The Big Short By Michael Lewis: A True Story Of The Build-Up Of The United States Housing Bubble
Introduction
“In the year 2008, the U. S housing market saw what is considered to this day one of the biggest economic crises in history often termed as “the second great depression” by many historians. People were adversely affected in enormous numbers, with millions losing homes and jobs across the country. The events and contributing factors that led up to the collapse of the credit and housing markets were, at the time, considered unpredictable, even by most experts. In simple terms, an ignorant lack of foresight and greed on the part of the banks were the primary cause of the financial collapse of such proportions. It was an alarming and traumatic situation that caused Americans to ultimately question the economy and those that play major roles it. Nevertheless, a few denizens in the field of finance were able to predict and take advantage of the situation, in a way that they thought would benefit most. ‘The Big Short’ is a book that depicts the true story of the lucky few men in the banking industry who foresaw the credit and housing bubble and decided to take advantage and benefit from the “stupidity of the big banks”. This review will aim to provide a brief plot synopsis of the book, describing how the situation arose as a tragic consequence of various factors, with insight into the main people involved. It will also attempt at critically analyzing the procedures taken by them to predict, risk and ultimately benefit at a time when the economy failed millions.
Plot Summary
The book is set in the U. S. A in the mid-2000s, at a time when the average American man could fulfill the American dream envisioned by millions. One would find employment, work hard, start a family, purchase a house, pay the mortgage, and eventually retire with savings. The economic structure of the banks thanks to Ronald Reagan’s era of deregulation, and the idea that mortgages can be used as assets by banks(the brainchild of Lewis Ranieri) had created a system that would accommodate such a dream, which would benefit the system as a whole from both ends.
Characters
The Big Short opens with Jared Vennett, a banker, explaining how banking in the 1970s did not involve large profits and had been ‘a snooze. ’ Bonds were just simple, low risk, low yield until one idea changed them forever. Louis Renerie had created the concept of Mortgage Backed Securities, a bundling of thousands of mortgages to get a high yield, yet at the same low risk. Dr. Michael Burry, is the founder of the Scion Capital LLC hedge fund that managed over half a billion dollars. He had been known to be a great investor, specializing in value investing’ and noticing patterns in general, that allowed him to make predictions and investments. Burry faced difficulty with social anxiety and had a glass eye due to a childhood injury. He was a genuine investor and was considered brilliant by many, despite his investments and ideas being ridiculed and questioned.
Mark Baum is an outspoken money manager. He had a reputation of critically analyzing concepts and systems, but since the death of his brother had been pessimistic and speculative of anything he came across as unusual. The hedge fund he manages is owned by Morgan Stanley but is a separate entity. With his team, Mark attempts to scrutinize the mortgages, credit rating companies, banks and economic system altogether, questioning the stability of the U. S housing market.
Charlie Geller and Jamie Shipley, were recent college graduates and money managers that managed their own money of $30 Million that they made investing with a startup of $110, 000. Their strategy was to bet on less likely events, so they could get a higher ratio of potential profits. Their losses would be small, and returns would be large.
Ben Rickert, is a distinct character among the rest. He is a retired banker, and stock-trader who quit the business on moral grounds and dissociated himself from the modern world. He believed that the not only certain markets would collapse, but the entire world economy would eventually going to face a downfall as it was motivated by greed and capitalist interests alone, completely ignoring the human element. Ben had been Jamie’s neighbor and was willing to guide him on his trading decisions.
Economic Plot Summary
The book portrays simultaneously the major parts of the character’s decisions and actions that were made with regard and in response to the prediction of the economic bubble. Dr. Michael Burry observes a pattern while analyzing the Mortgage Backed Securities and individual Mortgages. He notices that there are too many risky, or ‘sub-prime’ mortgages in the bonds that could potentially cause them to become worthless. He is told that the housing market is rock solid but he believes it is ‘propped up on these bad loans. ’ ‘It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so. ’ He plans to short the bonds by ‘betting against’ the housing market. Burry visits the top banks in Manhattan and meets with them to discuss purchasing Credit Default Swaps. He spends a total of $1. 3 Billion in purchasing the Swaps, as well as monthly premiums amounting to $80-$90 Million per annum, which would fluctuate depending on the value of the bond. He is the first person to purchase such a swap, due to which he is required to pay more over a longer period of time.
Jared Vennett hears about this particular investment and it catches his attention. With his knowledge and experience with banking, he puts the pieces of the puzzle together and realizes that what Michael Burry had predicted may be quite probable, if not inevitable. He approaches firms that he thinks would be interested and potential brokers that could purchase swaps as Burry had done. During the process of doing so, he unintentionally comes across Mark Baum’s hedge fund. With Mark Baum’s skeptic mindset, he and his team are also intrigued and consider the possibility of the crisis. They meet Vennett and are explicated in brief how the prediction is a high probability. Vennett describes to them what happens inside the banks; how loans are ignorantly approved and grouped together, appearing less risky on paper but not in reality. He shows how even low-risk, high rated bonds could collapse as they include tranches with high-risk loans which, if they fail, would make the entire bond worthless. Mark Baum and his team members are interested but decide to investigate at the ground level to see the current situation of mortgages and housing. They are surprised to find that mortgages are being given ignorantly and effortlessly, for the benefit of the bond and investors. It is found to their surprise that most people were purchasing houses without adequate information, financial security and credibility. A couple of mortgage brokers also explain how the number of loans has increased approximately five times and that around 90% of them were adjustable rate mortgages. They say that applicants have nearly no chance of being rejected and denied a loan. The loans that are applied for were usually approved and bought by the ‘big banks’ within no time, with no real verification whatsoever. The riskier loans with low credit applicants are more profitable in the long run and are in fact preferred by the mortgage brokers, as they are sold for a higher price to banks. The worse the credit, the higher the price the mortgage can be sold for. Mark Baum decided to proceed with the idea proposed by Jared Vennett. Similar to Michael Burry, they decided to purchase credit default swaps by betting against the housing market. In return, Vennett gets the monthly premiums, out of which he would receive his share. In the end, the hedge fund would ultimately profit most when the market collapses.
Charlie Geller and Jamie Shipley, who happen to come across this particular prediction, seek the help of Ben Rickert. They focus on the CDOs that consist of high-risk mortgages and decide to purchase Credit Default Swaps on the mortgages with lowest ratings and highest risk. They spend their own money to purchase the swaps, as opposed to Michael Burry, and Mark Baum and his team, who purchase with the hedge funds’ liquid money. As months passed, the situation that was presented by the banks was not what had been predicted. Mortgage defaults had risen, and as a result, the mortgages were supposed to decrease in value. Although the subprime loans fell in value, the banks valued subprime bonds at a higher price. The flawed logic of the banks was simply made by overlooking the simple fact that the subprime bonds consisted of subprime loans. They valued the bond as a whole instead. This alarmed and distressed owners of the swaps, as it meant that they would have to pay a higher premium for as long as it would take for the bonds to decrease in value. Baum visits a rating agency to enquire about the process and method of giving ratings to mortgages and bonds. To his dismay, he finds that they are not regulated by any authority, nor do they take precautions to accurately assign ratings. Even among rating agencies, he finds that there is the factor of competition and the motive of profits that make it just like any other ordinary business. They provided the banks with what they want instead of what is right. For instance, many high-risk mortgages that deserve ratings below A were given AAA ratings. Jared explains how clueless and negligent the system really is, speaking from experience on the inside of the banking world.
The American Securitization Forum in Las Vegas is attended by almost all bond and CDO salesmen, subprime lenders and swap traders every year. Jared and Mark along with his team attend with the intention of finding out just how and with what intentions the people in the top positions make decisions and how they created such a cluttered, vulnerable system. Charlie, Jamie, and Ben attended with the intention of figuring out where the best bet could be placed by purchasing swaps. They debate on what to bet against within the bond and decide on the AA-rated tranches (mortgages) of the bonds. They are low risk, which means a high ratio profit for the swap owner in case the loan defaults. The reason for their decision is the fact that the rating agencies have been known to assign a better rating for a loan than it deserves, implying that even the AA rating is not truly low-risk. After Charlie and Jamie finalize details after discussion with various banks, they are told by Ben that they should not enthusiastically celebrate the situation. He explains how they have bet against the American economy, and their victory would necessarily mean that millions of people would lose homes, jobs, retirement savings, and pensions.
Meanwhile, Mark meets a CDO manager who explains to him how they function. The managers decide the securities that are put into the CDO and although they represent the investors, they only accept the bonds and customers of one particular bank. This ‘relationship’ between CDO managers and banks allow for a win-win situation for both parties. Concepts like different CDOs with same loans, CDOs consisting of other CDOs, called CDO squared, and Synthetic CDOs baffled and frustrated Baum. Realizing how faulty the system really is, he has a moment of detestation and dreads that the U. S economy would inevitably collapse. He immediately decides to purchase more Credit Default Swaps worth $500 million.
Michael Burry, after receiving constant disapproval by investors of the hedge fund regarding his decision, decides to restrict investors’ ability to withdraw from the fund. Some investors threaten and proceed to sue. on April 2nd, 2007, Jamie and Charlie watch CNN as the first occurrence of the bankruptcy of a leading subprime mortgage lender is broadcasted. The crisis had begun. In these early stages, Morgan Stanley requested that Baum sells his shorts so that they could purchase them. Baum refuses the offer. Even as the value of the bonds decreased, the banks did not increase the value of the swaps. It was difficult to comprehend, as it contradicted the logic that a standard insurance contract value is correlated to whatever is being insured. The demand for purchasing CDOs reduced nearly to zero while the demand for purchasing swaps increased phenomenally. Now those banks had no choice but to increase and accurately position the value of the insurance contracts. Michael Burry, being the one that paid the most premium over the years, sells the swaps as soon as possible, avoiding any chances that the market may close if delayed longer. He writes on his whiteboard after receiving and depositing profits in the investors’ accounts. It reads, ‘+489%’, indicating the value of the swaps increased 4. 89 times. He closes the hedge fund shortly after. Ben assists Charlie and Jamie with unloading their $205 Million worth of credit default swaps from a remote location. They end up making profits of $80 Million.
Mark Baum, who is exasperated by the banks and their fraudulent activities, decides to wait until the banks face difficulty with the situation. Bruce Miller and Mark Baum speak at a debate regarding the current situation. While Miller is ignorant and foolishly optimistic, the realist Baum passionately emphasizes that the average American has to pay for the decisions made by the top few in Wall Street. The ignorance of those people in banking making the blunders can be observed with the simple example of Alan Greenspan, who was not even aware of Credit Default Swaps for mortgages. Baum is still frustrated and miserable about how the events played out and how they will play out in the future; banks get bailouts, immigrants and poor Americans are blamed, people lose houses, unemployment rises, etc. Unfortunately, he is right. They decide to sell the swaps while they can, not only to make profits but to, in a way, take revenge against the banks. ‘When the dust settled from the collapse, 5 trillion dollars in pension money, real estate value, 401k, savings, and bond had disappeared. 8 million lost their jobs, 6 million lost their homes. ’ To put that into perspective 5 trillion dollars is entire cash present in the form of bank notes referred as Mzero in financial terms.
Economic Terms and Concepts
Mortgage Backed Security: Mortgage-backed securities and Asset-backed securities are types of asset classes. When the securities are created by pooling mortgages, it is abbreviated as MBS. These are then sold to investors who later receive payments and interest.
Tranchés: In mortgage-backed securities, the bonds are comprised of many mortgages that have varied ratings. Tranchés mean a portion of something. In this context, the mortgages of varied ratings are tranchés of the bond.
Short Stock/Bond: The term ‘short’ bond refers to the act of selling the stock while it has a high market value. It means that the seller has had the stock for a relatively short amount of time, be it rented stock or a form of a swap.
Credit Default Swaps (CDS): This term is used for a transaction that has the model of insurance. When it is observed by a broker that a certain stock price seems to be declining, he may insure himself by purchasing credit default swaps. This process is done by a third party, without any investment in that particular stock. Broadly speaking, it is a form of gambling, where the insurance provider would receive premium payments from the purchaser until and unless the stock in question decreases in value. For the housing market, the credit default swaps were first purchased by Michael Burry, who was given bonds in return. The bond in this context is similar to a receipt, and can be shorted when the market fluctuated and value falls.
Collateral Debt obligation (CDO): The riskier, low-rated mortgages of varied ratings are combined and bundled as a CDO. Due to the variance in rating, it is claimed to be of lower risk and is hence given a higher rating.
CDO Squared: Individual CDOs that are combined and added to a third CDO are termed as ‘CDO squared. ’
Synthetic Collateral Debt obligation (SCDO): The debts of Credit Default Swaps are also bundled and made into a form of CDO, which is also sold as bundle of loans of low risk.
Conclusion
‘The Big Short’ depicts the aspects of the housing market bubble that are often neglected. It is a powerful explanation that passionately and logically reveals how the inside of the system is not what it is presented to be. It is directed from a somewhat neutral standpoint, but at the same time portrays realistically and boldly how the banks function in a fraudulent manner. The direction and screenplay were executed in a simple and effective method and successful in getting the point across to the average audience, creating a blend of fiction and documentary that educates viewers from a different perspective about the housing market bubble. There is only a glimpse into the aftermath and no real explanation regarding the recovery and fate of the unfortunate millions. It does not intend to show the full picture, but only one aspect of it. The main characters were portrayed by the actors in a clever, somewhat shrewd manner that gives a picture of the personalities in those positions in real life. Wall Street is known for such brokers, traders, managers, and these characters being based on ones in real life, creates a better depiction of the events that took place leading up to the crisis. There may be some moral dilemma about the fact that the swap purchasers benefitted greatly at the loss of countless middle and low-income people. What is to be understood ultimately is that there is no immoral or unethical intention behind the decisions and outcomes of the lucky few that benefitted from the crisis. We must be objective in analyzing that they simply found a way to earn billions at a time when millions were on the streets and out of jobs. Morality is often in conflict with opportunity. Taking advantage of the situation does not necessarily mean that their actions were wrong, nor does it justify them. It simply means that they were at the right place at the right time and looked in the right places. This very conundrum was also addressed in the book by Ben Rickert’s character.
