The Big Short Inside the Doomsday Machine by Michael Lewis

The global financial crisis of 2008, which resulted in several trillion dollars of financial losses, was triggered not by a war or a natural disaster, but by a handful of greedy executives on Wall Street. The financial and social consequences of these people's actions have been well documented. By some estimates, 40% of the world's total wealth simply evaporated during the 2008 meltdown, and it has been painfully slow to return.

While most Wall Street banks escaped relatively unscathed (thanks to massive government bailouts), millions of innocent by-standers around the world lost their retirement savings, lost their homes, and in many cases also lost their livelihoods.

It's not hard to find people who lost substantial amounts of money in 2008. Most of our friends, relatives and co-workers lost out. But believe it or not, there were actually a few people whomade money that year. A lot of money. And until now, no one has told their story. In The Big Short, Michael Lewis tells the story of a comparatively small number of people who saw the disaster coming and cashed in on it. Unlike the rest of us, this clever bunch actually figured out a way to profit from Wall Street's greed and corruption.

For readers of Lewis's earlier books, including Liar's Poker and Moneyball, The Big Short may have a bit of a familiar ring to it. Like those other books, The Big Short is essentially a story of insatiable greed and financial shenanigans. In fact, in the prologue to The Big Short, Lewis actually positions it as a sequel to Liar's Poker, which was an account of Lewis' own short-lived stint as a trader on Wall Street during the 1980s.

It was during the latter years of the 1980's that complex new financial products like "Credit Default Swaps" were first being piloted by a handful of big Wall Street firms. Of course, at that time, neither Michael Lewis, nor anyone else working on Wall Street, could have possibly imagined how much collateral damage these confounding "financial innovations" would one day exact on the global financial system (and on the lives of real, everyday people). Consequently, the tales of financial manipulation that Lewis told over a decade ago in Liar's Poker — the multi- million dollar rip-offs that shocked his readers at the time — now seem almost quaint in the context of the trillion-dollar meltdown of 2008.

In The Big Short, Lewis chronicles the trials and tribulations of a handful of investors who foresaw the coming financial meltdown, and set-out to turn a (handsome) profit from it.

These five men — Michael Burry, Steve Eisman, Greg Lippmann, Charles Ledley, and Jamie Mai — somehow managed to see what precious few other investors in America were able (or willing) to see in the period leading up to the 2008 global meltdown. They recognized early on that America's sub-prime mortgage market, once dubbed the "the most powerful engine of profits and employment on Wall Street," was little more than a glorified Ponzi scheme. And more importantly, they figured out a way to use arcane and poorly-understood financial instruments, such as Credit Default Swaps, to leverage their modest individual fortunes into possibly the biggest short-sell in American history.

The Gathering Storm

Early in the book, Lewis paints a frightening picture of the financial calamity that's about to unfold. He explains how greedy Wall Street firms had been turning sub-prime mortgages — loans made to (generally poor) people with low creditworthiness or little documentation — into exotic (and toxic) financial products. Those firms then made a fortune re-selling those sub-prime mortgage derivatives to largely overseas investors (German banks, in particular, were eager to buy these particular Wall Street offerings).

As Lewis explains, the investment banks were aided and abetted in their re-packaging and selling of garbage derivatives by ratings agencies like Moody's. The main function of a ratings agency is ostensibly to identify and police risk. Instead, for reasons no one will ever know, the agencies labeled the new sub-prime mortgage backed securities as "AAA investment grade" (i.e. effectively risk-free), and then washed their hands of the whole thing. According to Lewis, the global feeding frenzy in sub-prime mortgage derivatives continued to grow even as the quality of the underlying loans deteriorated, and it became increasingly inevitable that the U.S. housing market was going to crash.

Yet, almost no one saw it coming. Not the chief executives of America's premier banks. Not Treasury Department officials, or the Chairman of the U.S. Federal Reserve. But Burry, Eisman, Lippmann, Ledley, and Mai saw it coming. And their stories — summarized below — reveal an important lesson about the value of independent thinking.

Steve Eisman

The first of Lewis's five central actors is Steve Eisman, a former securities trader for the centuries-old U.S. investment bank Oppenheimer. Eisman is easily one of the book's more colorful characters, but this isn't due to any particular literary flair or embellishment on the part of Lewis. In his own right, Eisman is simply a character.

On one hand, Steve Eisman is a brilliant man. But he's also rather difficult to get along with, and he does not suffer fools easily. In that regard, Lewis reports that his own wife describes him as "sincerely rude." For example, on one occasion, the CEO of a large Japanese real estate

Ss firm was with Eisman in a boardroom at Oppenheimer, along with a number of other execs. The CEO had sent Eisman his company's financial statements in advance, and then followed in person to solicit an investment from Oppenheimer.

"You don't even own stock in your company," said Eisman, through an interpreter, after the typically elaborate Japanese businessman introductions.

"In Japan it is not customary for management to own stock," responded the CEO.

Eisman then noted that the financial statements didn't actually disclose any important details about the company. Then, he lifted the document up and pretended to flush it down the drain, saying: "This is toilet paper. Translate that!" Then Eisman walked out.

Perhaps because he was so disinterested in playing nice with others, Eisman was able to detach himself from the mainstream thinking at his bank to fully immerse himself in the intricacies of the growing sub-prime lending market.

By 2006, Eisman had come to understand the sheer magnitude of the downside risks associated with the sub-prime market, he began looking for ways to bet against it. At first, Eisman and his small team found it very difficult to short the sub-prime market in any meaningful way. But then they stumbled upon the opportunities afforded by Credit-Default Swaps, a form of insurance that big financial institutions such as AIG sold against fixed-income securities.

For a high-stakes gambler like Eisman, the great thing about Default Swaps was that you could buy insurance on a particular security (in this case bundles of hundreds of sub-prime mortgages) without actually owning the underlying securities themselves (which would have been prohibitively expensive, even for someone in Eisman's league). Thus, if the value of the securities one day dropped below a certain threshold, Eisman would be able to cash-in on all the insurance policies. By contrast, if the value of the underlying securities remained constant, or even rose, then he would have to pay interest on the insurance policies. Over time, the interest payments became significant. But still, Eisman soldiered on, certain that a huge payout would soon come his way.

Over a period of about two years, Eisman amassed a huge cache of Credit Default Swaps; all hedged against crappy sub-prime mortgage securities. Then, when the credit crisis began spiraling out of control in mid-2008, Eisman wisely began cashing-in those insurance policies, not waiting until the market hit rock bottom out of fear that AIG and the other banks that had sold him the policies would be left unable to pay their bills.

As obvious as Eisman's investing strategy may seem in hindsight, the fact of the matter is that shorting securities is a very difficult game. Indeed, as Lewis explains, it's remarkable that Eisman was able to pull it off on such a massive scale. "When you're short, the whole world is against you," writes Lewis.

For Eisman, this meant that his bosses at the bank were against him. With every day that went by, he tested their patience and they tested his resolve. It is impressive to understand that Eisman's short bets on sub-prime mortgages didn't pay off in 2006 when he first started making them, even as the underlying housing market was beginning to weaken at that time. Nor did his bets pay off in 2007, when the housing market was increasingly weakening. Nor did they pay off in early 2008, when it was obvious to just about everyone with a pulse that the housing bubble was about to burst. It took time.

Throughout that time, Eisman was shelling out millions in carrying charges on insurance policies, and he was the only one on Wall Street doing it. People thought he was crazy. One can only imagine the heated conversations he had during that time with his superiors at Oppenheimer, who watched him bleeding money at a time when everyone else at that bank — and nearly every other bank — was raking in record profits. An investor with less tenacity and clear-headedness than Eisman would not have held on.

In the end, Eisman's gamble of betting against the sub-prime market paid off so well that the assets under his control rose "from a bit over $700 million to $1.5 billion," according to Lewis's accounting. But for Eisman, it was never really about the money. It was about making a point to the rest of Wall Street, which he most certainly did. And interestingly enough, now that his investing theories have been vindicated in the eyes of his peers, Lewis reports that Steve Eisman has "suddenly developed a capacity for tact."

Michael Burry

At around the same time that Steve Eisman was getting into the sub-prime shorting game in New York, a former medical student turned hedge fund manager named Michael Burry was independently doing the exact same thing out on the West Coast.

Like Eisman, Michael Burry is a rare duck. Lewis describes him as a loner. He's also exceptionally honest with others, almost to a fault. To wit, Burry once described himself in a personal ad as "a guy with only one eye, an awkward social manner, and $145,000 in student loans." Lewis speculates his hyper-honesty may be due to a mild case of Asperger's Syndrome; as are some of Burry's other excessive compulsive character traits, including his fascination with number-crunching (Burry devours baseball statistics).

It was Burry's rare talent for number-crunching that led him to leave his neurology residency after an online investment blog he'd started as a hobby attracted unexpected attention from several well-heeled money managers. Those investors were impressed with the quality of the financial analysis that Burry had posted — it was better and more professional than what their in-house guys were able to do. So with their initial backing, Burry dropped out of medical school to start a hedge fund named Scion Capital, which almost from day one became "madly, almost comically successful" according to Lewis.

In its early years, Scion did not dabble in sub-prime mortgage securities. But one day in 2004, while investigating stocks to invest for his customers, Burry discovered that the bond

Ss market was absorbing sub-prime mortgage loans in remarkably large volumes. Soon, Burry realized that the millions of dollars of credit swirling around the bond market were artificially inflated and headed for a massive correction. Through his own research, Burry figured that he could bet against pools of these sub-prime mortgage loans using Credit Default Swaps. But unlike Steve Eisman (who Burry had never met), Burry did not work for an investment bank. So convincing someone on Wall Street to sell him one or more Credit Default Swaps was no small feat. Yet, through considerable effort and ingenuity, Burry eventually persuaded a bank to sell him some.

Just like Eisman, once Burry had acquired the Default Swaps and added them to the Scion portfolio, Burry was obligated to carry them at a loss; a loss that eventually bled into the millions. As the performance of his fund soured, Burry's wealthy backers began strongly hinting that they might want to withdraw their money.

At first, Burry tried to assuage their concerns by trying to explain, in intricate detail, what he was trying to accomplish by holding onto these arcane financial instruments. But in this situation, Burry's tendency to be hyper-honest with other people had precisely the opposite effect. The investors were unable to wrap their heads around Burry's long-winded explanations, and couldn't begin to fathom how Credit Default Swaps actually worked, so they became even more spooked. And so, as Scion's investors moved to pull their money, Burry invoked a clause in their investment agreements which allowed him to lock-down their funds. For a once high-flying Californian hedge fund manager, this unilateral move amounted to reputational suicide for Burry. But he didn't care. Naively, Burry believed that once his sub-prime mortgage shorts eventually paid off — and Burry was certain they would — his investors would more than forgive him for his heavy-handedness.

As it turned out, precisely the opposite thing happened; Burry's investors effectively went to war with him, using every legal tactic at their disposal to get their money out. Burry barely managed to hold them off long enough for the housing market to crash. But hold them off he did, just long enough for his strategy to pay off. Yet, even after the housing market crashed and Burry's crazy-sounding scheme was clearly vindicated by a massive $720 million profit returned to Scion, not a single one of his investors called to say "thanks." Instead, they simply cashed-out and moved on, never to speak to him again.

Michael Lewis writes of Burry's situation: "What had happened was that Burry had been right, the world had been wrong and the world hated him for it," Lewis writes. "And so Burry ended where he began — alone, and more comforted than ever by his solitude."

Greg Lippmann

With his wild suits, outrageous language, and unusually long and thick sideburns, Greg Lippmann, a mortgage bond trader at Deutsche Bank, "never quite fit in on Wall Street." According to Lewis, when Lippmann first began making bearish bets on sub-prime mortgages during the autumn of 2005, his colleagues at Deutsche Bank would roll their eyes and call him "Bubble Boy." They simply didn't believe the market would crash. Never phased by their lack of

Ss confidence in him, Lippmann (now famously) decided to up the ante by having a t-shirt made to wear to corporate functions that read "I'm short your house," (which basically means I'm going to make money when the value of your house falls). Much like Steve Eisman, Lippmann seemed to thrive on being a loud-mouthed contrarian with few (if any) friends on Wall Street.

Lippmann's Wall Street colleagues simply didn't know what to make of him. "I think he has some kind of narcissistic personality disorder," said one money manager in an interview with Lewis. "He comes into a meeting one day and says that ‘You have no way out of this swimming pool (aka the looming sub-prime meltdown) but through me, and when you ask for the towel I'm going to rip your eyeballs out." So they avoided him.

When all was said and done, Lippmann's sub-prime shorts made over $2 billion for Deutsche Bank, and earned him some very tidy bonuses. But even though he's a much wealthier man these days, it's still hard to find someone who'd openly call him a friend.

Charles Ledley and Jaime Mai

Ledley and Mai were two young Berkley graduates who decided on a whim to start their own hedge fund with just over $100,000. Neither of them had any previous investing experience. Yet they quickly made more than $15 million by betting on financial events that are extremely unlikely to occur — and therefore didn't cost much to bet against.

"Ledley and Mai thought that Wall Street underestimated the likelihood of black swans (aka really unlikely events)," explains Lewis. "So they would buy options to buy stocks at prices far, far away from where the stocks were currently trading. And they didn't just limit themselves to stocks. They did it with currencies, and they did it with commodities. They scoured the world, essentially looking to make bets on extreme things happening."

Soon, Ledley and Mai stumbled into the sub-prime mortgage market and realized that they could bet against not only the loans but also the financial institutions themselves. Because of their previous experience with short-selling, Ledley and Mai were able to piece together a clear picture of what was happening in the market in just a matter of months. But unlike Eisman, Burry and Lippmann, who sought only to get rich, these two young guys with a social conscience actually tried to do something to fix the problem.

"Ledley and Mai were less interested in the bet itself than the societal implications of what they were learning," writes Lewis. So they went to the SEC. They went to The Wall Street Journal. They screamed at the top of their lungs, 'There's fraud in the system!'"

But no one listened.

So, Ledley and Mai threw their hands up in the air and re-focused their energies on simply getting rich. By betting against sub-prime mortgages, their original $15 million investment soon grew to $120 million. Not bad for a couple of rookies out of Berkley.

A Few Common Threads

While the five main actors in Lewis's drama may not appear to have much in common on the surface (e.g. Eisman, Burry and Lippmann were all seasoned big time investors, whereas Ledly and Mai made their fortunes as rookies), they all possessed a handful of common traits. Perhaps because of these unique character traits, Lewis' protagonists were able to foresee the coming financial meltdown — and figure out a way to profit from it — while the rest of us could only watch helplessly while our fortunes evaporated:

First and foremost, they were all outsiders. Living on the West Coast, three of the five characters were geographically far removed from the Wall Street establishment. And in the case of Eisman and Lippmann, despite working in Manhattan for large Wall Street banks, they nevertheless saw themselves as outsiders, and acted accordingly. As a result, none of the five were particularly respectful of traditional authority figures, nor were they particularly interested in conforming to mainstream investment thinking.

Secondly, all five men were empirical thinkers. They had no time for theories, opinions and conjecture. They cared only about facts. Indeed, at one point in the book, Lewis describes Michael Burry as "probably the only human being on earth who read the prospectuses for sub- prime mortgage bonds, apart from the lawyers who drafted them."

On the surface, investing based on facts may not seem like such a revolutionary idea. Yet, most investment professionals — even some of the super-successful ones — are often guilty of bending facts to fit their theories. But Lewis's central characters did just the opposite — they adjusted and re-adjusted their investing theories based on the facts.

Still, notwithstanding their endless appetite for facts, Eisman, Lippmann, Burry, Ledly and Mai also had a healthy respect for the unknowable. Lewis writes about his protagonists that they were "predisposed to feel that people, and by extension markets, were too certain about inherently uncertain things." In other words, they understood that events in the past could not be relied upon to predict the future. And while most other investors dismissed certain possibilities outright — including the possibility of a global financial collapse — as unthinkable, Lewis's heroes never did. They were open-minded.

Conclusion

In hindsight, we've all come to appreciate the cascading financial consequences that can ensue when the banking system seduces millions of people with shaky — or in some cases non- existent — credit histories into accepting adjustable-rate mortgages, beginning with tantalizingly low "teaser" interest rates. But in the lead-up to the financial meltdown, you could probably count on two hands the number of people who accurately foresaw what was about to go down, and who cleverly figured out a way to profit from it. Nearly everyone on Wall Street — and around the world — was suffering under the same delusion that an extreme market correction would never occur. And we were wrong.

And so it seems that in order to succeed spectacularly as an investor, you really do need to be spectacularly different from the rest of the crowd. Does that mean you have to behave as an outsider — not caring what others may say or think about you — as Lewis's central characters did? That's hard to say. But if nothing else, Michael Lewis's book should serve as a reminder to us as investors to question the wisdom of crowds, not put too much stake in what the "experts" have to say, and most of all, trust our own instincts.