Sunday, August 8, 2010

The Big Short

The Big Short: Inside the Doomsday Machine, by Michael Lewis

My review

Every tragedy has a tale. This tale of greed is told through the eyes of outsiders who bet against Wall Street's greed, and won. Ironically, so did Wall Street. There lies the tragedy.

Told by retracing the path taken by a few contrarian outsiders - Steve Eisman, Michael Burry, Greg Lipmann, Howie Hubler, and others - who saw the house of cards for what it was: built by a grotesque mix of greedy and sometimes outright stupid Wall Street bankers, and stamped with the authority of incompetent, "brain-dead" employees of the ratings agencies - S&P, Moody's, and Fitch.

Burry said, "... I also immediately internalized the idea that no school could teach someone how to be a great investor. If it were true, it'd be the most popular school in the world, with an impossibly high tuition. So it must not be true." [page 35]
Steve Eisman is a second-generation Wall Street fellow (his parents worked on Wall Street), who is marked by an almost complete lack of social grace (he does try and develop some inter-personal skills after the collapse of Wall Street though).
"The single greatest line I ever wrote as an analyst," says Eisman, "was after Lomas said they were hedged." He recited the line from memory: "The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment.' I enjoyed writing that sentence more than any sentence I ever wrote." A few months after he published that line, the Lomas Financial Corporation returned to bankruptcy. [page 3]

It doesn't end here. Steve Eisman was plain blunt when it came to voicing his opinions. There doesn't seem to be a shade of gray here - things for him were either black or white, never anything in-between.
Once, he got himself invited to a meeting with the CEO of Bank of America, Ken Lewis. "I was sitting there listening to him. I had an epiphany. I said to myself, 'Oh my God, he's dumb!' A lighbulb went off. The guy running one of the biggest banks in the world is dumb!" They shorted Bank of America, along with UBS, Citigroup, Lehman Brothers, and a few others. They weren't allowed to short Morgan Stanley because they were owned by Morgan Stanley, but if they could have, they would have. [page 174]

"We have a thesis," said Eisman. "There is going to be a calamity, and whenever there is a calamity, Merrill is there." When it came time to bankrupt Orange County with bad advice, Merrill was there. When the Internet went bust, Merrill was there. Way back in the 1908s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. [page 175]
A prominent theme of Barry Ritholtz's book, Bailout Nation (my review post, my review), was that the ratings agencies were, if not outright hand-in-glove with the investment firms in the ratings fraud that enabled the subprime mortgage bonds catastrophe, at best outright incompetent, who were clueless on how to rate these CDOs, and relied on the investment firms' models. Sort of letting the thief select the combination to a vault. Michael Lewis comes to the same conclusion, pretty much, but it is much more devastating an indictment when delivered through the words of an insider - yes an insider.
But everyone on Wall Street knew that the people who ran the models were ripe for exploitation. "Guys who can't get a job on Wall Street get a job at Moody's," as one Goldman Sachs trader-turned-hedge fund manager put it. Inside the rating agency there was another hierarchy, even less flattering to the subprime mortgage bond raters. "At the ratings agencies the corporate credit people are the least bad," says a quant who engineered mortgage bonds for Morgan Stanley. "Next are the prime mortgage people." Then you have the asset-backed people, who are basically brain-dead."

So you have greed, a willing accomplice in the ratings agencies. Now you need to cover your theft in a cloak of incomprehensibility. I.e., to be able to pull off a fraud, you first have to not call it a fraud. In the world of finance, in the esoteric world of asset-backed securities, you began the process of dissemination by calling them anything but junk.
It's too much to expect that the people who run big Wall Street firms to speak plain English, since so much of their livelihood depends on people believing that what they do cannot be translated into plain English. [page 218]
Bond market terminology was designed less to convey meaning than to bewilder outsiders. Overpriced bonds were not "expensive"; overpriced bonds were "rich,", which almost made them sound like something you should buy. The floors of subprime mortgages bonds were not called floor - or anything else that might lead the bond buyer to form any sort of concrete image in his mind - but tranches. The bottom tranche - the risky ground floor - was not called the ground floor by the mezzanine, or the mezz, which made it sound less like a dangerous investment and more like a highly prized seat in a doomed stadium. A CDO composed of nothing but the riskiest, mezzanine layer of subprime mortgages was not called a subprime-backed CDO but a "structured finance CDO." [pages 126, 127]
To wipe out any triple-B bond - the ground floor of the building - all that was needed was a 7 percent loss in the underlying pool of home loans. That same 7 percent loss would thus wipe out, entirely, any CDO made up of tripe-B bonds, no matter what rating was assigned it. [page 129]

Eisman  had long subscribed to a newsletter famous in Wall Street circles and obscure outside them, Grant's Interest Rate Observer. ... In late 2006 Grant decided to investigate these strange Wall Street creations known as CDOs. ... In early 2007, Grant wrote a series of pieces suggesting that that the rating agencies had abandoned their posts - that they were almost surely rating these CDOs without themselves knowing exactly what was inside them. ... For his troubles, Grant and his trusted assistant, was called into the S&P for a dressing-down. "We were actually summoned to the rating agency and told, 'You guys just don't get it,'" says Gertner. "Jim used the term 'alchemy' and they didn't like that term." [page 177]

Michael Burry was perhaps the first to buy a credit default swap on these sub-prime mortgage bonds. He had what people called an anti-social personality. It was only later, much later, that he learned that he had Asperger's Syndrome, and that too because his wife took their son to a doctor, who diagnosed their son with Asperger's.
When he thought of it that way, he realized that complex modern financial markets were as good as designed to reward a person with Asperger's who took an interest in them. "Only someone with Asperger's would read a subprime mortgage bond prospectus," he said. [page 183]
Investment firms like Goldman Sachs invest hundreds of millions of dollars in technology to build cutting edge trading platforms that can give them a fraction of a second advantage in executing trades, millions of trades a day. Funny then that when the sub-prime excreta hit the fan, these firms should come up with the excuses they did.
On June 14 (2007), the pair of subprime mortgage bond hedge funds effectively owned by Bear Sterns went belly-up. In the ensuing two weeks, the publicly traded index of triple-B-rated subprime mortgage bonds fell by nearly 20 percent. ... On Friday, June 15, Burry's Goldman Sachs saleswoman, Veronica Grinstein, vanished. He called and e-mailed her, but she didn't respond until late the following Monday - to tell him that she was "out for the day."
On June 20, Grinstein finally returned to tell him that Goldman Sachs had experienced "systems failure."
That was funny, Burry replied, because Morgan Stanley had said more or less the same thing. And his salesman at Bank of America claimed they'd had a "power outage."
It was precisely the moment he had told his investors, back in the summer of 2005, that they only needed to wait for. Crappy mortgages worth three-quarters of a trillion dollars were resetting, from their teaser rates to new, higher rates.
[pages 195-197]
Barry Ritholtz comes down very hard on Alan Greenspan in his book, Bailout Nation. As does William Fleckenstein in his book, Greenspan's Bubbles: The Age of Ignorance At The Federal Reserve. This book is no different, but the criticism is all the more scathing when it comes from these characters:
Greenspan he viewed as almost beneath his contempt, which was saying something. "I think Alan Greenspan will go down as the worst chairman of the Federal Reserve in history," he'd say, when given the slightest chance.
There was now hardly an important figure on Wall Street whom Eisman had not insulted, or tried to. ... Esisman had invited the bullish-on-subprime Bear Sterns analyst Gyan Sinha to his office and grilled him so mercilessly that a Bear Sterns salesman had called afterward and complained.
"Gyan is upset," he said.
"Tell him not to be," said Eisman. "We enjoyed it." [page 229]
In ending, while one can argue that investing is a form of gambling, what separates this crisis from others is that not a single gambler left the table losing. The only losers were the government. Or to put it more accurately, the taxpayer.
The line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet ... Maybe the best definition of "investing" is "gambling with the odds in your favor." The people on the short side of the subprime mortgage market had gambled with the odds in their favor. The people on the other side - the entire financial system, essentially - had gambled with the odds against them. Up to this point, the story of the big short could not be simpler. What's strange and complicated about it, however, is that pretty much all the important people on both sides of the gamble left the table rich. ... The CEOs of every major Wall Street firm were also on the wrong end of the gamble. All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the United States government. They all got rich, too. [pages 256, 257]
This is an excellent read. The only shortcoming is that somehow the narratives of the characters - do not seem to tie together very well. They run in parallel, but are never coalesced together. This minor quibble aside, the book is an enjoyable read.

The Big Short | W. W. Norton & Company

© 2010, Abhinav Agarwal. All rights reserved.