Book: The Big Short
Author: Michael Lewis
Publication: 2011
Pages: 268
Completed on: 5/13/25
This book is about the 2008 financial crisis, how it started and the main players buying and selling credit default swaps (a type of insurance on corporate bonds) and collateralized debt obligations.
* The main sellers of subprime bonds and buyers of credit default swaps (CDS’s) and collatereralized debt obligations (CDO’s) were hedge funds as follows:
* Steve Eisman of Frontpoint Partners, wholly owned by Morgan Stanley. Also working with him were Vinny Daniels, Porter Collins & Danny Moses.
* Michael Burry of Scion Capital, who sold a portion of his fund to Joel Greenblatt. Michael dropped out of medical residency to trade stocks, had one eye and was diagnosed with Asperger’s syndrome.
* Jamie Mai, Charlie Ledley & Ben Hockett of Cornwall Capital. They had started in 2002 with a few very successful trades.
* Gregg Lippman, a bond trader employed by Deutsche Bank & some of his clients:
– Whitebox hedgefund from Minneapolis
– Baupost Group from Boston
– Passport Capital from San Francisco
– Elm Ridge hedge fund from New York
– a gaggle of other smaller hedge funds.
* The main buyers of subprime bonds & sellers of CDS’s & CDO’s were investment banks like Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch and Citigroup.
* Subprime mortgages are home mortgages or loans extended to cash-strapped or poor homebuyers, who are most likely to default on these loans. If the bank sells the mortgage to someone else, these mortgages are pooled together with thousands of other mortgages. A mortgage bond is a claim on the cash flows (loan payments from homeowner) from a pool of thousands of individual home mortgages.
* There are various floors or tranches of subprime morgage bonds (bonds of subprime mortgages only). A giant number of individual loans got piled into a “tower.” In the event of default, the top floor got its money back first and had the highest ratings from Moody’s and S&P and thus had a lower interest rate due to lower risk. The low floors got their money back last, suffered the first losses and got the lowest ratings. Because they were taking on more risk, the investors/buyers of the bonds in the bottom tranche received a higher rate of interest than investors in the top floors. Buyers choose which floor of the tower to buy. Also, the bottom tranche (the risky ground floor) are not called the ground floor, but the mezzanine, which made it sound less like a dangerous investment. Starting in 2005, some of the hedge funds wanted to figure out how to sell short these bonds, which isn’t really possible. The only way to do it was buy purchaing a Credit Default Swap.
* Credit default swap is not really a swap. It is an insurance policy on a corporate bond with semi-annual premium payments and a fixed term. For example, you might pay $200,000 a year to buy a ten-year CDS on $100 million in General Electric bonds. The most you can lose is $2 million (10 years * $200K/year). The most you can make is $100 million, if GE defaulted on its debt any time in the next ten years. Since you have the “insurance policy,” you make $100M and the actual bondholders get nothing. It is much easier & cheaper to buy a CDS than it was to sell short an actual cash bond – EVEN THOUGH THEY REPRESENTED EXACTLY THE SAME BET. All of the hedge funds felt they were not just making a bet on a bond, but making a bet against an entire, and flawed, system.
* To trade CDS’s, a standard widely agreed-upon contract, needed to be created. Mike Burry took the lead on through an organization called International Swaps & Derivatives Association, which formalized the terms of these new securities.
* Collateralized Debt Obligations (CDO’s) is a synthetic subprime mortgage-bond-backed financial instrument. This takes 100 different mortgage bonds (a bond already consists of 1,000+ home mortgages), usually the riskiest, lower floors of the original tower and uses them to create a new tower of bonds. If these bonds, as wrapped up into the CDO’s, could get re-rated as AAA , by a rating agency like Moody’s – then they would be perceived as less risky and therefore sell at a higher price. The banks argued to the agencies since there was a larger number of bonds, it was thus more diversified and less risky. The rating agencies went along with it. In the end, there were CDO’s consisting of nothing but the riskiest, mezzanine layer of subprime mortgages. It was not called a subprime backed CDO (sounds bad), but a structured finance CDO.
* The hedge funds realized that real risk was not volatility in the market, but stupid investment decisions associated with the subprime mortgage market. They soon learned that home prices did not need to fall for the CDS’s and CDO’s to become profitable – they just need to stop rising so fast. In November of 2005, Greg Lippman realized that housing prices were still rising and the default rates were 4%. If they rose to just 7%, the lowest investment grade bonds, rated triple-B-minus, went to zero and the CDS became profitable.
* As the securities became more complex, the rating agencies became more necessary. Eisman knew that the people working at the ratings agencies were those who could not cut it working for hedge fund managers or investment banks. He described it as follows: “You know when you walk into a post office you realize there is such a difference between a government employee and other people? The ratings agency people were all like government employees.”
* The banks buying the bonds had nearly fifteen years that were consistently, amazingly profitable. This is one of the reasons that the bond departments of investment banks grew so large.
* All of the banks felt that there was no way that housing prices would fall in the 2000’s. However, in 1933, during the 4th year of the Great Depression, the US found itself in the midst of a housing crisis that put housing starts at 10% of the level in 1925. Roughly half of all mortgage debt was in default. During the 1930’s, housing prices collapsed nationwide by roughly 80%.
* Buying CDS’s means you have to pay the insurance premiums for months or years while waiting for the homeowner defaults. For example, it was costing Lippmann tens of millions per year – making his losses look even larger. His superiors started trying to talk him out of the position, just as investors for Frontpoint, Scion and Cornwall were doing to their brokers. Lippmann had an idea to speed things up and “kill the market” for sellers of CDS’s & CDO’s. In late 2005, he walked into the office of the biggest buyer, AIG, and explained to them what they were doing and what their risks were.
* In May 2006, two things happened. First, Standard & Poor’s was going to change the model they used to rate subprime mortgage bonds. Secondly, a housing market analyst at Credit Suisse showed that the medium house price to income had moved from a historical 3:1 to 10:1 in LA & 8.5:1 in Miami. Housing prices peaked in the summer of 2006.
* It was always hard to accurately price the CDS’s & CDO’s until a CDO index called TABX began to trade on February 21, 2007. At the end of its first day of trading, its price implied that the underlying bonds would have experienced losses of more than 15%. The double-A-rated tranche that Cornwall had bet against had lost more than half of its value. This was the beginning that proved to the hedge fund managers that their thesis was correct. With a portfolio of $30 million, Cornwall Capital owned $205M of CDS’s on subprime mortgage bonds. Still, some banks continued selling CDO’s into June of 2007 even though the collateral underneath them had collapsed. It was like buying a dollar that allowed you to turn around and sell it for $20 if you could just wait a few months.
* 70% of Bear Stearns CDS’s were sold to Cornwall Capital. It now became apparent to Cornwall that they were exposed to the liquidity of Bear Stearns, meaning that they might not be able to collect their money if the investment bank closed. As a result, Cornwall bought $105M in credit default swaps on Bear Stearns (a bet on the collapse of Bear Stearns) from British Bank HSBC – the third largest bank in the world. This was a hedge on getting paid on the original CDS’s. In one bet, Cornwall Capital, started 4.5 years earlier with $110,000 netted $80M from a $1M bet on UBS.
* On March 14, 2008 – Eisman was invited to speak at a large group of investors. Other speakers were Alan Greenspan & Bill Miller, a large investor in Bear Stearns (B-S). Bill was speaking about the soundness of B-S given that he owned $200 million worth of the company and when he started speaking B-S shares were at $53/share. When Eisman started speaking at 9:41, B-S shares were trading at $47/share. At 9:55 they were at $43 and trading closed at 10:02 am at $29. Bear Stearns shares had collapsed in half in one day.
* In the end, B-S was sold to JP Morgan for $10/share and the US government guaranteed the assets. Lehman Bros went bankrupt. AIG was bailed out with a $180 billion. Wachovia bank was sold to Citigroup and the USG backed up the assets. In late 2008, the USG created TARP (Troubled Asset Relief Program) to support the entire financial industry with a $700 billion bailout of Citigroup, Morgan Stanley, Goldman Sachs and a few others.
* Over the same period of time, Cornwall netted $135M on $30M investments. Michael Burry almost tripled his investment. It is not known how the other hedge funds did, but they did VERY WELL. Some investments paid off at 50:1.
* None of this would have been possible without the ignorance of the investment bank traders, the stupidity of the rating agencies, the lack of oversight of the US goverment and that this was an event-driven situation which allowed for high multiple returns from event-driven investing using options, swaps and other complex financial instruments.
* There was a short piece in the book where Charlie Munger stated “If you wanted to predict how people would behave, you only had to look at their incentives. FedEx couldn’t get its night shift to finish on time; they tried everything to speed it up but nothing worked – until they stopped paying night shift workers by the hour and started to pay them by the shift. I think I have been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.” I thought this quote should be here, even though it is only tangentially related to the book.
What I learned from this book that will help increase my prospects for success after prison:
1) There is always a way to make money if one will be extremely diligent and look for it.
2) If you have a belief in something (as most of the hedge fund managers did), then you must have faith & conviction to stick with the belief – as long as you are going into it with open eyes and mathematically based proof. All the hedge fund managers faced strong opposition from their investors early on to stop this trade & get out of it. After the extremely positive returns, there were no thank you’s written to any of the hedge fund managers, even though they had been harangued for many months about the position.
3) Incentives – in the future, wherever I am, I need to be sure that the incentives are aligned so that my employees, customers, etc. are incentivized to give me the result that I want.
