Monday, May 31, 2010

The Big Short, by Michael Lewis

Michael Lewis may be the greatest non-fiction storyteller of his generation. His new book, The Big Short, takes its place alongside Liar's Poker, The New New Thing, Moneyball, and The Blind Side as a classic of its genre, and a masterful showing of how a dedicated outsider can triumph over the groupthink-prone majority.

The credit crisis that shocked the global economy in 2007 and 2008 was drive by mortgage-backed securities. Enormously simplified, a mortgage-backed security is a fund created by a bank, which has accumulated large numbers of mortgage loans, then divided them up, and sold the rights to percentages of the pool of money that came in from the mortgage payments every month. The greater the risk that these mortgages would default, the greater the interest rate, and, therefore, the greater the profits that the bank - and the fund's investors - would realize if they mortgages were paid off. The profitability of these investment vehicles was premised on two things - that most of the loans would be paid off, and that, with the real estate market rising through the roof, the banks being able to foreclose the houses and make a profit by selling them for more than the amount of the mortgage. Unfortunately, just about everybody in the world of finance both overestimated the percentage of mortgages that would be paid off, and assumed that the value of real estate in Florida, California, and the rest of the sunbelt would continue to rise.

These two mistaken assumptions led to an enormous boom in the "sub-prime" mortgage market. Basically, a sub-prime mortgage is one that is made to a person considered to be somewhat of a credit risk. For obvious reasons, these loans are more common in good financial times than in bad. But by the early 00's, outdated models were being used to justify the extension of $500,000 mortgage loans to migrant workers earning $14,000 per year, or to immigrants who barely spoke English. One of the investors profiled in the book decides to begin to short the housing market when his secretary tells him that she and her husband just took out a mortgage on their fifth Queens townhouse. The majority of bankers, however, had become so good at disguising the risk from consumers that they ended up disguising the risk from themselves.

The housing, subprime mortgage, and subprime mortgage-backed securities markets all suffered from groupthink. The more subprime mortgages that were extended, and the more securities that were created out of them, the higher the stakes supported by a foundation of half-truths and wishful thinking. Eventually, it reached a point where the consequences of a burst bubble were so enormous that financiers literally couldn't fathom the consequences. When one "short" investor tells a "long" investor that he thinks that subprime-backed securities have lost about 30 percent of their face value, the long investor didn't believe him, and said "if these [lose] 8 pecent, there'll be, like, a million homeless people." You can imagine the shock when everybody eventually realized they were worth even less than that.

Lewis profiles three groups of investors - one led by the hilariously profane Steve Eisman, another by Michael Burry, an idiosyncratic doctor with Asperger's Syndrome, and a third, "garage band" hedge fund founded by inexperienced investors Jamie Mai and Charlie Ledley in a friend's garage with just $100,000 - who, for a variety of different reasons, were immune to the group think, and realized how much money people were going to lose when the sub-prime loans inevitably went bad. They were able to buy Credit Default Swaps, which were, for all intents and purposes, bond insurance. You can buy credit default swaps without owning the underlying securities. Analogizing these investors' actions to the real world, this would be like buying billions of dollars of flood insurance on the entire city of New Orleans in the summer of 2005, without having to buy any of the underlying houses, which, in the event of a flood, would cause you a loss, or that you would need to rebuild.

Every investment-banker-as-douchebag stereotype is validated in this book. The book prompts the reader to consider what purpose Wall Street brokerages serve in today's economy - do they have any redeeming societal value, now that they are so far removed from their original purpose of spreading risk and raising capital, what do they do, other than provide people with Ivy League MBAs an opportunity to earn billions of dollars in fees from the rest of us? Along the way, Lewis shows us investment bankers acting their worst. When, for instance, a group of assholes from a once-enormous, now-defunct investment bank take Mai and Ledley to a shooting gallery in Las Vegas, then never talk to them, merely so they can bill the trip to their bank, or when Bear Stearns refuses to take their calls, and makes fun of the name of Mai and Ledley's hedge fund, while, for pennies on the dollar, selling them credit default swaps that would net the outsiders tens of millions of dollars while bankrupting several of Wall Street's largest firms, the sense of schadenfreude is overwhelming.

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