Wednesday, November 5, 2014

Reflection on Michael Lewis's The Big Short: Inside the Doomsday Machine


(Note: Relevant article at the end)

If you’re looking for a textbook, definitional account of the Financial Crisis, this is not the book for you. Rather, Michael Lewis describes the onset of the housing bubble and eventual crash using a dry-humored, story-like style. His book is both entertaining and informative, especially for those (like me) who lack extensive background in the development of the housing bubble. By telling the stories of a few men who recognized the failure of the subprime mortgage bond market before it happened, Lewis explains how subprime lending worked and why the market essentially failed.

The Wall Street “big shots” like Goldman Sachs, Merrill Lynch, Bear Sterns, Morgan Stanley, and JP Morgan found themselves in the midst of a booming mortgage bond market that took off in the 1980s. Mortgage bonds, as Lewis describes, were “a claim on the cash flows from a pool of thousands of individual home mortgages” (7). Investment banks structured mortgage bonds by “tranches.” The lowest tranches were more risky, with higher interest rates, while higher tranches had lower interest rates and lower risk. Subprime lending began as lenders disregarded the fact that a low credit scored- borrower may not be able to make mortgage payments, because as home prices kept rising, borrowers could just pay off the mortgage by selling the house. As subprime mortgages became packaged into bonds, investors relied on Moody’s and Standard & Poor’s ratings to make their investment decisions, where riskier mortgage bonds would receive lower ratings. Lewis, however, highlights a botch in the rating system, found in collateralized debt obligations (CDOs). AIG insured CDOs, which “disguise the risk of subprime mortgage loans,” by packaging them with “better loans,” ultimately allowing them to receive a better rating (72). Stephen Eisman, Michael Burry, Jamie Mai and Charlie Ledley not only recognized this “ponzi scheme,” but they took advantage of it.

Lewis introduces Michael Burry, a neurosurgeon with Asperger’s who was fascinated by the bond market, specifically the subprime mortgage boom. Burry watched the housing bubble grow, leading to his discovery and purchase of credit default swaps (CDS)- “insurance against the failure of a mortgage bond” (72).  Eisman, a fickle and hotheaded hedge fund owner, saw disaster coming when Wall Street banks’ fixed-income departments would package mortgage loans with “teaser” fixed interest rates into mortgage bonds. He saw the rating inefficiencies and the potential for profits by betting against (“shorting”) the bonds with the worst underlying loans.  Ledley and Mai started Cornwall Capital Management and executed investments based on predicted failures in certain markets. After getting placed on Deustche Bank’s “institutional” trading platform, they bet against (bought CDS) CDOs. By 2007, as defaults rose and CDOs began to fail in large numbers, Burry and Cornwall Capital sold their credit default swaps and heavily profited. The subprime mortgage- backed financial system collapsed as housing prices fell and borrowers defaulted on their loans, bringing a series of bankruptcies and acquisitions on Wall Street. Lewis ends with the startling statistics, including the Fed’s announcement of a $85 billion towards AIG to pay off its losses on the CDS sold to Wall Street.

I’ll start with what I liked. I liked that Lewis used his book to describe the Financial Crisis from a rare point of view; “rare” based on the fact that he followed those few who predicted and benefited from this economic catastrophe. Instead of saying “This is how the housing bubble started, this is why it was bad,” Lewis takes a journalistic approach (appropriate since he is a financial journalist) and includes quotes and thoughts that these financial geniuses had as they watched the housing bubble expand and pop. For example, Lewis quotes Ledley in his discovery of the botched rating system, “The more we looked at what a CDO was, the more we were like, Holy shit, that’s just fucking crazy. That’s fraud (129). By including actual quotes and reactions of the “winners” in his book, Lewis depicts their personalities and their ability to analyze a complex situation.  Including the fascinating stories behind his core characters, like Murry’s battle with Asperger’s, made learning about the subprime mortgage crisis more personal, enjoyable and overall, readable. The insertion of the “F Bomb” throughout the book made it feel like I was hearing a real conversation between Wall Street honchos and big-time money managers.

While the writing style and context of the book encouraged me to read more Michael Lewis books (next on my list is Panic!), I’m somewhat uncomfortable with his portrayal of these figures as “heroes.” Eisman, Murry and the Cornwall brothers saw an opportunity and seized it. When I was little, I had 10 pennies and gave my younger brother a proposition: “I will trade you ALL of these pennies for that ONE, single dollar bill.” Naively, he thought he struck gold. Does the recognition of an opportunity for personal gain (and his loss) make me a hero? Yes, the housing crisis is far more complex, dealing with numerous additional variables. The point is, the characters in this book also recognized opportunity and seized it. Regardless of their gain, thousands suffered from substantial losses (on the lending and borrowing side). They benefited while everyone else suffered. This, in my opinion, may make Eisman, Murry, Ledley and Mai clever, observant and financially talented—not  heroic.

Lewis acknowledges the weaknesses in rating agencies, but for me, not enough. He constantly points back to Wall Street and the big banks, the investors and manipulation in bond structuring. According to Lewis, Wall Street firms were able “to hide the risk by complicating it.” He includes an interaction between Eisman’s partner and a woman from Moody’s: “How could you rate any portion of a bond made up exclusively of subprime mortgages triple-A?” asked Eisman’s partner. The Moody’s rep responded, “That’s a very good question” (103). Lewis used this to point out that the banks convoluted the structure of subprime mortgage bonds to facilitate more investment. However, reading this made me attribute a large part of the blame to the rating agencies themselves. They have the responsibility of evaluating and reviewing bonds in order to designate a specific rating, meaning they should have reviewed all loans within the bonds thoroughly. So, while I agree that the banks were manipulative in their structuring of the CDOs, Moody’s and S&P are also a large part of the issue.

Reading The Big Short: Inside the Doomsday Machine was both critical in my understanding of the development of the housing crisis and towards my ability to develop an opinion of those directly involved. Prior to this book, I have not considered the position of the rating agencies, who I now think play a substantial role in the mismanagement and mistakes behind CDOs and faults within the subprime mortgage market. Lewis took a darker view of Wall Street, opening his book with discouraging words about working in finance and banking. While I acknowledge that he is far more experienced than I am, I cannot completely agree with the representation of his characters as “heroic” based on the fact that they foresaw the explosion of the housing bubble and used this to reap profits. As far as designating a victim, I still go back and forth between investors and borrowers. Lewis presents his characters as sympathetic to the borrowers. Personally, I can’t help but to feel that both the investors and the borrowers acted without thinking in the long term. 

Recent and relevant article about AIG: Former CEO Hank Greenberg files a lawsuit against the US Government for 'overstepping its authority in demanding a 79.9% equity stake in exchange for providing an $85 billion emergency loan." ....Mr. Greenberg, you accepted the bailout package and you needed it. There's no such thing as a free lunch. 




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