David Pezarkar, Head - Equities, Shinsei Asset Management (India), reviews Big Short written by Michael Lewis
The Big Short gives a very lucid explanation of the intricate financial instruments involved in causing the greatest financial debacle since the Great Depression. Michael Lewis, the author has exposed the short term nature and greed involved in modern finance. The book tells interconnected stories of brilliant market participants who recognize that most of the large Wall Street banks along with many other financial institutions spread across the world have highly leveraged positions on mortgage backed securities which could result in massive losses even if the underlying assets decline in value by a small amount. These participants become convinced that a massive calamity is waiting to happen and take large bets to profit from their analysis. In market parlance, these players are "shorts" - speculators who bet that the price of a given stock or bond or commodity or any derivative thereof will fall, rather than rise. Most shorts pick on a single company or have a negative view on the direction of a commodity. "The Big Short" chronicles the story of shorts that are more ambitious: it's a bet on financial sector collapse. The book provides details of the happenings and the key protagonists who put their money on the line.
The book clearly lists the villains, a few heroes, and a lot of people who look extremely foolish: high government officials, including the watchdogs; and heads of major investment banks.
The chief protagonists are Steve Eisman, Michael Burry and Jamie Mai and Charlie Ledley. Steve Eisman is the former Oppenheimer analyst who regularly demonstrated a prodigious talent for offending people. Michael Burry is a doctor with Asperger’s syndrome (which refers to physical inelegance and frequent use of uncommon language), and is obsessed with investing. Burry started a fund with money from a small settlement his family received when his father died after a medical misdiagnosis. Jamie Mai and Charlie Ledley started a “garage band hedge fund” in 2003.
These protagonists find out which mortgage lenders are making the worst quality loans, and then determine which mortgage bonds (or collateralized debt obligations created out of slices of these mortgage bonds) are constructed from those loans, and then buy insurance, via credit default swaps. This insurance pays off if the borrower fails to honour his obligation. This is an asymmetric bet, as roulette, where the losses are limited, but the profits could be multiples of the amount wagered, even thirty, forty or fifty times. These speculators realize that the whole edifice is built on flawed mathematical models that most financial executives did not really understand themselves.
The book illustrates how these financial instruments (which had names like “the synthetic subprime mortgage bond-backed C.D.O., or collateralized debt obligation”) grew increasingly opaque and complex to help obscure the fact that they were built around increasingly poor quality loans, which required little documentation, adjustable-rate mortgages that ballooned after two years, “interest-only negative-amortizing adjustable-rate sub-prime” mortgages, and mortgages given to migrant workers and poor immigrants. Wall Street firms were able to hide the risks by complicating the products and thus getting the rating agencies - notably, Moody’s and Standard & Poor’s - to give triple-A ratings to bonds that were far lower in quality. The evaluation models used by these agencies were based on rising house prices and used the past to predict the future.
The book shows how market distortions are caused by oligopoly power. An index of subprime bonds started falling in January 2007, and these bonds lost 30% of their value in the next six months, but the CDO market held firm as it was controlled by a few firms. These banks started marking down these assets only after their own hedging strategies were in place. The top executives were to a large extent unaware about the risks their organizations were taking.
The author has not only described the market positions taken by the main protagonists, but has gone beyond those details and analyzed their underlying character traits. The book goes on to detail what goes on in the minds of the speculators who bet that the entire system would collapse: their own self-doubt, the trepidation of the investors whose money is being managed by these “shorts”, the arrogance of investment bankers, and the irrational exuberance of financial markets. These speculators are going against the crowd, which causes a dynamic sense of tension, which continues through the text, even though we all know what the ending is.
From a $1 million bet, Cornwell netted $80 million, while Burry realized profits of $720 million. Eisman’s fund doubled in size, to $1.5 billion.
The book does not aim to apportion political blame for the catastrophe, but covers in detail the causes: the dismantling of regulatory oversight, the US Government’s efforts to boost lower-class home ownership, ratings agencies, regulators, mortgage lenders and the greed of investment bankers. The banks come out as the chief villains - they discovered that billions of dollars could be made transforming poor quality mortgage loans into apparently safe securities, and played the game to the hilt. On top of this foundation, they created a superstructure of credit default insurance swaps to buy and sell, to have another way to make another speculative bet, as there were physical limits to how many real mortgages could be created.
Overall, it’s a very interesting account of the sub-prime crisis and one hopes that more robust market mechanisms are put in place in future to prevent a repeat of a similar crisis.
