You Are What You Read

Reviews of books as I read them. This is basically a (web)log of books I've read.

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Location: Lawrenceville, Georgia, United States

I am a DBA/database analyst by day, full time father on evenings and weekends.

Monday, December 06, 2010

The Big Short

The Big Short: Inside the Doomsday Machine is a gripping account by Michael Lewis of the Wall Street players who made big bets against the sub-prime mortgage market and helped to bring down entire investment banks. While most of the Wall Street banks and investment firms were finding ways to pour more and more money into mortgage backed securities, a few people saw how crazy the system was and how to take advantage of it. A bond backed by mortgages might have a AAA rating, but this was based on the theory that mortgage defaults would not increase higher than about 7%. This in turned was based on the assumption that home values would continue to rise and homeowners could refinance after a few years, often with taking cash out to pay off other loans. Assumptions were built on assumptions, risk piled on risk, until few people comprehended just what they were buying and selling.

Michael Burry was a doctor who left his residency to start an investment fund based on value investing. Without much interest in human interaction, he devoted much of his time to studying the market. When he turned his attention to mortgage backed bonds he realized that they were much riskier than the market realized and tried to figure out a way to bet against them. These bonds are different than regular bonds, since different pieces of the bond might get paid off or defaulted at a time. Burry set up some of the first Credit Default Swaps, of CDS's, on subprime mortgage bonds. CDS's are a sort of insurance against the default of a bond, as a hedge against risk. Here is where Lewis explains in fascinating detail exactly how these arcane financial instruments work. He brings his experience in finance to explain how Wall Street works as well as how it fell apart.

Other plays are Steve Eisman, a hedge fund manager; and the founders of Cornwall Capital, basically two friends running their hedge fund's $110,000 in their garage. They saw that the mortgage bond market was overblown and ripe for betting against. Cornwall Capital ended up holding millions of dollars worth of CDS's against Bear Stearns and worried about their ability to collect. Lewis compares investment banks to casinos, and the analogy is very fitting. In this case the casinos let a bunch of customers make bets that appeared safe; but the customers had seen that the true odds
were much more in favor than the conventional wisdom said. When the customers all started hitting Blackjack at the same time, the house started to go bankrupt.

It is truly amazing that all the big banks took such big risks that endangered their stability and that of the whole system. The CEO's had little or no understanding of the risk they were taking, even as the system began to crumble. The mortgage bonds were separated into different tiers called tranches. Lewis carefully explains how the different tranches affected the different bondholders who owned them. He also explains how the lowest tranches, the triple-B tier, were bundled together into completely new instruments called Collaterized Debt Obligations, or CDO's, and amazingly these CDO's were given triple-A ratings by the rating agencies. Even though the rating agencies didn't understand the instruments, they took the banks' advice on how to rate them.

Michael Lewis describes the background of the people involved in all these trades, providing a fascinating narrative as well as an explanation of Wall Street banking. The book is filled with humor, though mostly dark humor. There is a sense of impending doom but also the thrill of being on the inside while the people who can see the collapse coming make their bets. They are betting not just against individual mortgages or bonds but against the system as a whole. The result is a story made of up the individual insiders' stories. With its lack of sentimentality a strength, this book presents an informative and compelling account of the recent financial collapse. A-

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