The Big Short

Michael Lewis, “The Big Short (Inside the Doomsday Machine)”, W.W. Norton & Co, 2010, 266 Pages

Michael Lewis really knows how to write a book that laymen can understand. This is another must have book.

Unlike other financial books which follow the Fed, Treasury, or investment banks, this book follows some rather peculiar investors who determined early on, 2003, the folly of the subprime mortgage business. This book follows Michael Burry, Steve Eisman and other investors as they build their credit-default-swap positions. This looming catastrophe turned the few like minded investors into short sellers.

Shorting is difficult. “When you’re short, the whole world is against you,”. And as John Maynard Keynes noted, the market can stay irrational longer than an investor can stay solvent. The short bets on subprime mortgages didn’t pay off in 2006, even as the under¬lying housing market began to weaken. Those few hedge funds shorting this irrational market had a hard time in 2006 as their investors castigated them.

In 2007, however, it all came down: marginal lenders defaulted, subprime firms went belly up, two Bear Stearns hedge funds that invested heavily in subprime collapsed. The big short positions paid off. In 2007, Lewis writes, Eisman’s subprime short paid off so well that his fund’s assets rose “from a bit over $700 million to $1.5 billion.” Michael Burry racked up $720 million in profits for his investors.

My Notes:
Pg. xv: The 1980s financial debacle, described in Lewis’s book “Liar Poker,” did not awaken government that a reform of the regulation system was needed. Nobody seemed to place any importance on the fact that Wall Street gave up the partnership organization structure and became publically traded entities. This demise of the partnerships would lead to the socialization of losses and privatization of profits. Quickly the pay and bonuses became outrageous, and continued to escalate through the decades after the scandal that sank Drexel Burnham, the scandal that destroyed Salomon Brothers, the collapse of Long Term Capital Management, & the Internet bubble.

Pg. 7: The big fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all.
At the time, investors could bet against bonds of corporations through credit-default swaps — contracts that function as insurance policies that pay off in the event of default. But credit-default swaps didn’t exist on subprime bonds. Burry pestered Wall Street firms until Deutsche Bank agreed to sell him swaps on a batch of subprime bonds in May 2005. By July, he had amassed credit-¬default swaps on $750 million in bonds.

Pg. 94: Ivy Zelman maintains that the ratio of median home price to income is a simple measure of sanity for the industry. Historically, in the U.S., the ratio ran around 3:1; by late 2004, it had risen nationally, to a 4:1. But the problem wasn’t just that it was 4:1. In Los Angeles it was 10:1 and in Miami, 8.5:1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.

Pg. 99: The highest possible FICO score was 850; the lowest was 300; the U.S. median was 723. These scores were misused by the rating agencies. Moody’s and S&P asked the loan packagers not for a list of the FICO scores of all the borrowers but for the average FICO score of the pool. To meet the rating agencies’ standards-to maximize the percentage of triple-A-rated bonds created from any given pool of loans—the average FICO score of the borrowers in the pool needed to be around 615. Now a pool of loans composed of borrowers all of whom had a FICO score of 615 was less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680. A customer with a FICO of 550 was almost certain to default. But the hole in the rating agencies’ models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615.
In any event, the distinction became superficial:
Alt-A borrowers had FICO scores above 680
Subprime borrowers had FICO scores below 680

Alt-A loans were poorly documented, however; the borrower would fail to provide proof of income, for instance. In practice, Alt-A mortgage loans made in the U.S. between 2004 and 2007 totaling $1.2 trillion were as likely to default as subprime loans totaling $1.8 trillion.

Pg. 115: The Black-Scholes models for pricing options thought of the financial world as an orderly, continuous process (normal distributions). This is a serious error based on an erroneous assumption. The same assumptions that Modern Portfolio theory is premised upon.

Pg. 169: The rating agencies were giving bonds backed by floating-rate mortgages higher ratings than bonds backed by fixed-rate mortgages—which is why floating rates had risen in the five years previous to 2007 from 40 to 80. (You can’t make this stuff up).

Pg. 172: One of the reasons Wall Street had cooked up this new industry called structured finance was that its old-fashioned business was every day less profitable. The profits in stockbroking, along with those in the more conventional sorts of bond broking, had been squashed by Internet competition. Then the market stopped buying subprime mortgage bonds and CDOs backed by subprime mortgage bonds and the investment banks were then in trouble. They made it worse by holding these toxic assets on their own books. Of course their was no disclosure so you could not determine exactly what they had on their balance sheets.

Pg. 228: By June 2007 Bear Stearns had increased its leverage in five years from 20:1 to 40:1. Merrill Lynch’s had gone from 16:1 to 32:1; Morgan Stanley and Citigroup were now at 33:1. Goldman Sachs looked conservative at 25:1, but then Goldman had a gift for disguising how leveraged it actually was. To bankrupt any of these firms, all that was required was a very slight decline in the value of their assets. (Of course, home prices never fall).