“That’s why opportunity exists. It’s nobody’s job” – Greg Lippmann
In May 2007, I graduated from college and was excited to finally join the workforce with a job in Manhattan. As a wide eyed graduate fresh out of school, the transition to work was a significant life adjustment. I had no idea that I would also be witnessing the worst financial catastrophe since the Great Depression. The first dominoes fell in 2007 when subprime mortgages began to default at drastic rates. Mortgage lenders, such as Countrywide Financial, would fall soon after. However, calamity was not isolated to those lenders. Financial institutions were exposed due to their long positions in the related mortgage backed securities too. In March 2008, Bear Stearns shockingly faced collapsed but was bailed out when they were purchased by JP Morgan Chase. However, the run on investment banks did not stop with Bear. While it was too big to fail, Lehman Brothers was not. On September 15, 2008, Lehman Brothers filed for bankruptcy and the world faced financial Armageddon. I remember that day very vividly. Naturally, there was a lot of fear and anxiety of what would happen next and whether the world was sliding into another Great Depression. I worked on a client whose office is close to the former Lehman Brothers’ headquarters in midtown Manhattan. Since I understood that day would be remembered infamously for symbolizing the financial crisis that ensued, I needed to see the devastation for myself. I walked over to the Lehman Brothers building and watched as its employees somberly left with boxes containing their belongings from the office. I also remember an anarchist gleefully holding up a sign celebrating the beginning of financial Armageddon. Luckily, we never fell into a Depression. Nevertheless, I stood across the street from the Lehman Brothers office on that day stunned and asking myself “How did all this happen? How did we get to this point?”
It has been a decade since the financial crisis. The underlying reasons for it have been dissected and written about by many writers. We understand why and how the disaster occurred. The best book I have read about the financial crisis is definitely Michael Lewis’s The Big Short: Inside the Doomsday Machine (The Big Short). Lewis is a brilliant writer and storyteller who has an uncanny ability to explain complicated situations in plain words and an interesting way. His other great works include Liar’s Poker (1989), Moneyball: The Art of Winning an Unfair Game (2003), and The Blind Side: Evolution of a Game (2006). In The Big Short, he does a phenomenal job explaining the complexities of mortgage back securities and credit default swaps and what specifically went wrong leading up to the financial crisis. He tells the story through the eyes of the individuals who identified the real estate bubble and acted to short the market and make hundreds of millions of dollars off of it: Frontpoint’s Steve Eisman, Scion Capital’s Michael Burry, Deutsche Bank’s Greg Lippman, and Cornwall Capital’s Jamie Mai, Charlie Ledley, and Ben Hockett. It definitely helps Lewis’s book that each of these people are characters with fascinating stories. Moreover, they share with Lewis how they diligently uncovered the indicators and brilliantly devised a way to profit off of the knowledge. In this regard, the story is like a mystery novel. Even though we know how it ends, it is still very interesting to see how very different people put together the pieces and came to a similar conclusion. Nevertheless, shorting a market is not cheap. All of these people need to stick to their convictions. Some of them even need to fend off their own investors so they can make them a lot of money. Naturally, there are moments when they question their conclusions or whether the market is rigged when it should begin correcting itself but does not do so immediately. There is a lot of drama in regards to empathizing with the stress and confusion they experience while waiting for their trades to pay off and keeping their investors at bay before they force them to liquidate the trades that will pay off. These tense moments totally keep the book interesting throughout even though we know the ending. Of course, the book is written from the perspective of the winners. As a result, it prods Wall Street for the blunders it makes. Nevertheless, the book presents enough of Wall Street’s perspective to understand why they think they made good trades even though they clearly did not understand the pitfalls that become obvious after the collapse.
The book has also subsequently been adapted into a film, The Big Short (2015). It is a very successful film that was nominated for five Academy Awards, including Best Picture, Best Director, Best Supporting Actor in Christian Bale, Best Film Edit, and Best Adapted Screenplay [which it won]. Christian Bale plays Michael Burry. The other people featured in the book are not mentioned by name but they are portrayed by a corresponding movie character who is based on them. The movie does a good job explaining the causes of the financial crisis with simple analogies that movie audiences can understand (e.g. using celebrities Margot Robbie, Anthony Bourdain, and Selena Gomez to explain complex concepts in plain language) and hitting the key points of the book within a 2 hour run time. In addition, the movie’s disdain for Wall Street is obvious as the characters make explicit rants against it. Naturally, it is expected because anti-Wall Street sentiment has become prevalent after the crisis. In my opinion, the movie is good but the book is much better. The book is not constrained by a time limit and does not need some of the theatrics a movie likes to use. For this reason, the book’s explanation of the crisis and telling of the stories of the characters is much more thorough and comprehensive. I definitely recommend the book for anyone who wants to understand the financial crisis or watched the movie.
The people Michael Lewis highlights in The Big Short are unique individuals with compelling stories. The first is Steve Eisman. In the movie, Steve Carrell’s Mark Baum is based on Eisman. He starts his career as an Aames Financial analyst. He makes his name when he refuses to change his analysis on a company and is later proven correct: “The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment”. Like Carrell’s Baum in the movie, Eisman can be overbearing and blunt. His wife, Valerie Feigan, has the perfect description of her husband: “Even on Wall Street people think he’s rude and obnoxious and aggressive. He’s not tactically rude. He’s sincerely rude”. Another defining characteristic of Eisman is his insatiable curiosity. Once he sets his mind on something, he cannot let it go until he completely dissects it. A funny example is his study of the Talmud as a young man “not because he had the slightest interest in God but because he was curious about its internal contradictions”. This point is also portrayed in the film when Baum’s rabbi complains about him trying to find inconsistencies in the “word of God” to his mother. In response, she hilariously asks, “Did he find any?” It is a trait that serves him well in uncovering the hidden indicators of the financial crisis. In the movie, Baum is also grief stricken by the suicide of his brother. In real life, Eisman deals with an even more heartbreaking tragedy: the death of his newborn and first child, Max. Naturally, the death of one’s child is incomprehensible. Lewis does a good job linking how this life event shapes Eisman’s cynical view of the world.
Eisman and the fictional Baum have Vincent “Vinny” Daniel, who is portrayed by Jeremy Strong in the movie, as a top lieutenant. Daniel graduates from SUNY Binghamton and starts his career at Arthur Andersen, which was one of the “Big Five” accounting firms before it was dissolved after the Enron scandal. Vinny does not last long at Arthur Andersen. He constantly asks questions about the Wall Street firm he is assigned to audit. After a few months, his manager grows weary of his questions because he cannot answer them and scolds him that “Vinny, it’s not your job. I hired you to do XYZ, do XYZ and shut your mouth”. In this moment, Vinny knows to leave the firm. For anyone with “Big Four” experience, it is a relatable observation. The big accounting firms are great in training graduates straight out of college to do XYZ then move up into leadership positions and teach fresh staff how to do XYZ. However, there are strict time and budget constraints on completing audits. For this reason, auditors are generally fixated on completing XYZ but their firms could do better in teaching them how to audit and challenge their client’s accounting and valuations. It is definitely one of the key challenges and considerations of the auditing profession going forward. For someone like Vinny who is compelled to challenge the status quo, it is no surprise that he does not last long at Arthur Andersen.
Another main character in the book is Michael Burry, who is portrayed by Christian Bale in the film. In my opinion, he is the most interesting and unique person in the book. As a two year old, he loses an eye due to a tumor. Eventually, he goes to college to be a doctor. He is a rare case of a person who does not enjoy medicine but goes into the field because he does not find medical school difficult. His investment career starts on a message board and his personal blog. He picks and comments on stocks in his spare time when he is not practicing medicine. Of course, other investors notice his uncanny ability to select winners and they make money by piggybacking off his picks. Eventually, he garners the attention of big companies. One of them, Gotham Capital, and its founder Joel Greenblatt stakes Burry with capital to start Scion Capital. Burry’s investing philosophy centers on sage advice that he hears the legendary Warren Buffett say: “If you are going to be a great investor, you have to fit the style to who you are.” Buffett’s mentor is Ben Graham. Although he learned from Graham, he does not copy him. Similarly, Burry learns from other successful investors but does not copy any of them. Burry is a unicorn and he knows he can excel doing it his way. He is also atypical from other money managers in other ways. He turns away money. He does not think it matters if investors love their money manager. In other words, he is socially awkward and has trouble connecting and communicating with other human beings. In the film, Bale accurately portrays Burry as socially unaware and peculiar. Even when he tries to compliment someone, it comes out wrong. For example, he attempts to praise a job candidate’s haircut but accidentally insults him by asking “Did you do it yourself?” Burry does not try to be rude. It is just an accident that others perceives his words as such. His other oddities include dressing casually in the workplace and playing heavy metal music in his office.
His poor communication skills are fine when he makes his investors a ton of money because he they do not ask many questions as long as he produces results. However, it is a significant detriment in lean times when investors need to feel comfortable and have reassurance. Obviously, he does not understand the need to manage feelings and expectations. When he is questioned, he responds logically but awkwardly and bluntly. Naturally, it is terrible customer service but Burry has no patience or care for it. His personality flaws cause a lot of drama when he gets questioned on his short positions. Nevertheless, his manners and investing philosophies are “bad for business but good for investing”. He ensures he has the proper incentive to generate higher returns for his fund. Instead of taking the standard 2 percent of assets managed as other money managers do, he charges actual expenses and only takes a return for himself when he makes his investors’ money grow. In his industry, his practice is unheard of but it definitely provides him the proper motivation to make money instead of just manage a lot of it. In the book, it also details why Burry is socially awkward and how he finds out the reason indirectly. His son is a little different like Burry. At school, the teachers diagnose his son with Asperger’s. In this moment, Burry realizes he also has Asperger’s and passed it on to his son. One of the symptoms of Asperger’s is being abnormally intense and focused on one’s interests. People with the disorder feel restricted to those interests and perform them repetitively. Burry realizes that it is extremely fortunate that his interest is financial investments. It explains why he is a great investor because he will dissect information and drill into it more than most people will until he finds a trend or conclusion he can utilize to make brilliant investment decisions.
The next person Michael Lewis follows in the book is Greg Lippmann, who works for Deutsche Bank leading up to and during the financial crisis. In the film, Ryan Gosling’s Jared Vennett is based on Lippmann. He is a great bond trader. Lippmann is blunt and “said things”. He detects the “shadowy motives” in everything. An example in the book is if an alumni of a school donates $20 million to his alma mater, Lippmann will immediately assume the person is only doing it to get his name on a building on campus. Without a doubt, his skeptical nature is a reason he is able to identify the real estate bubble before it bursts. In telling his story, Lewis explains how Lippmann does not feel too much loyalty to the firms he works for. They are just places he is working for at any given time to make money. Lippmann also provides brilliant insight on employee compensation from the perspective of companies. He notes that an employee’s feelings about his pay is either happy, satisfied, dissatisfied, or disgusted. The sweet spot for employers is between disgusted and dissatisfied. If someone is happy, his employer is paying him too much. If he is disgusted, the firm risks losing a valuable contributor to its organization. As a result, Lippmann’s identification of the sweet spot is hilarious but true. It makes total sense for anyone who works and been through a compensation discussion. I never thought of it like the way Lippmann describes it before I read the book but cannot think of it any other way since reading it. Lippmann’s story intertwines with Eisman’s story when he pitches the idea to short the housing market to Eisman’s team. At the time, Eisman is already shorting mortgage originators, New Century and Indymac bank, at a cost of $32 million per year. Eisman’s lieutenants, Vinny Daniel and Danny Moses, are very skeptical and accusatory of Lippmann. On the other hand, they should be because Lippmann is selling an idea that basically bets against his own firm, Deutsche Bank, and thus his self-interest. For this reason, they suspect that Lippmann is trying to hustle them. Of course, they should be professionally skeptical of Lippmann’s motives especially when his pitch seems too good to be true. Unbeknownst to them, Lippmann is being generous because he entered into expensive short positions for Deutsche Bank but his superiors told him that he could only keep them if he proved there is a market for his positions. Consequently, he is engaging funds like Eisman’s to foster a market and prove there are investors out there who would buy his positions if he wanted to sell them.
The final set of main characters Lewis follows in the book are Jamie Mai and Charlie Ledley. They start their small fund in a shed in Berkeley and call it Cornwall Capital. In the film, Jamie Shipley (Finn Wittrock) and Charlie Geller (John Magaro) represent each person respectively. In the book, they are described as young eager beavers who stumble upon then realize the once in a lifetime opportunity to make a fortune off a grossly mispriced subprime market. Compared to the more experienced investors in the book, Jamie and Charlie can be described as “innocent”. Due to their inexperience and the modest size of their fund, they have trouble getting taken seriously by the big Wall Street firms. It is especially a problem when they try to get an ISDA agreement, which will give them access to trade derivatives. When they call up the big boys, such as JP Morgan or Bank of America, they are laughed at and called names (e.g. “Cornhole” Capital). Nevertheless, they stay persistent and do not get deterred even though the experience is humiliating and humbling. Eventually, they hire Ben Hockett, who has previous work experience at Deutsche Bank selling and trading derivatives in his early thirties. In the book, Brad Pitt’s Ben Rickert is based on Hockett. However, Pitt’s Rickert is much older and portrayed as a wise, retired trader who is brought back into the game by Jamie and Charlie. In both cases, the real Ben and fictional Ben help Cornwall Capital obtain the ISDA agreement through Deutsche Bank, Hockett’s previous employer where he still has connections. Normally, it requires $2 billion in capital for a fund or company to be treated as an institution. As result, it is a big deal that a small fund with tens of millions of dollars is able to obtain an ISDA and be treated like a financial institution. Cornwall Capital is an inspiring story because it shows that no one is ever too young to challenge the status quo, work hard, perform enhanced due diligence, and stay resilient to find a golden opportunity unnoticed by others and profit off of it.
One of the most amazing aspects of Lewis’s book is how it details how these very different and unique individuals arrive at the same conclusion about the housing market and make fortunes off of it. Of course, understanding their analyses requires understanding how mortgage backed securities (MBS) work. Lewis is thorough in explaining the history of the securities and how they work. At a high level, MBSs are comprised of many mortgages which are securitized into different tranches that represent various levels of risk of prepayment or default. For example, a lower credit rating (e.g. BBB) is higher risk but the interest rate for that tier is higher to entice an investor to take on the risk. In that tranche, the risk of prepayment is higher too so the risk of it is also factored into the additional yield. On the other hand, a higher credit rating e.g. (AAA) is a lower risk of default and prepayment so it has a lower yield. I picture it like a pyramid with multiple levels. In the event of a flood, the lower levels bear the brunt of the risk of being wiped out. The highest levels are most likely safe unless it is a catastrophe. In the 1980s, the fear of investing in mortgage bonds was the risk of prepayment and not default. Since mortgages would only be re-financed when rates are lower, holders of the bonds risked prepayments and getting their principal back at times when they did not want it because they would be forced to reinvest in times rates or yields are lower. Accordingly, MBSs were created to address the issue. In addition, the large pool of mortgages in the bonds/ securities provide diversification that minimizes default risk. For all those reasons, MBSs added a lot of value to the market. Eventually, the idea occurred to take the concept another step and create subprime MBSs that would diversify the risk of lending to significantly riskier borrowers: low income, no income, or no documents to prove income. In addition to theoretically diversifying the risk, these MBSs had higher yields because the borrowers are riskier. It is the basic investing rule of higher risk, higher returns.
The book does an excellent job describing how each of the highlighted investors piece together the clues to figure out that subprime MBSs are ticking time bombs. This part of the book is very interesting because it is like following detectives uncovering clues and solving the mystery. We have all met or know people who continually spew predictions of doom because they are anarchistic and want to see the system or civilization collapse. In other instances, they speak of impending calamity to sell some idea they have. However, these individuals usually speak in generalities and do not know any specifics (why, how, when, etc.). In reality, they do not know anything. They are cynics who talk until something bad happens then take credit for it. Only individuals who do not know any better believe the nonsense they are spewing. What makes The Big Short different and so fascinating is that the investors in the book know exactly why and when the market is going to crash and how to short it to make a fortune. In the book and the film, Mike Burry gets the most credit for deciphering the situation and conceptualizing a way to profit from it. Burry reads the subprime MBS prospectuses, analyzes the underlying mortgages, and makes startling revelations. First, the subprime loans are fixed the first two years then floating. The fixed rates are at lower teaser rates to incentivize borrowers to enter into the mortgages. The floating rates later on will be too expensive for subprime lenders to pay. However, they do not need to so as long as the value of their homes continue to increase and they can use the equity to borrow more. Burry understands that the reset interest rates and the home values will become issues beginning in 2007. He knows the general time period, but not the exact time, the loans and related MBSs will begin to default. As such, he needs a financial instrument that allows him to short the market but provide a period of time when he has a high confidence level that the projected credit events will occur. For this reason, he conceives the idea of utilizing credit default swaps (CDS) for speculation. The swaps allow him to buy insurance on securities he does not own nor does he want to own. In addition, it solves the timing issue because it allows him to be paid based on a credit event that occurs within the length of the swap (e.g. 5 years, 10 years, etc.). Moreover, Burry is smart enough to realize that he needs to buy the CDSs from firms that will survive the financial calamity. If he buys the swaps from firms that fail, the swaps will be worthless. After he concocts his plan, he goes around Wall Street asking to buy the swaps. The firms have no idea what he is seeing. Most of them do not pay him any attention. Only Deutsche Bank and Goldman Sachs even continue the conversation. He persists and firms eventually sell him the swaps. Burry picks the MBSs, on which the swaps are bought on, based on reading the prospectuses for specific indicators: loan to value, second liens, and absence of loan documentation. Since the banks do not comprehend why he is buying insurance on securities that seem unlikely to suffer any significant losses, they do not care what MBSs he buys them on because he seems like a fool giving them free money. He plays dumb and buys in increments as investments banks sell him more and more swaps. In every aspect, Burry’s analyses on identifying the issues, creating a way to successfully short the market, and execution of his plan are absolutely brilliant.
Greg Lippmann arrives at a similar conclusion to Burry’s. Lippmann realizes that the CDS solve the timing issue and allow buyers to bet on shorting the housing market without laying out cash. In addition, it provides the opportunity to win many more times [the massive notional value of the swaps] than times a buyer could lose via the fixed premiums paid to own the swaps. Lippmann also watches as his counterparts at Goldman Sachs convince AIG to sell cheap insurance on the subprime market via CDSs. While Goldman is still selling subprime bonds to its customers, it is also betting against those same bonds by purchasing CDSs. If true, it is obviously a conflict of interest and unethical. Michael Lewis reached out to Goldman when he wrote the book. Not surprisingly, it did not comment. Of course, the primary reason is legal. Next, there is really no way to win a public relations battle when the public already assumes guilt. Saying anything will only make it worse. In 2016, Goldman settled with the Department of Justice for $5 billion related to misleading investors. While most defendants usually do not admit guilt in settlements, the DOJ actually got Goldman to agree to a statement of facts that describes “how Goldman made false and misleading representations to prospective investors about the characteristics of the loans it securitized and the ways in which Goldman would protect investors in its RMBS from harm”. Again, Lippmann enters into CDS positions himself but needs to prove to his employer, Deutsche Bank, that there is an active market for it to allow him keep them.
As such, Lippmann sells the idea to Steve Eisman and his team. Although they wisely question and keep their professional skepticism of Lippmann, they also understand it does not hurt for them to independently verify the claims. Accordingly, they study the structures of the MBSs as well as the rating models used by the ratings agencies to assess them. Moreover, they make site visits to various real estate markets to evaluate the underlying assets of the MBSs, the homes and neighborhoods the mortgages were taken out on. Based on their due diligence, they arrive at some eye opening observations. First, they encounter a housekeeper who bought six townhouses by refinancing when a house rose in value in order to buy another one. She replicated the process many times until the values of the homes decreased and she could no longer borrow nor make payment on the homes. Next, Eisman’s team analyze the models of the ratings agencies, most notably S&P and Moody’s, and identify the flaw in the system. The primary input into the models is fixed FICO scores. For this input, the agencies rely on the models and general characteristics of the mortgages as a group. They do not look at individual home loans before assigning ratings. Moreover, they relied heavily on the average FICO score of the pool which could easily be manipulated. For example, high thin FICO scores are given to borrowers who have yet to borrow money. Since they have never borrowed, they have never failed to repay. Lewis’s example in the book are a Jamaican baby nurse and a strawberry picker, who never failed to pay because they never borrowed. These individuals are great finds for any MBS originator who wants to completely distort the credit worthiness of the pool by manipulating the models with high thin FICO scores. In addition, Eisman’s team speaks with a Moody’s employee during a subprime mortgage conference in Orlando. During the conversation, the employee notes that she has not been allowed to downgrade MBSs in the past because her boss overrode her. It points to the conflict of interest that the ratings agencies have been accused of. Since they are paid by the originators of the MBSs, it is really not in their interest to downgrade, upset their client, and lose the business. Eisman’s team also notes that the subprime rating model changed on July 1, 2006 but the MBSs rated before that date would continue to be rated with the old models. It is a striking observation since it makes no sense to grandfather flawed models that generate junk ratings. From all these observations, Eisman and his team confirm Lippman’s claims and join him in shorting the housing market.
In terms of Cornwall Capital, they are late [but not too late] to the game. By the time they become interested in trades, similar to the ones made by Burry and Eisman, to short the market, they already have the benefit of reviewing analyses that are already out there instead of starting from scratch. They quickly get up to speed on FICO scores and loan to values of California and Florida. Again, they are the innocent ones of the group of investors highlighted in the book. At the beginning of Cornwall Capital, they start with $100 thousand then make a small fortune of tens of millions by making educated speculation bets. Their general strategy is to search for long shot bets (e.g. having a 10:1 chance of hitting) that are mispriced (e.g. valued as if the chance of occurring is 100:1). They do not expect to hit on all of their bets. In fact, there are many that may not go their way. Nevertheless, their strategy accounts for losing. Since they are betting on long shots, the cost of entering into the trades is significantly less than trying to invest in assets with more predictable and better odds of gains. However, they lose little when they lose but gain a lot when they hit on a long shot. As one could see, the use of credit default swaps to short MBSs fits in perfectly with their strategy. Nevertheless, they do not completely understand what they purchase. Burry, Lippmann, or Eisman develop a much clearer picture on why their shorts will pay off. Cornwall Capital buys the swaps believing the chance of winning is a long shot but mispriced at the cheap prices the banks are selling them at. Although the swaps are grossly undervalued, they are not long shots. Unlike the other investors who understand that the bursting of the housing bubble is inevitable, Cornwall Capital identifies a mispricing of the market but kind of stumbles on to the “Big Short”. On the other hand, it does get credit for realizing a fact none of the more experienced investors knew. Cornwall Capital realizes that the AA rated MBSs have the same risk as the BBB rated MBSs even though AA securities are supposed to be much safer. Accordingly, they brilliantly short the AA MBSs. Why pay 2 percent to bet against BBB rated bonds when you could pay 0.5 percent a year to effectively replicate the same bet? It is amazing and very interesting how very different individuals (Burry, Lippmann, Eisman, and Jamie Mai and Charlie Ledley) arrive at similar conclusions to enter into the same bets that reward them with fortunes. Again, it goes back to the Warren Buffett quote noted by Burry: “If you are going to be a great investor, you have to fit the style to who you are.” Each of them do it their own way with various nuances. In the end, they are all very successful in their endeavors.
Although we retrospectively know the credit default swaps will pay off handsomely, it is not so clear they will in the moment for our characters in the fog of war. One of the most fascinating parts of the book is empathizing with how they still need to sweat out the trades even though they are certain they are correct about the market. It is not very easy to hold the short positions. The most intense example is Burry’s experience. When the Scion investors learn of his massive CDS bets, they are not happy. They want him to pick stocks instead of betting on macroeconomic trends. In 5 years managing Scion, Burry is up 242% for his investors. He assumes he has to “rope to hang himself”. He assumes wrong. When his investors email him to voice their concern, his abrasive communication style does very little to alieve fears. Even when credit events begin to occur and his swaps should begin to increase in value and pay off, the valuations actually go against him. Of course, the valuation of swaps involves a lot of judgment and non-observable inputs. Burry learns that the short term value of his bets are not determined by a free market. Instead, they are determined by Goldman Sachs, Bank of America, Morgan Stanley, etc. In Lewis’s words, it is as if the entire financial market tried to change its mind and then realize that it could not afford to do so. When there is good news for the housing market, the investment banks ask for collateral from Scion. When there is bad news, it is “pooh-poohed” as irrelevant to his specific bets. In other words, the investment banks are valuing the trades and they do not have incentive to recognize a mark against themselves unless they are absolutely forced to. Consequently, Burry and the other investors shorting the market realize they are facing a rigged system.
Moreover, Burry is concerned with a provision in his CDS contracts that allow for the Wall Street firms to cancel the swaps if Scion’s assets fall below a certain level. With the expensive premiums it has been paying on the swaps for a couple of years and the valuations continuing to go against it, Burry’s investors are naturally feeling uneasy about the situation. From their perspective, Burry is being stubborn and not listening to reason by keeping his trades. More importantly, they are costing them a lot of the money. Since he entered the trades, the S&P is up 10 percent while he is down 18.4%. Although he is still up 186% for his investors during the entire life of the fund, they are going by the old adage of “what have you done for me lately”. They are definitely nervous. If they start pulling their money, Burry’s trades will get canceled and never pay off. More seriously, Scion is done as a fund. However, he figures out a loophole in Scion’s by laws. As the money manager, he can lockup the investors’ capital and restrict them from pulling out their money if he deems the fund is invested “in securities for which there is no public market or that are not freely tradable”. Obviously, his investors are incensed. Specifically, Joel Greenblatt and John Petry of Gotham Capital, the fund that initially staked him to start Scion, fly over to California to pressure him and threaten to sue him. For Burry, it is a very stressful and tense experience. In terms of the story, it keeps the situation interesting even though the ending is spoiled for the reader already.
Similarly, Greg Lippmann is paying expensive premiums, $100 million per year, to short the market. He is still getting fees from facilitating the sale of similar swaps but his buyer start to suspect Wall Street is rigging the marks so that the swaps will never pay off. In order to reassure and allay the fears of his buyers, Lippmann devises a clever idea to hold a conference for the mortgage market in Las Vegas so that his investors can meet the investors on the long position of the trades. He theorizes that his buyers will feel totally comfortable once they realize that the other side knows nothing. In the book and the film, the Las Vegas conference is a critical moment in the story. The highlight of the conference is when Steve Eisman meets Wing Chau, who runs Harding Advisory. In the movie, Mark Baum also speaks to Chau. In my opinion, the interaction in the book is much better than the scene in the film. Before joining Harding Advisory, Chau makes $140 thousand a year managing a portfolio at New York Life. He leaves his old job to work with collateralized debt obligations (CDO), which are asset backed securities that are backed by MBSs. As a CDO manager, he makes $26 million. In his conversation with Eisman, he admits that he does not worry about what is in the CDOs. His goal is to maximize the money in his care. He does not care about the quality of the investments because he has no exposure himself. In contrast to Burry who ensured he is motivated to make money for his investors, Chau has the wrong incentives and works for himself instead of his investors. He only cares to synthesize more and more bets because he is paid on volume. Accordingly, he multiplies his clients’ exposure and impending losses to the subprime market. During the interaction with Eisman, Chau also exudes a condescending tone. He declares that he loves people who short the market, like Eisman, so he can buy more. Accordingly, Eisman gets completely comfortable that the other side really does not know something he does not. He no longer needs to worry that he is getting hustled instead of doing the hustling. In addition, Eisman realizes that the garbage subprime loans have been replicated 100 times over and over again through the market’s use of CDSs and CDOs. As a result, the coming loses to the financial system will be much greater than the actual subprime market. Subsequent to the release of the book, Chau and Harding Advisory faced litigation because they “were shockingly oblivious to their fiduciary duties”. Although they were only fined $3 million, the judge also recommended that Chau “should be barred from the securities industry and that Harding should be stripped of its registration as an investment adviser”. During the trial, Chau lashes out in an incoherent and ridiculous manner. Of course, he blames Michael Lewis’s book for his predicament.
Eisman also has other revelations during the conference. He realizes that Wall Street just trusted the ratings agencies and do not understand the CDOs at all. In his words, “In Vegas it became clear to me that this entire huge industry was just trusting in the ratings. Everyone believed in the ratings, so they didn’t have to think about it.” In addition, he states his blunt opinions and disdain for the ratings agencies: “The rating agency people were all like government employees. Collectively they had more power than anyone in the bond markets, but individually they were nobodies”. He notes that the employees at the agencies are underpaid and the smarter ones will leave for Wall Street. In his opinion, they just do not care. In general, they are timid, fearful, and risk averse. The movie also portrays a classic Eisman moment from the book. During the scene, Mark Baum sits in on a seminar that is still optimistic about the subprime market. After the speaker notes that he expects subprime losses to stop at 5%, Baum interrupts by raising his hand and asking whether he thinks that 5% loss rate is a possibility or probability. When he answers a probability, Baum raises his hand again to show the number zero and shout zero to declare that the probability will be zero that losses stop at 5%. It is a moment straight out of the book that Eisman actually does. In the book, it is explained that he purposely has his wife call him so he can answer the phone and leave the room in dramatic fashion. Going to Las Vegas, he has $300 million in short positions. When he leaves, he recognizes the situation is worse than he could have imagined and increases his bet to $550 million. He shorts mortgage originators, home builders, rating agencies, and the banks. More specifically, he tells his team to short anything Chau has touched.
Eisman is not the only one attending the conference. Cornwall Capital is also present. Based on information they procure during the conference, they arrive at the revelation that their odds of hitting on their bet is significantly higher than they thought: “The market, and the rating agencies, effectively had set the odds of default at 1 in 200. They thought the odds were better than that – say, 1 in 10”. In a specific situation, Charlie asks a CDO guy from Bear Stearns his thoughts on the CDO market in 7 years. He responds “”Seven years? I don’t care about seven years. I just need it to last for another two.” Like Chau, that individual does not have the proper incentives or attitude. After the conference, Charlie, Ben, and Jamie believe the market is rigged. They attempt to go to the New York Times and Wall Street Journal to publish a story about it but neither newspaper has any interest in the matter. They also try to inform the SEC but it does not understand what they are suggesting. In the end, no one listens so instead, they buy $105 million in CDSs on Bear Stearns from HSBC for Cornwall Capital. If Eisman, Cornwall Capital, or anyone else has any thoughts they might have misread or misunderstood the market going into the Las Vegas Conference, they leave completely confident in their analyses and resulting trades. It is definitely one of the best chapters in the book.
So why would anyone, in his right mind, enter into long positions on mortgage backed securities or sell insurance on them? In retrospective, it makes no sense. The book provides a couple of stories from the other perspective. Of course, it is written from the winner’s perspective so the tone of the losing side is meant to make the reader shake his head. Nevertheless, one can understand why they entered into the trades if they consider the points objectively and ignore the tone of the book. Although the results prove the decisions are catastrophically wrong, the bases for most of those decisions are not entirely as insane or sinister as the general public likes to believe. One of the stories is about Joe Casano, who runs the AIG subprime department. Even though some of his employees bring up concerns with MBSs, he belittles their opinions about it because he believes he is getting free money selling CDSs on AAA rated bonds. He is a domineering personality with absolute power. Accordingly, there is no way to force him to reconsider his position if he is set on it. From his perspective, Moody’s and S&P have both signed off on the high ratings. In addition, US housing prices will need to fall everywhere for him to take substantial losses on the swaps. Since it has never happened before, he dismisses the possibility of it. For these reasons, he views any worries about his long positions as a waste of time when he can be directing his attention and effort to other matters that will continue to grow profits. Unfortunately, he never assesses the soundness of the rating agencies models, which are gravely flawed. The ratings models incorrectly assumes borrowers will continue to make interest payments when they are at higher rates once the floating rates kick in. Moreover, the ratings agencies do not account for the lack of history in the subprime bond market and have no history of a collapsing national real estate market to factor into their models. Casano does not realize he has sold insurance on MBSs that are 95% subprime and destined to fail. A more interesting story is the one about Howie Hubler of Morgan Stanley. He actually realizes there is a major problem with the subprime market. For this reason he buys $2 billion in CDSs on the B rated tranches. Again, holding the short positions are costly. Of course, his management is going to notice the significant expenses coming from the premiums of the CDSs. In order to offset the losses, he decides to sell $16 billion in CDSs on the A rated tranches to offset the premiums he is paying. Again, Cornwall Capital deduces that the A rated tranches actually carry the same risk as the B rated tranches. In Hubler’s defense, even Burry, Eisman, and Lippmann do not realize this fact. It speaks to the complexity of the securities, the underlying assets, and the underlying drivers for their collapse. With the benefit of hindsight, the problems become obvious. However, it is not so clear cut with the fog of war in the moment because the rating agencies and market are saying they are low risk, high quality assets.
Other critics may question why managements of the financial institutions did not do more to prevent the crisis. Their subprime divisions generated a good return but only a small part of their firms’ overall net income. For example, Joe Casano’s CDS’s generated only $180 million per year for AIG. As free money, it is a great return but modest compared to the revenue generated from the other businesses of the firm. Of course, we know it is not free money. The $180 million is unbelievably miniscule compared to the actual risk the swaps are taking on. For AIG’s management, there is very little reason to micromanage a department that they are being briefed is selling insurance on highly rated securities that appear riskless. For managements of all major financial institutions, they are managing trillions of dollars of assets. They need to take a risk based approach in overseeing their balance sheets. Of course, it is impossible to justify that they understood the risks when the results are so catastrophic. In addition, the public will not feel much sympathy for Wall Street executives who they feel are handsomely compensated to get the decisions correct. As much as critics would like to sensationalize the reasons for the collapse or the motives of the banks leading up to the crisis, the answer could be pretty simple. Most of them just made bad business decisions and the market corrected itself. A significant price has been paid in terms of massive net losses during the crisis, damaged reputations, and heavy fines. Obviously, the punishment will never be enough for the sharpest critics. I can understand the anger and outcry to have a witch hunt to round up scapegoats to put in jail. In instances where clear crimes are committed, I expect the justice department and government will continue to pursue cases. However, there is a huge difference between poor investing decisions and crimes.
Nevertheless, safeguards can be put in place to learn from past mistakes and reduce the probability of another collapse. Five years ago, I sat in on one of a CEO of one of the Big Four accounting firms who guest spoke during a seminar. Although he was specifically speaking about auditing, his words definitely apply to the financial industry as a whole: “The public expects us to do better. We must do better”. In the end, individual firms are more equipped to manage their business and risks to prevent their demise more than any outsider (e.g. auditors, regulators, etc.). Of course, the goal of management is to make money and have great quarterly earnings. However, it still wants to preserve the long term health and reputation of the company. As a result, it is very much incentivized to have strong internal control and processes that prevent taking on dangerous exposures. The role of government and regulation is also a matter of debate. Key elements of Dodd Frank attempt to provide regulators with a quantification of the systematic risk that large financial institutions pose to the overall market and require them to have viable “resolution plans” that allow for their orderly dissolution in the event of failure instead of the government providing a bailout. The Volcker Rule prevents banks from making certain kinds of speculative investments like the subprime MBSs. These regulations reflect the pitfalls that are detailed in The Big Short. On the other hand, it is also healthy to take a fresh look at the regulations to evaluate whether they are providing the benefit that was intended. Regulations increase the cost of business. Of course, not many people are going to care about the cost of business increasing for Wall Street. However, part of the cost is maintaining more capital reserves that are not used to provide financing to companies, business, homeowners, etc. and promote growth for the overall economy. Consequently, it is a balance that should continue to be debated. Obviously, the answer is usually a political one, the party that is in power, in the current environment.
The book concludes with the mad scramble during the collapse of the housing market. In April 2007, Howie Hubler can sell his swaps for losses in the tens of millions of dollars for Morgan Stanley. Naturally, he does not want to take a huge loss. He argues with Greg Lippmann and Deutsche Bank that his A rated CDOs are still worth 95 cents on the dollar instead of the 77 cents that Lippman and Deutsche Bank is suggesting. He argues all the way down to 7 cents. He does not understand that the correlation between the B and A rated CDOs are 100%. Hubler racks up a trading loss of $9.2billion that more than overwhelms the profits of Morgan Stanley’s other fifty thousand or so employees. It is a prime example why it is too broad to blame all of Wall Street for the financial crisis since most employees had no hand in it. Interestingly enough, some of the other financial institutions see the crisis as an opportunity to buy MBSs and CDOs they believe are now undervalued. For example, Mizuho and UBS buy $1 billion and $2 billion from Morgan Stanley. In UBS’s models, they value their gain on the transaction as $30 billion at the time of the purchase. Of course, they jump on to a sinking ship. Again, the financial crisis may be easy to explain in simple language after the fact but there are many factors and variables to sort out during the moment that make it very complicated to comprehend at the time. Of course, the protagonists of the book also face extremely nervous moments during the mad scramble in the midst of the crisis. For Cornwall Capital, they bought CDSs on Bear Stearns. Although Bear is on the verge of collapse, there is a real chance of government bailout which will save Bear and make the swaps on it worthless. As we know, Bear is sold to JP Morgan which wipes out Bear’s shareholders. Of course, Cornwall Capital does not have a crystal ball during the chaos and makes a wise decision to sell their swap for a significant gain instead of trying to wait it out for an even bigger gain: “We had positions that were being valued by Bear Stearns at six hundred grand that went to six million the next day”. Michael Lewis does an amazing job detailing similar experiences that the other protagonists go through during the same time. Burry and Eisman game when it is the best time to sell since it is unlikely that they get the full notional amount. Just for fun, Burry keeps a couple just to see if he can get paid in full for them. Eisman and Frontpoint’s situation is complicated by the fact that they are owned by Morgan Stanley are there are legitimate fears that it could go under at any point. It definitely keeps the book interesting to the very end. In the aftermath of it all, Cornwall Capital starts as a fund with $110 thousand and net $80 million by the end of the story. Michael Burry turns $550 million into a $720 million profit. Nevertheless, it is no triumph for him. He gets no thanks for going through a hell caused by his angry investors to make sure they profit. Afterwards, they just take their money and run. Most of them end their business relationship with Burry because they do not appreciate the way he talked to them. Naturally, the whole experience is just too stressful for Burry. It should not be so difficult to convince investors to allow him to make them a fortune. Not surprisingly, he shuts down Scion and only invests for himself now. For Steve Eisman, his fund Frontpoint starts with $700 million and turns it into $1.5 billion. For these savvy investors, their “Big Short” pays off immensely. However, it is a zero sum game. For the subprime market, it logs trillions of dollars in losses.
Michael Lewis’s The Big Short is definitely the best book about the financial crisis of the late 2000s. Lewis is brilliant in explaining a very complicated story in very simple terms. From the telling of the incredible stories of the investors who make fortunes shorting the market to the stressful experience they each go through waiting to be proven correct, the book is a thorough and interesting portrayal of the collapse of the housing market.