Friday, March 4, 2011
The Big Short by Michael Lewis
Back in the 1980s, Michael Lewis went straight from Princeton to Wall Street, though his degree had nothing to do with finance. His lack of expertise did not hurt his career, but he quit the field just a few years later, much wealthier and terrified as hell. He turned his experiences into the book Liar's Poker, and in the bargain found a calling better suited to his talents, writing non-fiction best sellers.
Not without cause, Lewis thought he was watching an industry headed for an apocalypse and right soon. Conservative sectors of the financial industry were going nuts in the 1980s, due in no small part to de-regulation. He was in the game when the previously dull and solid savings and loan industry crashed, and he worked at Salomon Brothers, the first investment bank to go public. This meant the owners were no longer gambling with their own money, but instead with the money of the stockholders. Old timers were appalled, but it wasn't really the end of the world, even though some big names went to prison, including Michael Milken, Charles Keating and John Gutfreund, Lewis' former boss at Salomon Brothers.
No, the real crash of the financial industry was still about twenty years in the future, and when it came, Lewis decided to write an article about it for the now defunct Portfolio magazine, and then expand the shorter piece into the book The Big Short.
While Liar's Poker was kind of a bug's eye view of the financial world because Lewis was such a little fish, The Big Short is more like a worm's eye view. Because of non-disclosure agreements, it's hard to get the people at the top to talk. He did get some valuable information from insiders who saw the trouble in subprime loans early like Meredith Whitney, Steve Eisman and Greg Lippman, but a lot of the narrative of his book follows some very small fish indeed, investors local to the San Francisco Bay Area instead of New York. (Lewis lives in Berkeley.) These outsiders saw that if it was possible to bet against the loans being made by subprime lenders, the odds were massively in their favor.
Home ownership used to be straightforward. Get a down payment together, show proof of income and a solid credit rating and you could have your piece of the American Dream. That, of course, was in the quaint 20th Century. With sub-prime lending, down payments and proof of income would vanish as criteria and all that remained was your credit score. The thing was, it was pretty easy to go from no credit history to good enough to get a loan in a matter of months by getting a single credit card and paying off the entire balance every month. Lewis tells the tale of a migrant worker making $14,000 a year picking strawberries getting approval for a home loan of over $700,000.
You might argue the strawberry picker was an idiot, and I wouldn't disagree. But what about the idiocy of the company that made the loan? How can they possibly turn a profit on this? Lewis does a good job explaining this as well. A lot of subprime companies made the loan, got the points up front off the not really credit worthy buyer then sold the loan immediately.
Okay, you might say, but who's a big enough idiot to buy the loan? The loans were based on teaser rates and balloon payments. Maybe the strawberry picker could make the teaser rate payments, but he'd probably not be able to continue two years later when his monthly payment blew up. No matter, thought the alleged non-idiots taking the gamble on him. If he keeps paying, fine. If not, his house value probably went up, then he could re-finance. Worst case scenario, the company buying the loan now could foreclose and they owned a house, an alluring piece of the American Dream they could sell for a profit.
They could see no way this well-thought out plan could fail.
They couldn't, but others could. The thing was, to bet that the housing market was really a massive bubble, you needed to enter the bond market. Some people might think the stock market is a place where the big fish eat the little fish, but the stock market is to the bond market as a well maintained aquarium is to the deep blue sea. With exotic bonds like the Credit Default Swap (CDS) and the even more arcane Collateralized Debt Obligation (CDO), it was nearly impossible to know exactly what you were buying and even the alleged "experts" couldn't agree on what the things were worth. There's a very funny scene where Lippmann from Deutsche Bank, the biggest fish Lewis could talk to who bet against the CDOs, calls up his counterpart at Morgan Stanley, who thought the incredibly bad loans in the obscure package really deserved a triple A rating. The deal was set at 100. Lippmann's model said they are worth 72. The person from Morgan Stanley counters that their model put the value at 95.
"Fuck your model," Lippmann patiently explains. "If you really think they are worth 95, I will sell them to you at 77. Otherwise, dude, you owe me $1.2 billion, and I want it fucking now!"
Of course, this was not the end of the conversation. Lawyers stepped in and eventually Morgan Stanley paid Deutsche Bank half that amount, $600 million, for being on the wrong side of a tiny part of the biggest bet in the history of the world.
The Big Short is supposed to be the story of gamblers in a zero sum game, which means for every dollar one gambler might make, someone else at the table has to lose a dollar. But here's where the story gets scary. A single loan could be repackaged again and again into derivatives like CDSs and CDOs, and the amount of money actually tied up in home loans that wouldn't get paid off was a tiny fraction of the money floating around in the casino that every major player in the financial world was gambling in. Some were on the right side but many on the wrong side so deep, bankruptcy was their only option and the winners wouldn't get paid off.
Like I said, it's supposed to be the story of gamblers. The main characters in the book are smart guys on the right side of the bet like Dr. Michael Burry, an obsessive researcher who stopped being a surgeon to become an investment advisor, and Charlie Ledley and Jamie Mai, a couple of neighbors in Berkeley, California who started Cornwall Capital and dove bravely into the bond market, only to be mocked by the big fish with whom they swam as Cornhole Capital. But all the good guys get their bets paid off, and so do all the idiots, only two of whom are featured prominently by name, Howie Hubler at Morgan Stanley and a CDO manager named Wing Chau. All of them get paid off because of the massive bailouts of the financial sector under presidents Bush and Obama, engineered by the scum in charge Ben Bernanke and Tim Geithner.
While I have mentioned many of the plot points, there's plenty I haven't talked about, and The Big Short is still a ripping good read, largely because Lewis is a better writer than I am. While there is a good chance you will finish the book either somewhat depressed or pissed off as hell, I still recommend you read The Big Short. The sad moral is that the idiots and thieves are still in charge up and down the line, and you can see in slow motion the post mortem of the last train wreck they caused while waiting for the next one.