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Book Review: The Big Short

The Big Short

I was originally drawn to reading this book after seeing the movie adaptation in theaters. Steve Carrell, Christian Bale, Ryan Gosling, and Brad Pitt all did wonderful jobs of portraying their characters, and I was really amazed by how true to the book that the movie was (of course, that's not something I realized at first, but only after also reading the book).

When I found out the movie was based on a book by Michael Lewis, I knew I had to pick up a copy and give it a try. Michael Lewis is one of my all time favorite authors. He's written some world-class books, including The Blind Side, Liar's Poker, Moneyball, and, more recently, Flash Boys (which I am currently in the process of reading - maybe another book review to come!).

I thoroughly enjoyed the book, and if you're considering picking up a copy yourself, read on to hear my thoughts about it!

Setting

Any readers who are unfamiliar with the Global Financial Crisis (often abbreviated GFC in this post) of 2008 are about to get a history lesson. Since the book is set in the midst of the GFC, without having an idea of what happened, the book will be hard to understand.

Traditionally, the business models of banks were much more simple than they are today. While present-day banks are multi-product financial companies providing day-to-day banking services, credit cards, mortgages, and investments, in the past banks were focused on two products - deposits and lending.

The main method early banks used to make money was to accept deposits from people, paying them a low rate of interest, and then lend that same money to other people at a much higher rate. This difference in rates, or spread, was the banks profits on the transaction. This was a business model that was only largely profitable in large scale, so naturally banks began to scale up, leading to the big names today - names like RBC, TD, CIBC, BMO and ScotiaBank.

Two main factors led to the GFC in 2008. First of all, banks (mostly Amercian banks) dramatically lowered their standards for lending. Not only did credit scores become less important, but banks began performing "no-doc" mortgages, which means they didn't verify their customer's identities or incomes. In the Big Short's movie adaptation, there is a humorous example where a landlord had filled out a mortgage application under his dog's name because he had himself been declined. It is perhaps even more alarming that they didn't verify income. In my experience with mortgage applications, income confirmations have been just as important as credit scores when applying.

The second contributing factor to the GFC was the increased complexity of the mortgage market. This extends to loan-level detail as well as broader mortgage-backed-security detail. At the loan level, banks were increasingly creating policies that allowed people to qualify for mortgages that they had no right in receiving. For example, Lewis describes in the Big Short the creation of "interest-only negative-amortizing adjustable-rate sub-prime mortgages", which essentially means that if the mortgage-holder didn't make their payments, it didn't qualify as a default or a delinquency. Instead, the missed payment and interest were just rolled into the principal, creating a larger mortgage and a longer amortization period. The only way for the mortgage holder to "default" was for the principal of the mortgage to reach a certain, predetermined level, but this was avoidable under certain conditions - as long as home prices were rising like they were in the years leading up to the GFC, homeowners could refinance and avoid defaulting. This was very risky behaviour on behalf of the banks, because as soon as home prices started to drop, defaults would occur en masse.

At a larger level, banks were also creating more complex ways to gather capital to create more mortgages. While this didn't inherently make their operations more risky, what it did do was effect a lot more people if the mortgages did default. Let me detail what they did.

Recall that in the past, mortgages were funded by the deposits of the banks other customers. In 1968 the first mortgage-backed security (MBS) was issued. The main idea of a mortgage-backed security is that the banks issued mortgages to consumers, and then sold a "mortgage-backed security" to investors so that the bank doesn't have to lend out any of their own capital. Instead, they are lending the proceed from the sale of the MBS.

Mortgage-backed securities are like bonds in that they pay out a coupon. The way that banks make money off of these MBS-funded mortgages is by maintaining a spread between the mortgage's interest rate and the coupon paid out to the MBS investors. Overall, the spread is usually lower than on a deposit-funded mortgage, but it's essentially free money for the bank since they aren't putting up any of their own capital.

From 1968 until the GCF, larger and larger proportions of banks mortgages were funded via MBS and not deposit. As a result, innocent investors lost a lot in the GFC, not just the banks who were the cause of the crisis.

A sign used in protests on Wall Street in 2008. Photo courtesy of A. Golden

Further compounding the effect of the Global Financial Crisis was the introduction of Collateralized Debt Obligations (CDOs). Essentially, CDOs are groups of mortgage-backed securities that are sold to investors as a security, similar to a bond. CDOs are divided into tranches, with the "upper" tranches (often called AAA tranches) having the most creditworthy mortgage-backed securities and the "lower" tranches being less creditworthy, ranging from AA to A to BBB to "residual". Here, residual is a substitute word for "garbage" or "destined to default".

The benefit of CDOs was that is allowed banks to gather more capital from the same amount of mortgages. So if a bank sold $50 million of mortgages and sold only MBSs and no CDOs, they could really only gather $50 million of capital from the mortgages, rendering them capital-neutral and only making money off of the interest rate spread. If the bank issues CDOs alongside the MBSs, they can repackage the underlying mortgages into new securities and gather even more capital.

Some banks even took this to a higher level and made CDOs whose underlying securities were also CDOs. These complicated securities were called "CDO squared" or "synthetic CDOs", and were hilariously described in the Big Short's movie adaptation in a conversation between actor Steve Carrell and a CDO fund manager.

On a fundamental level, what all of this securitization of the mortgage market meant was that if homeowners defaulted on their mortgage, MBS & CDO holders would be holding a worthless security, and it would be for much more than the face value of the mortgage. In the Big Short, it is described at $50 million in mortgages could underly up to $1 billion in MBSs and CDOs. A common term used to describe this situation would be to say that the banks were "highly leveraged," a concept I wrote about in my earlier post Pay Down Debt or Invest?

The bottom line of all of this over-securitization of mortgages: due to the lackadaisical lending standards of big banks, the investors behind these securities were devastated when subprime mortgages started to default.

The Effect of the Global Financial Crisis

By any account, the events leading up to the GFC had a huge effect on the world. For example, the S&P 500 Index is a capitalization-weighted index of the 500 largest companies in the United States. The iShares family of funds produced by BlackRock has a S&P 500 Index fund that seeks to identically replicate the index - if you consider it's performace from 2005-2016, you can clearly see how the Global Financial Crisis effected the price of US equities:

Clearly the index got crushed, which shows that the GFC had an effect on the broader economy, not just the housing market. You would see similar results in graphs of GDP growth, bond prices, housing starts, and virtually every other indicator of economic health.

The recession also bankrupted some of America's biggest and "safest" companies. Perhaps the most famous case was Lehman Brothers, America's fourth largest investment bank at the time (behind Goldman, Morgan Stanley and Merrill Lynch). Most people would have considered them "too big to fail" in the sense that their collapse would have broader implications for the rest of the American and global economies. They were right - but when everyone else is facing bankruptcy too, it's hard to find someone to bail you out.

Eventually Lehman Brothers was acquired piece-by-piece by a syndicate of global companies, both banks and otherwise. Though they were the most famous bankruptcy of the GFC, they were not the only ones. General Motors is another notable name, along with Chrysler, Washington Mutual Savings Bank, Circuit City, and Countrywide Financial (a leading provider of mortgages of the subprime variety, later acquired by Bank of America).

So Where Does The Book Fall In All of This?

The Big Short follows the story of four groups who independently predicted the demise of the subprime mortgage market, thus profiting while the economy collapsed. In my opinion, a lot of people who have seen the movie without reading the book are still puzzled as to how anyone can make money when the markets are falling. It's called a short sale, and will definitely be the subject of one of my future posts.

In a nutshell, to sell something short means to bet against it. In equities, the most common way to do this is to borrow an equity from someone else while expecting the price to go down. Once you receive the borrowed equity, immediately sell it before buying it back later at a lower price. After you return the equity to the person that you borrowed it from, you get to keep the difference between your sale price and purchase price, less interest.

Obviously it's harder to short the housing market than the stock market.This is evidence in the Big Short's movie adaptation, when Michael Burry tells one of his investors that he wants to short the housing market and the investor replies "Through which security, Michael?!" In the past, there were no securities that existed to short the housing market, so investors invented credit default swaps.

Credit default swaps are like an insurance contract. You monthly premiums to the issuer of the swap, and in return they agree to pay you a predetermined amount if an issuing company default on some sort of underlying security (typically a bond). When the investors in the Big Short predicted the Global Financial Crisis by examining the credit quality of the bonds underlying the popular mortgage-backed securities, they purchased credit default swaps against the MBSs & CDOs and profited tremendously. Later in this blog post I wrote a section called "A Few of My Favorite Quotes", and one of the quotes is a beautiful description of how these credit default swaps work. Give it a look, The Big Short contains one of the most concise descriptions of credit default swaps that I've ever seen.

I now feel as though I've spent a tremendous amount of time writing about the historical context of the book, and not about the characters or plot. To give you a sense of what the book is about, I'll briefly describe each of the groups of characters, along with their stories leading up to the GFC.

Ryan Gosling. Photo courtesy of Elen Nivrae

Greg Lippman (portrayed in the movie under the name Jared Vennett, by actor Ryan Gosling) was a credit default swap trader who worked for Deustche Bank. He was the trader who worked with Steve Eisman's group (more on them later) and eventually actually sold them the credit default swaps. Currently, Lippman is a hedge fund manager and Chief Investment Officer of LibreMax Capital, LLC.

I found his story very interesting because he knew was working for a company (Deustche Bank) that was going to lose a lot during the financial crisis, but he sought to gain millions by shorting their instruments. In that sense, he was a double agent of sorts. I was also interested by his relationship with his employer - since the credit default swaps he had purchased required him to pay monthly premium for no immediate gain, Deustche Bank wanted him to unload them even though he knew they would be profitable over the long-term. Hence, his relationship with Steve Eisman & Co.

Steve Carell. Photo courtesy of Eva Rinaldi

Steve Eisman (name changed in the movie adaptation to Mark Baum, wonderfully portrayed by Steve Carell) & Co. were a group of four people who operated a hedge fund, FrontPoint Partners, that was owned by Morgan Stanley. This group likely provided the most comic relief in the plot, as Steve's no-bullshit approach to life led to lots of humorous situations. For example, at the American Securitization Forum, Michael Lewis hilariously describes the following:

"When the CEO of Option One got to the part of his speech about Option One's subprime loan portfolio, he claimed that the company had put its problems behind it and was now expecting a (modest) loss rate on its loans of 5 percent. Eisman raised his hand. Moses and Daniel sank in their cahirs. "It wasn't a Q&A," says Moses. "The guy was giving a speech. He sees Steve's hand and says, 'Yes?'"

"Would you say that five percent is a probability or a possibility?" asked Eisman.

A probability, said the CEO, and went back to giving his speech.

Eisman has his hand up in the air again, waving it around. Oh no, thought Moses, and sank deeper in his chair. "The one thing Steve always says is that you must assume they are lying to you," said Daniel. "They will always lie to you." Danny and Vinny both knew what Eisman thought of these subprime lenders, but didn't see the need for him to express it here, in this manner. For Steve wasn't raising his hand to ask a question. Steve had his thumb and index finger in a big circle. Steve was using his fingers to speak on his behalf. "Zero!" they said.

"Yes?" asked the obviously irritated CEO. "Is that another question?"

"No," said Eisman. "It's a zero. There is zero probability that your default rate will be five percent." The losses on subprime loans would be far,far grater. Before the guy could reply, Eisman's cell phone rang. Rather than shut it down, Eisman reached in his pocket and answered it. "Excuse me," he said, standing up. "But I need to take this call." And with that, he walked out of the speech. The caller was his wife.

Eisman & Co. fill the book (and the movie) with many more hilarious tidbits like this. I won't tip you off to any more, though - if this is appealing to you, you should pick up a copy of the book! One last teaser - my absolute favorite moment in the book is Eisman's interaction with CDO manager Wing Chau. If you do read the book, look forward to this part, because it's absolutely hysterical.

Interestingly, the group was actually tipped off about the subprime mortgage crisis by receiving a wrong-number phone call from Greg Lippmann's assistant. This led to their involvement with Lippmann, up to and including their purchase of credit default swaps from his firm.

Eisman's life after the events depicted in the Big Short seem to essentially be split into three chunks. First, he ran another hedge fund Emrys Partners for a few years after the dissolution of FrontPoint Partners. After Emrys Partners dissolved, Eisman became a vocal opponent of for-profit universities, comparing the ethics behind them to those of the subprime mortgage market. Now, Eisman appears to be working with his parents for at Eisman Group, which is (to my understanding) a division of Neuberger Berman. He seems to view this as coming full circle, as his first job in the financial sector was arranged through his parents' employment at Oppenheimer & Co., where they both worked as stock brokers.

Brad Pitt. Photo courtesy of Eva Rinaldi

Another group that successfully predicted the global financial crisis and is portrayed in the Big Short is Cornwall Capital, a garage-run hedge fun with only two employees, Jamie Mai and Charles Ledley. They started with $100,000 that was raised by buying and selling boats, and through clever investing tactics (namely, trading long-term options) were able to grow it to about $100 million when the market crashed. Rather incredible returns by anyone's standards, and now I've read on the internet that they have about $500 million of AUM. Clearly they've come a long way since The Big Short.

When Cornwall Capital was tipped off about the looming subprime mortgage crisis, they immediately began seeking to purchase complicated credit default swaps that would allow them to short the market. However, since their fund was so small they needed a special type of agreement known as an ISDA (this is something totally new to me before I read the book, and Lewis didn't spend too much time talking about it, so forgive me if I mistake some of the details). In order to secure an ISDA, they enlist one of Jamie's neighbours, Ben Hockett (renamed Ben Rickart in the movie adaptation and portrayed by Brad Pitt) who is a trader that retired from a large Wall Street firm. Ben secures them the ISDA, and they successfully short the housing market and make millions, just like the other characters in the book.

The dynamic between these characters that I have personally found interesting was the young vs. old dynamic. Ben is retired, and must be at least 25 years older than the other two. His attitude towards the whole incoming financial crisis is dramatically different as a result. He's frankly quite apocalyptic. For example, in the movie there's a notable scene where Jamie and Charles are dancing around in joy at the thought of profiting once their credit default swaps pay out. Ben snaps at them, claiming that in order for them to profit, the economy will have to collapse, investors will lose their money, and people will lose their homes. While it might be good for them, it's bad in the big picture.

I haven't been able to find a lot of information about what these three individuals have been up to since the setting of the book. If any of you readers find anything, let me know!

The Big Short

Christian Bale. Photo courtesy of Geoffrey Chandler

My last and favorite "group" chronicled in the Big Short is not a group at all, but rather an individual. His name is Michael Burry, and both through the Big Short and just general musings on the internet, I've come to take quite the interest in both his personal life and his investment philosophies. If you've read my blog post Three Books That Have Shaped My Investment Philosophy, then you will know that I practice a particular type of investing known as value investing. Burry, too, hails from the school of value investing.

Burry has a very unconventional background, at least for someone working in the financial field. After receiving his undergraduate education at UCLA, majoring in economics and grabbing enough credits for his pre-med requirements, Burry graduated from the Vanderbilt University School of Medicine. It was during his undergraduate and medical studies that he first became interested in the stock market. He was a known contributor to many online investing forums, particular MSN Money, and people actually started practicing his investment strategies. He became such a known figure in the world of online investors (posting as Dr. Michael Burry) that when he started his hedge fund, this is where he found a lot of his initial partners.

Michael Burry was most famous as the investment manager behind Scion Capital LLC, a hedge fund that operated during the period of 2000-2008 and generated tremendous returns for their investors (more than 400% over 8 years). By reading the complicated prospectuses of many of the MBSs on the market, he realized the poor quality of the loans that were packaged in these securities. From there, he used credit default swaps to short MBSs and CDOs. He maintains that he believes he was the only person to actually comb through the prospectuses, other than the lawyers who drafted them.

Burry was portrayed in the movie by Christian Bale. I hadn't really ever seen Bale act in any movies other than the Dark Knight trilogy, and I have to say I was extremely impressed with his performance. I think i was mentally prepared to see Bale acting as Bruce Wayne, so his portrayal of Michael Burry was made more spectacular as a result.

Now that I've described a bit about the characters of the book, I'll brief you on a few of my favorite quotes before I give you my verdict.

A Few of My Favorite Quotes

"As early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry's view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate sub-prime mortgage. You, the home buyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principle balance.

Why I like this quote: I've briefly mentioned this quote earlier in this post, and the reason why I like it so much is because it absolutely blows my mind that such a mortgage was ever created. Sometimes I wonder about the intelligence of the underwriters who created these mortgages.

"A lot of hedge fund managers spent time chitchatting with their investors and treated their quarterly letters to them as a formality. Burry disliked talking to people face-to-face and thought of these letters as the single most important thing he did to let his investors know what he was up to."

Why I like this quote: I can really relate to Burry's thought process here. At my workplace, I am known for communicating too much through email and not enough through face-to-face. But email offers a lot of upsides. First of all, you can always proofread your emails to make sure you're not saying anything you might regret later. Sometimes I find myself speaking faster than I think, which often leads to poor choices of words or just generally saying stupid things. Another advantage of communicating though letters or email is that everything is recorded. If your only correspondence is through written word, no one can ever claim that you made statements or promises that you actually didn't. You'll never be troubled by other people's poor memories, because you'll always have a reference to fall back on.

"A couple of years earlier, he'd discovered credit default swaps. A credit default swap was confusing mainly because it wasn't really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders received nothing. It was a zero-sum bet: If you made $100 million, the guy who sold you the credit default swap lost $100 million."

Why I like this quote: In all of my experience in the financial sector, all of the blogs and books that I read, this is by far the best definition of a credit default swap that I've ever encountered. Props to Michael Lewis for this one, I've often sent this quote from The Big Short (with credit to Lewis) to people who are confused about the instrument known as the credit default swap.

"In a few weeks Mike Burry bought several hundred million dollars in credit default swaps from half a dozen banks, in chunks of $5 million. None of the sellers appeared to care very much which bonds they were insuring. He found one mortgage pool that was 100 percent floating-rate negative-amortizing mortgages, where the borrowers could choose the option of not paying any interest at all and simply accumulate a bigger and bigger debt until, presumably, they defaulted on it. Goldman Sachs not only sold him insurance on the pool but sent him a little note congratulating him on being the first person, on Wall Street or off, ever to buy insurance on that particular item."

Why I like this quote: I'm amazed that these insurers, these financial institutions did zero due diligence on the very loans they were insuring. This is particularly frightening considering that Burry was the first person to purchase these types of insurance contracts - doesn't it seem intuitive that if someone wants to create a financial contract for the first time ever that it should be highly scrutinized and regulated? Perhaps not to Goldman, but it definitely does to me.

"To meet the rating agencies' standards - to maximize the percentage of triple-A-rated bonds created from any given pool of loans - the average FICO score of the borrowers in the pools needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom has FICO scores of 550 and half of whom had FICO scores of 680. A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place. But the hole in the rating agencies' models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615.

Where to find the borrowers with high FICO scores? Here the Wall Street bond trading desks exploited another blind spot in the rating agencies' models. Apparently the agencies didn't grasp the difference between a "thin-file" FICO score and a "thick-file" FICO score. A think-file FICO score implied, as it sounds, a short credit history. The file was think because the borrower hadn't done much borrowing. Immigrants who had never failed to repay a debt, because they had never been given a loan, often had surprisingly high thin-file FICO scores."

Why I like this quote: As I mentioned at the beginning of this post, I saw the Big Short movie before I actually read the book. In the movie, it was very unclear how the manufacturers of these mortgage-backed securities and collateralized debt obligations were capable of manipulating the credit ratings of their securities. This finally cleared it up for me, and while I'm sure there are other ways of manipulating the credit ratings of financial securities, at least now I'm familiar with one of the techniques.

What's My Verdict on The Big Short?

I've written a lot about the content of the book without really giving any analysis or feedback. I don't really have a lot to say about the book - it was so good that it's hard to criticize it, and I've tried to outline the best parts of the book in this post.

I've really enjoyed this book and am in the process of reading it through for a second time. If you're interesting in reading the book yourself, you can pick up a copy from Amazon here for only $10.88.

Readers, have any of you had a chance to read the Big Short? If so, what did you think of the book? What about the movie? Let me know in the comments!