Ms.pegasus's Reviews > The Big Short: Inside the Doomsday Machine

Michael Lewis turns the 2008 financial meltdown into a compelling narrative about two very smart, very abrasive skeptics who realized the juggernaut Wall Street had created was doomed to self-destruct, and worked out how to cash in big — the big short.

Steve Eisman began his career as a corporate lawyer. Eisman was an outspoken curmudgeon. Stupidity bored him. Tact was not one of his gifts. When others spoke it looked like he was sampling rather than listening. It's difficult to imagine how he managed to sit through corporate meetings or deal with clients. At 31 he switched careers and became an equity analyst at Oppenheimer. In December 1991 he wet his feet in the murky waters of the subprime lending world. In September 1997 he issued a prescient and bluntly worded report on publicly traded subprime lenders. The verdict — Sell. By 2002 publicly traded subprime lenders were gone. That opened the door to Act II, Household Finance Corporation's reincarnation as an aggressive home equity lender. The company enticed borrowers with fraudulent low interest rates based on voodoo math. When the company was brought to court it received a fine. Nobody went to jail. HSBC, a British congomerate, acquired HFC in 2002. The only losers were the hapless borrowers. Eisman with his black and white mindset was outraged, and the experience would fuel his subsequent zeal.

Eisman was determined to make his analytic gifts pay off. By 2004 he had started his own hedge fund, FrontPoint Partners. He knew he could profit from the debacle unfolding in slow-motion before his eyes. The key was timing.

The second protagonist in Lewis' story was an obsessive financial blogger completing his medical internship. His name was Dr. Michael Burry, and he was attracting a lot of attention from savvy, heavy-hitting investors. He, too, realized he needed a career change. In 2000 he founded a hedge fund called Scion Capital. Like Eisman, he discerned the inherent flaw in the logic of the subprime mortgage bond market. Like Eisman, Burry was looking for a way to capitalize on that insight.

Lewis follows these two men from 2000 to 2007 along with the rapidly mutating bond market. The narrative reads like a detective novel uncovering a trail of clues. The technique adds a measure of suspense to a story whose ending is already well known. The first clue was the rise of the originate-and-sell business model. Fees and commissions, not the mortgage bond itself, was the profit generator. Lenders needed increased volume not loan quality to feed profits. The same was true for the investment banks buying these bonds and collecting their own commissions. Default risk was the buyer's problem. Sy Jacobs, an analyst who trained at Salomon Brothers, summed up: “Any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people.” In that sense, what followed was inevitable. Originators waived documentation, lured borrowers with artifically low teaser rates which would not reset for 2 years, and finally, no money down loans to feed the profit machine. The adjustment, of course, would occur 2 years into the loan when the floating and substantially higher market rate would kick in. Borrowers would be forced to either sell or refinance, an easy decision as long as real estate prices continued to escalate steeply.

Who would buy such risky loans? The loans were bundled into huge pools where the risk could be disguised. As a further refinement, the pools were subdivided so that levels designated to absorb the earliest defaults were assigned higher rates of return to compensate for the increased risk. The underlying pitch, however, was: What were the odds that all (or a significant percent) of the borrowers in a given level would default? In the beginning Eisman and Burry were the only ones who reasoned the answer had to be 100%.

Other clues emerged. By 2005 75% of subprime loans were made at adjustable teaser rates rather than fixed rates. Housing prices were rising precipitously. However, if that rise merely slowed, a cascade of defaults would be triggered. The median house price to income ratio had risen from the traditional 3:1 to 4:1, but in some markets, such as Los Angeles, the ratio had climbed to an unbelievable 10:1. Eisman and Burry detected yet another clue when they examined the methodology applied by ratings agencies such as Moody's and Standard and Poor. Their examiners looked at the characteristics of an entire pool, not the characteristics of the individual underlying bonds. One metric was the FICO score or credit rating of borrowers. The average FICO for a pool was used for the rating formula. Packagers quickly created pools with a wide range of scores; the result looked exactly like a package whose scores clustered closely around the mean. Moreover, all FICO's were not equal. A Mexican migrant worker who spoke no English and who had no assets but had never borrowed could have the same high FICO as an affluent borrower with plenty of assets and disposable income. In his inimitable way, Lewis summarizes: “The Mexican harvested strawberries; Wall Street harvested his FICO score.” After learning all of this, Eisman and Burry realized that a triple A rated slice of the pool was no less risky that the worst slice of the worst pool.

Act III of this drama introduced Greg Lippman, a bond salesman employed by Deutsche Bank. People described Lippman as over-the-top: Loud, self-aggrandizing, self-confident, brash. Such chutzpah... and such a long long list of contacts. Lippman was the mobilizer, the catalyst. The insurance giant AIG had figured out a way to enter the lucrative mortgage market, now morphed into the synthetic subprime mortgage bond-backed collateralized debt obligation. Too much of a mouthful? How about the CDO. Certain the bond pools were safe, AIG began to sell bond insurance, a conventional instrument for hedging. The insurance was not called insurance but rather a credit default swap. Lippman also began to look into the bond market and discovered the flaw. To him, the swaps were a bonanza. It was the vehicle he and his customers needed to short the bond market and he began talking to anyone who would listen. Anyone within AIG who suspected the ugly reality was quickly silenced by AIG Financial Products division head Joe Cassano. By the time AIG woke up it was like closing the barn door after the cattle have escaped.

Lewis deftly reduces what are ultimately complex legal contracts and accounting strategies into terms understandable to the ordinary person. He strips away the ambiguities of Wall Street “market speak.” A collateralized debt obligation was actually the smoke and mirrors backed subprime bond. The bonds weren't even classed as mortgage bonds but as “asset-backed securities” like car loans, student loans and credit card debt. Mobile homes were termed “manufactured housing,” certainly a more stable sounding proposition for the unwary investor. Defaults were referred to as “involuntary payments.” The bottom or riskiest tranche wasn't called the basement; it was a mezzanine tranche. With this lexicon it is no wonder that bond buyers were befuddled and Wall Street started to believe its own lies.

Lewis never underplays the role of luck or the degree of risk in his account. Eisman and Burry did the meticulous grueling analysis that led to the right answers, but the market does not always reward those who are right. They were placing their bets in 2005 but the collapse did not begin until 2007. In the interim they were obligated to pay out huge sums in premiums and collateral. Their backers became alarmed at the short-term negative returns. Paradoxically, bond prices kept rising even as the bad news started to surface. The bond prices did not begin to fall uninterrupted until June 2007. By 2008 those on the short end of the bet had yet one more worry. The entire financial system could collapse and their creditors could declare bankruptcy. If that happened theirs would be a pyrrhic victory.

Those looking for a precise chronology of events or a nuanced quantitative narrative should look elsewhere. This is a riveting story about institutional greed and driven by colorful characters who say and do shocking things. The amounts of money involved are not millions but billions. Lewis draws from emails, letters, interviews and conversations and provides a context filled with striking metaphors and surprising drama.

NOTE:
The film based on Lewis' book is scheduled for release on December 23, 2015