The Big Short by Michael Lewis explores the origins of and fallout from the 2007-2008 financial crisis through the eyes of a handful of eccentric and oddball investors who saw that the U.S. housing market—and, by extension, the entire financial system—was built on a foundation of sand.
These investors were lifelong iconoclasts who refused to worship at the altar of high finance. They saw, simply by reading financial statements and exercising basic due diligence in their investment decisions, that Wall Street was caught up in a cycle of irrational exuberance regarding mortgage-backed securities. Major financial institutions had deeply overvalued these securities and had passed them off to investors throughout the financial system.
The group—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 simply 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 contrarian investors hypothesized that once the interest rates on those mortgages rose or housing prices stopped rising, the bonds and CDOs of which they were composed would become financial toxic waste that would poison the entire financial system.
The eccentric group of investors further saw that they could profit from the colossal 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 (or “short,” in Wall Street parlance) these soon-to-be-valueless bonds and CDOs. The 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 like 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.
By detailing how a group of individuals discovered they could profit from the greed and stupidity of some of the world’s leading financial institutions, The Big Short helps us make sense of an event that most of us remember but few fully understand. It’s more than just a story about mortgage-backed securities, credit default swaps, subprime loans, collateralized debt obligations, and systemic risk. At its heart, The Big Short is a tale about the perils of greed and short-sightedness. It exposes the true nature of modern capitalism and forces the reader to seriously question the wisdom of the financial elites who wield so much economic and political power in our society.
The Big Short explores several key themes and enablers of the financial crisis, as well as the human missteps that led to it.
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 that they sold off to unwitting and uninformed investors.
In just a few years, these poorly understood financial products spread like a virus throughout the financial system, exposing both Wall Street and Main Street to catastrophic risk. Major players—including the big investment banks, the ratings agencies, insurance companies—all contributed to the creation and proliferation of these dubious financial innovations because they were enormously profitable.
Ordinary homebuyers weren’t inexcusable either—many took on mortgage terms that they had little chance of being able to meet, and some bought multiple houses on meager salaries. 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 below.
The sheer complexity of the mortgage-backed securities is what enabled the risk from subprime mortgage bonds and CDOs to spread like wildfire throughout the financial system. No one seemed to understand how these convoluted financial products worked or how to properly evaluate what they were truly worth. 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 sorts of miscalculations. They were supposed to evaluate the riskiness of these products by assigning ratings to them—these ratings would then 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 would command in the marketplace. But the agencies’ ignorance and lack of sophistication led them to assign undeservedly high ratings to the CDOs.
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 the terms of the mortgage to the borrowers. They lured these borrowers 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.
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 paying clients of the agencies, and the agencies risked losing the banks’ future business if they issued poor ratings to the CDOs.
The agencies weren’t the only players who had short-term incentives that encouraged behavior which would be destructive in the long-term. Major insurance companies like AIG prioritized short-term greed over long-term financial stability, because it was highly profitable for them to do so. AIG, for example, 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.
People faced perverse incentives at every level of the subprime mortgage disaster.
Borrowers had an incentive to borrow more than they could ultimately afford because they thought that (with ever-rising home prices) they would always be able to refinance and take out new...
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The deadly virus that infected the global financial system in 2008 was a relatively new class of asset: the mortgage-backed security. At its most basic level, a mortgage-backed security was a bond, a debt instrument. But it was very different from a traditional bond that might be issued by a government or a corporation. These latter types of bonds were essentially loans, for which the lender would be paid a fixed interest rate over a given period of time until the bond matured and the bondholder received the principal (or “face value” as it’s sometimes known).
Traditional bonds always entailed some level of risk (the company or government from which you purchased your bonds could default, or fall behind on; payment or interest rates could rise and erode the value of your bond on the open market), but these risks were relatively transparent and easy-to-understand for most investors. This was not to be the case with mortgage-backed securities.
Mortgage-backed securities brought the world of high finance into the lives of everyday Americans—even if they had no idea how much their homes had become chips on the table in the vast casino of global finance. A mortgage-backed security was a bundle of home mortgages (often running into the thousands) that had been packaged together into a tradable asset. When an investor purchased one, she was purchasing the cash flows from the individual home mortgages that made up the security.
This type of asset had actually existed for decades before the global financial meltdown of 2008, though few investors (and even fewer ordinary people) had heard of it. For most of the 1980s and 1990s, it was an obscure corner of the overall bond market, drawing only occasional interest from major financial institutions like Morgan Stanley, Bearn Stearns, and Goldman Sachs.
Many investors at this time, in fact, shied away from them because the cash flows were undesirable. During this era, the bonds were made up of rock-solid mortgages to creditworthy homeowners who were in little risk of...
We’ve seen how the big banks had foolishly hitched their wagons to the subprime mortgage-backed securities market, which suffered from fatal structural weaknesses. But for some savvy investors who saw the mortgage bonds for what they really were, the banks’ short-sightedness represented an unparalleled opportunity. They could bet against Wall Street’s position and reap enormous profits. This was the world of short-selling.
Dr. Michael Burry was, along with Steve Eisman, skeptical (to say the least) about the confidence with which Wall Street sold mortgage-backed securities. Burry was another outsider to finance, who’d come to Wall Street with an unconventional background and unique life story.
He had lost his eye at the age of two, when it was removed during surgery for a rare form of cancer. He wore a glass eye to replace the one he’d lost. Burry later would observe that this caused him to see the world differently, both literally and figuratively. Perhaps out of self-consciousness, he had trouble with interpersonal relations and thought of himself as something of a loner. To compensate for his social struggles (he would learn much later in life that he suffered from Asberger’s syndrome, a disorder on the autism spectrum), he learned to analyze data with a rigorous eye to detail, seeing patterns that no one else could see.
He was a medical doctor by training, who discovered a knack for investing and stock-picking when he was in medical school in the 1990s after studying the teachings of the legendary investor Warren Buffett. In his spare time (which, as a medical student, was rare) he started a blog on value investing that quickly became a favorite among traders and investment bankers—all of whom were amazed by his aptitude as a newcomer to investing and by the fact that he was doing this while attending medical school. As a value investor, Burry specialized in identifying companies that could be acquired for less than their liquidation value—that is, **finding companies that the market was...
Think about how wrong popular opinion can be.
Like the investors we’ve met, have you ever been convinced that the conventional wisdom on some topic was wrong? Describe the situation in a few sentences.
By February 2006, many of the savviest players on Wall Street had their eyes on Dr. Burry’s big bet. Other traders were curious why Scion Capital, Burry’s fund, had taken such a dramatic short position against mortgage securities and why Goldman Sachs, in particular, had been so eager to sell him the credit default swaps. What did he know that everyone else didn’t? Greg Lippmann, the head subprime mortgage bond trader at Deutsche Bank, wanted in on the action.
Greg Lippmann was a bond trader with a reputation for being bombastic, crass, and nakedly self-interested. He was known for humble-bragging about how much money he made from his annual bonuses and loudly complaining that he wasn’t being paid enough. Even within the money-obsessed culture of Wall Street, this was beyond-the-pale behavior. Everybody was greedy, but you weren’t supposed to be so transparently greedy.
Although his nominal employer was Deutsche Bank, everyone who met him saw that he had zero loyalty to the bank or its leadership—he was in it purely for himself. This was also something he refused to disguise about himself, openly remarking, “I don’t have any particular allegiance to Deutsche Bank, I just work here.” But his own comically obvious self-interest also made him a keen observer of everyone else’s selfishness and greed. He saw through the phoniness of Wall Street decorum and noticed that everyone was exactly like him.
In early 2006, Lippmann went to Steve Eisman’s office with a proposal to bet against the subprime mortgage market. (As we’ll see in the next chapter, Lippmann couldn’t execute the scheme on his own.) Of course, he had simply copied Burry’s idea, but he presented it to Eisman as his own original strategy. He told Eisman that the underlying loans in the bonds would start to go bad even if housing prices didn’t fall—all they needed to do was stop rising. Borrowers would be unable to refinance using their homes as collateral, which would, in turn, trigger a wave of defaults. Lippmann noted that...
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Despite Steve Eisman’s keen awareness of how depraved, corrupt, and outright ludicrous the subprime mortgage market was, he still viewed Lippmann with deep suspicion. Lippmann seemed to be a caricature of a sleazy Wall Street bond trader, only out to screw the customer. If it was such a great deal, why was Lippmann offering them a cut of the action?
The answer was that Lippmann needed co-investors like Eisman for his plan to work. While he was confident that his bet against the market would pay off in the long-run, in the short-run, it was expensive. He was sustaining losses on the premiums due on the credit default swaps before the mortgages started failing. He needed other investors to help him share those losses. And, for once, he really wasn’t trying to screw his partners over—they would end up getting rich just like him.
As Eisman dug deeper into the subprime market, he became more and more convinced that Lippmann was right. The market was even worse than he could have possibly imagined. Lending standards, he saw, had deteriorated to the point where lenders were throwing money at people in the bottom 29th percentile of the income distribution—in other words, people who were poorer than 71 percent of the U.S. population!
Eisman and his partners went down to Miami—a flashpoint of the rising default crisis—and saw for themselves empty neighborhoods and subdivisions built entirely through subprime loans. This scene was replicated across the so-called “sand states” of Florida, California, Nevada, and Arizona. The “originate-and-sell” business model of subprime lenders like Long Beach Savings had thrown wads of cash at dubious borrowers, inflating a massive—and largely undetected—housing bubble in the process.
(Shortform note: Housing bubbles occur when the demand for houses increases and supply—the number of houses on the market—can’t keep up with demand. Consequently, home prices increase, sometimes dramatically. The bubble bursts when the tide turns and demand decreases sharply while supply...
Think about how greed and short-sightedness drive bad decisions.
Can you think of an incident from your personal experience in which greed led to a bad decision? Describe the event.
By fall 2006, Gregg Lippman’s proposal (again, largely copied from Michael Burry’s strategy at Scion Capital) to short the housing market through credit default swaps had made the rounds in the financial world. But he still had few takers. Too many investors, it seemed, were leery about the idea of taking a short position against an asset that major players like Goldman Sachs, Deutsche Bank, and Merrill Lynch seemed so sure about.
Two young, obscure start-up investors, however, heeded the call and saw the opportunity of a lifetime staring them in the face. Charlie Ledley and Jamie Mai had established their (admittedly short)financial careers by betting big on events that Wall Street seemed certain wouldn‘t happen. Profiting off the impending collapse of the subprime market fit perfectly into their theory of how the financial world worked.
Ledley and Mai weren’t career Wall Street guys. They barely had careers at all. Starting their fledgling money management fund, Cornwall Capital Management, with just $110,000 in a Schwab account, they were the sort of bit players that couldn’t even get a phone call returned at Goldman or Merrill. They were scrappers, a “garage band hedge fund.” In fact, they literally started out of a backyard shed in Berkeley, California.
But they had a theory about financial markets that proved to be all too prescient—and that would give them a powerful advantage as the subprime market spun itself into a more and more complex web. Their insight was that investors only understood their own particular slice of the market, whether it was Japanese government bonds or European mid-cap healthcare debt. Everyone was looking at the small picture, the micro. Cornwall’s strategy was to go macro and look at the big picture. With information so unevenly distributed, there had to be pricing mistakes—assets that were priced for far more or far less than they were actually worth, simply because investors didn’t understand what they were actually buying and selling. And that...
By early 2007, Greg Lippmann’s big gamble should have been paying off. Housing prices were falling, defaults were creeping up, but subprime bonds were somehow still standing strong. To him, it was almost as if the market had believed its own lies about the value of these assets.
And Wall Street’s continued delusions about subprime were costing him. With the swaps he’d purchased, he was paying $100 million in premiums, waiting for the bonds to go rotten. He was sure it was a profitable bet in the long-run, but it was costly in the short-run. He needed co-investors like Eisman and the team at Cornwall in order to maintain his position. And even a dyed-in-the-wool market cynic like Steve Eisman was beginning to have his doubts. Lippmann had to act. He had to show Eisman just how arrogant and dumb the people on the other side of their bet truly were.
In January 2007, Lippmann flew Eisman and his team out to a giant annual convention of subprime lenders, speculators, and investors, dwarfing the similar convention Eisman had already attended in Miami. Given the excesses and financial hedonism of the subprime industry, the irony of the convention being held in Las Vegas certainly wasn’t lost on Eisman (nor would be the fact that Las Vegas would become ground zero for the housing market meltdown that was shortly to ensue).
Lippmann had Eisman meet a CDO manager named Wing Chau. Eisman hadn’t even known that there was such a thing as a CDO manager (because what was there to manage?), but here was one in the flesh. Chau was a middleman whose job was essentially just to take triple-B tranches of original CDOs (again, themselves composed of subprime mortgage bonds) and repackage them into new towers of bonds. He would then pass them off to unwitting investors like pension funds and insurance companies. And by buying more and more mortgages to immediately repackage and resell, CDO managers like Wang directly contributed to the demand for these bonds and the subprime mortgages of which they were composed. It was like a machine that...
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Examine why skeptics and cynics turned out to be the big winners in the financial crisis.
Why were Eisman and the Cornwall Capital team so cynical about the financial system and CDOs specifically?
While Eisman, Lippmann, and the Cornwall Capital team were looking into the eye of the coming storm in Las Vegas, Michael Burry was trying to placate his investors at Scion. He was confident that his bet against the housing market would be vindicated. But it was an expensive position to maintain, and one that was costing his wealthy clients significant money in the here and now, as he continued to owe the banks the premiums on the credit default swaps he’d purchased. For the first time, Burry was underperforming the market. In 2006, the S&P had risen by more than 10 percent—Scion had lost 18.4 percent.
Burry was baffled by how the market was behaving. The data from the mortgage servicers kept getting worse and worse as 2006 turned to 2007 (and the teaser rates expired). The loans were faltering at higher and higher rates, yet the price of insuring the bonds composed of these loans kept falling. It was as if a fire insurance policy on a house had become cheaper after the house was on fire. Logic, for once, had failed Dr. Burry. And he was facing an investor revolt, as his clients began to clamor for their money back out of his fund, thinking that he was either a criminal, a madman, or an idiot.
This was a major problem for Dr. Burry. There was language in Burry’s credit default swap contracts with the banks that allowed the major Wall Street firms to cancel their obligations to Burry if his assets fell below a certain level. Thus, even if Scion’s predictions proved to be correct, the big banks could bluff their way through the crisis, maintain high prices for subprime mortgage bonds, run out the clock on Burry, and force him to void his position before he collected a dime. It was imperative to him (and to his investors, though few were convinced) that there not be a mass withdrawal of funds from Scion. They would lose everything, right when they were on the cusp of winning everything.
So what did Burry do? He told his investors, no, they couldn’t have their money back. He exercised a rarely used provision in his...
Explore the main takeaways from The Big Short.
Why do you think the eccentric clique of investors we’ve followed pursued such a different strategy and had such a unique view of the financial system?