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Summary and Analysis of The Big Short: Inside the Doomsday Machine
Based on the Book by Michael Lewis
By Worth Books OPEN ROAD INTEGRATED MEDIA
Copyright © 2017 Open Road Integrated Media, Inc.
All rights reserved.
ISBN: 978-1-5040-4429-5
CHAPTER 1
Summary
Chapter One: A Secret Origin Story
It had to be in his blood. Both of his parents had worked for years as brokers at Oppenheimer, the esteemed financial services firm. They urged him to join them. Steve Eisman surely felt the desire to get into the financial sector, too. He eventually did, but only after graduating from Harvard Law School and realizing that being a lawyer wasn't what it was cracked up to be. Eisman was outspoken with little desire to be like everyone else. He didn't seek consensus from those in the room before expressing his point of view, and was known to speak out of turn. Such brashness would make some of those around him cringe, but it would be welcomed by those he championed and a few associates in the years to come as the subprime mortgage debacle started to overheat.
Eisman's first foray in the subprime mortgage industry would come during his days as an attorney representing the Money Store, which was active in the subprime mortgage market in the 1990s. Management at Oppenheimer viewed this as good experience, using it to propel him to lead analyst covering Ames Financial, a subprime mortgage lender. And along the way, he became something of a Pied Piper, a surrogate for those he knew were being misled.
Wall Street's initial interest in subprime mortgage lending had started at least two decades before the Great Recession, which ran from December 2007 to June 2009. Those in the bond industry began speculating on the rate that solvent Americans would repay their mortgage through refinancing. Wall Street was wading into waters it hadn't treaded before: Americans' ability to pay their debt, in this case, home loans.
Need to Know: The subprime mortgage market evolved astonishingly fast. In the 1980s, the quality of loans underpinning a mortgage bond was good because standards for the loans were being met. The 1990s ushered in a new era of subprime mortgage lenders, poorer quality of loans, and second mortgages.
Chapter Two: In the Land of the Blind
In 2004, Michael Burry, a neurologist turned hedge fund manager, decided to get into the bond market. He was especially interested in subprime mortgage bonds. He knew about the towers — the "stacking" or "bundling" of home mortgage loans. There were the designated top and bottom floors that investors could get in. Top floors were low risk and low return, but you saw profits quickly; bottom floors were high risk and potentially high return, but they took longer to pay off. Top floors housed bundled loans, or bonds, that rating agencies Moody's and S&P labeled triple-A (the highest possible rating). Burry didn't want either of these. His focus was on shorting or borrowing and betting against the subprime mortgage bonds.
Burry began earnestly reading mortgage bond prospectuses — an activity few investors would have the patience for — and soon saw a trend developing in the subprime mortgage industry. Within a matter of months in 2004, the number of adjustable rate mortgages (ARMs) in a pool of loans increased from 5.85% to 17.48%. How could this be, he wondered, when other categories like the FICO scores and percent of no-documentation (no-doc) loan-to-value measures remained unchanged? With the increase of ARMs, one would expect to see higher FICO scores and lower loan-to-value measures. However, what Burry saw was a higher rate of "interest-only" mortgages leading him to believe that the quality of loans wrapped up and bundled for investors was substandard.
Burry wondered how standards set for home loans could be compromised, not just by the lender but by the borrower as well. Within a two-year timeframe, between 2003 and 2005, restraint had become an obsolete word for both lenders and borrowers.
There was a way for Burry to capitalize on this market, as he had come across credit default swaps (CDS) a couple of years earlier. CDS is a misnomer of sorts as there were no actual swaps of any kind. At the time these were, essentially, insurance policies on corporate bonds. Burry was concerned about the real estate market and the potential for a free fall, given the lower standards by which lenders were doling out home loans. He suspected that there was trouble ahead for players including the lenders, insurers, and firms that owned subprime mortgage bonds. Constantly educating himself on finance issues, he began studying credit derivatives, which led him to the idea of applying CDS to the subprime mortgage bonds. He believed there was cause for concern regarding the quality of subprime mortgage loans made in 2005: Most of them, he felt, would go bad. But it was a timing issue.
At the end of the first half of 2005, defaults on credit cards were at an all-time high. Home prices continued to climb and, astonishingly, Wall Street was finding even more ways to loan money to people. Following the latest data, Burry was even more convinced that the subprime mortgage industry was going to collapse. He wasn't pining for an Armageddon in the industry. After all, his responsibility was to his investors.
He saw an opportunity to make money on an overheated financial sector and he took it. He was determined to short the sector. Upon learning that Burry's Scion Capital fund was increasingly focused on credit default swaps, his investors were none too pleased, as they counted on his accurate stock predictions on the equity side of the house. However, he knew what they didn't: A fortune was coming their way via these credit default swaps, even if the number of defaults was small.
Need to Know: In 2004, it became apparent that subprime mortgage lending standards had started to decline. Lenders were eager to hand over credit to borrowers who, in prior years, would not have qualified for such loans. Borrowers with little or no credit took the loans knowing they would not be able to afford them. New investors in the market began to see the insanity of the subprime market loans and began to short the bonds that housed the loans.
Chapter Three: "How Can a Guy Who Can't Speak English Lie?" Word of this bubble was getting around. In February 2006, Greg Lippmann entered the FrontPoint Partners' conference room to meet with a wary and apprehensive Steve Eisman. Vincent Daniel, an accountant also in attendance, had zero trust for anyone in the bond market. The stock market held a different aura than the bond market. It was more regulated and transparent. The bond market was a different animal. The players were fewer in number and many of them were large investment houses. Bond traders felt invincible, and it was this elitism — and the lack of transparency on the part of bond traders — that kept customers in the dark and unaware of what was going on behind their backs.
Lippmann did not exude much humility. Like Eisman, he was brash and outspoken. Unlike Eisman, however, he didn't mind telling others what he was worth, and what his opinions were. He was a self-promoter. He was considered a top-notch bond trader at Deutsche Bank, able to discern the story behind the facts. And this was his approach to Steve Eisman on the idea of betting against the subprime mortgage bond market. His presentation, titled "Shorting Home Equity Mezzanine Tranches," was clean, crisp, and informative, pushing the idea of buying credit default swaps on the worst of the triple-B slices subprime mortgage bonds.
But who besides Deutsche was on the other side of the credit default swap? Who else was starting to read the tea leaves of the subprime mortgage market that was now cranking out nearly a half trillion dollars worth of loans? Goldman Sachs was one such company. Then along came American International Group (AIG), a triple-A rated insurance company whose unit, AIG Financial Products (FP), would beat out others like Berkshire Hathaway and General Electric to cover what must have been seen as insignificant risks. Initially, that perception was probably true. AIG FP agreed to insure "consumer loan" piles containing 2% subprime mortgages for Goldman Sachs and other firms. It would soon find itself insuring 95% of the subprime mortgages on the market.
In the meantime, Goldman Sachs had devised the collateralized debt obligation (CDO). Wall Street firms were beginning to understand the perils of triple-B bonds. Rating agencies, which made exorbitant fees from such firms, would declare the majority of such bonds as triple-A, thus masking the increasing risk and potentially high volume of defaults in these CDOs.
In 2005, Greg Lippmann, at the behest of his employer Deutsche Bank, would short these CDOs. He would become a buyer of credit default swaps. Not eager at first, he would soon realize there was much to be won in those swaps. The hard part was selling credit default swaps to investors. With a lack of knowledge of these instruments, investors had very little reason at the time to be concerned with subprime mortgage bonds. However, that November, concern for the bond market started to change.
Need to Know: There were two entities with common interests that would collude to disguise the true value of the collateralized debt obligations — the rating agencies and the Wall Street firms. On the other side were the credit default swaps, essentially insurance against the possible collapse of these CDOs underpinned by bonds consisting of many triple-B-rated loans. With few believing that the subprime mortgage market would crumble, companies such as AIG FP didn't hesitate to insure the CDOs.
Chapter Four: How to Harvest a Migrant Worker
New Century, a mortgage lender heavily engaged in subprime mortgages, had unflattering financial statements in mid-2005. Gene Park, employed at AIG FP, considered investing in New Century until he determined that many of the company's subprime mortgages were unstable. Almost in sync, his colleague Al Frost was churning out deal after deal for credit default swaps. With the exception of Citigroup, the biggest Wall Street firms lined up to do business with AIG FP.
Park, in trying to determine why there was this sudden influx of business for credit default swaps from Wall Street, ascertained that AIG FP was insuring more subprime mortgages than it or anyone else realized. That, coupled with the possibility that homeowners might begin defaulting on their mortgages, caused Park to wonder whether his company could cover the losses. He took his concern to Joe Cassano, the head of AIG FP, and was told that he was wrong.
After Frost was promoted, Cassano needed a "yes" man to fill the slot of taking orders to insure billions of dollars worth of subprime mortgage bonds supported by consumer loans. Park appeared to have the inside track for the job. However, he had reservations after investigating the loans that his company was insuring. Meeting Cassano in London in late 2005, Park knew that he was the guy with whom the company wanted to continue the growth of the credit default swaps. He turned it down, but not without angering Cassano, who wrongly believed Park just didn't want to have to work to get the deals done.
Park explained that AIG FP was in deep with $50 billion, not in triple-A-rated collateralized debt obligations, but in triple-B-rated subprime mortgage bonds. A masquerade had occurred with the bonds, and all Cassano could believe was that it would not be an all-at-once crumbling of housing prices.
A few months later, by early 2006, Cassano had changed his mind. He realized that investing in these CDOs was nothing more than investors betting that house prices would continue to rise. It was too risky to think that they would never fall. AIG FP would no longer insure subprime mortgage bonds, with the exception of those they were already insuring. The company (and the financial market) was not out of the woods with their decision, as they were still saddled with $50 billion of credit default swaps.
Was there anyone who questioned AIG FP's betting on the subprime mortgage market, trying to get management to put a halt to such measures? Greg Lippmann tried, at first succeeding, then failing.
What did Deutsche Bank want Lippmann to do with the credit default swaps they encouraged him to purchase? The bank was now a long and a short player — a buyer of both CDOs and (CDSs). Lippmann was hoping the bank's bond traders would realize the truth: The majority of subprime mortgages were bad, and many would go into default. He would now try to instill fear in stockholders who had a big investment in the second largest subprime mortgage lender, New Century.
Which stockholder did he pick? None other than Steve Eisman and his firm, FrontPoint Partners. However, Eisman was already ahead of the game, betting against the "share of companies such as New Century and IndyMac Bank." But carrying out his plan would not be cheap. Quite the opposite: Shorting shares of companies in the housing ecosystem would come at a huge cost.
The ominous signs of trouble in the subprime mortgage industry started to get more worrisome. By the middle of 2005, the number of homes for sale was increasing, but buyers were qualifying for loans they could never afford to pay back (people without long credit histories and without annual incomes to support the mortgage payments). And then there were the speculators who purchased properties with an eye toward flipping them for profit. They'd see housing prices peak in the middle of summer 2006 — and then watch them decline thereafter.
Loopholes in how credit-rating agencies did their business were beginning to become clear for Vincent Daniel and Danny Moses of FrontPoint when they spoke to a representative from Moody's at a conference in Florida. They now understood that assigning a triple-A rating to a financial instrument did not require meeting a high degree of analysis, and that a bond that included high-risk subprime mortgages could be packaged up and given, essentially, a stamp of approval.
Need to Know: It was becoming clear that subprime mortgage loans were not meeting the standards in place. Standards for any issue are there to protect the parties involved. When criteria is lowered, in this instance, for loan approval — i.e., no docs, no money down — it stands to reason why there were more and more homes for sale beginning in the middle of 2005.
AIG FP would soon realize its erroneous position and eventually stop selling insurance on this teetering bond market. However, it did not absolve itself from the $50 billion worth of credit default swaps it had sold.
Chapter Five: Accidental Capitalists
In the fall of 2006, Greg Lippmann had pitched credit default swaps to hundreds of investors in one-on-one conversations and at sales conferences sponsored by his employer, Deutsche Bank. Less than 1% of the 13,675 hedge funds were "active" in credit default swaps. However, not in the way Lippmann, Eisman, and Burry were. Their decision to get into credit default swaps was more of a hedge against their bet on certain subprime mortgage bonds in which they invested.
John Paulson, a listener and a follower of Lippmann's advice, would do what Burry wasn't able to do: start a fund totally focused on accumulating credit default swaps. He was obsessed with making bets against the subprime mortgage market. He was able to convince investors that there was a slight chance of catastrophic failure coming to the financial market. But convincing many of such a catastrophe in 2006 was a difficult task even with the continued reporting of falling house prices.
Charlie Ledley used a different means of psychology in addressing Wall Street. He believed in betting on occurrences that Wall Street didn't think would happen. He and his colleague, Jamie Mai, had accumulated $110,000, though they were largely inexperienced in high-stakes finance. They would, in 2003, begin Cornwall Capital Management, an investment fund. Shortly thereafter, Charlie Ledley brought Berkeley neighbor Ben Hockett, a trader of derivatives at Deutsche Bank, into Cornwell's fold.
He would be instrumental in getting Ledley and Mai — whose financial investing revolved around "the probabilities of disasters in financial markets" — a foot in the door at Deutsche Bank. Cornwall Capital, with nearly $30 million under management ($70 million less than most Wall Street firms required), was finally considered a serious institutional investment firm, and was able to secure an International Swaps and Derivatives Association (ISDA) agreement and play with the major financial firms.
In mid-2006, Ledley and his partners would get into the credit default swap arena buying from Greg Lippmann, and betting on the possibility that mortgage borrowers would default — at scale.
Need to Know: The subprime market consisted of overpriced bonds, with different floors or tranches — the bottom of which was the most risky but required just a low percent loss to make the entire pool worthless. Then there were thin-file and thick-file (determined by the small or large amount of personal financial data available) FICO scores, all of which could be manipulated to assure a borrower got a subprime mortgage loan.
(Continues...)
Excerpted from Summary and Analysis of The Big Short: Inside the Doomsday Machine by Worth Books. Copyright © 2017 Open Road Integrated Media, Inc.. Excerpted by permission of OPEN ROAD INTEGRATED MEDIA.
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