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The Big Short: Inside the Doomsday Machine

by Michael Lewis

2010, W.W. Norton & Company, Ltd., 266 p., hardcover, US$27.95 list.
ISBN  978-0-393-07223-5

Michel Lewis stumbled into a job at Soloman Brothers when he was 24. Without special training or experience, he was paid a lot of money to dispense investment advice. He found the experience "totally preposterous." Lewis felt that he was a fraud. After three years walked awayto an apparently lucrative career as a best-selling author (see several of his book titles, below).

Securitization is a process that aggregates assets into a portfolio that represents security for a bond. Retail banks making home loans usually sell all or part of the mortgages to a investment bank (e.g., Soloman). The investment bank, in turn, issues mortgage-backed securities. Since the 1990s, the banks wanted to extend the securitization to lower-quality loans. "Financial engineering" would be able to manage the risks. The investment banks would devise bond tranches (layers) in ways that reward bond investors for different levels of risk tolerance. In the extreme, they thought that very bad loans could be packaged such thatdue to diversificationthe aggregate would actually be very-low risk. Incredibly, the ratings agencies accepted this idea and rated packages of the worst loans as AAA credit.

Much of this financial engineering was built on faith. Very few people understood the risks, including heads of financial institutions and their auditors. A few people were tenacious about learning how bonds worked. They found that almost no one understood. What the merchant banks did understand was that they were making lots of money.

Several champions emerge in the book. Understanding that the bonds were overvalued, they endeavored to "short" them. That is, they bet that the bonds would not perform. In some cases, they were able to purchase credit default swaps, a form of insurance that would pay if the certain bonds (or tranches of the bonds) did not perform. It was as if "they had bought flood insurance that, if a drop of water so much as grazed any part of the house,  paid them the value of the entire house (p.202)." Additionally, they shorted companies that would be hurt by a housing industry crisis, such as homebuilders and certain banks large mortgage-backed security positions.

Anticipated the Melt-Down

These people, among others, prospered by recognizing the coming mortgage problems and collapse of the housing bubble.

What went so very wrong?

  1. Where were the auditors? If an audit firm cannot confidently establish asset values, then they should not be issuing "clean" opinions. Counterparty risk was under-appreciated. Derivatives exposure is inadequately represented in financial statements because they are held off balance sheets.

  2. Where were the regulators? Some of the investment banks were levered 30:1, and more. A very slight loss wiped out their equity. The implicit backing of the U.S. government let people to a moral hazard: where insurance against a risk (mortgage bond default) led people to be incautious about risk-taking (making bad loans).

  3. Where were the bankers? They issued "liar loans" (suggesting that loan applicants should lie on their loan applications). Many of the loans were "Sub-Prime" or "Alt-A" (substandard), and most of these were made at "teaser rates" where the borrower paid only interest for the first two years.

Lewis is a fantastic story-teller. Studying would have been easier with the addition of an index. A e-book version would be nice for searching, though I like to mark-up my hard copy.

Other of Michael Lewis's books related to the financial industry:

—John Schuyler, April 2011.

Copyright 2011 by John R. Schuyler. All rights reserved. Permission to copy with reproduction of this notice.