The Big Short


Lewis does a great job of making what could be a very dull and complex topic into a compelling read. If you are interested in learning about the reasons for the 2008/09 financial crisis, this is a great first step

The Rabbit Hole is written by Blas Moros. To support, sign up for the newsletter, become a patron, and/or join The Latticework. Original Design by Thilo Konzok.

Key Takeaways
  1. Not for a moment did I suspect that the financial 1980s would last for two full decades longer, or that the difference in degree between Wall Street and ordinary economic life would swell to a difference in kind.
  2. She’d wound up landing a job at Oppenheimer and Co. and then had the most incredible piece of luck: to be trained by a man who helped her to establish not merely a career but a worldview. His name, she said, was Steve Eisman.
  3. It’s not easy to stand apart from mass hysteria—to believe that most of what’s in the financial news is wrong, to believe that most important financial people are either lying or deluded—without being insane.
  4. A mortgage bond wasn’t a single giant loan for an explicit fixed term. A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages. These cash flows were always problematic, as the borrowers had the right to pay off any time they pleased. This was the single biggest reason that bond investors initially had been reluctant to invest in home mortgage loans: Mortgage borrowers typically repaid their loans only when interest rates fell, and they could refinance more cheaply, leaving the owner of a mortgage bond holding a pile of cash, to invest at lower interest rates.
  5. To limit this uncertainty, the people I’d worked with at Salomon Brothers, who created the mortgage bond market, had come up with a clever solution. They took giant pools of home loans and carved up the payments made by homeowners into pieces, called tranches. The buyer of the first tranche was like the owner of the ground floor in a flood: He got hit with the first wave of mortgage prepayments. In exchange, he received a higher interest rate. The buyer of the second tranche—the second story of the skyscraper—took the next wave of prepayments and in exchange received the second highest interest rate, and so on.
  6. When Steve Eisman stumbled into this new, rapidly growing industry of specialty finance, the mortgage bond was about to be put to a new use: making loans that did not qualify for government guarantees. The purpose was to extend credit to less and less creditworthy homeowners, not so that they might buy a house but so that they could cash out whatever equity they had in the house they already owned.
  7. Vincent Daniel
  8. He concluded that there was effectively no way for an accountant assigned to audit a giant Wall Street firm to figure out whether it was making money or losing money. They were giant black boxes, whose hidden gears were in constant motion.
  9. How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.
  10. To sift every pool of subprime mortgage loans took him six months, but when he was done he came out of the room and gave Eisman the news. All these subprime lending companies were growing so rapidly, and using such goofy accounting, that they could mask the fact that they had no real earnings, just illusory, accounting-driven, ones. They had the essential feature of a Ponzi scheme:
  11. He held a picture of the financial world in his head that was radically different from, and less flattering than, the financial world’s self-portrait.
  12. Half a trillion dollars in subprime mortgage–backed bonds in a single year. Subprime lending was booming even as interest rates were rising—which made no sense at all.
  13. In the fog of the first eighteen months of running his own business, Eisman had an epiphany, an identifiable moment when he realized he’d been missing something obvious. Here he was, trying to figure out which stocks to pick, but the fate of the stocks depended increasingly on the bonds. As the subprime mortgage market grew, every financial company was, one way or another, exposed to it.
  14. He didn’t talk to anyone about what became his new obsession; he just sat alone in his office, in San Jose, California, and read books and articles and financial filings. He wanted to know, especially, how subprime mortgage bonds worked.
  15. Michael Burry wasn’t thinking about buying mortgage bonds. He was wondering how he might short subprime mortgage bonds.
  16. “What you want to watch are the lenders, not the borrowers,” he said. “The borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint, and when they lose it, watch out.”
  17. He now had a tactical investment problem. The various floors, or tranches, of subprime mortgage bonds all had one thing in common: The bonds were impossible to sell short. To sell a stock or bond short, you needed to borrow it, and these tranches of mortgage bonds were tiny and impossible to find. You could buy them or not buy them, but you couldn’t bet explicitly against them; the market for subprime mortgages simply had no place for people in it who took a dim view of them.
  18. “Credit default swaps remedied the problem of open-ended risk for me,” said Burry. “If I bought a credit default swap, my downside was defined and certain, and the upside was many multiples of it.”
  19. On March 19, 2005, alone in his office with the door closed and the shades drawn, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit default swaps on subprime mortgage bonds.
  20. Inside of three years, credit default swaps on subprime mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of dollars’ worth of losses inside big Wall Street firms. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.
  21. His obsession with personal honesty was a cousin to his obsession with fairness. Obsessiveness—that was another trait he came to think of as peculiar to himself. His mind had no temperate zone: He was either possessed by a subject or not interested in it at all.
  22. Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied; indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. “If you are going to be a great investor, you have to fit the style to who you are,” Burry said.
  23. As he scrambled to find office space, buy furniture, and open a brokerage account, he received a pair of surprising phone calls. The first came from a big investment fund in New York City, Gotham Capital. Gotham was founded by a value investment guru named Joel Greenblatt. Burry had read Greenblatt’s book You Can Be a Stock Market Genius. (“I hated the title but liked the book.”) Greenblatt’s people told him that they had been making money off his ideas for some time and wanted to continue to do so—might Mike Burry consider allowing Gotham to invest in his fund?
  24. Scion Capital
  25. “Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’”
  26. “I am extremely bearish, and feel the consequences could very easily be a 50% drop in residential real estate in the U.S…. A large portion of current [housing] demand at current prices would disappear if only people became convinced that prices weren’t rising. The collateral damage is likely to be orders of magnitude worse than anyone now considers.”
  27. “I hated discussing ideas with investors,” he said, “because I then become a Defender of the Idea, and that influences your thought process.”
  28. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation—one reason why so many derivatives had been derived, one way or another, from bonds.
  29. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage.
  30. That was the pitch in a nutshell: Home prices didn’t even need to fall. They merely needed to stop rising at the unprecedented rates they had the previous few years for vast numbers of Americans to default on their home loans.
  31. The beauty of the credit default swap, or CDS, was that it solved the timing problem. Eisman no longer needed to guess exactly when the subprime mortgage market would crash. It also allowed him to make the bet without laying down cash up front, and put him in a position to win many times the sums he could possibly lose.
  32. The party on the other side of his bet against subprime mortgage bonds was the triple-A-rated insurance company AIG—
  33. Greg Lippmann
  34. CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans.
  35. The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs.
  36. The closer you were to the market, the harder it was to perceive its folly.
  37. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.
  38. smaller number of people—more than ten, fewer than twenty—made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market and, by extension, the global financial system.
  39. Among them: a Minneapolis hedge fund called Whitebox, a Boston hedge fund called The Baupost Group, a San Francisco hedge fund called Passport Capital, a New Jersey hedge fund called Elm Ridge, and a gaggle of New York hedge funds: Elliott Associates, Cedar Hill Capital Partners, QVT Financial, and Philip Falcone’s Harbinger Capital Partners.
  40. Dallas, Texas, a former Bear Stearns bond salesman named Kyle Bass set up a hedge fund called Hayman Capital in mid-2006 and soon thereafter bought credit default swaps on subprime mortgage bonds.
  41. Paulson, too, had heard Greg Lippmann’s pitch—and, as he built a massive position in credit default swaps, used Lippmann as his sounding board.
  42. All of them were, almost by definition, odd. But they were not all odd in the same way. John Paulson was oddly interested in betting against dodgy loans, and oddly persuasive in talking others into doing it with him. Mike Burry was odd in his desire to remain insulated from public opinion, and even direct human contact, and to focus instead on hard data and the incentives that guide future human financial behavior. Steve Eisman was odd in his conviction that the leveraging of middle-class America was a corrupt and corrupting event, and that the subprime mortgage market in particular was an engine of exploitation and, ultimately, destruction. Each filled a hole; each supplied a missing insight, an attitude to risk which, if more prevalent, might have prevented the catastrophe. But there was at least one gaping hole no big-time professional investor filled. It was filled, instead, by Charlie Ledley. Charlie Ledley—curiously uncertain Charlie Ledley—was odd in his belief that the best way to make money on Wall Street was to seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening.
  43. You Can Be a Stock Market Genius,
  44. There were times, Greenblatt explained, when it made more sense to buy options on a stock than the stock itself. This, in Greenblatt’s world of value investors, counted as heresy.
  45. Greenblatt’s simple point: When the value of a stock so obviously turned on some upcoming event whose date was known (a merger date, for instance, or a court date), the value investor could in good conscience employ options to express his views. It gave Jamie an idea: Buy a long-term option to buy the stock of Capital One. “It was kind of like, Wow, we have a view: This common stock looks interesting. But, Holy shit, look at the prices of these options!”
  46. Black-Scholes option pricing model, made some strange assumptions. For instance, it assumed a normal, bell-shaped distribution for future stock prices. If Capital One was trading at $30 a share, the model assumed that, over the next two years, the stock was more likely to get to $35 a share than to $40, and more likely to get to $40 a share than to $45, and so on. This assumption made sense only to those who knew nothing about the company. In this case the model was totally missing the point: When Capital One stock moved, as it surely would, it was more likely to move by a lot than by a little.
  47. The options suited the two men’s personalities: They never had to be sure of anything. Both were predisposed to feel that people, and by extension markets, were too certain about inherently uncertain things. Both sensed that people, and by extension markets, had difficulty attaching the appropriate probabilities to highly improbable events. Both had trouble generating conviction of their own but no trouble at all reacting to what they viewed as the false conviction of others.
  48. “It’s really hard to know when you’re lucky and when you’re smart.”
  49. What struck them powerfully was how cheaply the models allowed a person to speculate on situations that were likely to end in one of two dramatic ways.
  50. The model used by Wall Street to price trillions of dollars’ worth of derivatives thought of the financial world as an orderly, continuous process. But the world was not continuous; it changed discontinuously, and often by accident.
  51. Financial options were systematically mispriced. The market often underestimated the likelihood of extreme moves in prices. The options market also tended to presuppose that the distant future would look more like the present than it usually did. Finally, the price of an option was a function of the volatility of the underlying stock or currency or commodity, and the options market tended to rely on the recent past to determine how volatile a stock or currency or commodity might be.
  52. The longer-term the option, the sillier the results generated by the Black-Scholes option pricing model, and the greater the opportunity for people who didn’t use it.
  53. Each CDO contained pieces of a hundred different mortgage bonds—which in turn held thousands of different loans. It was impossible, or nearly so, to find out which pieces, or which loans. Even the rating agencies, who they at first assumed would be the most informed source, hadn’t a clue.
  54. Now he got it: The credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets in order to synthesize more of them.
  55. Charlie Ledley
  56. Stacey Strauss.
  57. John Devaney.
  58. Vegas it became clear to me that this entire huge industry was just trusting in the ratings,” Eisman said. “Everyone believed in the ratings, so they didn’t have to think about it.”
  59. Ben Hockett
  60. “Either the game was totally rigged, or we had gone totally fucking crazy. The fraud was so obvious that it seemed to us it had implications for democracy. We actually got scared.”
  61. That was Eisman’s logic: the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things.
  62. Steve Druskin
  63. “I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind.”
  64. “I think these personal foibles of mine were tolerated among many as long as things were going well,” he said. “But when things weren’t going well, they became signs of incompetence or instability on my part—even among employees and business partners.”
  65. Howie Hubler
  66. “There was no market. It was really only then that I realized there was a bigger issue than just our portfolio. Fundamentals didn’t matter. Stocks were going to move up or down on pure emotion and speculation of what the government would do.”
  67. The main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders.
What I got out of it
  1. Greed had a lot to do with the financial crisis. Amazing that almost nobody saw this coming

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