Michael Lewis’ Big Short an unsettling experience

March 11, 2010

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.

Join Reuters.com for a live chat with Michael Lewis on March 16. Leave your questions here.

21 comments

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Geithner Didn’t see this coming?
Sheesh, I knew the whole thing was amiss even before the liar loans were created and I’m not even in the Real Estate field.

Posted by KirkD | Report as abusive

This society belongs to the banks.

Apparently they don’t care if we have 1 in 8 on foodstamps.

Is the expanding number of poor and the overflowing riches of banks a coincidence?

Here -
http://leftsolutions.wordpress.com/2008/ 06/09/the-rich-get-richer-and-the-poor-g et-poorer-is-this-a-coincidence/

Posted by reverse_cloud | Report as abusive

Just woke up from a blissful dream.

Life without banks.

http://leftsolutions.wordpress.com/

Posted by reverse_cloud | Report as abusive

Full article-

Banks as Public Enemy

http://leftsolutions.wordpress.com/banks -as-public-enemy/

Posted by reverse_cloud | Report as abusive

I suspect this was a ‘controlled burn’ trying to set a backfire that would deflate the bubble enough to keep it under control at the same time as creating enough of a scare in congress to recollateralize the capital pool. The timing, circumstances, players and outcomes lay out like a well rehearsed con. Like any fire, look at the triggering mechanism – who was the first to blink and stop the cycle of credit? What made them balk – was it a word from the Gods of Capitalism? Who stood ready to benefit? – the same Gods of Goldman. These are the sharpest financiers in the world and their defense is ‘they didn’t see it coming’. Please SOMEBODY restore reality so blatant lies are exposed.

Posted by HileeSuspect | Report as abusive

Bob prechter and his Elliott Wave forecast saw this coming too but more importantly and frightenly, he is forecasting the “TIDAL WAVE” about to come ashore. Prechter is one of the most brilliant people on the planet and Michael can write his next book about Bob and his efforts not to chase the dollar sign but to save us from being crushed.
dunwoodydave1

Posted by dunwoodydave1 | Report as abusive

what a ship of fools we all are. sunk by a bunch of junk (bonds?). as a group, we’re to stupid for any new jobs. better off staying ‘depressed’!

Posted by jborrow | Report as abusive

what a ship of fools we all are. sunk by a bunch of junk (bonds?). as a group, we’re too stupid (and can’t spell well enough) for any new jobs. better off staying ‘depressed’!

Posted by jborrow | Report as abusive

check http://ow.ly/1dZJr for home and flood insurance coverage for your home

Posted by letacecily | Report as abusive

First, stop calling them banks. They are not banks. They are stock brokers!

Posted by NowYouKnow | Report as abusive

Peter Schiff and Roubini foresaw it.

Michael Lewis lost credibility when he said nobody foresaw it.

http://www.youtube.com/watch?v=2I0QN-FYk pw

Posted by ron_paulite | Report as abusive

It’s a sad state of affairs that all these very smart people are sucked up by the financial markets because of all the money they can make. We as a society lose out because many of them otherwise could have been doctors, engineers, scientists…

Posted by bluemen | Report as abusive

Great article.

Posted by Ghandiolfini | Report as abusive

If you want to know who to blame just look into the mirror. American’s from all walks fell into the trance of easy money. Taking out second and third mortgages, having multiple credit cards. Looking for risky investments which promise to pay back huge. People living way beyond their means. Government’s spending like tax payer’s did not care. Oh, the list goes on and on. But trust me we will not learn from it and it will happen again!

Posted by jscott418 | Report as abusive

Yes Scott, what bothers me most is whether the US consumer and trader consumption patterns triggered a ‘global’ meltdown ? Why should the US take the credit/debit ?

It’s like the ‘Big Bang’ (I prefer “The Big Expansion”), was it one trigger/singularity or did everything come into existence at the same time ?

I think all 196 odd economies are to blame at the same time, else the US and its financiers must get us all out of this messy Big Dwang.

Posted by Ghandiolfini | Report as abusive

What is scaring me a little is the fact that without all the “funny money” there may not be enough to go around. The country will try to return to the so called good old – equally illusory – days of “gilt edged securities”, but that will only work for those well placed.

I am beginning to resent that Obama’s stimulus money was spent on keeping teachers and firemen employed with their union negotiated contracts when he could have let them take a cut in pay like so many others – who had terminal cuts in pay. And why are Broadband services being extended to outlying areas with what is essentially grant money – when they could just as well have been expanded with bond issues?

Aren’t we seeing the full-fledged birth of a two-tier economy? It’s been talked about since Reagan. I expect the economy to be composed of those at the very well fixed top and the rest, just scraping by. The birth of the controllers and the great mass of abject controlled? The wealthy get what they want – the rest get only what they need according to definitions set by those at the top.

In a way – if this is the US economy of the future than we should be demanding that the very wealthy read Thorsten Veblen (Reagan would have found that book sarcastic) and take up the job of living like lords and spending money like water, in spite of the fact that Veblen seemed to be so supercilious about the historic phenomenon of conspicuous consumption. The top tiers of world wealth will have to pay it back somehow if they can’t stand to part with it in higher taxes. It will be their task to force feed themselves on all the gimmicks and come-ons the post industrial society seems to need to keep the money moving at all. And if “patriotism” and dieing for the cause is being touted too loudly – it will be their job to lead the way and pay most of the costs for wars that keep them secure and not just send those they deem expendable – to do their the dirty work for them. That was the saving grace of the historic lordly classes. They could often find their high places destroyed like those they ordered into battle.

This world of jobless recovery is being created by people who want to keep what they have without any risk what so ever.

The wealth holders in this society weren’t all that clever and they could find they created a system that trapped them into being cash cows for the rest of us. It will make me laugh to hear them say that their foresight was responsible for their success and position in the new world of very selective wealth and prevailing poverty. The successful have a disgusting habit of giving themselves credit for virtues and capacities they don’t always possess. They frequently have the ability to show that they can be the biggest spoiled brats than all the smaller people they tend to despise.

I am waiting to see whether Mr. Buffett actually invests in the enlargement of Burlington Northern or merely milks the vitality of it until it is worn out. He is not living in the days of those who originally built the railroads. He is hanging on to one of the few that survive at all without Government subsidies and promises to be the only game I that part of town.
In some ways there is very little difference between a business baron and a mafia lord. They can both buy the legal system and now, thanks to the recent Supreme Court decision, they can buy the whole Congress and presidency too. .

Posted by paintcan | Report as abusive

I’m not buying this story, they knew the meldown was coming and they were makeing money all the time the houseing bubble was growing Then GS godfather of wall street got out of the mess smelling sweet. More fiction than non fiction here IMO…

Posted by DOUBLEDIPPER | Report as abusive

I’m not buying this story, they knew the meldown was coming and they were makeing money all the time the houseing bubble was growing Then GS godfather of wall street got out of the mess smelling sweet. More fiction than non fiction here IMO…

Posted by DOUBLEDIPPER | Report as abusive

Actually alot of people were in self denial: Wall Street got drunk; to paraphrase Bush. My friend was in real state for over 30 years in Rancho Mirage, California. Yet, he was in denial the boom will continue to go….poor fellaw refuse to accept the reality.

Posted by Especulator | Report as abusive

“The wealth holders in this society weren’t all that clever”

Rubbish. They were extremely clever. They got one of their own appointed to the Treasury, spent the better part of a decade ruining their own balance sheets and awarded themselves billions of dollars every year for that favor, and when it all came collapsing they got YOU (the taxpayer) to pay for it through their buddy at Treasury and continued giving themselves billions of dollars in bonuses every year for starting the whole cycle again.

That’s nothing if not clever.

Posted by eltopo71 | Report as abusive

Anyone know how to get in touch with Cornwall Capital? I’m really impressed by their methods and I’m looking into establishing my own derivative based hedgefund.

Posted by ARH | Report as abusive