Business

The Big short

Inside the Doomsday Machine

The Big Short is an alarming tale told by master storyteller, Michael Lewis, who is probably best known for the book The Blind Side, and lesser known for such works as Liar’s Poker, Moneyball, and The New New Thing, among others. Lewis’ talent is in taking an event or phenomenon – usually dealing with difficult-tounderstand financial matters such as the inner workings of Wall Street, Dot Com stocks, or the management of professional baseball – and making them accessible to the layperson by focusing on one obscure component. In The Big Short, Lewis tells the story of the few people who made vast fortunes on the demise of the housing market.

In financial circles, to “short” something means to bet against it by speculating that its value is about to drop. This story profiles the managers of three small investment groups as they scramble to short the housing market starting around 2005 – far before the crash. Their research in all three cases leads them to the cozy relationship between Wall Street and the ratings agencies, those firms that judge the value (or riskiness) of certain investments. This relationship created what Lewis calls “the doomsday machine.”

What the three savvy investors found was that Wall Street was buying up sub-prime mortgages (loans to “high risk” home buyers with low-credit worthiness) as fast as they were sold by banks, other mortgage lenders and brokers (those who made the loans to home buyers). The loans individually would normally carry the lowest credit rating (sometimes referred to as “junk,” such as “junk bonds”), however, something “magical” took place once they were packaged up into bonds (a collection of many hundreds or thousands of individual home loans bundled together) and then divided up again into “tranches” (a fancy Wall Street word for the splitting of a bond or some other financial instrument) and resold to unsuspecting Wall Street customers (pension funds such as CalPERS, university endowments, and other public institutions were big buyers of these bonds). The guys on Wall Street somehow convinced the rating agencies to give these investments AAA ratings (the highest, best level, meaning they were also the safest and most unlikely to default).

Whether this was a case of Wall Street tricking the rating agencies or the rating agencies simply being incompetent, at least from Lewis’ point of view, it seems to be combination of the two. Reading this book, you will witness the depths of greed that exists on Wall Street, as many firms knew that they were selling “junk” that was being masqueraded as AAA bonds to their customers, all the while betting against it (shorting) by buying credit default swaps, which insures the bonds in the event of a default. [Incidentally, this is what nearly brought down the insurance giant, AIG, and our entire financial system. As they had been the leader in issuing these credit default swaps, which yielded a fortune in premiums, but when the sub-prime loans started to default they became responsible for paying the bond holder for their losses. This is when, for better or worse, the Federal Government stepped in to save AIG and allow it to make good on these policies, creating another less understood bail out of Wall Street]. In other words, they did not believe in what they were selling although they pushed it like there was no tomorrow [it should be noted that when “tomorrow” finally did come in the aftermath of the financial meltdown, Michael Lewis was called to testify before Congress where he provided some of the most damning evidence of fraud by Wall Street].

When two of the people in the book realize the world economy was on the precipice - it seemed to Lewis that they “had always sort of assumed that there was some grown-up in charge of the financial system whom they had never met; now they saw that there was not.” It is impossible to read this book and not come away from it with some new formed opinions about our capital markets in general and Wall Street specifically. But, perhaps if enough of us educate ourselves to the massive shell game that had been going on, we can prevent this sort of thing from happening again. SLO LIFE