Michael Lewis’ Big Short an unsettling experience
Henry Paulson didn’t see it coming. Nor did Timothy Geithner foresee the meltdown of the financial markets. According to Standard & Poor’s President Deven Sharma, testifying before Congress in the fall of 2008: “Virtually no one – be they homeowners, financial institutions, ratings agencies, regulators, or investors – anticipated what is occurring.”
Why? Perhaps “it took a certain kind of person to see the ugly facts and react to them – to discern, in the profile of the beautiful young lady, the face of an old witch,” says Michael Lewis, author of numerous best-sellers including 1980s Wall Street memoir Liar’s Poker and now The Big Short: Inside the Doomsday Machine (W.W. Norton, $27.95).
Lewis’ new volume is an entertaining and very edifying look at several such insightful people — the tiny handful of investors “for whom the trade became an obsession.” These were unusual, “almost by definition odd” folks, soon to make big money on the cataclysm: There is Steve Eisman, the former Oppenheimer analyst who regularly demonstrated a prodigious “talent for offending people,” notably in a tendency to trash subprime originators as early as 1997.
Next up is Michael Burry, a compulsive, “one-eyed money manager,” a man profoundly uncomfortable around other people who could only work alone in his office with the door closed and the shades drawn. Poring over obscure corporate documents, Burry saw the insanity in the financial markets and in 2005 began prodding big Wall Street firms to offer credit default swaps, or financial insurance policies, against the failure of mortgage-backed derivatives. Finally, there’s the “weirdly like-minded” threesome who made up the money-management outfit they called Cornwall Capital Management. They were “sweet-natured, disorganized, inquisitive” –”the kind of guys who might turn up at their fifteenth high school reunions with surprising facial hair and a complicated life story.”
This band-of-outsiders conceit is familiar — reminiscent of everything from Huckleberry Finn to The Dirty Dozen – and if The Big Short were no more than a collection of such profiles, it would satisfy many readers. But Lewis’ volume has lots more to offer thanks to its clear explication of exotic derivatives and meltdown events.
Much of this may be familiar to regular readers of the financial press, and may remind some of Wall Street Journal writer Gregory Zuckerman’s much lauded account of hedge-fund trader John Paulson’s $15 billion coup, The Greatest Trade Ever. But even these readers are likely to admire the lucidity of Lewis’ book. Here, for example, is how Lewis explains the two financial instruments at the heart of the mess. The subprime mortgage-bond-backed collateralized debt obligation, or CDO, was “so opaque and complex that it would remain forever misunderstood by investors and rating agencies.”
It was a bunch of mortgage bonds, often rated triple-B, used to construct an entirely new tower of bonds, which ratings firms like Moody’s and Standard & Poor’s were persuaded to rate triple-A. The CDO, which hid huge risks via obfuscation, “was a machine that turned lead into gold” for Wall Street, writes Lewis. The credit default swap, meanwhile, was effectively an insurance policy with semiannual premium payments – but also an asymmetric bet. As in roulette, “the most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money.”
A buyer of credit default swaps like Burry, moreover, was not insuring anything he actually owned, since he had no CDOs. “It was as if he had bought fire insurance on some slum with a history of burning down.” And who took the risk? Goldman Sachs, the firm that sold Burry credit default swaps in $100 million chunks? No, of course Goldman was just a middleman. For a long while, the true risk-taker was insurer AIG. That company, “effectively long $50 billion in triple-B subprime mortgage bonds, masquerading as triple-A-rated diversified pools of consumer loans,” seemed to have little appreciation for the level of risk it was swallowing. Its position represented nothing more sophisticated than a colossal “bet that home prices would never fall”
Lewis is also instructive on the matter of market distortions caused by oligopoly power on Wall Street. The realization that all was not well began to dawn on investors in January of 2007, when the index of subprime mortgage bonds began falling. But even as these bonds lost 30 percent of their value over the next six months, the tricked-up CDO market held firm. “To Charlie Ledley at Cornwall Capital, the U.S. financial system appeared systematically corrupted by a cabal of Wall Street banks, rating agencies, and government regulators,” notes Lewis. For months, Burry saw little change in the value ascribed to his credit-default-swap investments: “They were worth whatever Goldman Sachs and Morgan Stanley said they were worth.”
Once it was clear that the sky was falling, the firms that had their own money invested in mortgage-backed CDOs began ducking for cover. In August, UBS, Citigroup, Merrill Lynch, and Lehman Brothers all expressed eagerness to buy Cornwall’s $205 million in credit default swaps. Soon, Wall Street’s powerhouses were crumbling one by one, and the Federal Reserve was deciding to loan $85 billion to AIG so it could pay off its credit-default-swap liabilities. “This is what [Eisman and the others] had been waiting for: total collapse,” writes Lewis. From a $1 million bet, Cornwell netted $80 million, while Burry realized profits of $720 million. Eisman’s fund doubled in size, to $1.5 billion.
It’s an unsettling experience to read The Big Short: Identifying with its main characters, you begin rooting for Armageddon — but there’s a hollow feeling once the short sellers triumph. Likening his experience to that of the Biblical flood, Eisman reflected: “You’re on the ark. Yeah, you’re okay. But you are not happy looking out at the flood. That’s not a happy moment for Noah.” Such, it seems, is the penalty for prescience.
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