Lorin Kleinman's Reviews > The Big Short: Inside the Doomsday Machine

Remember that point, in recent years, when we all started to notice something strange? Houses were getting more and more expensive, interest rates were dropping more and more, and most of us knew someone who had no money, but was able to get a huge mortgage. And then there were all the stories of people buying houses with no money down and interest-only payments for three years. How exactly were these people expecting to make principal payments in three years? And why was anyone lending them money?

In “The Big Short,” Michael Lewis explains that all of this was just the tip of an iceberg: an iceberg floating in exceedingly murky water. There was a reason for all of the bad mortgages. The people making the mortgages were selling them, so they didn’t care how bad they were. The mortgages were being bought by companies that bundled them and turned them into bonds—which they were able to sell, so they didn’t care how bad the mortgages were either.

In order to be sold, the bonds had to be rated by one of three rating agencies. In a reasonable financial system, rating agency analyst would be the career the most ambitious business students aspired to. As it is, these analysts are some of the lowest-paid and least-respected employees in the financial world. The smartest and most talented people on Wall Street are never at the rating agencies. (They tend to become bond traders.) The agencies are paid to rate bonds by the very companies that produce the bonds. As mortgage bonds were a new kind of bond, they needed help understanding them. So the same companies also explained the bonds to the rating agencies. None of this was illegal: in fact, it is standard practice.

Not surprisingly under the circumstances, a great many of these bonds (which increasingly consisted of utterly worthless mortgages) were rated triple A, the highest possible rating. The bonds that consisted of the absolutely worst mortgages were given a triple B rating. But the financial companies soon realized that triple B-rated mortgage bonds could in turn be bundled into another financial product, a collateralized debt obligation (CDO). Presented with the CDOs, the rating agencies tended to give them triple A ratings—which suggested that they were as safe an investment as U.S. Treasury bonds. Shockingly, very few people, at any level of the financial world or the U.S. government, understood that the ratings—and the bonds they described—were worthless.

This is a book about many things, but it is particularly a story of incentives, and the calamitous effects of incentivizing irresponsible behavior. In a system in which virtually everyone had an incentive to do the wrong thing, almost everyone did: and almost everyone, from mortgage lenders to the Fed, failed to understand that disaster was imminent. “The Big Short” describes the very small—and very eccentric—group of people who saw it coming.

The cast of characters begins with Steve Eisman, a socially inept hedge fund manager, who had turned cynic after witnessing a flagrant case of fraud on which the government refused to take action. Mike Burry is a brilliant hedge fund manager who is virtually incapable of human relationships, a problem which he blamed on his glass eye but turned out to be undiagnosed Asperger’s syndrome. Charlie Ledley and Ben Hockett were two rather aimless friends who proved to have an uncanny ability to work the financial market. Greg Lippmann was a cynical Deutsche Bank bond trader who realized that the market was unsustainable.

They shared a key insight: that the market was going to collapse, and therefore the only safe bet was a bet against the market. (To short a bond is to bet that it will lose value.) Michael Lewis rivetingly describes how they first made, and then won, this bet, becoming extremely rich in the process.

Recently–at Politics & Prose Bookstore, at an entertaining event with Michael Lewis–Joel Achenbach said that this book had undermined his belief in capitalism, and asked if we should all become socialists. It was a joke, but it’s also a fair question. Lewis depicts a system in utter disarray, where financial products are too complex to be understood by either buyers or sellers; the agencies in charge of evaluating these products are both under-valued and embroiled in a serious conflict of interest; and there are no incentives to encourage responsible behavior. All of this links the health of the U.S. economy to a large gamble in which virtually no one has any idea what he is doing. It is to be hoped that this book will help foster a movement toward a truly sane financial system.