Saturday, July 23, 2011

Book Review (#22 of 2011) The Big Short

I'm catching up on financial crisis history reading since we're a month out from classes starting and a couple classes I teach deal directly with the lessons (hopefully) learned from the event.

The Big Short: Inside the Doomsday Machine by Michael Lewis.
This book is primarily about greed. I would sum up the moral of this book with Proverbs 22:16:
He who oppresses the poor to make more for himself
Or who gives to the rich, will only come to poverty.

Lewis (The Blind Side, Liar's Poker) is one of the best nonfiction writers of our time, a fantastic storyteller. If you've not read his long-form article in Vanity Fair on the Greek debt crisis from last year, it's very much worth your time and you'll see why any efforts to keep Greece on the euro will ultimately fail.

This tells the story of some of the very few people who called the housing bubble correctly, put their money where their mouth was, and made hundreds of millions of dollars.

Michael Burry (this video posted by Bloomberg today tells his story), a former neurosurgeon turned California hedge fund manager who discovers he has Asperger syndrome during the course of his story. His Aspergers explain why he was so successful at consistently being ahead of the market, but also why he burnt out emotionally.

Steve Eisman, a cynical bond trader who also probably has some mental disorder, who often confronted CEOs and other people he saw as villains. He saw shorting the housing market as part of a greater crusade.

A trio of normal guys who start fund called Cornwall Capital, basically betting on "Black Swan" events, even when they didn't know what they were doing.

These guys didn't get famous like John Paulson, but Paulson might not have existed without Burry originating the idea. But these guys pioneered the market for credit default swaps on housing-related CDOs. For Burry and Cornwall, they got to experience the rough treatment that outsiders get from firms like Goldman Sachs-- who basically cheat their customers when they can. (What are you going to do, sue Goldman Sachs?)

The underlying greed of those making money off of housing is the central theme in this book.
"In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000."

The loan is an adjustable rate loan made by someone-- a bank or a mortgage broker-- who knows the migrant won't be able to repay, but the lender doesn't care. Because he has already sold the loan to an investment bank and gotten paid a nice commission for it. Reproduce this transaction thousands of times over in the U.S. Lenders even start making interest-only loans where the borrower never pays down any principle. A stripper in Vegas somehow gets five home equity loans...The investment bank takes the loans and packages them into asset-backed securities (ABS), a pool of mortgages of varying quality which it convinces Moody's or S&P to rate AAA.

Moody's and S&P get paid fees for doing this, so they have an incentive to rate as many assets as they can, even if they think the underlying loans are junk-- that's not their problem. Next, another investment bank might buy several of the ABS and strip out some of the worst tranches, repackage them into a CDO. Even though the underlying mortgages are of low quality, the ratings agencies again rate the CDO as AAA. Maybe because their models say that the low-quality loans are from various regions of the country, and U.S. home values have never all fallen at once (no one was alive in the 1930s, right?). Or their models were flawed in other ways -- rating a floating-rate mortgage higher than a fixed rate, assuming someone could make payments just as easily at 12% as 8%, etc. Maybe because the fees they're raking in help their bottom lines and boosts their stock price--they are publicly traded companies. Maybe because they're incompetent (the smartest guys on Wall Street don't work at the ratings agencies).

When there are no more loans to be made, CDOs are re-created synthetically, multiplying the amount of people who are basically betting on these assets. But very few people recognized that these assets would go bust when rates adjusted upwards in a couple years. Their trading desks kept billions of dollars worth on their books. Their risk management models only speculated that maybe 5% of the underlying loans would default. Everyone is basically passing the buck-- we collect our fees and commissions now, worry about the rest later.

Guys like Burry and Eisman bought millions of dollars worth of credit default swaps on these CDOs, insurance that would pay out if the assets became worth less. When they finally did, the biggest financial companies in the world paid up and went bust.

At one point in 2006 Eisman is invited to a subprime conference in Vegas organized solely to promote mortgage-backed securities and convince investors to stay in the market. He is basically awestruck by how how dumb everyone is and how "the world has turned upside down." The guys creating the CDOs, the trading desks buying them up, everyone seems to be drinking the kool aid that these are safe bets.
"Something must have come over Eisman, for he stopped looking for a fight and started looking for higher understanding. He walked around the Las Vegas casino incredulous at the spectacle before him: seven thousand people, all of whom seemed delighted with the world as they found it. A society with deep, troubling economic problems had rigged itself to disguise those problems, and the chief beneficiaries of the deceit were its financial middlemen. How could this be?"

There is a lot of profanity in this book, Lewis wants the world to see that Wall Street, where he used to work, is not holy. The "villains" of the story, the mortgage brokers, the CDO sellers, the traders and CEOs who lost their companies billions betting on CDOs, mostly walk away with their bank accounts intact, and keeping the millions in bonuses they earned along the way. The taxpayers took the ultimate fall along with, of course, those who lost their homes.

Despite the profanity, I have made it a required text in Money & Banking. The students will see that they will be confronted with incentives that may conflict with Christian ethics. Would you really care what the adverse consequences for others might be so long as you're making millions of dollars? Would you pass the buck? They will also see that it's not true or that simple to say "everyone knew the housing bubble would burst," or "it was all the government's fault."

I give this book 4 stars out of 5. What I really gleaned from the book is the importance of the ratings agencies in all of this. There are so many accounting rules and laws in our financial system that revolve around capital cushions and the value of assets, and if something is rated AAA and is really BBB-, that causes a lot of problems. It doesn't appear to me that those problems are very easily solvable.

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