The Big Short by Michael Lewis

Photo by Rick Tap on Unsplash

The Big Short is a book written by Michael Lewis, an ex-investment banker turned writer. His first book I read is Liar’s Poker, a very fascinating and entertaining tale of Wall Street back in the 1980s.

With the Big Short, the author wants to create another “Liar’s Poker” of the twentieth century. The book is the story of how Wall Street led the world into the Great Financial Crisis in 2007–2008, focusing on how three different groups of people foresaw the doomsday of the financial market caused by the subprime mortgage and their bets against it.

Here are the things I’ve learnt from the book:

  • Wall Street, or the financial market, has been structured in a way that monetary incentives drive its people’s greed to the extreme. It draws very bright and smart people, who in turn come up with very innovative products and ways to make more and more money for their firms and for themselves. In the process, they put their interests above anything and anyone else. Investor interests lie at the bottom of the concern scale. Using Lewis’ language, “investors are f**ked”.
  • A subprime mortgage bond is created from a pile of subprime loans made to homeowners. It’s called “subprime” because the credit quality of these borrowers is below the standard. At one time in American history, a stripper, a strawberry picker, and a domestic helper owned five houses each. They could do that because the banks lent them freely, sometimes requiring borrowers no document to prove their credit history. Subprime mortgage bonds were rated by the rating agencies and blessed with high ratings because somehow Wall Street managed to trick the rating companies into agreeing that different loans in a subprime bond will bring about diversity, which will lower its risk. In fact, the different loans in a subprime bond are prone to the same underlying fundamentals. When one loan collapses, the possibility of the other loans in the bond to follow is very high.
  • The complexity does not stop just yet. Mezzanine tranches of many subprime bonds are packaged to create another product, called CDO — collateralized debt obligation, a confusing terminology like many other terminologies used in the subprime mortgage market to hide their true nature. A CDO then has a few tranches, or what is called in the book, “floors”. The lowest floor bears the highest interest rate, but also the highest risk. The highest floor gives the lowest return but has the highest level of protection. Think of a CDO like a house with different floors. When a flood hits, its lowest floor gets flooded first, subsequently the higher floors. Triple-B rated bonds, when packaged up to be a CDO, were magically turned into triple-A by the rating agencies.
  • Then there is CDS, credit default swap, which is insurance on CDO. A CDS buyer buys protection on a CDO in the event the CDO defaults. The main characters in the book shorted the market mainly via buying a long CDS position. They bought CDSes from investment banks, who sold them to earn the annual premiums buyers paid them. However, the ultimate protection bearers of CDSes were not Wall Street banks, but companies like AIG who underwrote these policies and went into big liquidity troubles when subprime loans defaulted like a domino collapse. Wall Street made money by being the middle man. They, however, did not escape the trouble because they themselves hoarded billions of dollars worth of CDOs and ran into billions of losses.
  • The entire market relied on and trusted agencies’ ratings and bought into these toxic products with an assumption that high ratings mean high quality. Investors including high net worth individuals, pension funds, and other institutional investors in many parts of the world stocked up these products in their portfolios without understanding their complexity and risk. They were not alone in not apprehending these products because even many people on Wall Street understood little or none either.
  • It pays to be an outsider. The three groups of people featured in the story as among those who saw the crisis coming and made millions of dollars by betting against it are outliers in different ways. The commonality among them is that they took a step outside the crazy circle of Wall Street to evaluate the fundamentals of the market and think for themselves. It sure took a lot of clarity of mind and bravery of heart to do what they did. Among the three, Steve Eismann and his two partners had the closest connection to Wall Street, but they distrusted Wall Street. Michael Burry, a one-eyed money manager with a neurology background, kept his bets in spite of the threats and isolation from his investors. Charlie Ledley and Jamie Mai, two young amateurs founded a money management company of their own and made millions of dollars from an initial $110,000k. They studied the market with its fundamentals, using their senses and expecting the Armageddon to come one day when the “teaser-rate” ended. They became very rich when what they had expected came true. But they all grew disenchanted with the society and the way it allowed the financial market to rip off investors in order to profit the pockets of Wall Street banks.

To all graduates, go do something else meaningful in life instead of working for Wall Street.

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