Saturday, September 25, 2010

Book Review: The Big Short

Coming off of one of the best books I have read in a while, Mustaine, I didn't think I would steam through another book so quickly. However, when I picked up The Big Short by Michael Lewis I was hooked instantly. The book is an incredible read that takes the reader on a surprisingly tangible trip through the subprime mortgage crisis.

Michael Lewis, most famous for his piece The Blind Side, which was recently turned into a major motion picture, does an excellent job of not only making what happened to our economy understandable but also entertaining. He does so by profiling a few interesting and important characters in the subprime mortgage meltdown. Although he does showcase some big name players and tell of their roles in how history played out, the real magic of his work comes from telling the tale through eyes of the few who saw it coming. Hence the title The Big Short.

The Big Short is not the story of the crisis, as the crisis is commonly understood. The failure of Lehman brothers and of Fannie Mae and Freddie Mac; the stock-market crash; the bail-out of Detroit; the fevered all-nighters pulled at Treasury and the New York Fed; the fears that the entire global financial system was on the brink of collapse -- little if any of that is in this book.

Instead, Lewis has found a different story -- one which he started mining for a spectacular cover story in the December 2007 issue of Portfolio magazine, and which has culminated in this book, over two years later. It's the story of what used to be called the "subprime crisis" before it metastasized into something much larger and more dangerous than that. And it's also, like all Michael Lewis tales, a human story, which takes us deep inside unique characters like Steve Eisman and Mike Burry.

Telling the story through the eyes of those betting against Wall Street's big hitters and the mortgage backed securities that eventually led to the chaos experienced in September of 2008 makes for a truly interesting perspective. It also allows Lewis to come off as less of an I know it all author who has forgotten that hindsight is 20:20. The story is told from the guys who can truly say 'I told you so' because the whole time they were putting their money where their mouths were.

Here are some notes from the book:

Prologue: Poltergeist:
- Predicted crash would occur almost 20 years ago in his first book Liar's Poker
- "If you'd gotten a few drinks in me and then asked what effect the book would have on the world, I might have said something like,'I hope that college students trying to decide what to do with their lives might read it and decide that its silly to phony it up, and abandon their passions or even their faint interests, to become financiers.'
- He kept waiting for a rebellion but it didn't happen

A Secret Origin Story:
-Steve Eisman was a nerdy badass
- "You don't even own stock in your company" said Eisman to the Japanese businessman. "In Japan it is not customary for management to own stock," said the businessman. Eisman noted that the guy's financial statements didn't actually disclose any of the really important details about the guy's company but rather than simply say that he lifted the statement in the air as if disposing of a turd. "This......this is toilet paper. Translate that!" he said.
- When asked about the pattern of upset he leaves in his wake, Eisman simply looks puzzled, even a bit wounded. "I forget myself sometimes."
- The big fear of the 1980 mortgage bond investor was being repaid too quickly not fear of not being repaid at all.
-"And the story they liked to tell was that 'we're helping the customer. Because were taking him out of his high interest rate credit card debt and putting him into a lower interest rate mortgage debt.' And I believed that story." Then something changed.
- None of his fellow accountants was able to explain why the traders were doing what they were doing. "I didn't know what I was doing," said Vinny. "But the scary thing was, my managers didn't know anything either. I asked these basic questions--like, Why do they own this mortgage bond? Are they just betting on it, or is it part of some larger strategy? I thought I needed to know. It's really difficult to audit a company if you can't connect the dots."
- Essentially a ponzi scheme. As long as they were growing the illusion was masked.
- Eisman wrote a report and trashed all the subprime mortgage originators. "Here is the difference between the view of the world they are presenting to you and the actual numbers." The subprime companies did not appreciate his effort. "He created a shitstorm," said Vinny. "All these subprime companies were calling and hollering at him: you're wrong. Your data's wrong. And he just hollered back at them, 'It's YOUR fucking data!"
- "You have to understand, I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn't give a shit what it sold."
- "The very first day we said, 'There's going to come a time when were going to make a fortune shorting this stuff. It's going to blow up. We just don't know how or when."

In The Land Of The Blind:
- Worst loans by Michael Burry's standards are interest only negative amortizing adjustable rate subprime mortgages
- "What you want to watch are the lenders, not the borrowers. The borrowers will always be willing to take a great deal for themselves. Its up to the lenders to show restraint, and when they love it, watch out." By 2003 he knew the borrowers had already lost it. By early 2005 he saw that lenders had too.
- You couldn't short the mortgage bonds
- Burry began buying corporate credit default swaps on companies he though may suffer from a real estate downturn but there was no guarantee these companies would go bankrupt and that is the only way he would get paid.
- He bought credit default swaps on subprime mortgage bonds in 2005 guessing in two years after teaser rates jumped his bet would pay off.
- The market didn't exist so Burry pitched Wall St. Only Deutsche and Goldman had any interest and no one saw what he was doing.
- He went from blogger to millionaire overnight because Gotham Capital was making money off his picks and offered him a million to open his own fund.
- White Mountain followed shortly after
- Volatility doesn't equal risk. "By and large the wealthiest of the wealthy and their representatives have accepted that most managers are average, and the better ones are able to achieve average returns while exhibiting below average volatility. By this logic a dollar selling for fifty cents one day, sixty cents the next day, and forty cents the next somehow becomes worth less than a dollar selling for fifty cents all three days. I would argue that the ability to buy at forty cents presents an opportunity, not risk, and that the dollar is still worth a dollar."
- He was turning away money after a few years. "He designed Scion so it was bad for business but good for investing."
- Charlie Munger said you can always predict how people are going to behave by looking at their incentives.
- "You can say everyone knows that. I think I've been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther," said Charlie Munger.
- He went against the industry fee standard to properly align incentives
- Their decision making was one guy in a room pouring over publicly available information
- 2003 Bury called the real estate bubble. "You just have to watch for the level at which even nearly unlimited or unprecedented credit can no longer drive the housing market higher. I am extremely bearish, and feel the consequences could very easily be a 50% drop in residential real estate in the US....A large portion of current housing demand at current prices would disappear if only people became convinced that prices weren't rising. The collateral damage is likely to be orders of magnitude worse than anyone now considers."
- In 2005 when he first tried to convince Wall St of the credit default swaps for subprime mortgage bonds his first big problem was that they didn't share his sense of urgency
- He started buying and was amazed that no one on Wall St cared which funds he was shorting. It was like all subprime bonds were the same thing
- "Burry devoted himself to finding exactly the right ones to bet against. He'd read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them."
- He even found a mortgage pool that was 100% floating rate negative amortizing so the borrower could not pay any interest and just have their loan grow and grow until default. Goldman sent him a congratulations for being the first to buy a credit default swap on it!
- He tried to start a fund to do only CDS but no one would pony up money
- The S&P was down 6.84% in 5 years and he was up 242% but no one believed him when it came to credit default swaps
- People wouldn't give him money but started prodding Goldman on how to do it themselves
- All the Wall St players started coming to him to buy back his CDS all at once
- He sold back to Deutsche and then saw an email that said "Greg Lippmann, the head subprime mortgage trader at Deutsche bank was in here the other day. He told us that he was short 1 Billion dollars of this stuff and was going to make 'oceans' of money. His exuberance was a little scary"

How Can A Guy Who Can't Speak English Lie?:
- Greg Lippmann of Deutsche went to pitch Eisman as if the CDS idea was his own
- Lippmann used a Chinese guy to give credibility to his numbers. "Eugene Xu was responsible for every piece of data in Lippmann's presentation. Once Eugene was introduced into the equation, no one bothered Lippmann about his math or his data. As Lippmann put it 'How can a guy who cant speak English lie?'"
- Eisman had two questions: 1. How does a CDS work again? 2. Why are you asking me to bet against the bonds at your firm?
- "When he walked in and said you can make money shorting subprime paper, it was like putting a naked supermodel in front of me. What I couldn't understand was why he wanted me to do it," said Eisman.
- Burry didn't know who was to be left holding the bag from Goldman and others if the CDS turned out the way he thought. He knew Goldman wouldn't have done the deals if the risk was on them.....turns out it was AIG
- Goldman had created Collateralized Debt Obligations (CDO) which just lumped together a bunch of the mortgage bonds to supposedly mitigate the risk but that already happened with the mortgage bonds
- The did CDO's to get shit bonds re-rated as AAA
- The CDO was, in effect, a credit laundering service for the residents of lower middle class America. For Wall St. it was a machine that turned lead into gold
- After a while they didn't need to do CDOs of mortgage bonds they did them on the CDS. This essentially created a market and money for banks out of nothing
- Ratings agencies didn't know how to rate these
- Lippmann although forced into the shorting of mortgage bonds by Deutsche realized it was a gold mine
- He couldn't convince others to short so he went to AIG to try and blow up the market so he could cash in

How to Harvest a Migrant Worker:
- Joe Cassano was the bullying prick CEO of AIG
- Gene Park asked people most closely tied to CDS what percentage of the loans were subprime. They were all saying 10-20%. No one knew it was 95%
- No one believed housing prices could fall nationally all at once
- Park convinced Cassano to stop insuring but they didn't unload what they had
- Lippmann went looking for others who agreed with his beliefs and ran into Eisman
- The simple measure of sanity in housing prices was the ratio of median home price to income. Historically in the US it ran around 3:1 by late 2004 it had risen nationally to 4:1. "All these people were saying it was nearly as high in some other countries. But the problem wasn't just that it was four to one. In Las Angeles it was ten to one and in Miami eight to one. And then you coupled that with the buyers. They weren't real buyers. They were speculators."

Accidental Capitalists:
- A smaller number of people, more than ten, fewer than twenty, made a straightforward bet against the entire multi trillion dollar subprime mortgage market and by extension the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed.
- The few who saw it coming could be traced back to Lippman, except Mike Burry
- "I loved the concept of shorting a bond because your downside is limited. Its an asymmetrical bet." Said Paulson. He was shocked how much easier and cheaper it was to buy a credit default swap than it was to sell short an actual cash bond even though they represented the exact same bet.
- Charlie Ledley got a hold of Lippman's presentation
- He and a few buddies began buying options they viewed as mispriced and built their own fortunes in a short time
- They eventually got Wall St to sell them CDS
- "It took us weeks to really grasp it because it was so weird. But the more we looked at what a CDO really was, the more we were like Holy shit, that's just fucking crazy. That's fraud. Maybe you cant prove it in a court of law. But its fraud." - Charlie Ledley
- They were even buying the AA tranches of the CDS and they were the first to do so because they realized they were no better than the BBB but cheaper
- "A lot of people when we called them said hey why don't you guys buy some stocks? They couldn't believe that these young guys wanted to buy not just CDS but CDS's so esoteric that no one else had bought it."
- They didn't realize yet that the bonds inside their CDOs were actually credit default swaps on the bonds, and so their CDO's werent ordinary CDOs but synthetic CDOs or that the bonds on which the swaps were based had been handpicked by Mike Burry and Steve Eisman and others betting against the market. In many ways they were still innocents.

Spiderman At The Venetian:
- Eisman met Wing Chau a CDO manager and thought he would be hurting with the housing prices falling because the CDO managers had filled the void left by AIG. But the CDO managers were selling to Institutional Clients. Everyone was passing the risk.
- "He 'managed' the CDOs. But managed what? I was just appalled that the structured finance market could be so insane to allow someone to manage a CDO portfolio without having any exposure to the CDOs. People would pay up to have soomeone 'manage' their CDOs as if this moron was helping you. I thought, you prick, you dont give a fuck about the investors in this thing." - Eisman talking about Wing Chau a CDO manager
- Chau's real job was to serve as a new kind of front man for the Wall St firms he "hired"; investors felt better buying a Merrill Lynch CDO if it didnt appear to be run by Merrill Lynch.
- After the dinner Eisman grabbed Greg Lippmann and said "Whatever that guy (Chau) is buying, I want to short it." Lippman took it as a joke but Eisman was serious. He wanted to specifically bet against Wing Chau. "I want to short his paper. Sight unseen."
"Usually when you do a trade you can find some smart people on the other side of it. In this instance we couldnt. Nobody we talked to had any credible reason to think this wasnt going to become a big problem. No one was really thinking about it." Cornwall Capital guys
- People believed the collapse of the subprime market was unlikely precisely because it would be such a tragedy.
- Eisman, "In Vegas it became clear to me that this entire huge industry was just trusting in the ratings so they didnt have to think about it."
- "You know how when you walk into a post office you realize there is such a difference between a government employee and other people? The ratings agency people were all like government employees." - Vinny
- "That was the moment when we said, 'Holy shit, this isnt just credit. This is a fictitious Ponzi scheme." - Vinny
- "There were more morons than crooks but the crooks were higher up." - Vinny and Eisman
- Eisman got back from Vegas and increased his shorts by $250M

The Great Treasure Hunt:
- Charley traded with Morgan Stanley and literally overnight they said they couldnt do CDS anymore.
- In a portfolio of 30 million Charley and Cornwall Capital owned 250 million and were disappointed they didnt own more
- Charley even went to the SEC but they didnt get it and never investigated
- "We always asked the same question. Where are the ratings agencies in all this? And I'd always get the same reaction. It was a physical reaction because they didnt want to say it. It was a smirk. They were just assuming home prices would keep going up," Eisman said.

The Long Quiet:
- Mike Burry had 1.9 billion in CDS and he shouldve been recieving money as the market took its lumps but since he was one of the only players Wall St was setting the market price of his shorts
- So he started asking to buy at the prices they were telling him his shorts were worth but of course they wouldnt sell him any more. It was BS.
- "One of the oldest adages in investing is that if youre reading about it in the paper it is too late. Not this time."
- Burry's investors all wanted their money back including partner Joel Greenblatt. When he locked up their funds from withdrawal they started organizing to sue.
- Wall St stopped responding for a few days then all called at once saying they wanted to ensure the value of his shorts were fair. They were getting in on the shorts themselves before the crash.
- "When I first started shorting these mortgages in 2005 I knew full well that is was not likely to pay out within two years. And for a very simple reason. The vast majority of mortgages originated in the last few years had a rather ominously attractive feature called the teaser rate period. Those 2005 mortgages are only now reaching the end of their teaser rate periods and it will be 2008 before the 2006 mortgages get there. What sane person on Earth would confidently conclude in early 2007, smack dab in the midst of the mother of all teaser rate scams that the subprime fallout will not result in contagion? The bill literally has not even come due." Burry
- "Nobody came back and said, 'Yeah you were right.' It was very quiet. It was extremely quiet. The silence infuriated me." Burry

A Death Of Interest:
- Howie Hubler of Morgan Stanley is profiled as the stereotypical trader with the blinders on
- "It was more than a little weird. There was a lot of angst about it. It was sort of viewed as, These folks dont know what theyre talking about. If losses go to ten percent there will be, like, a million homeless people." Losses in Hublers group would eventually go to 40%.
- "They kept saying That state of the world cant happen!"
- "It is one thing to bet on red or black and know that you are betting on red or black. Its another to bet on a form of red and not to know it."
- "They werent lying. They genuinely failed to understand the nature of the subprime CDO
- Howie went on vacation and never came back. The losses left behind were 9 billion, the largest in Wall St history for a single trader
- The last buyer of subprime mortgage risk had stopped buying
- Cornwall began to worry Bear Stearns would go out of business and would be unable to pay up so they sought buyers of their CDOs.
- UBS offered 30 points up front. That means Cornwall's $205M in CDS were now worth $60M (30% of $205M) when it cost them only $1M to buy them
-"It's the first time were seeing any prices that reflect anything close to what they're really worth. We had positions that were being valued by Bear Stearns at six hundred grand that went to six million the next day." Charlie Ledley
- Mike Burry also started to make a killing. In a portfolio totalling $550M he maid $720M in one year
- "Even when it was clear it was a big year and I was proven right, there was no triumph in it. Making money was nothing like I thought it would be," said Mike. To his founding investor, Gotham Capital, he shot off an unsolicited email that said only, "Youre welcome." He'd already decided to kick them out of the fund and insist they sell their stake in his business. When they asked him to suggest a price, he replied, "How about you keep the tens of millions you nearly prevented me from earning for you last year and we call it even?"

Two Men In A Boat:
- "Being short in 2007 and making money from it was fun, because we were short bad guys. In 2008 it was the entire financial system that was at risk. We were still short. But you dont want the system to crash. Its sort of like the floods about to happen and youre Noah. Youre on the ark. Yeah youre okay. But you are not happy looking out at the flood. Thats not a happy moment for Noah." - Eisman
- Frontpoint's fund went from $700M to $1.5B
- "What, the entire American population woke up one morning and said, 'Yeah I am going to lie on my loan application'? Yeah people lied. They lied because they were told to lie."
- Sept 18 2008 all hell was breaking loose
- Eisman sold all his CDS back to Lippmann two months earlier. They were now back to stock market investors and shorting all the banks. On the 18th minutes after opening they were up $10M
- "There wer no bids in the market for anything. There was no market. It was really only then I realized there was a bigger issue than just our portfolio. Fundamentals didnt matter. Stocks were going to move up or down on pure emotion and speculation of what the government would do." Danny
- They were a subsidiary of Morgan Stanley
- "I'm thinking, Weve got the world by the fucking balls and the company we work for is going bankrupt."
- Mike Burry and Scion earned invesors a 490% gain in 3 years but all his investors were pulling their money out
- He shut down his fund and vanished
- Eisman ran into Merrill's CFO Jeff Edwards and said "You remember what I said about those risk models of yours? I guess I was right huh?"
- "I felt bad about it. It was obnoxious. He was a lovely guy. He was just wrong. I was no longer the underdog. And I had to conduct myself in a different way." Eisman
- "The investment banking industry is fucked. These guys are only beginning to understand how fucked they are. Its like being a scholastic, prior to Newton. Newton comes along and one morning you wake up: 'Holy shit, I'm wrong!" Eisman

Everything Is Correlated:
- The worst part of the crisis is that everyone came out rich. All the guys who called it and they guys on the wrong side of the bet. Even those who ran their companies bankrupt
- "What are the odds that people will make smart decisions about money if they dont need to make smart decisions--if they can get rich making dumb decisions" The incentives on Wall Street were all wrong; theyre still wrong."
- Handouts by the government
- "There's no limit to the risk in the market. A bank with a market capitalization of one billion dollars might have one trillion dollars' worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!"
- Michael Lewis has lunch with an old associate who basically created the credit default swap. He is a former king of Wall St. Lewis says he is thinking about doing a book on the subprime, revisiting his old Liars Poker days. Wall St guy says, "I think we can agree about this; Your fucking book destroyed my career and it made yours."

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