The Big Short

By Felix Salmon
March 15, 2010
my review of Michael Lewis's new book was posted on Friday, Sandrew asked for a bit more detail on this bit, about the people who shorted the subprime mortgage market:

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After my review of Michael Lewis’s new book was posted on Friday, Sandrew asked for a bit more detail on this bit, about the people who shorted the subprime mortgage market:

What these men did was not “socially useless,” to quote the chairman of the UK’s Financial Services Authority, Lord Turner. It was worse than that: it was actively harmful, since they provided the fuel which kept the subprime mortgage furnace burning even when the country was running out of new junk mortgages to write. In most financial markets, bearish bets act as a dampener; in this one, they were a necessary part of the subprime-mortgage machine, and a Deutsche Bank mortgage trader named Greg Lippmann ended up making billions of dollars for his employer — not to mention a $50 million bonus for himself — by aggressively going out and finding fund managers to put on the short bets needed to keep the market ticking.

The point here is that credit bubbles, like all bubbles, feed on trading activity and upward momentum. If you look at the history of the subprime mortgage market, it started off small and then slowly sped up as Fannie and Freddie started accepting increasing amounts of subprime paper. Then banks started selling private-label subprime CDOs directly to investors, bypassing the GSEs; a lot of the profits in that activity came from taking the unattractive lowest-yielding tranches and insuring them with AIG.

Then, after AIG exited the market, everything should have ground to a halt. But it didn’t, because banks continued to build synthetic subprime CDOs out of the credit default swaps which were being bought by Greg Lippmann and others. The demand for those CDOs from investors like Wing Chau was enormous, and helped to ratify the valuations that everybody else was placing on their own subprime assets. Remember that this is a market with almost no pricing transparency in the secondary market: because all securitization deals are unique, the only way to get a feel for the health of the market is by looking at where primary deals are pricing. Whenever anybody said that the marks being put on subprime assets by banks and hedge funds were delusional, it was easy to point to the booming market in synthetic subprime CDOs to prove them wrong. No one, of course, remarked on the irony that the synthetic subprime CDO market was only booming because John Paulson and others were providing a huge amount of demand for bearish bets.

My review got quite a lot of attention elsewhere, too, largely because of the last line, where I call Lewis’s book “probably the single best piece of financial journalism ever written”. It is a very good book, but at the same time there’s a faintness to the praise. As I wrote back in 2002,

With the possible exception of Michael Lewis at the New York Times Magazine, the financial journalism which appears in the generalist press (John Cassidy in the New Yorker; Joseph Stiglitz in the New York Review of Books) aspires more to authoritativeness than it does to any kind of lasting style.

Lewis’s achievement with The Big Short is that he’s written a book that a huge number of people will love to read: it’s not just for finance geeks. It’s pretty much the first crisis book about which that can be said, because Lewis has expended enormous effort on the kind of things that most financial journalists consider optional extras: carefully-structured narrative, intimately-colored characters, beautifully-written prose.

The churlish pushback against Lewis’s book, then, is misplaced, especially because The Big Short is a book-length refutation of the notorious column that Lewis wrote in January 2007, where he called the subprime bears wimps, ninnies, and pointless skeptics. Lewis clearly did an enormous amount of research for this book, which is more detailed and more accurate than anything he’s written in his Bloomberg column or for a glossy Condé Nast magazine.

Of course, in any book it’s possible to find mistakes, but people like Michael Osinski should be careful about throwing stones: I’m not at all sure he’s right, for instance, that the subprime CDS market ever “overwhelmed the actual market in the underlying bonds”. For what it’s worth, my quibble with the Lewis book is when he starts talking about the ABX index as being indicative of prices more generally, a mistake which Gillian Tett also made multiple times in her book. But that really is only a quibble. The Big Short isn’t ambitious in the sense of trying to explain everything that happened over the course of the financial crisis, but it’s very ambitious in the sense of trying to get a great book out of the crisis — one which can compete not only with finance books but also with fiction and non-fiction books more generally. I just wish that someone other than Michael Lewis would share that ambition.

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