PDF Summary:The Big Short, by Michael Lewis

Michel Lewis’s The Big Short: Inside the Doomsday Machine takes us inside the madness, corruption, and greed at the heart of the 2007-2008 financial crisis. It tells the story of an eccentric collection of investors who saw the folly of the subprime mortgage-backed securities market—and found a way to bet against it.

By focusing on individuals who saw these worthless securities for what they truly were, The Big Short explores the complexities and irrationalities of modern capitalism and forces us to seriously question the wisdom (and motivations) of the financial elites who wield so much power over our economy, society, and politics.

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In Wall Street parlance, to “short” an investment is to bet against it, so that you’ll make money if the investment’s value goes down. In the mid-2000s, during the US housing market boom, that’s exactly what a handful of investors did. Steve Eisman, Michael Burry, Greg Lippmann, Charlie Ledley, Jamie Mai, and Ben Hockett discovered that subprime mortgage-backed collateralized debt obligations (CDOs) were essentially worthless. By doing the research and analysis that no one else was willing to do, this group (working largely independently from one another) saw that the CDOs were nothing more than repackaged bundles of mortgages issued to un-creditworthy Americans.

These instruments had been wildly overrated by the credit ratings agencies, whose job it was to evaluate the riskiness of the securities. The bonds and CDOs sold for far more than they were worth because they’d been wrongly issued sterling grades from the agencies. The investors Lewis writes about hypothesized that once the interest rates on those mortgages rose, or if housing prices stopped rising, the bonds and CDOs they’d been packaged into would become financial toxic waste that would poison the entire financial system.

The Bet Is Made

These investors further saw that they could profit from the short-sightedness and mismanagement of major Wall Street investment banks. By purchasing a financial instrument known as a credit default swap, they could bet against these soon-to-be-valueless bonds and CDOs. Lewis explains that these swaps functioned like an insurance policy. The purchaser of the insurance policy paid regular premiums to the seller. In the event of a calamity, however, like the collapse of the housing market, the seller of the swaps would have to pay the full face value of the referenced bond.

The group saw that the impending collapse of the subprime housing market would soon make their credit default swaps worth far more than they’d paid for them, as investors would be scrambling to buy insurance coverage against the losses on their devalued bonds and CDOs. It was as if this group had found a way to purchase dirt-cheap fire insurance coverage on a house that they knew was going to be engulfed in flames the next day.

The Bill Comes Due

The downturn in the subprime market that these analysts foresaw began in 2007. Loans were going bad and borrowers were getting slammed with higher interest payments. In just one pool of mortgages that investor Michael Burry bet against, delinquencies, foreclosures, and bankruptcies rose from 15.6% to 37.7% before the end of June. More than a third of borrowers had defaulted on their loans, and the bonds based on them were suddenly worthless. The house was on fire. Investors were scrambling to either sell off their bonds for a fraction of their original value or purchase insurance on the bad bets they’d made—insurance that Burry (as well as Eisman, Lippmann, Ledley, Mai, and Hockett) now owned in spades.

By July 2007, the housing market was in freefall, and the few investors who'd bet against it started calling in their debts. Burry’s profits alone were over $720 million. Of all the investors involved in the “big short,” Steve Eisman held out the longest. He didn’t want to just make money—he wanted to make the banks hurt. To him, the big investment banks were little more than criminal operations that had preyed on the hopes and dreams of ordinary Americans. In their greed, they’d brought themselves and the entire global economy to its knees.

A Post-Mortem of the Subprime Crisis

Throughout The Big Short, Lewis lays bare the various contributing factors that led to the subprime mortgage crisis, the fall of mortgage-backed securities, and the economic downturn that followed. In this section, let’s look at each of these factors in turn: greed, complicated financial products, corruption, and a system of destructive incentives.

Greed: The Foundation

Lewis writes that above all, greed and short-sightedness were the prime drivers of the financial crisis. The big banks saw that they could get rich by extending mortgage loans to the least creditworthy Americans and then bundling those loans into complex financial derivatives they’d sell off to unwitting and uninformed investors.

In just a few years, these poorly understood financial products spread like a virus through the financial system, exposing both Wall Street and Main Street to catastrophic risk. Major players—including the big investment banks, the ratings agencies, and insurance companies—all contributed to the creation and proliferation of these dubious financial innovations because they were enormously profitable.

Ordinary homebuyers weren’t faultless either—many accepted mortgage terms they had little chance of being able to meet, and some bought multiple houses on meager salaries. Lewis argues that while the deceptive nature of how mortgages were marketed played a part in this behavior, consumers were also clearly trying to cash in on skyrocketing housing prices. In short, all major stakeholders in the ecosystem were fueled by the desire for profit, which made it easy to overlook the other systemic problems that follow.

Inscrutably Complex Financial Instruments

The sheer complexity of the mortgage-backed securities is what enabled the risk from subprime mortgage bonds and CDOs to infect the financial system. No one seemed to understand how these convoluted financial products worked or how to properly evaluate what they were truly worth. Lewis says even the big investment banks themselves were confused as to how much of these toxic assets they actually owned.

The ratings agencies were particularly susceptible to these miscalculations. They were supposed to evaluate the riskiness of these products by giving them ratings, which would be used by investors to determine whether or not they were good investments. Thus, the ratings agencies had enormous influence over the prices that CDOs could command in the marketplace. But the agencies’ ignorance and lack of sophistication led them to assign undeservedly high ratings to the CDOs.

Corruption and Fraud

Explicit corruption and fraud also played a powerful role in creating the crisis. In many cases, the lenders who created the original bad loans that were to be packed into the CDOs deliberately misrepresented mortgage terms to their borrowers. They lured them in with “teaser rates”—low initial interest rates on their mortgages—which then ballooned into exorbitant rates after a few years. This acted as a ticking time bomb in the financial system, triggering a moment where millions of mortgages would fail at the same time.

Lewis argues that there were also blatant conflicts of interest that made the subprime mortgage bond market dysfunctional. The ratings agencies already had a poor understanding of the financial products they were meant to be evaluating. But they were also corrupt—they were essentially paid by the big investment banks to issue rosy ratings to the dodgy financial products that the banks were cooking up. The banks were clients of the agencies, and the agencies risked losing the banks’ future business if they issued poor ratings to the CDOs.

Bad Incentives Drive Bad Behavior

The agencies weren’t the only players whose short-term incentives encouraged behavior that would be destructive in the long-term. Major insurance companies prioritized short-term greed over long-term financial stability, because it was highly profitable for them to do so. For example, the insurance company AIG insured billions of dollars worth of subprime CDOs because they were raking in a fortune in insurance premiums. Few at the company bothered to think about what would happen if the underlying bonds failed, because the business was so lucrative in the short-term.

These kinds of perverse incentives motivated people at every level of the subprime mortgage disaster. Borrowers had an incentive to borrow more than they could afford because they thought that (with ever-rising home prices) they’d always be able to refinance and take out new loans to cover the old ones, using their homes as collateral. Meanwhile, lenders were motivated to shower uncreditworthy borrowers with cash because they knew that they would just be bundling the loans into subprime mortgage bonds and passing them off to other investors.

And, of course, the big banks themselves got bailed out by the federal government to the tune of $700 billion when the whole market collapsed. This raises another question: Did the big banks know that they were too big to fail, and that they would receive a bailout no matter what kind of irresponsible risks they took? If so, this would be a powerful incentive to take wild financial risks. After all, it’s easy to gamble when you know you’re playing with someone else’s money.

Outsider Perspectives Can See Through the Smoke

Given the madness into which Wall Street had descended, it took a true outsider perspective to see through the smoke and mirrors. It’s no coincidence that the group of investors who saw the crisis coming and found a way to profit from it were a collection of cynics, pessimists, oddballs, and neophytes who held no reverence for the supposed wisdom of the market. They were able to see how irrational and chaotic the subprime mortgage bond market had become because they’d always looked askance at Wall Street’s conventional wisdom. This gave them the necessary perspective to see a once-in-a-lifetime opportunity where no one else could.

Some of them, like Steve Eisman, were morally aghast at Wall Street’s fleecing of ordinary Americans. For others, like Michael Burry, betting against the housing market was simply an extension of the eccentric investing strategy they’d always pursued. According to Lewis, what they all had in common was that they were iconoclasts and nonconformists who zigged when the rest of Wall Street zagged.