Book Club Review – The Big Short – GDNAL

Reviewed by gdnal

It’s been more than twenty years since Michael Lewis penned the opening act of the mortgage securitization era, detailing the Salomon Brothers’ development of the mortgage backed security market.  A bond salesman in his first job out of graduate school in 1984, Lewis’s Liar’s Poker gave a ground-level view of Wall Street culture and the securities that would eventually grind the financial system to a complete halt.  That book became a must-read for anyone looking to find a job on Wall Street, capturing the personalities and gambling ethos of high finance.  How did we get to the edge of a financial catastrophe?  And how did so few people realize that we were speeding towards this precipice? Ego, greed, fear, brains, and not a little myopia, and not necessarily in that order.  And I suppose, fittingly, how were some people standing ready to make money on the collapse?  Fortunately, Lewis is there to bookend the mortgage back security era with The Big Short, documenting how the major players had become so engrossed in making money, sticking their necks out just a little bit farther, just a little more than the next guy, that most lost track of their footing; their risk exposure and bringing the collective system to disaster.

Lewis’s easy writing style underscores some pretty important ideas without oversimplification, not the least of which was how Salomon Brothers turned home mortgages into bonds attractive to investors, by pooling the mortgage payment cash flows and separating them into tranches to cover against the threat of homeowners’ early repayments. There was big money to be made in packaging these mortgages into securities: fees for the mortgage loan originator, the guy who negotiated loan terms with the homeowner, fees for the bank that actually issued the mortgage to the homeowner, and fees for the investment banks that bought the mortgages off the banks, and could pool all of these mortgages into securities, selling the pieces to investors, and even more fees for servicing the bonds.  It was a great party, Lewis writes, but there was a problem—there’s a finite number of reasonably good credit risk home owners.  Without more mortgages, the fee train was grinding to a halt.  Enter the subprime homeowner.  At first, it made sense, Lewis notes, the “efficiency in the capital markets would allow lower-middle-class Americans to pay lower and lower interest rates on their debts.”  Except that the people on the front lines of the mortgages didn’t care if the subprime borrowers could make their payments, they were getting paid just for finding new borrowers.  The banks didn’t care, because they got paid for lending the money and then selling the mortgage to the investment banks.  The investment banks didn’t care, because they could package them all up into opaque securities and sell them for profits and fees to “sophisticated investors” who were stunningly unsophisticated.

In commendable detail, Lewis explains how the crash of the system wasn’t driven by these front-line mortgages or even the first-level mortgage backed securities.  There were two more, related securities that would magnify the problems of the eventual implosion of subprime mortgages, the collateralized debt obligation (bonds of pooled subprime bonds) and the credit default swap (insurance on bonds).  Lewis sums up the process succinctly: “The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs.  And then—because it could extend home loans fast enough to create a sufficient number of lower-rated bonds—it used credit default swaps to replicate the very worst of the existing bonds, many times over.”

Throughout all of this, there were very few people that caught on to the impending problem.  I loved the characters Lewis shadows in this journey, most particularly Steve Eisman, the sell-side analyst willing to buck the herding trend, and identifies the major problem with the subprime mortgages—no one knew what 1000 mortgages underlay a particular mortgage backed security.  At the core, he’s a good guy and I found his lack of diplomacy more than a little endearing.  Mostly, I agreed with his growing disenchantment with the system, towards the social implications of the banking and subprime mortgage industries.  After attending a lunch to hear the CEO of a major Savings and Loan operation describe how banks stick it to the poor, Eisman dryly noted, “That’s when I decided the system was really, ‘Fuck the poor.’”  Michael Burry, the California investor, and Greg Lippmann, the Deutsche Bank trader, and the guys at Cornwall Capital were each fascinating in their own ways, struggling to understand how no one else could have figured out what should have been obvious to anyone willing to spend ten minutes thinking about it—a trillion dollars of securities had been created out of, in effect, nothing.  And then the homeowners who probably shouldn’t have gotten mortgages in the first place started to default.  It was bound to happen.  The whole thing began to unravel.

My biggest complaint with The Big Short is that I’d have liked more detail, more explanation to the Great Unraveling.  The setup of the subprime situation and the bets made by Eisman, Burry, Cornwall, and Lippmann covered the first two thirds of the book.  Then in stunning quickness, while the trades came home to wild profits for them and utter disaster for shareholders in Bear Stearns, Lehman Brothers, and AIG, I yearned for more detail, more intrigue, more clarity.  It was fun to read the account of Eisman’s calling out Bear Stearns’ investor, Bill Miller, at exactly the moment that Bear’s stock cratered. “The minute Steve [Eisman] starts to speak, the stock starts to fall,” as a run on Bear commenced from all of its counterparties.  Yet it isn’t until this scene that Lewis gets to the nuts and bolts question—how did Bear Stearns, one of the largest financial institutions in the world implode in a matter of days for a reason other than fraud?  The basic answer—leverage that enabled the financial firms to chase greater profits through more speculative bets for every dollar of capital—is too simplistic.  Lewis acknowledges as much, but brushes over the more complex answers and details of these speculative trades, and their implications with too broad a brush.

In the end, it would seem that the big players had somehow gotten lost in the race for bigger profits.  Lewis traces the start of this to his days as a bond salesman for Salomon, the days when the big investment banks traded in partnerships for publicly traded stock, “transferring the financial risk to the shareholders.”  With a broader clientele of owners, the firms chased profits, and thinking that there were nearly endless profits in the subprime securities and related derivatives lost sight of the idea that risky bets imply lots of opportunity for major losses.  When the Wall Street investment bank screwed up badly enough, its risks became the problem of the United States government.  “It’s laissez-faire until you get in deep shit,” said John Gutfriend, Lewis’s old Salomon boss.

The Big Short offers a layman’s look at the complex subprime transactions and the financial incentives that killed, in stunning swiftness, several enormous institutions.  I’d like to think that it would give anyone pause when reflecting on the oversight of the financial industry.  Considering the industry’s scope, depth, power, and entanglement in nearly every aspect of our lives, our society should pay more attention to the risks and systemic issues that confront it.  I suppose that everyone involved, from big investment banks like Goldman Sachs and Bear Stearns, the Federal Reserve chairmen, Alan Greenspan and Ben Bernanke, and countless others, didn’t fully appreciate the systemic risk that was inherent in the bets being made so enthusiastically by big, central players.  At least we have good reviews of the disaster, like Lewis’s The Big Short, to remind us how we might not repeat our mistakes.  Unfortunately, considering the industry’s vehement opposition to any oversight and its allies in Congress, I’m sadly convinced that we’re bound to see a repeat.  At least we might get another Lewis book out of the deal.

@orphani’s review can be found here and discussion is on Facebook.

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