By 2004, we had experienced a countrywide collapse in home mortgage credit standards, and industry heavies had already failed once a few years back. Many loans were structured around first-time homebuyers who couldn’t make the interest, and "flipped” properties to cash in on home prices going up. Incredibly, to allow that to happen, these speculators were charged teaser rates for two years, often no initial monthly payments at all. Lenders now made their profits from origination fees, not interest, and passed the loans off on Wall Street, making room for more originations. Wall Street did its thing, holding some product, but unloading most onto institutional customers, deceiving them and the rating agencies about the bad, or “sub-prime“ loans thrown into the mix.
Then home prices topped out and started going down, a thing hardly anyone thought possible. That’s where Michael Lewis steps in with his extraordinary book, The Big Short.
It’s a reality check spun around 1) thugs securitizing bundles of individual sub-prime home mortgage loans into a single bond issue, the toxic asset that unleashed financial Armageddon upon the civilized world and Iceland, and 2) wise guys creating two brand new financial derivatives allowing bets to be placed against that toxic asset: a) the credit default swap (CDS) specifically for home mortgage-backed bonds and b) the synthetic collateralized debt obligation (CDO), a nuclear option, famously rated AAA and A++ in error, allowing hedge fund managers to short whichever mortgage loans defaulted first. Or last, or blew up at various levels in between, called tranches in Wall Street newspeak.
The writer works much of his magic through the eyes of a few short-sellers who, foreseeing a highly improbable future, placed those bets and cashed in. Our regulatory hotshots didn’t seem to fathom what was going on, which is barely mentioned, and appropriately so, as again they deigned to step in and prevent a cataclysmic securities fraud from crippling its unprotected victims.
Chillingly, whistleblowers here, as in the Madoff freak show, warned the Securities and Exchange Commission (SEC) that an outsized financial catastrophe was looming. Actually went to their offices this time and laid out the whole kit and kaboodle, and …
Nothing. Not a thing.
The Big Short, recommended to us by an original subscriber, is mandatory reading for MacDougal Post regulars, and we almost never hand out homework. The author’s surreal view includes Wall Street racketeers screwing first their customers, then Düsseldorf, hideous jargon for the overseas investment community, and finally us. His compelling take encompasses the arrogance, blind stupidity, and unfettered greed that greased this doomsday machine. Michael names names, painting real faces on real people, while chronicling the flagrant criminality that accompanied the “originate and sell” adjustable rate sub-prime home mortgage loan from issuance through securitization and distribution right up to its ultimate demolition of life as we then knew it. The story lays out precisely how the financial community’s winners won, and their losers lost, and indulges our morbid fascination with this, delving unflinchingly into every remarkable twist and turn along the way.
His hero is the foresighted short seller, and there were almost that few of them around, and the author has no problem with these guys, and neither will you. If one or two had hooked up with the Crime Families in the past, no one can fault them on their part in this one. Not even us. A crooked financial system offered up unimaginable riches to anyone with the mettle to back right against overwhelming forces of wrong, and they puzzled out the map to the mine.
There’s no law enforcement to turn to, the SEC a cheerleading squad for market gamers, so short-sellers grabbed what lawlessness set before them.
In 2004 you could spot a decline in sub-prime mortgage lending standards from reported numbers, and at least one hedge fund manager did, and by the second half of 2005 the deterioration drew more managers in, and the 2004 guy got investment bankers to create the appropriate CDS, and one of the 2005 guys had them work up the synthetic CDO so the worst tranches of bonds backed by these now-toxic assets could be shorted. Ultimate returns of 50 to 1, or higher, were virtually guaranteed in the stats that popped up on computer screens the twenty-fifth of every month.
For those who knew to look for them.
Teaser interest rates underlying the toxicity of these assets expired after two years, and by 2007, as forewarned back in 2005, home owners en mass couldn’t meet the real monthly payments kicking in. For the longest time investment bankers on the wrong end of the bet tried to convince the shorts this wasn’t happening, blatantly marking fraudulent prices to hold up a collapsing market, and we’re forever indebted to Michael for putting this kind of criminal activity in print. One day law enforcement might even notice. Suddenly one morning, the market makers switched sides, found suckers of their own, and went short themselves. Started quoting real values for a change, the reason why markets seemed to crater overnight.
That part probably took Michael two sentences to write, but is the core of the book’s message to us. Market makers marking not to markets but to their own positions. When they’re long, prices are supposed to go up, and only when a firm is short will its con artists even think about taking prices down. The angst our heroes were forced to endure throughout this phase is all too familiar to the investment novice who jumps all over the right trend, only to see his dreams dashed while bloodsucking thieves scare his naive a$$ out of the market with a deep swoon and then take prices up where everyone knew they should be.
Upon finishing the book, readers should have no trouble parsing Wall Street’s role from that of the banking system that originated the doomed paper. You’ll have lived it through Gangland eyes, and come away feeling you know who and what they are.
That Crime Families used characters like the second smartest guy in China to come up with financial products even they themselves couldn’t understand serves to draw readers in to take a virtual part in the financial bloodbath. There’s the almost comically successful asocial hedge fund manager/neurologist living his life by email, stock picker extraordinaire lambasted by his investors for throwing their money away on esoteric bond derivatives helping generate what proved to be a total portfolio return of 489.34 % over 8 years. And the brash, bigger-than-life genius bullying CEO’s every time he runs into one because, as a class, they have no idea what’s going on, and we meet the CEO’s too, and they don’t. Everybody’s a crook on our lovable bully’s Street, and crooks here won’t even tell the boss how they really scam out a living. These pages are riveting.
Michael “is the finest storyteller of our generation“, according to one critic on the jacket. That may be. Certainly, The Big Short is far and away the finest business book we’ve run into. The kind of narration you don’t read. You experience this colorful adventure.
That said, we rush to note that a financial accountant is writing your review. If the business exotica overwhelms, skip over that gobbledygook, arcane even to the nosiest of CPA‘s, but hang tight with the characters and do not miss the last couple of chapters. Nobody goes to jail, most everyone lands on their feet, and even the biggest losers on Wall Street walk away after a brobdingnagian personal payday. A miserably unhappy ending to be sure, given what these vicious hoodlums did to the gentle peoples of the world.
The way a malignant Crime Family culture gets bailed out pretty much intact while all those bondholders and home buyers go under is spellbinding, and we’re confident that nobody has covered that side of this epic tragedy better than Michael Lewis, or more succinctly.
Get your hands on The Big Short. We read it twice ourselves last week.
