A collection of essays by Bill (website@ccjj.info) accompanied by feedback from his friends.

Sunday, November 6, 2011

Book Report: The Big Short by Michael Lewis

This book provides an inside look at the mortgage meltdown, through the eyes of investors.

The mortgage meltdown is something of huge importance and relevance to our times, in that it is responsible for the current recession. It is also not very well understood at all by the lay public.

  • Many see the problem as "greed", whatever that means.
  • Leftists see the meltdown (which they didn't predict) as an inevitable consequence (like everything else they don't like in the world) of the Evils of Capitalism.
  • Democrats were quick to blame it on "deregulation". For awhile they were at a loss to say the removal of which regulation, in particular, was responsible. Eventually some of them said that the 1999 repeal of some provisions of the Glass-Steagall Act was to blame, and the rest of them echoed this sentiment without the foggiest idea of what Glass-Steagall actually was. I have yet to hear a coherent account of how Glass-Steagall would have prevented any bad mortgage loans from being made.
  • Predictably, Republicans countered the Democrats, blaming the meltdown on too much, rather than too little, government, somehow laying it at the feet of Fannie Mae and Freddie Mac, the government agencies set up to facilitate home loans.
Many people say they saw the meltdown coming, and most of them are full of baloney. In The Big Short, the author, Michael Lewis, focuses on the few investors who can credibly make this claim, those who not only saw the meltdown coming, but anticipated it well enough to profit from it.

Three groups are followed, a lone investor in Silicon Valley, a pair of rich hippies in Berkeley who liked making long-odds bets, and some very cynical New York investors who just smelled a rat in the mortgage market from the very beginning.

Michael Burry, the lone investor in Silicon Valley, was a smart fellow with Asperger's Syndrome. Asperger's Syndrome is just a formal way of saying someone is extremely geeky. Such people have great difficulty with interpersonal relationships, but are quite bright and often focus on very narrow areas of interest, becoming experts in their fields. Burry had gotten a medical degree but lost interest, particularly because he didn't like interacting with his patients. He became interested in finance and demonstrated a precocious talent for picking stocks. He eventually found himself running an investment fund worth many millions of dollars of other people's money, and his fund greatly outperformed the rest of the stock market.

At some point he became interested in mortgage bonds, and unlike most other investors, read the fine print. He really didn't like what he saw, some of these home loans being made were so bad that there was a fortune to be made betting against them. He figured out how to make such bets. Unfortunately, it was hard to predict exactly when the loans would go bad and the bets against them would pay off, and he didn't do a very good job of selling his strategy to his investors, most of whom lost faith in him and deserted him. In the end, he and those who stuck with him made a killing.

Jamie Mai and Charley Ledley were a pair of 30 years olds who started investing with $110,000 and a Charles Schwab account in 2003, working from a shed in the back of a friend's house in Berkeley, California. They had an interest in long-odds bets, and some of their early bets paid off, leaving them with many millions of dollars. At some point they became interested in credit default swaps, where, for a small sum of money, you can bet to win a large amount of money if a bond defaults. They decided to bet against mortgage bonds and the rest is history.

Steve Eisman was a New York investor whose bias about the world was that most other investors were crooks for phonies. When he started dealing with the mortgage market, it seemed to confirm his bias, and he ran with it. Unlike Burry, who sat secluded in his office in California reading the fine print of contracts, Eisman went out of his way to seek out all the people he felt were blowing it and confront them with his world view, to confirm whether he or the world was going insane.

The book follows these three characters as they travel through the investment world, and we see all the signs that the subprime mortgage bond market was insane, which looks so obvious in hindsight, while so few people actual paid attention to these signs at the time.

My own take on the mortgage meltdown, which I wrote nearly two years ago, is here. One thing that was really apparent to me before the meltdown was that no one I talked to who was buying real estate seemed to take seriously the idea that there was any possibility whatsoever that home values could sink. This shows up in The Big Short, when Steve Eisman encountered someone who worked for the rating agencies. Eisman had calculated that if real estate prices just stopped rising, there would be massive defaults. Eisman asked the rater if he had run calculations on the prospects for the bonds if real estate values were to decline. The rater replied that the software he used refused to take input predicting a decline in real estate values. But the book doesn't stress this as much as I do, in fact the book does not hold the home buyers accountable at all -- it is mostly focused on the relevant people on Wall Street.

I've heard a lot of talk about the rating agencies being "corrupt" (the media is obsessed with labeling financial activity as criminal or borderline so) in that the agencies were paid by the banks whose bonds they were rating, which undermined their objectivity, but one problem discussed in the book that I hadn't previously been hearing about was with the quality of the people at the rating agencies. The salaries to be had working for a rating agency paled in comparison with what one could make as an investment banker. As one investor put it, "If you couldn't get a job working at an investment bank, you could always go work for the rating agencies". On top of that, the lowest-ranking people in the rating agencies were the ones rating mortgage bonds. As a result, the investors who would put together deals of mortgage loans were much smarter than the people rating the resulting bonds, and learned to game the system and fool the rating agencies into giving the bonds much better ratings than they deserved.

One thing the book talks about is how, after the cataclysm, people on both ends of the deals gone bad wound up rich. The people who had shorted the bond market were obviously rich, and justly so, but the major players who lost their banks billions of dollars by betting on subprime loans wound up out of work, but sitting on tens of millions of dollars they made before losing their jobs in disgrace. I'm not sure what can be done to counter this -- if I were a bank, I would want to provide a disincentive for my employees to lose me billions of dollars, but I'm not sure how I could hold them accountable. The worst thing you can do to an employee who hasn't violated a contract or done anything illegal is fire them in disgrace. If you've been paying them tens of millions of dollars a year up to that time, they wind up unemployed, disgraced, and very rich. I can't think of a solution here. It's a big problem, because it seems plausible to me that an investor might see a 10% chance of a financial meltdown in a few years. If he bets against the meltdown, he has a 90% chance of making a large salary over those few years, and if he gets held accountable for the meltdown, he just takes a very luxurious vacation for a few years afterward. Furthermore, if you make bets alone against the system and you're wrong, everyone thinks you're a fool. If you make bets with everybody else and the whole system fails, you don't get held individually accountable, you were just one of many people wiped out by hard times.

The psychologies of the different characters were very different, in interesting ways. Michael Burry, with his Asperger's, was quite content to sit in his office, read the fine print, and calmly conclude that the world had gone insane and bet millions of dollars on that opinion without further ado. Steve Eisman, a more normal character, wasn't going to make huge bets that the world was going insane unless he met the people involved, publicly called them idiots to their faces, and confirmed beyond a shadow of a doubt that they were insane, or at least very stupid. It all makes for fascinating and dramatic reading.

There are some things that are not well explained by this book. For example, the worst mortgages sold were these adjustable-rate mortgages that started out with a small monthly payment being required for a couple of years, then would suddenly reset to much larger monthly payment that the homeowner had no hope of being able to pay. What was going through the heads of the homeowners who signed those mortgages? Did they know about the reset? Were they fooled? And if they were fooled, what were the mortgage originators thinking when they loaned people money that wouldn't possibly be repaid? As it was, these originators were able, for awhile, to fool the homeowners into signing the mortgages and fool the banks into buying the loans, but it must have gone through their heads that this was not a sustainable state of affairs. This isn't mentioned in the book, but I remember the CEO of Countrywide, one of the worst mortgage originators, saying, when confronted with the fact that he had generated a huge number of bad loans, "If these loans were so bad, why were the investors buying them?".

There was a lot of money lost on credit default swaps. A credit default swap is where you buy insurance in case a bond will default. This is fine, but all insurance is based on basically making a bet that something bad will happen -- if the bad thing happens, the insured "wins", and gets money to help him recover from his misfortune, and the insurer loses, paying that money. Well, a lot of people were buying credit default swaps on bonds they didn't own, so it wasn't really "insurance" any more, it was just a bet. A lot of money was obviously lost when homeowners couldn't pay back the money they borrowed, but there was a huge shadow market of credit default swaps, where banks lost a lot of money just betting that the home loans were good, multiplying those losses.

One issue that comes up a lot in the book is that Michael Burry was one of very few people who was actually reading the fine print of these contracts. This highlights one problem our society has -- many people are entering into agreements without reading the contracts, just signing long documents with the belief that since "everybody else is doing it too", so if the deal goes bad, no matter how stupid signing the contract was, the government will come to everyone's rescue. Signing a mortgage is an extremely important contract, probably second only to marriage contracts in importance as the most important contract one signs in one's whole life. If the contract is too long or too boring to read, one should hire a lawyer to at least make sure one understands what one is signing.

There is a push in the current administration to have regulation simplifying mortgage contracts, in such a way that, for instance, people will plainly see what the maximum mortgage payment they will be expected to make will be. In an ideal world, people would just refuse to sign contracts they don't understand and thus force the banks to write simple contracts in plain English, but apparently we don't live in such an ideal world so such regulation is probably a good idea.

One change that I think would be constructive is if the banking system changed the way it handled credit default swaps. I think if I were in the business of selling credit default swaps, I would want to make sure that for every swap I sold, the buyer of the swap actually owned the bond being insured -- so I would know that I was selling to people looking for insurance for what they perceived to be an unlikely event, not making bets against people who knew more than I did. I don't think any government action is necessary to bring this change about, just the sellers of credit default swaps need to wise up.

I think, and this is my own take, it's not stated in the book, that too many people in too many places in the investment system were assuming that, even if their own piece of the system were a weak link, the rest of the system was sound and would make up for that weak link. Thus, the loan originators figured that if the investors bought the loans, they must be good loans. The investors assumed that the ratings were sound, though they should have known better. Everyone assumed that the value of the house would always be at least as much as the outstanding value of the loan, so if the homeowner didn't pay, you could foreclose and get your money back.

A lot of reform has already happened, independent of the government. The bond market now realizes that the ratings are fallible. Everyone now realizes that real estate values can sink. Banks will not recklessly sell credit default swaps on mortgage loans like they used to.

In the afterword, Michael Lewis discusses a lot of conversations he had with politicians and government officials after he published the book. Most of them really hadn't figured out what on Earth had gone wrong, and were trying to get him to explain it to them. After a lot of such conversations, an official who actually was pretty knowledgeable called him and they had a conversation. At the end of the conversation, the official asked him "I understand you've discussed this with a lot of politicians and officials. Was anybody particularly insightful who I might call up and interview?". Lewis explained to him that none of those callers were explaining anything to him, they were all asking him to explain the situation to them. The official laughed, thanked him for his time, and ended the call.

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