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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How is this supposed to work? If the bears were not there to bet against the market and act as a synthetic source of supply of subprime risk, the demand for such risk from the likes of Wing Chau would have driven spreads even tighter, to levels that were even more ridiculous, and that would have somehow exposed the bubble earlier and the whole thing would have blown up sooner than it actually did?

Posted by danyzn | Report as abusive

danzyn- stop asking questions. Bears are bad. Markets work best when everyone is bullish. The subprime mortgage market started to fall apart when not everyone was bullish anymore. If everyone had stayed bullish it would probably still be rockin’ and rolling. Got it?

Posted by johnhhaskell | Report as abusive

Danzyn, the non-sarcastic answer to your question is that Felix got confused. Lippmann found hedge funds that would buy equity tranches of CDO pools. Without an equity tranche to make the bond tranches “safer,” institutional type investors wouldn’t buy the bond tranches.

What the hedge fund guys understood was that the whole structure was unsound, and tranching it into equity and debt created an illusory protection for the bond tranches. The hedge funds then agreed to buy the equity (which they pretty much knew would not survive) in order to have the ability to short the bond tranches which slow, dumb, brain-the-size-of-a-walnut pension funds thought were safe “because housing prices never go down.”

When the “totally unforeseeable” house price decline hit, the equity tranches were in fact wiped out. As were the BBB and BB tranches, which the hedge funds (I generalize, of course) were short. Net net, a win for the HF’s.

Posted by johnhhaskell | Report as abusive

Huffpo works like the Business Inciter? Just repost something that appears elsewhere, with a headline?

Also, what’s with all the fancy Lords prancing about these reviews? Lord Turner here, Lord Skidelsky (stifling snicker) doing a blurb for Yves’ book. Lord Professor “Gottahavefun” Layard popping in from time to time to frown sternly.

There will be no best book written on the financial crisis until an author details the role of the PR people in creating the bubble and deflating the bubble. That is the book that tells the important story. How these devious little pricks run around and play 300 Card Monty is boooooring.

In other news: watch The Goebbels Experiment on Netflix. Selections from his diary read by Kenneth Branagh over clips from the 30′s and 40′s.

Posted by Uncle_Billy | Report as abusive

danzyn, my point is that CDOs are and always were buy-and-hold investments. Wing Chau never bought CDOs in the secondary market, and if the synthetic CDOs didn’t exist, there wouldn’t have been much in the way of subprime CDOs for him to buy at all. The existence of synthetic CDOs allowed demand to expand indefinitely, even as the actual supply of subprime mortgages was limited.

Anyone who watched Lewis’s unconvincing performance on “60 Minutes” (a publicists’ dream nevertheless) might say that to describe Janet Tavakoli’s post on HuffPo as “churlish pushback” incorporates a high degree of churlishness in its own right. In Shakespeare’s time they had a nice phrase that captures the essence of books like The Big Short: “claptrap to catch the groundlings.” Or as the Italians say, “Se non e vero, ma e ben trovato.” It may not be true – but it’s well told. I find Lewis’s lack of an index telling, since an index generally is a good guide to what has been omitted (very possibly because not understood.)

Posted by midasw | Report as abusive

Thanks for the response/post, Felix. Still, I find myself in danzyn’s camp. The lack of a secondary market seems like the real problem, not the shorts.

Posted by Sandrew | Report as abusive

But Sandrew, there’s never a liquid secondary market in any kind of securitization, it’s endemic to the asset class. But it’s true that the shorts weren’t the biggest problem. It’s just that they didn’t help, in terms of popping bubbles, in the way that shorts often can.

Lewis is paid to stir the pot. He isn’t all that interested in solutions. If he happens upon a few in the course of making something more marketable, great. If not, no big deal. He is just like most of the rest of today’s elites. Who care if anything actually gets fixed. He gets paid to create entertaining commentary either way….while Rome burns.

Posted by Sad_Oligarch | Report as abusive

Felix, I’m not arguing the fact that there’s never been a secondary market for funded structured products; only that complete markets are preferable to incomplete ones.

But I don’t yet buy-in to your thesis that the shorts contributed to the size of the bubble (or prolonged its life). It’s as if you’re saying that lifting the supply curve *causes* an increase in demand. That may be the case for the work of certain artists (a particular Young British Artist springs to mind), but I’m unconvinced the same paradox exists in any financial market–even one where the demand curve is perversely distorted by foolish regulatory mandates that privilege highly-rated paper irrespective of risk.

Shorts not helping pop the bubble (even if true) is not evidence that they helped prop it up.

Posted by Sandrew | Report as abusive

How do you classify books like The Money Game and Random Walk — not great or not financial journalism?

Posted by MarkPalko | Report as abusive

Sorry, should have added Lewis’ Liar’s Poker

Posted by MarkPalko | Report as abusive

I suppose it is just as well that 3 columnists write and multimedia about the same topic as it is so critical to understand. Let me therefore take the liberty to quote Hardy Green ex the Great Debate:

“There is Steve Eisman, the former Oppenheimer analyst who regularly demonstrated a prodigious “talent for offending people,” notably in a tendency to trash sub prime originators as early as 1997″ – that will teach people to ignore the (ex-) advisor of a family that trashed and stripped out (Southern) African gold and diamond mines and left an environmental legacy of note…Avatars unite !

The World is run by the brightest, shrewdest and most greedy traders and portfolio managers.

There must have been other contributing factors to the ‘meltdown’. Banks could simply have provided for the decrease in market values of properties, sometimes to below book value, against their massive and untouched (‘dividended’) (sic) earnings. These provisions would have smoothed out, let’s say during the 5 years up to 2013.

Or am I conjuring and missing something ?

The Big Chill.

Posted by Ghandiolfini | Report as abusive

The Lewis column from 2007 is amazing. Watch out Mr. Salmon, I’m saving the links to all your posts defending CDS. :)

Posted by silliness | Report as abusive

Felix says “But it’s true that the shorts weren’t the biggest problem. It’s just that they didn’t help, in terms of popping bubbles, in the way that shorts often can.”

I cannot improve on Sandrew’s sensible response to this irrelevant defense of a most unlikely claim. Felix, it is your own fault that your position is untenable. You should just cut your losses, admit you are wrong, and move on.

Posted by Greycap | Report as abusive

Sandrew, in the simplest sense, of course the shorts propped up the bubble in CDOs, since without them there wouldn’t have *been* all those synthetic CDOs, and you can’t have a bubble in a product which doesn’t exist. As a result, lots of investors in subprime synthetic CDOs lost a lot of money, as did the banks who failed to properly fund the super-senior tranches. Yes, there were equal and opposite profits on the short side. But there was still a bubble, and there were still big losses when it burst.

“Of course the shorts propped up the bubble in CDOs, since without them there wouldn’t have *been* all those synthetic CDOs, and you can’t have a bubble in a product which doesn’t exist.”

That is putting the cart before the horse: it was the market for CDO tranches that propped up the synthetics, and not the other way around. Of course, in principle there would have been less financial damage to investors and banks if synthetics had not existed. But the cash CDO market was always substantially bigger than the synthetic and made for quite enough bubble to constitute a disaster.

Furthermore, there is an important point that is eluding you: the demand for cash CDOs pushed back on the underlying housing market in a way that side-bets like synthetics could not. Nobody ever cold-called property owners to refinance, encouraged liar loans, or bid over par for mortgages on the back of a synthetic CDO. It was these things that forced up housing prices and so spread the damage to property owners who had never heard of a sub-prime mortgage.

In light of the underlying market distortions produced by the demand transference of cash CDOs, it is absurdly tendentious to claim that the cash market was somehow “validated” or “propped up” by synthetics. It was quite strong enough on its own.

Posted by Greycap | Report as abusive

You see the tulip farmers as enablers and shout. I see the same and shrug. I suppose we agree on the facts but disagree on the appropriate response. Ain’t the first time.

Posted by Sandrew | Report as abusive

I disagree that “shorts” are the cause of the problem.
To the contrary ! Shorts are the only way of telling the market that there is something wrong with the way things are going. “Shorts” keep the market honest. The market is going to go “down” regardless of shorts. Shorts just let you know ahead of time and not be off guard. Of course, you have to be smart enough to even know a short exist. Perhaps the ones on this blog critizing the shorts as the cause of the the current economic crisis , are not savvey enough to understand the role of “shorts”

Posted by zenladen | Report as abusive he-hedge-funds-1.html#more

11. Whether we consider the investment through the hedge fund is good or bad depends on us. If we don’t mind the collapse of the financial institutions then it is good. But most people regard the current financial meltdown as bad.

Posted by AsianCrisis | Report as abusive

What these guys did to screw the financial system is unbelievable.

I just finished listening to the audio version of The Big Short which really brought the story to life. Truly unbelievable.

Here’s the link to the audio. ig-short-doomsday-machine-unabridged

Posted by hathman65 | Report as abusive

I’m about a third of the way through “TBS” and I have to say I’m nearly as angry as I was after 9/11. It’s clear there’s a huge gap between the average intelligent person and Wall Street. I could sense it while watching the committee hearings with Goldman Sachs yesterday. The people who defend these kind of instruments can’t possibly understand how ridiculous this appears to an intelligent person on the outside. There’s a danger: understanding something, or at least thinking you do, becomes the rationalization for it’s existence. It’s payday someday, folks. This is such a joke that people are actually rationalizing the existence of a market that existed only on the back of one that should have never existed because “that’s the way it works.” Shame on this country.

Posted by mirv | Report as abusive

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