Sunday, April 10, 2011

The Big Short

Inside the Doomsday Machine

Lewis’s books are either about sports or finance. An odd combination, yet his procedure is the same in either case. He focuses on people to such an extent that his books read almost like novels.

The Big Short then is not a dry financial text, but a fascinating look at a handful of characters who figured out what was wrong with subprime mortgages and were able to profit from it.

All were mavericks to some extent. One was an abrasive iconoclast who identified with Spiderman and enjoyed disrupting meetings. “He’s not tactically rude,” his wife says. “He’s sincerely rude.”

Another was a one-eyed doctor with Asperger’s Syndrome who refused to wear shoes with laces, and blogged about investing between 16-hours shifts at the hospital. These and other characters as well as Lewis himself deliver some withering criticism of Wall Street:

“However corrupt you think this industry is, it’s worse.”

"The fraud was so obvious that it seemed to us it had implications for democracy. We actually got scared.”

For more than twenty years, the bond market’s complexity had helped the Wall Street bond trader to deceive the Wall Street customer. It was now leading the bond trader to deceive himself.


Lewis’s first book, Liar’s Poker, describes his job as a bond salesman at Salomon Brothers in the 1980s. He relates how the firm pioneered the pooling of home mortgages for resale as mortgage bonds, which made the firm immensely profitable. In The Big Short, he picks up the story 20 years later with the subprime loan fiasco.

Subprime loans were devised to make the purchase of homes available to people who couldn’t afford them, borrowers who “tended to be one broken refrigerator away from default.” They were enticed into the deal with a fixed-interest “teaser” rate that would remain in place for two years, after which the rate would float. The floating rates were inevitably more expensive, forcing people to refinance, which was not a problem as long as the value of their home had increased. The banks didn't care what happened, because either way they stood to gain -- by repossessing or refinancing.

The loans were risky, but a loophole in the bond rating system allowed investment banks to hide the fact. They did such a good job that virtually no one in the industry had a clear idea of exactly what the mortgage bonds contained. It was a financial shell game that in the end conned the banks themselves. By the time they got a whiff of financial rot, they were so exposed to risk that they tried to reduce their losses by making side bets (credit default swaps) against them. It was, as Lewis puts it, like taking out fire insurance when the house was already engulfed in flames.

A fascinating book.