CDSs. In great haste in the last stages of the collapse they scrambled to offload them and managed to get out before the final collapse.
The rest is history: several major bank collapsed; hundreds of billions of dollars were pumped into the system to keep others afloat; Congress stepped in and bought subprime mortgage assets for up to 2% of the US GDP; and senior bankers who had lost billions in the debacle were allowed to walk away with ‘bonuses’ of tens of millions of dollars. But the householders who had defaulted on their loans received nothing and were dispossessed.
What this sad story revealed was widespread cynicism in the financial industry, banks, rating agencies and regulatory bodies, bordering on corruption, and a remarkable lack of understanding of the fundamentals at the highest level in the banks. There have been many books about the causes of the financial crash of 2008, but few can match this one in the detailed knowledge of its author and the clarity of his presentation. There is some repetition in explaining technicalities, but this is acceptable. If the reader understands it first time these can easily be skipped over without loss of continuity. Overall it is an excellent book.
Two criticisms of the book, although it's explained it's sometimes hard going to understand some of the detail (the gist is always clear), and it is sometimes repetitive. Still a five starer though, for the effort of producing something so revealing, and which clearly stung a few people, people who were incredibly fortunate to have only been stung rather than buried.