Book Review: The Big Short by Michael Lewis

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.

My Objections

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.

Investor Conclusions

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.

Comments

[oldprof]

Lurker -- Thanks for your observations. Marty (an old friend and former colleague) is well-grounded in reality, but perhaps not from the investment manager perspective. He may expect other investors to be as smart as he is.

Thanks to both you and Marty for sharpening up my use of "investor." There are many types of market participants, many motives, and many ways to win -- or to lose.

I agree about speculators....

Jeff

[oldprof]

Marty -- I should note that Lewis believes the leverage on borrowed money would not have been as great in a partnership structure. I am reading a number of the key books, including those you mentioned, although a review of Hank Paulson's book is next on my schedule.

As to investor motives, I could have been a little more precise. You describe well what an investor time frame should be, but in my experience it often is not. The investors in the book were hedge fund investors -- known to be "hot money."

Sorry not to be sharper on this point, and thanks for your comment on public policy.

Jeff

[lurker]

I take issue with Marty taking issue with your statement that "Investors think in terms of a few months." And I take issue with your use of the term "investor" in this regard.

First, Marty. Obviously he's completely out of touch with the mainstream reality. There's a disconnect between what people say and what they actually do with their money, and study after study has shown that both retail and institutional money is incredibly short-sighted and reactionary to movements that last only a few months. Study of sentiment indicators should bear this out quickly, if done with an open mind. :-) As you know, Jeff, dealing with retail clients daily, they are emotional and short-sighted and a few months' experience will cause them to pass negative judgment on methods that may underperform for a year or more at a time ("value") but will overperform over multiple years.

Second, Jeff, "investor" really only applies to those who purchase a stream of cash flows for its own sake, hence applicable to people buying businesses or rental real estate. People who buy stocks for the purpose of gaining through selling at appreciated prices(or hire others to do so on their behalf) are more properly labeled "speculators."

[Predictor]

> Without this belief, The Big Short would not have been >possible.

that's the perception gap combined with path gap (or jump gap) will help to make sense of some things

[You know who!]

Journal of Alternative Investments has a good article on how the recovery assumptions in the CDO pricing models basically dictated the % of the tranche that would wind up getting priced as "investment grade." Worth getting a trial script and d/l the paper.

Next time you're in TX ask me about the data the rating agencies use to rate catastrophe bonds ...

[Marty]

Thanks for reviewing The Big Short. Although I have not yet read it - I plan to - I've read a number of his other books (such as Moneyball and the Blind Side). As you point out, Lewis has the great ability to explain complex subjects very clearly and in a most compelling way. He does this through serious story telling that requires much due diligence.

Two points of your review deserve further attention.

1. I'm sure that I would agree with your notion that investment banks as public companies is not the issue. Say more here. It's their proprietary trading based on borrowed money, not their investment banking activities, that turned the big 5 investment banks into the big 0. Readers might be intrigued by the detailed stories told by William Cohan (House of Cards), about the rise and fall of Bear Stearns, and Andrew Ross Sorkin (Too Big to Fail), which traces all the major players and their actions from roughly March 2008 through roughly the end of 2008.

2. I take issue with your statement "Investors think in terms of a few months." How do you distinguish an investor from a speculator or trader? Even the IRS - at least for some forms of asset transations - requires a year before one can obtain capital gains treatment. As a Ph.D. economist, I view an investment as an expenditure that generates a series of returns over at least three years. Until public policy can clearly provide incentives for such, funds for investment will remain at the mercy of speculators and traders. Each has his or her place in stabilizing markets, but as derivatives trading has begun to swamp trades in the underlying assets, in good times, we muddle through. In bad times, ...

[John the Cheap]

Definitely on my list to read. BTW what are the vertical scales on the Google charts? Seems like there's a scaling factor missing from the first one.