Book review: “The Big Short” (Michael Lewis)

I am partial to Michael Lewis.

In fact his only book I am missing is “Liar’s Poker” which I surely will read next. And “The Big Short” even has its own star-studded casted film coming.

In a nutshell, this is the story of four people who made a fortune betting against the market that in 2005/2006 was generating the bulk of Wall Street’s profits, subprime loans.

However I must say I expected a little more both in terms of explanation of the underlying mechanisms and in terms of what actually went wrong. Here is what I understood, even though I am ready to stand corrected.

2016 01 07 The Big Short scheme

  1. Lending money to people who do not qualify as “prime borrowers” (i.e. very likely to pay back the loan) expands the pool of loans enormously, expanding therefore the profit of those who lend.
  2. The teaser rate mechanism made those loans very attractive, even though a 6% “teaser” rate seems sky high now that we are dealing with ~1% rates.
  3. A booming real estate market made it easy for borrowers to refinance when the teaser rate expired, on the back of an appreciated asset (the house) and un-scrupulous lenders took the opportunity to increase the loan amount to totally unreasonable levels.
  4. BBB-rated loans got securitized as bonds (MBS) representing bets that “no more than (say) 5% of this loan pool will default”; by pooling them together in large numbers they earned an AAA rate upgrade because “at no time in history house prices went down across the country at the same time”.
  5. Depending on the pecking order of repayments, MBS could be sliced in tranches, the worst of which got shuffled up again to create CDOs and again these got upgraded thanks to the further distribution of risk.
  6. The rate upgrades were largely instigated by the investment banks who created the instruments, as the rating agencies did not have adequate models of their own.
  7. Each of these bets (alongside the stocks of all players) could be shorted; in fixed-income parlance, shorting is done with credit default swaps (CDS) which, due to the high rating of the bonds, costed very little. Think of shorting as purchasing an insurance policy against the security not reaching maturity.
  8. At this point, the very banks who originated the instruments forgot (or maybe did not understand really) that the rate upgrades were based on the unproved assumption of a very weak correlation between real estate markets in different part of the country, and started treating them as “true” triple-A bonds: instead of dumping them on “dumb money” (as was the original plan), they started accumulating them.
  9. When teaser rates ended in a real estate market that had ceased to grow, debtors defaults increased and a whole avalanche of bets became due.
  10. At reckoning day, the bill was footed not by rich, dumb investors but (in part) by the failed investment banks’ shareholders and (the majority) by the U.S. taxpayers.

What I still am not sure I understand:

  • What was the faulty assumption of uncorrelation in #8 based on?
  • Why did loan defaults (historically geographically uncorrelated) suddenly became correlated in 2007?

I wish the Author had spent a little more time on these two crucial questions; my best guess is that – hence my interest – what caused the rout was not the defaults in themselves, but rather the run to cover positions due to the sudden collapse of the Trust that had until then propped up the castle of lies.


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