The Big Short: Inside the Doomsday Machine, Michael Lewis

I went to see The Big Short earlier this year and it was pretty interesting movie. That made me want to read the book (once I heard it was based off a book) and here we are.

The book traces the 2007-2009 financial crisis/recession. The reasons for it and how some people made a boat load of money off of the misfortune of big time Wall Street executives. So let’s begin..

After the 2001 terrorist attacks on Wall Street, the U.S. economy went into a recession. It was pulled out a year or so later and the housing market started to boom. How you say? Well, in that same time period, people started really wanting to own their own house for obvious reasons. The housing market is typically very strong so this is, in most instances, a safe place for your money. A house you buy will incur equity and you can sell it usually for more than you bought it. For a host of other reasons, the housing market shot up. And the people who were buying houses were the kind of people that really shouldn’t have been buying them. A strawberry picker who made 14,000 a year in California, for example, bought a house for 700,000. The mortgage these kind of people took out to buy a house seemed to be at a fixed interest. That is, the mortgage was suppose to stay at a fixed interest rate through the life of the loan. What nobody told these people, was that after a couple of years, the interest would begin to rise.

So when you have someone who has more risk of defaulting on their mortgage takes out a mortgage, these are called subprime mortgages. It means that they have a greater chance of defaulting during the life of the loan. What people in the housing market started to do was mass produce these mortgages. These mortgages then were wrapped up in a bond. The bonds were interlaced with good and bad sub-prime mortgages so the rating agencies would give the bond a double B or a triple A rating, meaning they were good investments. All of these kinds of bonds were then wrapped up again in what is called a CDO (Consolidated Debt Obligation). That would get a rating too. It turns out that the ratings agencies were corrupt too: they didn’t accurately rate the bonds making them seem like they were all ok to invest in. That’s what makes this whole affair even more sinister: people gave mortgages to people who shouldn’t have had them, who in turn made a ton of money by selling bonds, who in turn were given a seal of approval from the ratings agencies that they were a worthy investment. That is the definition of irresponsibility.

Why did they do all this? Well first of all, it made people rich. Really, really rich. Especially traders on Wall Street. It also helped the economy because building companies started to build lots and lots of houses to live up to the demand of all the new home mortgages that were being shelled out.

In 2005, a small time hedge fund manager named Mike Burry was looking through these subprime mortgages and came to a realization: the whole system is going to fail. Because the interest rates weren’t fixed, in a couple of years, the people who thought their interest rate was fixed were going to default on their mortgages because they wouldn’t be able to pay for it. He predicted that in 2007, the housing market would collapse. So he came up with a brilliant plan: he would short the bonds. What this means is simple: when someone invests in a bond, you are experiencing risk because the bonds might fail. So what if you took out insurance to make sure that if the bonds did go bad (which would only require a 7% default rate), you’d be able to cash in your insurance policy? This had never been done before but Mike Burry got his wish and bought shorts on subprime mortgages. Because the housing market is typically a worthy investment, everyone thought that Burry was crazy to buy shorts. He would have to pay the interest to keep the shorts and that was just more money in the pockets of greedy investment banks.

This created a cascade effect of people who saw the same thing. Vinny Daniel, Steve Eisman, etc. all bought shorts on subprime mortgage bonds. And that’s what really made this story interesting: you see a coherent narrative behind all of this jargon so it’s not just an explanation of what happened. What eventually did end up happening is the market crashed and these guys who were smart enough to buy insurance, or shorts, became filthy rich.

What are some things that I noticed that the book doesn’t really cover as much is the theme of greed. The “good guys” in this story are the Mike Burry’s and the Steve Eisman’s. But were they really all that good? The housing market was full of people who wanted a lot of money and wanted it quick. Even in the fallout of the financial crisis where the average American away from Wall Street, hardly involved in the process, suffered the most. People lost their jobs, people went through hard times. And yet we are to look up to the Mike Burry’s and Steve Eisman’s as if they are saints to be applauded for taking from the rich. That doesn’t make much sense to me. If they were really that noble, why didn’t they try to stop this from happening? That was the central question that was running through my mind throughout this whole story. Mike Burry predicted this in 2005. Was there nothing he could do to stop the machine? Is he really any better than the Wall Street Execs whose bank failed?

These are important questions before we proceed to canonize Mike Burry and Steve Eisman, arguably the hero’s of this story. Nonetheless, Michael Lewis does a spectacular job in writing this book and I look forward to reading more by him.

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