The Big Short – Michael Lewis (2010)

I first read Michael Lewis back in the 80s with Liar’s Poker, where he covered the initial bond trading explosion.  His new book, The Big Short, is back in the same territory, covering the subprime mortgage blowup in 2006-2008, and it’s a very readable story centering on a handful of traders who got the idea early that they should start betting against this market.  If only to have a quick reference for later, I want to jot down a few notes on the various trading vehicles.

First off, note that any cash stream can essentially be thought of like a bond.  A mortgage is a cash stream from the borrower to the lender.  The risk on a particular mortgage is that the borrowers won’t be able to re-pay, but since the penalty for not paying will be to lose the house, most borrowers with some skin in the game will try hard to re-pay.  Back in the 80s they came up with the idea of bundling mortgages together, and making bonds out of them, called collateralized debt obligation (CDO).  That worked OK for awhile, but in the 2000’s real estate boom, in part to keep the party going, we saw the massive increase of subprime loans (where there was little to no downpayment, and perhaps no income verification either).

But it wasn’t until about 2005 that some smart traders decided they needed a vehicle to bet against mortgage bonds, and in particular mortgage bonds on subprime mortgages.  Now it’s apparently very hard to short a bond, but bankers were able to come up with the next best thing, which was called the credit default swap (CDS).  The CDS is like an insurance policy on a mortgage bond – to hold a CDS you pay a yearly insurance premium (usually a percent or two of the amount of the bond) to the issuer, and if the underlying mortgage bond defaults (because individual loans in the bond are not being repaid), then the issuer pays out to cover the losses.  Note that the issuer of the CDS is potentially on the hook for the entire value of the underlying bond.

Now we can see that in fact one can look at the CDS as a cash stream of insurance premium payments, and since the chance of a pay out is the same as the chance that the underlying bond will default, it means that you can create a CDO made out of CDS policies (called a synthetic CDO). And if your assumption was that the underlying mortgages would always be repaid since real estate always goes up, then you’d be presumably happy to buy synthetic CDOs as well as regular CDOs, seeing them as equally risk-free.

The other important factor here is that as long as you can find an issuer, anyone can buy a CDS.  Thus the volume of trading of these things was not limited to the number of home loans being made!  For awhile AIG was a big issuer of CDS’s, but after awhile they saw they might run into trouble with them, and others stepped in. Also note that most purchases of these things were brokered by the big banks, and they liked the fact that there was not a transparent market – i.e. they could charge a nice profit for being the middleman.  They also, of course, had some of their own money in these holdings.

So, The Big Short tells the story of some investors who bought CDS’s, and what happened next.  Funny enough, while they were convinced that the underlying mortgage bonds would go bad, several of them were very worried that they would not be paid off, because they could see that the issuers would be losing a lot of money.  Thus typically they did not hold the CDS’s until the end, but sold them at a big profit to desperate buyers who had the underlying bonds and saw that they were in big trouble.

This books gives me some idea of why the banks are so opposed to regulations, but that doesn’t mean the rest of us need to listen to them!

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  • Jim  On April 12, 2010 at 8:28 am

    Last Friday Peggy Noonan addressed this problem in her inimitable way.
    Her pseudo Charles Prince testimony is on point:

    “Let’s be real. This is what happened the past 10 years. You, for political reasons, both Republicans and Democrats, finagled the mortgage system so that people who make, like, zero dollars a year were given mortgages for $600,000 houses. You got to run around and crow about how under your watch everyone became a homeowner. You shook down the taxpayer and hoped for the best.

    “Democrats did it because they thought it would make everyone Democrats: ‘Look what I give you!’ Republicans did it because they thought it would make everyone Republicans: ‘I’m a homeowner, I’ve got a stake, don’t raise my property taxes, get off my lawn!’ And Wall Street? We went to town, baby. We bundled the mortgages and sold them to fools, or we held them, called them assets, and made believe everyone would pay their mortgage. As if we cared. We invented financial instruments so complicated no one, even the people who sold them, understood what they were.

    “You’re finaglers and we’re finaglers. I play for dollars, you play for votes. In our own ways we’re all thieves. We would be called desperadoes if we weren’t so boring, so utterly banal in our soft-jawed, full-jowled selfishness. If there were any justice, we’d be forced to duel, with the peasants of America holding our cloaks. Only we’d both make sure we missed, wouldn’t we?”

    OK, Charles Prince didn’t say that. Just wanted to get your blood going. Mr. Prince would never say something so dramatic and intemperate. I made it up. It wasn’t on the news because it didn’t happen.

    It would be kind of a breath of fresh air though, wouldn’t it? ”

    Wouldn’t that be refreshing? I agree with Peggy Noonan, but disagree with your fix. We need to REGULATE the politicians, not the banks and the rest of us need to listen to Peggy Noonan – not the politicians!

  • Curt  On April 12, 2010 at 1:24 pm

    Well I agree with Noonan to a point. Politicians of both parties pushed home-ownership without much regard to ability to pay. Bankers got stupid in their own rush to cash in on the mortgage bonanza. And it would be nice to hear some straight talk about the situation.

    But as Noonan concludes, “Can’t we do better than this?”

    I think we can, and I think some regulation is part of the answer. Personally I think we need to figure out a way to get rid of ‘too big to fail’ banks – the moral hazard is looming. I’d like a scheme where we don’t try to regulate away all risk taking, but instead try to make it so that when the inevitable stupidity crops up again, the bad decision-makers take a fall and the rest of us don’t have to pay for their mistakes (too much, anyway).

    I also think there is a level of opaqueness in these ‘markets’ for CDS’s and synthetic CDOs that leads to quite a few problems. There was an interesting quote from the book about this. This is about a trader named John Paulson (p. 107):

    He was shocked how much easier and cheaper it was to buy a credit default swap than it was to sell short an actual cash bond – even though they represented exactly the same bet. “I did half a billion. They said, ‘Would you like to do a billion?’ And I said, ‘Why am I pussyfooting around? It took two or three days to place twenty-five billion.” Paulson had never encountered a market in which an investor could sell short 25 billion dollars’ worth of a stock or bond without causing its price to move, even crash. “And we could have done fifty billion, if we’d wanted to.”

    Now whether our politicans can deliver regulations that effectively do something about this is another question, but I think it’s worth a try.

  • Jim  On April 13, 2010 at 8:04 am

    You are missing the point, though I don’t disagree with your comments if we accept the status quo!

    The politicians interfere in the free market to “help the masses” for votes and this creates an opening for the banks to become “finaglers” – thieves! – along with the politicians.

    If the politicians had stayed out of it banks would still require 20% down payment and an extensive credit check. And our current problem would not have happened. And now you want to let the foxes guard the chicken coop!

    Reminds me of an article I read last evening on John Paul Stevens and the Kelo decision. Our founders wrote in the Constitution constraints on the Government from taking private property for “public use”. Stevens, in his decision stated that the society must yield to the judgement of the Government on what “public use” is. If the Constitution put this protection in from bad or corrupt decisions by the Government, how could John Paul Stevens give this capability back to them!

    Your logic follows the same pattern!

  • oakhill193  On April 28, 2010 at 6:32 am

    Not that there was anything simple about this, but wasn’t this simply betting on the bettors?

  • Curt  On April 28, 2010 at 9:05 am

    One way of looking at things is that lots of people were placing different kinds of bets. Unqualified home buyers were betting that they could flip if need be and make a profit. Bond buyers, encouraged by ratings that were probably not well founded, bet on a steady income stream from the underlying mortgages. CDS buyers were betting that there would be bond defaults, in which case they’d get paid off. CDS sellers were betting that the housing market would stay buoyant, so they could collect premiums and never pay out. To what extent the various betters really understood the risks they were taking is questionable at best.

    And all that’s fine if everyone can stand to take the losses when their bet goes bad… but if ultimately the taxpayers are on the hook for some of the losses then it’s not so fine.

  • Jim  On April 29, 2010 at 3:16 pm

    Address the root cause: if government had not interfered none of the betting you reference would have happened. Do you agree?

    I am writing this from London and let me tell you I hope the US does not follow the Brits path. They are now paying for decades of “Obama Policies”.

  • Curt  On April 29, 2010 at 5:00 pm

    I don’t have a lot of confidence in my ability to judge counterfactuals! In fact, I don’t even have a lot of confidence to judge what actually happened…

    I do believe some government actions tended to push toward easier mortgage credit. But I don’t know that government actions caused the whole trend. The world would be a different place if there had never been a Fannie and Freddie, and if Johnson hadn’t made them quasi private companies, and so forth, but how much different I don’t know (and I don’t think anyone can know).

    Once the bubble gets going I think it takes on its own momentum, and my understanding is that at some point the private mortgage companies were aggressively pushing the envelope toward easy mortgages much more than Fannie/Freddie. As The Big Short book helps explain, there were plenty of instances of very poor judgment by people who probably should have known better (and it wasn’t that they were counting on a government bailout). I would have preferred that more investors had taken their lumps, but letting that happen in a disorderly way (such as with letting Lehman fall) may have created quite panic that would have had widespread consequences, it’s hard to say.

    I understand the general principle that once government gets involved with something, it changes the dynamics, sometimes drastically. But once rules are set up, then people have to make their best call as to how to proceed within that framework.

  • Curt  On April 29, 2010 at 5:10 pm

    Or another way of thinking about this ‘betting’… we’ve all heard lots over the last 20 years about ‘financial innovation’ – surely this is a result of private markets, not government sponsored programs… Markets are not static – people do things, governments do things, and markets react in various ways – often that’s all well and good, occasionally it seems to threaten the whole system.

  • Jim  On April 29, 2010 at 11:36 pm

    I think the above illustrates our different perceptions quite well:

    You are content to let the government set the rules and then you assume people will operate correctly within those rules. Of course they never will, but you do not perceive this.

    I am content to let the free market set their rules – controlled by profit and stockholders in the long run – hurting some people in this process (this allowing the government to play on our sympathies and interfere for votes or ???) but lifting the economy as a whole. We saw this work well – by my definition of well – for over 200 years. Pain for a few for the general welfare of the economy.

    I think we both understand each other.

    Let me give you an example of the problem with government interference: social security is simplly a transfer of wealth from the young to the old – you probably don’t agree, but if you don’t it is simply an ideological bias, because whatever you call it or how you account for it, that is what it is.

    Last year I turned 66 and began receiving $25,000 per year when I make a solid 6 figure income. I thank you for your contribution to my income, but it is the most irrational thing a government could do! Why can’t they change the rules? Because they will lose votes!!

    That is what all government programs become: a source of votes. I hate to be so cynical, but that is my perception and those who want more government involvement are making a big mistake!

    I could refuse the payments, but I’m not going to – just like all citizens will take advantage of government programs when they are established – just as the banks did over the last decade or two and got our economy into trouble.

    I’m no diffferent than the banks, and that is the problem!

  • Curt  On April 30, 2010 at 2:35 pm

    While there’s no doubt we see things differently, I want to state things in my own words here…

    Jim wrote:
    You are content to let the government set the rules and then you assume people will operate correctly within those rules. Of course they never will, but you do not perceive this.

    My take on it:
    I wouldn’t say I’m always content with it, but it is how the US has been for my entire life in many areas. Markets have externalities, and government is frequently called upon to regulate in some way (I don’t always think that’s a good thing, but it’s what happens). And I also don’t assume everyone will “operate correctly” – I know some people will try to get around the rules or perhaps argue for more rules when they are best positioned to take advantage of them.

    Jim wrote:
    I am content to let the free market set their rules – controlled by profit and stockholders in the long run – hurting some people in this process (this allowing the government to play on our sympathies and interfere for votes or ???) but lifting the economy as a whole. We saw this work well – by my definition of well – for over 200 years. Pain for a few for the general welfare of the economy.

    My take:
    In some markets I think this basically happens, and it’s ok. But some markets are different than others – there are externalities, there are consequences of market failures, etc. In banking and investing, my original subject here, there are issues of panic and so forth. In the US, we’ve been on a slippery slope of government regulation in banking for nearly a century now. I think there are some very good reasons for it. And the markets change over time – now with computers there are trading schemes that would not have been possible 20 years ago.

    I’d be interested in your take on when that 200 year period was, and what event or events put an end to it? Personally I think we’ve been on the slippery slope for a long time, and will likely continue to live there.

    So the question in my mind becomes what type of regulation works best in the here and now, given where we’re at today. Regulation often misfires, but where it works well we’re not very aware of it – we’re aware of the problems. We can either de-regulate, which is sometimes a good choice, or we can think about what regulations make sense and what don’t. I don’t see things in nearly the stark black and white terms that you do, so I don’t think there’s a ‘one-size-fits-all’ answer to these kinds of issues.

  • Jim  On May 1, 2010 at 8:23 am

    I need time to digest your response. From your responses the overall summation is you want the Government to regulate as it sees fit and then it can deregulate when it misfires. (I might note that Social Security has misfired – by the way you didn’t resoond to my question on my good fortune in the last entry – and I do not see much of an effort to deregulate, Can you answer that one! W spent his political capital trying to fix that – a real known problem – and was trashed by the left

    Sit back and think about that for a minute!

    Why wouldn’t that be true of every Government regulated program?

    Back at you later

    By way, I saw a great Tom Stoppard Play Friday at the Old Vic – “The Real Thing.” You might enjoy reading it if you get a chance. Lots of good philosophy about love, relationships and life in general. I really enjoyed it – better on stage than a read, so look for it in Portland if any of your theater groups put it on!

  • Curt  On May 1, 2010 at 8:31 am

    To be as clear, I think the dynamic is that we experience certain kinds of market failures, and there is pressure for the government to “do something” – often, admittedly, more from the left than the right, but not completely so.

    So we get regulations. Sometimes they work reasonably well and we stop thinking about the problem. Sometimes they don’t work, and then there is tinkering – more regulation, sometimes de-regulation, etc.

    I didn’t comment on Social Security for a couple reasons – for one, it’s not regulation of a market, but a wholly government created beast (and two it’s not what the book was about – the book was about banks and investing). The rules of it will likely be changed in the coming years – maybe means-testing of some sort, which some percentage of the population will go to lengths to get around… or some other changes.

    I am still interested in hearing your take on this 200 year free market period and what ended it.

  • Jim  On May 1, 2010 at 12:13 pm

    The 200 year period was 1776 through 1976. I hope you would agree that the US was extremely successful economically during this period. And through that period we saw no major problems manifesting themselves – certainly we had recessions, depressions, etc, but always pulled ourselves out of them quite successfully. But in the left’s view (Marx, et al) people were hurt and this was not “fair”. So they promote Government regulations (“control” being their real goal so they can gain power!). The left “leaders” know they can use the “useful idiots”

    The economy has continued to do well over the 34 years since this 200 year period. But problems have been identified with Government policy and very little has been done about it. I believe we are headed for a disaster. The demise of our “free market” began in ernest with FDR – he and Dems having the 1929 crash as an excuse to begin interfering (I don’t think they were driven my Marx, et al, but it was a good excuse to gain the power with support of the “progressives” of the 1930;s,-40’s and early -50’s- much as Obama and the left have an excuse now with the 2008 “crash” – which is a questionable definition of the problem we faced at that time. But to quote Emanuel: “Never let a crisis go to waste.”)

    Maybe I am wrong, but since we know lack of government interference works – it did for most of 200 years and the ill effects of the change in policy with FDR had not been seen by the end of 200 years – and we know that government interference is driven by other motives than the “free market” why would a rational person want to change? This is what I do not understand!

    Your most telling statement in the last entry is that the government has involved themselves with regulation during your life. But your life period is insignificant! As is mine! But I experienced the true free market – let’s say until 1976 when I was 33 years old – even though the seeds of government interference had been sewn, they had not blossomed as they have the last 20 or 30 years – and you did not have the opportunity to experience this.

    Let me have you comment on the mechanics of the left regarding the latest fiasco: Obamacare! It was sold on the fact that thousands of people die each year because they have no medical insurance – I don’t remember the exact numbers Obama’s cohorts used, but they were stated often.

    I say nobody dies in the US because of lack of medical insurance. They are taken care of by all hospitals because federal law requires that they be taken care of, and that is paid for currently by all of us in various ways.

    Why change that system? And don’t come back with medical insurance would allow preventative care. That is another subject and is not affordable according to most experts.

    I wait for your retort.

  • Curt  On May 1, 2010 at 5:29 pm

    Here’s my take on things – and note that I agree with you on a variety of points – but I don’t really see any clear division point at 1976. I think that since at least about 1890 we’ve gotten more and more government, it’s been a gradual process. Where it leads is a darn good question…

    Some key events in my mind:
    – 1890’s – beginning of anti-trust activity against railroads, etc. In part a reaction to panic of 1893
    – 1900s – Teddy Roosevelt’s progressive activities
    – 1913 – creation of Federal Reserve in reaction to the panic of 1907
    – 1914 – Woodrow Wilson getting US involved in WWI, leading to big increases in the income tax rates.
    – 1930s – FDR’s activities as you mention
    – 1940s – WWII leads to permanent ‘Department of War/Defense’
    – 1960s – Johnson’s Great Society & expansion of Vietnam War
    – 1970s – Nixon’s introduction of EPA, price controls, etc.

    So I see it as a long slippery slope. I don’t agree that we have good evidence that “we know lack of government interference works”. I tend to think that as an economy gets more complex, and use of technology and wealth grows, there is an overall demand for government involvement.

    I am less cynical about it than you, in that I don’t see all of it as a power grab by Washington, at least not initially (but that is a factor that can’t be discounted). I definitely acknowledge that once a government structure is in place, it is very hard, if not nearly impossible, to dismantle.

    If we stick to the original subject of banking regulations – it is already heavily regulated. So the question as I see it is this: is the current regulatory structure the best we can do? We can either leave things as they are, change things, or try to get rid of the regulations altogether.

    The left tends to feel confident that changing the regulations can make things better, while the right might like to get rid of regulations, or barring that, leave things as they are (in general – there are exceptions). And I believe that sometimes the left is correct, and sometimes the right is correct. How’s that for wishy-washy?

    In banking, I feel there are some regulatory changes that are worth making. For example, the SEC allowed the big investment banks to increase their leverage up to 30:1 – I suspect that was a poor decision, and that we need banks to control their leverage more.

    It’s a similar question for healthcare – the government was already quite involved – in terms of tax breaks for companies providing medical insurance, rules on state boundaries, etc. You prefer to leave things as they were.

    Whether in practice we can actually count on legislation to improve things is indeed questionable… and I too have my doubts about the healthcare bill. In some ways I actually think that gridlock in DC can be a good thing, because they will do less and what does get passed will have to get some votes from both sides. I suspect we will move in that direction in November.

  • Jim  On May 2, 2010 at 12:22 am

    Good summary. A couple of points and we can drop this discussion:

    I don’t disagree with your timeline. I just interpret 1890’s to 1976 as dabbling in the economy, not knowing where it would lead, until finally they figured out, with Europe as a model since WWII as monarchies collapsed and the left dominated a ravaged continent which was hungry for “the easy life” after really 31 years of turmoil (1914-1945), that it would lead to domination of the economy and the society by a power elite, both left and right (which is why it is difficult to get Republicans to fight back most of the time – Reagan was an exception – and the left gave up their “attempted progressive upheaval” of the 1930’s-1950’s, realizing that patience and chipping away at the economy and the society would lead them back to the “monarchy” in a sense – a power elite.

    If you look at our President and Congress – let’s say since JFK – 1960 – it is more like a monarchy every day, the difference is we change “kings” every 4 or 8 years!

    You have only lived in this period so really do not have the perspective that that myself and most baby boomers have.

    Our concern is that the road we go down, either involving the banks and economy which is the beginning subject, or government involvement in general – remember WE are the government, but we turn our power over to the power elite – must lead to totalitarianism in the not too distant future.

    This has not happened in the rest of the world because the US has protectted them since WWII. Without us supplying this protection, you will begin to see it in Asia, the Middle East, and Europe before too long.

    Finally, I do not prefer to leave things as they are. I prefer that we go back and with our knowledge of problems created with government involvement since the 1890’s, reevaluate and adjust (almost certainly reduce) government involvement to assure we avoid the coming totalitarianism.

    So complex a problem, and at my age I need to communicate my ideas to your generation so at least you understand our perspective and if there is any truth in it you will recognize that and avoid the potential future problems!

  • Jim  On May 2, 2010 at 12:32 am

    I happned to read this article in the London Times today on Greece:

    This is one result possible – and likely – result of the lefts policies in the not too distant future!

    Do you know how to avoid this given current policies?

  • Jim  On May 2, 2010 at 12:44 am

    Sorry, but here is another explanation of what I believe from a blogger I follow on a regular basis – yea, I know, I only follow conservative blogs, but I do ocassionally read the NYT and WaPo. You might want to read her post on the lefts reaction to Arizona’s law and there exactly opposite reaction in their policy:

    “Let me end this by telling you simply the difference in conservative and liberal thought. Liberals (leaders) believe that we are too ignorant to govern ourselves. But this is the complete opposite of what the founding fathers believed. Conservatives, like our founders, believe that we can and should govern ourselves. We do know better. Liberals just think they do.

    Liberals love government, but only when they are in charge. The same can be said in recent times for Republicans. But that is because they haven’t been true conservatives. In truth, government should be limited. It should be small, no matter who is in charge. And everything it does should depend on “consent of the governed.” Because we still are…a government of the people.”

    OK, I am done!!

  • Curt  On May 2, 2010 at 5:25 pm

    Thanks for sharing your thoughts on all these big topics!

    I agree with your observation on the increasingly ‘monarchical’ nature of the US presidency, and indeed the overall trend toward government involvement in various aspects of the economy and society without even an attempt to show how it can be justified via the Constitution.

    At the same time if feels as if we are slowly moving toward the situation that Greece finds itself in now – we have consumed far more than we can actually pay for, and continue to make promises into the future that will be hard if not impossible to fund. The US however is in control of its own currency, which may well mean the game can play out much longer… but there’s no question that the balance of power in the world is shifting, and we may be surprised one day when certain things the US has taken for granted are no longer so easy to come by (such as financing its debt).

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