I have been reading books about the financial crisis, and I plan to write a review of each. A reviewer should have an audience in mind. Mine is the financial community, especially those of us wanting to learn. I look specifically for what lessons we might find -- the unusual idea you might not see anywhere else.
This book has an insight on the most important issue for current investors: Evaluating forecasters.
It is a good time for you to read these books, think about them, and learn the lessons. My own interest is a bit broader than most of the financial punditry. I am looking at books by policy makers as well as financial journalists or analysts.
My starting point in this series was Barry Ritholtz's Bailout Nation, highly recommended and now available in paperback with updated material.
The Big Short by Michael Lewis
The book, now added to our recommend readings, tells the story of the crisis from the perspective of three obscure hedge fund managers and a bond salesman. The personal approach makes the material both interesting and accessible. Reading it will help you understand some of the key factors behind the crisis. The author makes technical subjects easy to understand, and includes plenty of examples.
Michael Lewis fans will not be disappointed. This is a great tale, well told. The characters are interesting and colorful. Even though we know how it all will turn out, we appreciate the twists and turns on the way. The author captures the tone and nuance of the insider -- descriptions of meetings, the isolation of the fledgling hedge fund managers who are the protagonists, and the drive for profit from the big firms. The book is very well-written.
We really get into the lives of the major characters, and that is part of the lesson.
My Favorite Lessons
This is a very important book. There are several points, extensively documented and described, that you will not find in other sources. These are not necessarily highlighted in the book, but I find them worthy of emphasis.
- The details about rating agencies and how loans got their ratings.
- The story took a long time to play out -- a very long time. The heroes had to deal with angry investors. One fund manager even resorted to an aggressive legal move to stop investors from withdrawing funds. We read the story knowing that the heroes would be vindicated, but the challenges they faced were awesome. Colleagues, family, and investors all challenged their wisdom.
- Taking the winning positions was costly. While the heroes thought that the insurance premium was cheap, investors disagreed. The monthly costs were significant and they went on for years. The managers kept buying, even when everyone thought they were wrong.
- Nearly everyone involved was ignorant of the process. The heroes could not figure out why there was an insatiable demand for the other side of their trade -- why they continued to lose on daily mark-to-market in the face of a deteriorating housing market. They did not even know what a CDO was or that there were CDO managers.
- And most importantly, how the synthetic CDO market came to dwarf the actual market for loans -- subprime or otherwise.
I want to go gently on the objections, since I like the book so much. It is natural for an author to look for the main themes from his work. I happen not to agree, but you might. The author finds implications for Obama priorities and sees the root of the trouble in investment banks becoming public companies. I found myself shaking my head at each unconvincing point.
This should not in any way detract from the wonderful story, with rich characterization and authentic detail.
There is important information that you will not see anywhere else. If the author was more attuned to the current debate over economic policy and forecasting, he might have better appreciated the significance of the first point.
Any current discussion of economic forecasts or investment decisions begins with the question of whether someone was right about 2008. Lewis's work is illuminating on this subject.
Why did so many get this wrong?
Why did so many underestimate the effect of the subprime crisis? Why did they think it would be "contained?" Why did they think that various policy actions might deal with the problem? Why were recession forecasts by economists so far off?
The answer? No one knew the extent of the synthetic market. Lewis makes it clear that this market dwarfed the actual market in subprime loans. More investors were "betting" on this synthetic market than were actually invested in mortgage securities.
Let me illustrate this with some charts. Here is the Google Trends chart for searches on CDO's.
Now let's compare that to searches for synthetic CDO's.
The difference in interest and knowledge is obvious.
Even analysts who recognized the potential for a collapse in subprime lending would seriously underestimate the total impact. This statement is just as true of the heroes in the book -- the ones betting against the market -- as it is of Ben Bernanke or others. No one really new the magnitude of bets in the unregulated market for synthetic securities. As the book describes, it was a huge market of people who had no direct interest in the loans, betting on the outcome.
The current assessment of blame and credit about forecasting is seriously flawed. None of those "getting it right" understood the synthetic market. They over-estimated the regular market. Mainstream economists did the opposite.
We need to understand the tough trade
Any investment manager understands this. Investors think in terms of a few months. A year is supposed to be a good test of a strategy. The stalwart successful fund managers in this book had to withstand negative returns for several years before collecting a huge return.
They also did so in the face of near-universal conviction that they were wrong.
The demand for yield
There is an enduring investor perception that yield is good and is (somehow) a guaranteed return. A fundamental factor in the crisis was the willingness of investors to believe that they could get outsized yields on AAA securities. Without this belief, The Big Short would not have been possible.
We can see the same behavior in today's market -- coupons over variable stock returns, regardless of potential.
Enjoy the book and you may find your own lessons. If you have already read it, please feel free to share observations in the comments.