Journal Of Investment Management, Vol. 9, No. 1, (2011), pp. 101–102 © JOIM 2011 JOIM

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BOOK REVIEW

Mark Kritzman, Senior Editor

THE BIG SHORT---INSIDE never heard of. These include, made up the mortgage bonds THE DOOMSDAY MACHINE among others, Steve Eisman, that made up the CDOs were, By Michael Lewis a portfolio manager at Front- presumably, largely uncorre- Norton, 2010, Hardcover Point; Michael Burry, founder lated led the rating agencies to (Reviewed by Javier Estrada, of Scion Capital (also featured assign investment-grade ratings IESE Business School, Barce- in Zuckerman’s book); Greg to CDOs made up of lower- lona, Spain) Lippmann, a bond trader at quality mortgage bonds. These Deutsche Bank; Jamie Mai and investment-grade instruments Ever since he wrote his clas- Charley Ledley, founders of offered returns slightly better sic Liar’s Poker it has been Cornwall Capital Management; than Treasuries, but that still clear that Michael Lewis is a and Howie Hubler, a bond made them attractive in an envi- gifted writer. In The Big Short, trader at Morgan Stanley. ronment of low interest rates. his latest book, Lewis pro- Thus, banks, investment banks, In a nutshell, Lewis’ story goes duces another entertaining and and rating agencies, all encour- as follows: As property prices captivating story, a behind-the- aged by the fees obtained from started rising at an unprece- scenes look at the unraveling of the new game in town, “con- dented rate, banks started to the credit crisis as seen through spired” to keep the machine lend money to less and less the eyes of some of its players. going. Until, of course, the qualified borrowers. This led inevitable happened. Interestingly, rather than focus- to the now-infamous subprime ing on some of the market’s loans, most of which started What is the inevitable? That well-known players, such as with a low (teaser) rate that property prices simply could John Paulson (who made $15 rose substantially after a cou- not keep increasing at unsus- billion in a single year betting ple of years. These loans tainable rates forever. And they against the housing market, as were later packaged into mort- did not. Eventually they started chronicled in Gregory Zuck- gage bonds, and eventually to fall, at pretty much the same erman’s The Greatest Trade repackaged into CDOs (col- time that teaser rates came to Ever), Lewis focuses on sev- lateralized debt obligations). an end and much higher ones eral people you most likely The fact that the loans that kicked in. This led to massive

First Quarter 2011 101 102 Book Review defaults in loans, mortgage “Shorting Home Equity Mez- many other trades discussed in bonds, and CDOs, and the rest zanine Tranches” talk, in which the book, and Lewis tells us is history. And part of that his- he showed that since 2000 peo- about them too. Needless to tory is that some market players ple whose homes rose in value say, AIG was in the middle figured out that sooner or later between 1% and 5% a year of the mess through its AIG the moment of reckoning will were four times more likely to FP unit, which eventually led come and found creative ways default than those whose home the Fed to extend a loan of to profit from the doom. prices rose by 10%. In other over $180 billion so that the words, prices did not even need company could make good on Michael Burry, a former resi- to decrease to start a massive derivatives contracts with finan- dent in neurology at Stanford round of defaults; they only cial institutions. And so was Hospital, was one of the very needed to stop rising at the pace Howie Hubler, a bond trader first who tried to find a way they had been going the past at Morgan Stanley, who left to bet against specific mortgage few years. behind a loss of more than $9 bonds. As luck (or lack of it) billion, the single largest trad- Jamie Mai and Charley Ledley would have it, his Asperger’s ing loss in the history of Wall founded Cornwall Capital Man- disease led him to an obsessive Street, according to Lewis. agement with $110,000 held in passion for reading mortgage a Schwab account and run the bond prospectuses that nobody There are obviously many more company out of a garage in bothered to read, and eventu- companies (inevitably, Gold- Mai’s Berkeley house, which ally figured out that these bonds man Sachs had a role to play) doubled as Ledley’s bedroom. were bound to default as soon and people whose roles are They were some of the very first as the teaser-rate periods ended. intertwined into Lewis’ story, to notice that the presumed lack He first bought $60 million of but I will not bore you with of correlation among the loans credit default swaps (protec- details. I will go as far as say- in a mortgage bond was an illu- tion) in May, 2005, and by ing that if you want to find sion, and therefore that rating a July had amassed $750 mil- out more about the earthquake CDO better than the mortgage lion, all of them at prices that hit us, whose aftershocks bonds it held inside created that reflected a negligible prob- we are still feeling (and prob- a tragedy waiting to happen, ability of default. The mar- ably will for years to come), as well as a profit opportu- ket had not yet visualized the it will be worth your time to nity. Their insight enabled them future that Burry was correctly read Lewis’ account. He may to turn their $110,000 into forecasting. not tell us the whole story, but $120 million when the market the story he does tell us is com- Greg Lippmann, a bond trader crashed. pelling and instructive. More at Deutsche Bank, went around Of course, there had to be losers likely than not, Lewis has pro- the country presenting his on the other side of these and duced another classic.

Journal of Investment Management First Quarter 2011