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Book Review: The Big Short: Inside the Doomsday Machine by Michael Lewis

The Big Short: Inside the Doomsday Machine” presents a different perspective of the financial crisis from that given in Roger Lowenstein’s “The End of Wall Street”. In that book we saw first-hand how the events transpired in the big Wall Street firms and the millions lost by them. In this writing Michael Lewis leads us through the crisis hand in hand with the select few who made millions because of it – short sellers who foresaw the impending crisis and who placed timely bets against the financial system.

Even though this latter group of people is often criticized today for having fed the monster that was the financial system Lewis draws attention to their insight, their ability to have foreseen the makings and potential results of a catastrophe. They may be popularly denounced for having created the necessary liquidity through their bets (via CDS) that spurred the growth of dangerously complicated and misleading derivatives (subprime mortgage bonds, their evil offspring the deadly CDOs and their like), but what the author highlights in his book is that these people saw the opportunity in a deceptively healthy but in factor cancer ridden financial system.

We get to know each of these selected players (Steve Eisman, Michael Burry, the guys at Cornwall Capital, etc) personally, as if Lewis believes in some measure that their ability to have forecasted the storm lies within their individual characters. Each is an oddity, built outside the generic mold, a person given to taking the less-travelled route. We are left feeling that maybe it was this difference that led to their ability not to accept the status quo- the belief that house prices would continue increasing, that defaults in one region were uncorrelated to defaults in another, that profits would continue to grow without limit, and that collapse was unimaginable.

However there are lessons to be learned here. What appears to be a common thread among all of them is the importance they place on hard facts rather than being blinded by popular opinion; they

  • carried out proper due diligence by reviewing financial statements, and other public available information (like court rulings, deal completions, government regulatory changes) that could impact or change the value of a potential investment;
  • did not rely on tools (e.g. VaR, Vol, Black Scholes) widely used by those within the financial system, on the understanding that based on these models most players in the financial market tend to underestimate the chances of a dramatic change;
  • did not rely on ratings by external rating agencies. They were able to gauge the conflict of interest that lay between the fee structure of these agencies and the credit assessments carried out by them for the Wall Street firms, as well as lack of understanding, analysis carried out and due diligence exhibited regarding the instruments being rated that led to their being gamed by their clients;
  • assessed the pools of loans underlying each individual subprime mortgage bond before placing their bets, in particularly considered their  changing composition such as % of subprime mortgages within a pool, the meaning behind obscure terminologies, the lending terms on mortgages themselves (teaser rates, silent seconds, no-doc, Alt-A, etc), their underwriting and credit analysis processes (or lack thereof), the due diligence processes followed, the type of people borrowing and lending, etc;
  • became familiar with the broad macro economic factors impacting the housing market- rapidly rising home equity-to-income ratios, fundamentals of the house price markets, the interest rate environment, the impact of defaults on the system, the correlation that existed because of this common macroeconomic exposure between mortgage markets in various regions of the country;
  • gained knowledge of the regulatory environment surrounding the bond markets;
  • understood of the impact of a greed inducing incentive system that focused on volume building through leverage and fee generation rather than on performance and quality- this led to a degradation of underwriting standards for mortgage originators, bond underwriters and issuers, rating agencies, investors, etc;
  • understood the mispricing in the cost of insurance, CDS, in relation of the actual risk involved; and the fact that investment banks/ AIG were not adequately reserved for this situation;
  • investigated and gleaned as much information about potential investments from all relevant sources- traders, other investors, Wall street firms, rating agencies, loan originators, home owners, builders, etc.

Throughout the book the author develops a thorough understanding of the mechanics of the instruments at the heart of the crisis in language that is simple (or as simple as is possible for these complicated securities) and easy to grasp. In particular:

  • Subprime mortgages with their deceptive terms
  • Subprime mortgage bonds and their tranches
  • Collateralized Debt Obligations (CDO), in particular the laundered triple A tranches of packaged triple B rated tranches of subprime mortgage bonds
  • Different types of credit default swaps (CDS), the vehicles of the short bet against the derivative instruments. (In addition to shorting the derivatives instruments these investors also shorted the stocks of entities that would be impacted by the collapse in the subprime mortgage market).
  • Synthetic CDOs, again the laundered triple A tranches of packaged triple B rated tranches of CDOs and CDS, and
  • Further increasingly complex iterations

“The Big Short” is very informative and highly readable. It is written as one reviewer puts it “like a thriller”. It is fast moving and engaging. Above all it provides value to those within the finance, investment and risk management fields for the lessons that it imparts within its pages.

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