I’ve read two of Michael Lewis’s recent books, Home Game and the baseball economics classic, Moneyball and loved both of them. I knew that I had to read his latest, The Big Short, after reading two of his excellent essays (link and link) about the financial meltdown for Portfolio Magazine almost two years ago.
Lewis leads the way through the global financial meltdown by telling the story of those who saw it coming in the first place. While many claim to have seen the dangers of the subprime mortgage meltdown, only a few said anything about it before everything went south. Even fewer put their money where their mouths were and took short positions against the bonds that were based on the U.S. subprime mortgages (i.e., they bet enormous sums of cash that the system would fail spectacularly).
Realizing that virtually everyone else on the globe was wagering on the success of what were perceived as (and marketed as) zero risk bonds, the handful of clear-eyed money men who saw the situation for what it was began to take short positions on every financial institution that they could. They were ultimately proven right and made tremendous sums of money along the way.
The short side buyers described seem to be alike in striking ways. While maybe not iconoclasts exactly, they all seemed to be socially inept and didn’t really care what other people though of them. They all looked deeply into the small print and wanted to know exactly what they were investing in. They collectively couldn’t understand why anyone would want to buy these crappy subprime mortgage bonds and felt that they must be missing something. Then they talked to everyone hat they could to find out why they were wrong. And they listened:
The more they listened to the to the people who ran the subprime market, the more they felt the the collapse of the double-A-rated bonds wasn’t a longshot at all, but likely. A thought crossed Ben’s mind: These people believed that the collapse of the subprime mortgage market was unlikely precisely because it would be such a catastrophe. Nothing so terrible could ever actually happen.
The financial meltdown that these short siders were all betting on is incredibly difficult to understand, even in retrospect. Lewis describes the fiasco as well as anyone else I’ve read, but I’m still not sure that I understand all the details completely.
In a nutshell, piles of crappy mortgages were lumped together and rebranded as mortgage bonds that were given ratings much higher than they deserved. At each step of the way, risk was passed along to the next guy. The people who go screwed were at the front and end of the line.
At the front end, consumers were encouraged to take out loans that they were unlikely to be able to pay back (e.g., interest only for 3 years and 12% interest after that). Since home prices only go up, the homeowner could refinance before the loan became onerous (generating more fees for the originators). When home prices did go down (or just stop going up), the house of cards collapsed leaving you, the taxpayer, on the hook for billions of dollars in losses. Everyone in between those two points made money hand over fist. Sure, they may have caused their firms to go bankrupt, but as individuals, they did just fine.
A few charts, graphs, or other infographics to help aid understanding would have been nice. Not being able to understand the full complexity and magnitude of this wholly manufactured bond market is largely Lewis’s point though. No one knew what was in the bonds or what the other financial instruments were that grew around them. Not really. Unfortunately, it was their job to know. The lack of understanding coupled with the greed, short-sightedness, and outright fraud driving the financial engine almost led to the collapse of our entire financial markets. Reading this book will make you very angry. As it should.
I have a journalist friend who is not a fan of Michael Lewis. One of his issues is that Lewis wrote this book and provided no end notes or other detailed accounting of his sources. I doubt that the general reader will miss those, but he finds it professionally unconscionable. For my part, I found it a gripping account of an important part of our recent history. It reads almost like a thriller. It’s just too bad that it’s all true.
Additional reading: This NYT article sees familiar signs of underestimating risk in the BP Oil Spill.