Saturday, April 2, 2011

The Big Short

I recently read "The Big Short" by Michael Lewis. It tells the story of some of the people who were able to foresee the end of the housing bubble and made a lot of money shorting (or otherwise betting against) mortgage backed securities. I thought it was pretty good.

In part this is simply because I find Lewis an entertaining writer, I also quite liked two of his previous books, "Liar's Poker" and "Moneyball". And I find the idea of making a lot of money by seeing through a bunch of lies appealing. However I also thought the book was an instructive, albeit somewhat narrowly focused, account of the recent financial crisis. It left me feeling I understood aspects of what had happened a bit better.

One of these aspects was the effect of misratings by the bond rating agencies like Moody's. These agencies were giving inflated ratings to complicated mortgage securities which naive buyers foolishly trusted. It was if the agencies were declaring $5 bills to be worth $10 and this allowed them to be sold for $10. Obviously this allowed the Wall Street firms assembling such mortgage securities to profit, and the larger the discrepancy between the agency ratings and the true values the larger the profits. So this encouraged the creation of the most misvalued mortgage securities. So much so that there was a shortage of actual lousy mortgages to assemble into these overvalued mortgage securities. However Wall Street got around this by constructing synthetic mortgage securities using credit default swaps. A credit default swap is like insurance on a bond, in exchange for periodic premiums you are paid off if the bond defaults. So selling credit default swaps (or writing such insurance) is like owning the bond you get periodic payments but lose a lot of money if the bond defaults. So by selling credit default swaps on overvalued mortgage bonds to mortgage market bears (like the people portrayed in this book) the Wall Street firms were able to construct the equivalent of these overvalued bonds which the bond rating agencies would again bless and which could also be sold at inflated prices to naive buyers.

Another aspect was just how foolish these buyers were. Wall Street firms obtain their largest profits by taking advantage of their customers. Wall Street firms like complicated and illiquid securities because it is easier to sell them at inflated prices. So any naive buyer should never buy anything but the simplest, most liquid, most straightforward securities as otherwise they are almost certain to overpay.

There is a bit of a danger with an entertaining writer like Lewis that you will give undue credence to his point of view simply because he is such a good story teller. Lewis has been criticized along these lines but for the most part I think his books get the big picture (if not every detail) correct.

This book does portray its subjects sympathetically. One them was a hedge fund manager, Michael Burry. Many of Burry's clients were upset with him for using what they thought was to be a stock picking fund to make a massive bet against mortgage backed securities. Although this bet eventually turned out very well the clients were not actually being all that unreasonable in objecting.

In summary I liked this book quite a lot. However if you don't already know a bit about financial markets you may find it a little confusing in places and it is not a comprehensive account of the crisis.

1 comment:

  1. Its an interesting read, although desprssing to see how many stupid and /or dishonest people were running around creating or buying worthless paper. It was nice to have a bit of a description of the players in the drama and and what their lives were like. I believe Michael Lewis is being sued by Wing Chau.
    I do wish that the author had put an index in the back of the book for reference.