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Book Review Patrick M. Foley, CFP , QPFC Book Review The Big Short: Inside the Doomsday Machine By Michael Lewis Patrick M. Foley, CFP®, QPFC May 2012 I’ve read quite a few books on the 2008 Global Financial Meltdown at this point, including some that I’ve reviewed previously. There was Fools Gold, told from the perspective of JP Morgan; The Devils Casino, about the fall of Lehman Brothers; The Monster, which focused on subprime lenders; and House of Cards, which detailed the collapse of Bear Stearns. Recently I finished one that was particularly entertaining (I know… an unusual description for a financial apocalypse story!). Called The Big Short, it was easily the most compelling read of the bunch. The author is Michael Lewis, who is best known in the investment world for having written Liar’s Poker, and best know outside if it for Moneyball and The Blind Side. The Big Short views the meltdown from the perspective of traders who recognized the growing rot within the mortgage industry, and made fortunes betting against (“shorting”) that market and the major global financial institutions that were at the center of it. Lewis is a gifted writer with a particular talent for recalling historical events through descriptions of conversations and characters, such as this colorful depiction of Gregg Lippmann (A Deutsche Bank bond trader who guided several fund managers in making huge bets against the mortgage market): He wore his hair slicked back, in the manner of Gordon Gekko, and the sideburns long, in the fashion of an 1820s Romantic composer or a 1970s porn star. He wore loud ties, and said outrageous things without the slightest apparent awareness of how they might sound if repeated unsympathetically. Like all of the “2008” books, The Big Short serves as a cautionary tale, but this one also reads like a detective novel as a number of then obscure members of the investment community came to recognize that something was terribly amiss, and then sought to wager that it would all come crashing down. Meanwhile, the bubble continued to grow (casting serious doubt on the wisdom of their bets!), fueled in large measure by the conventional “wisdom” that residential real estate would never experience a significant decline. Large asset bubbles in the marketplace are usually no surprise if you are paying much attention. The .com, real estate, and oil bubbles of the past decade or so did not sneak up on anyone. They were debated at length in the financial press, and the exponential price increases were plain to see. When my wife and I bought our house in 2004, we discussed the idea that we probably wouldn’t make very much money on it since real estate had risen so sharply in recent years. Little did we know that prices would continue to escalate dramatically for several years to come. Although, eventually, it seems we were probably right in the first place. What is difficult to perceive about bubbles is how long they will continue, and what the impact will be when they burst. For example, at the peak of the technology bubble in 2000 it was becoming apparent that many of the .com businesses were smoke and mirrors, and were doomed to fail. Much harder to predict was that hugely profitable and stable businesses like Microsoft and Intel would suffer enormous drops in value, and that more than a decade later they would still be (along with the Nasdaq Index) well below their peaks. Likewise with the real estate bubble. While many recognized it as a bubble, few were in a position to perceive the tangled web of real estate exposures carried by the world’s largest investment houses. It was those intertwined investments that that eventually brought the global economy to the brink. The book does an excellent job of depicting the overall growth and collapse of the subprime mortgage market, but I’ll provide my own brief synopsis here. A mess of that proportion requires a number of elements to coalesce, but two particular factors help set the stage. The first was pressure from politicians in Washington for lenders to provide more loans to low income borrowers (the goal being to increase the overall level of home ownership in our country). The second was that Wall Street investment houses began to “securitize” mortgages, or bundle them up and sell them as investments that provided income. This had the effect of removing the risk of the loan from the actual lender, which meant that eventually many lenders came to have a complete disregard for the quality of the loans they were making. Early on, these “mortgage backed securities” were fairly secure and predicable investments, and accordingly were provided high scores from ratings agencies such as Standard & Poor’s and S&P (those ratings were heavily relied upon by buyers in the marketplace, including institutional investors). The problem is, over time the quality of the underlying loans began to degrade, while at the same time the investment structures grew more complex. The ratings agencies, meanwhile, seemed to be oblivious to these changes, and continued to slap their seal of approval – in the form of AAA ratings – on investments of increasingly dubious quality. The way it worked was that mortgage loans (often of poor quality) were packaged together into bonds, which were mostly then awarded the coveted AAA score. The diciest of the bonds (the leftovers, essentially) which did not receive high ratings were repackaged yet again into something called a “Collateralized Debt Obligation”, which then often earned the AAA rating (despite being made up of bonds that were made up of very questionable loans). If the complexity doesn’t make your head spin, the absurdity should! The next step in this slide toward economic Armageddon was the creation of so-called “synthetics”, which were essentially side bets on the outcomes of the actual bonds. As described in the book: Both sides could do a deal with Goldman Sachs by signing a piece of paper. The original home mortgage loans on whose fate both sides were betting played no other role. In a funny way, they existed only so their fate might be gambled upon. The market for “synthetics” removed any constraint on the size of risk associated with subprime mortgage lending. To make a billion-dollar bet, you no longer needed to accumulate billions of dollars worth of actual mortgage loans. All you had to do was find someone else in the market willing to take the other side of the bet. The other side of the bet, as it turns out, was often insurance giant AIG, which raked in enormous amounts of money selling relatively low priced insurance against the mortgage bonds. The problem is, they didn’t rake in nearly enough to cover all those bonds when everything came crashing down, and AIG ended up being one of the more notable victims of the meltdown (“victim” isn’t really the right word, and AIG’s participation in the whole mess receives much attention in the book). Into 2007 the quality of mortgages being written kept plumbing new lows. As described by one of the hedge fund managers profiled in the book, Michael Burry: The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. You, the home buyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principal balance. It wasn’t hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn’t understand was why a person who lent money would want to extend such a loan. “What you want to watch are the lenders, not the borrowers,” he said. “The borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint, and when they lose it, watch out.” And they certainly had lost restraint. Another hedge fund manager named Steve Eisman was noticing the signs all around him: One day Eisman’s housekeeper, a South American woman, came to him and told him that she was planning to buy a townhouse in Queens. “The price was absurd, and they were giving her a no money down option adjustable-rate mortgage” says Eisman, who talked into taking out a conventional fixed-rate mortgage. Next, the baby nurse he’d hired back in 2003 to take care of his new twin daughters phoned him. “She was this lovely woman from Jamiaca”, he says. “She says she and her sister own six townhouses in Queens”. As Mike Burry came to believe the mortgage market was rife with garbage loans, he sought to buy insurance that would pay off in the event of default. What he found to his great surprise was that not only did the rating agencies fail to differentiate between good loans and bad, but the pricing of insurance did not vary based on the quality of the loans either. He described the situation as follows: It was as if you could buy flood insurance on the house in the valley for the same price as flood insurance on the house on the mountaintop. Somehow though, the market kept humming along despite signs that cracks were forming. And there were many prominent voices on Wall Street and Washington still claiming, essentially, “all is well”: “The impact on the broader economy and the financial markets of the problems in the subprime markets seems likely to be contained.” - Federal Reserve Chairman Ben Bernanke, March 7, 2007 Of course, we all know now how it ended.
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