The Big Short by Michael Lewis

Whereas William Cohan's House of Cards looked at the bursting of the housing bubble from the vantage point of within a Wall Street firm, Michael Lewis takes a view of those same events from without. Well, kind of, anyway.

The Big Short follows two small bands of investors along with a lone maverick as they take full advantage of the housing bubble. The first person we meet is Steve Eisman. He began inside Wall Street working at Oppenheimer & Co. before moving on to Chilton Investment. Cynical by nature, Eisman grew disillusioned with the consumer finance industry when he saw how the mortgage company Household Finance Corporation was "tricking their customers". His road to Damascus moment came when he was at a luncheon and heard the CEO of a large bank describe free checking accounts as simply a way to rip off the poor. Eisman went on to start his own hedge fund called Front Point Partners which would end up being owned by Morgan Stanley. Along for the ride was Vincent Daniel whom Eisman had hired at Oppenheimer and who had proved his mettle sniffing out problems in the subprime mortgage industry from databases provided by Moody's, the rating agency.

The loner in this tale is Michael Burry. As a child he developed cancer and the treatment claimed one of his eyes. He grew up something of a loner, shying away from face-to-face contact. The world of finance became his idée fixe but at the time he was training to be a doctor. In the late 90s he started a blog at which he gave explanations for his stock trades that were remarkably prescient. Soon he gained a loyal following and abandoned the idea of being a doctor to instead start Scion Capital, an investment firm.

The trio is rounded out by Cornwall Capital Management which was formed by Jamie Mai and Charlie Ledley. Although they'd worked at a private equity firm, they didn't exactly have experience calling the shots and deciding where people's money went. Cornwall was formed in a friend's garage by Mai and Ledley who had $110,000 between them.

You can see why Lewis felt these gentlemen would make for a good story. Besides the fact they made investments which left them richer than Croesus when the housing bubble burst, they make for a very interesting cast of characters. Eisman and Daniel are portrayed as Robin Hoods out to fuck the system; Burry is like this mad genius holed up in his office obsessed with numbers; and Mai and Ledley started an investment company in someone garage. While most of these guys didn't just fall off the turnip truck, they're still, in one way or another, outsider enough to qualify as Alice-like characters roaming around the Wonderland of Wall Street.

Lewis tells their stories in similar ways. He starts with a little background and explains how they got into the world of finance. Then these investors train their gazes on the subprime mortgage industry and see that it's a house of cards. The book describes how the firms founded by these guys struggled to find capital at first but eventually found investors. They all started buying up credit default swaps which were like insurance policies on groups of subprime mortgages that paid off if they went bad. Everyone saw that the whole thing was like a pyramid scheme and that people who, in the bad old days, would not have gotten a home loan were getting them in droves.

There are two main elements which make The Big Short a good read. The first is simply the stories of the men profiled. Burry, we find out, has Asperger's Syndrome which accounts for his ability to focus so intensely on things and why he can spend hours just looking over numbers. His tale involves a lot of waiting. He sees what's happening and needs to keep his querulous investors at bay until 2007 when the first wave of crappy mortgages go under and his investments come to fruition.

The guys at Cornwall are sort of like a collective Jefferson Smith. Lewis calls them the “Accidental Capitalists”. They're this fish out of water that can't believe that it's stumbled on the investment opportunity it thinks it has. For instance, Cornwall's accountant knew Ace Greenberg, former head of Bear Sterns and Wall Street legend the firm's account is moved to Greenberg's. They were a bit incredulous at their luck. “So how is it that Ace Greenberg is our broker?” After enough prodding, the guys actually meet the man. But the encounter is so fleeting that they left the room wondering if they'd actually met the man. In another their Bear Sterns rep invites them out to Vegas for a big subprime conference. There he would get to shoot Uzis at a firing range and, in Lewis' words, try to find someone to tell them why they were wrong to be against the subprime mortgage market.

Eisman is the anti-Wall Street investor who rarely misses an opportunity to speak his mind. And so there are some great scenes where he calls bullshit on various Wall Street establishment figures. He too was at the aforementioned conference in Vegas and confronted the CEO of Option One which had a subprime loan portfolio. The guys said that Option One was expecting a rather small loss rate on the loans of five percent. At one point Eisman puts his hand in the air and makes a zero with his thumb and finger then tells the CEO “There is zero probability that your default rate will be five percent.”

Aside from the character studies, the other great thing about this book is Lewis' ability to explain just what the whole deal with subprime mortgages that took down the world economy was. I've read a lot of Matt Taibbi's articles about the housing bubble but it was after reading The Big Short that I finally understood what it was all about, albeit from a very high level. Subprime mortgages were bundled together into a financial instrument that was sold off. There was a lot of money to be made in creating these things and passing them onwards and so, when good mortgages to be packaged were in short supply, bad ones were used. Wall Street couldn't get enough bad mortgages to bundle and pass on. The rating agenices Moody's and S&P were complicit in the whole deal. In one section Lewis describes how they abdicated their responsibilities by not investing the mortgages within these packages. Instead they just asked for the average FICO score of the borrowers. This number got fudged so that some mortgages from creditworthy people could hide the fact that the instrument was composed of a lot of risky loans. With the good average score, the agencies could give the investments good ratings to make them look safe. It was like putting lipstick on a pig.

Yves Smith, the head of a financial advisory firm, has made some trenchant criticisms of The Big Short and you can read them here. The main one for me is her argument that the guys Lewis portrays as being heroes actually made the subprime mortgage collapse worse.

Eisman recognizes that the subprime market is a disaster waiting to happen, a monstrous fire hazard that, once lit, will engulf the housing market and financial firms. Yet he continues to throw Molotov cocktails at it. Eisman is no noble outsider. He is a willing, knowing co-conspirator. Even worse, he and the other shorts Lewis lionizes didn’t simply set off the global debt conflagration, they made the severity of the crisis vastly worse.

So it wasn’t just that these speculators were harmful, and Lewis gave them a free pass. He failed to clue in his readers that the actions of his chosen heroes drove the demand for the worst sort of mortgages and turned what would otherwise have been a “contained” problem into a systemic crisis.

I take her at her word but I never really thought of Eisman and company as being heroes. They were in the business of making money for their investors and themselves, not engaged in a sociaist redistribution scheme to funnel money from the rich to the poor. They didn't take their earnings and open homeless shelters and soup kitchens. So I am not all surprised that the guys in the book actually made things worse but I read it as a glimpse inside an industry of which I know precious little. For me The Big Short is a description of how Wall Street works as seen through the lens of intra-Street conflict, not a heart-warming David vs. Goliath story.

You can judge for yourself. I found The Big Short a fun read because of the characters and interesting because of Lewis' ability to explain the market in ways I could understand.