Weekend Book Review: The Big Short

Michael Lewis has put together a great book on subprime loans, home mortgage bonds and how their crash led to the Great Panic.

The Big Short starts with this quote:

The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him. – Leo Tolstoy, 1897

That was the challenge in 2006. To not be considered insane when standing apart from the mass hysteria to say the financial news is wrong and “the most important financial people are either lying or deluded.” People were quitting their jobs to become real estate investors. House buyers, lenders and the purchaser of home mortgage bonds seemed to think that house prices in the United States would never decrease.

I really enjoyed The Blind Side: Evolution of a Game. (The book not the movie. The book was about the evolution of football, using the unusual background of Michael Oher as a lens. It was not the sappy family story that was in the movie.) That turned me into a Michael Lewis fan. (Even though Liar’s Poker and Moneyball have not yet risen to the top of my reading list.)

In The Big Short, Lewis uses two people who saw the problems to act as the lens for the story. Michael Burry is a one-eyed hedge fund manager with Asperger’s syndrome. Burry liked to remain isolated from public opinion and human contact. He focused on hard data and the incentives involved in the human behavior in the financial markets. Steve Eisman was another money manager. Eisman was convinced that the subprime mortgage market was full of corruption and exploitation.

Lewis points out how Wall Street was gaming the rating agencies. One example is that the agencies were looking at an average credit score of the borrower, not each individual borrower. So Wall Street would package a barbell of loans. Throw together a bunch of credit scores that are horrible and very likely to default. Then sprinkle in enough loans with high credit scores to get the average credit score just right.

The rating agencies has flawed formulas and Wall Street knew it. After all, Wall Street helped create the formulas. Lewis paints a very dim view of rating agencies.

The rating agencies gave bonds full of floating rate loans a higher rating than those with fixed interest rates. The flawed logic was that borrowers would be just as likely to make payments at 12% as they were at 8%. Obviously, the bigger problem was that borrowers couldn’t make the payments at 8% in the first place.

Eisman and Bury both saw the flaws in the system and made big bets against sub-prime mortgage bonds using credit default swaps. They saw lots of subprime loans being made with loan interest rate teasers that would reset in two years. The borrowers couldn’t afford the property at the teaser rate and would clearly default when the rate reset unless property values continued their astronomical increases.

Lewis did write a great article in Vanity Fair on Iceland’s Financial Metldown if you need a taste of his writing. That story paints a similar of tale of over-exuberance in the financial markets.

The Big Short does a great job of explaining how loans are packaged into commercial mortgage backed securities (CMBS), then sliced up into tranches and sold as bonds, repaid by the cash flow from underlying mortgages. The tranches that get paid first receive the highest rating of AAA, labeling them as nearly risk free as US Treasury bonds.

Then Lewis focuses squarely on collateral debt obligations (CDOs) that repackage the poorly rated tranches of CMBS into new mortgage bonds. As with the CMBS, the tranches that got repaid first received the AAA rating. That was the alchemy, turning garbage into gold.

Lewis does a good job of explaining how all of these mortgage bonds work. If you want more detail on the market for subprime mortgage-backed CDOs read the thesis from A.K. Barnett-Hart, a Harvard undergraduate: The Story of the CDO Market Meltdown: An Empirical Analysis. Lewis cites her thesis as being more interesting than any Wall Street research on the topic.

The Tolstoy quote points out that many on Wall Street did not understand how they worked and did not understand the risks involved.

I recommend that you add The Big Short to your reading list and move it to the top of the list.