The Big Short, by Michael Lewis

The Big Short

The Big Short is hip financial writer Michael Lewis’s account of the trading in bundles of subprime mortgages that blew up the economy toward the end of the George W. Bush administration.

All these increasingly complex, bizarre, newfangled options and securities the Wall Street folks invented in that era are famously incomprehensible—evidently even to most of the people trading them, which may be the scariest part of all—but Lewis makes these mortgage bundles pretty understandable, at least in broad terms. Certainly there are all kinds of details about them and how they’re traded and such that I still don’t have a clue about, but the basic idea behind them isn’t hopelessly obscure.

Lewis focuses on a small number of traders—mostly maverick number crunchers working more or less on their own rather than big shots at huge conventional Wall Street firms—who figured out that something was amiss with these mortgage investments, that they were incredibly weak in a sense that could seemingly be exploited for big profit, and that they were creating bizarre incentive structures that sooner or later stood to devastate the economy.

Their betting against the big firms turned out to be an emotional roller coaster. For one thing, the flaws seemed too obvious. These really aren’t super subtle, complicated, hidden weaknesses we’re talking about; if you’re familiar at all with sportsbetting, basically the major institutional investors were totally ignoring the fact that they were on the wrong side of correlated parlays.

That is, they were treating mortgage defaults as independent events when in fact they’re not. Mortgage defaults don’t come about just as a result of facts specific to each case, but are also greatly influenced by larger events in the housing market and the economy as a whole. So if the economy tanked, or a certain part of the economy tanked in a certain way, most of these bundles of crappy mortgages would become worthless or nearly worthless all at once, which is pretty much what happened.

But at the time, these bettors had to keep checking and rechecking their research and calculations, because they figured there had to be something they weren’t seeing. Surely it couldn’t be that all these super smart, super rich people at highly profitable institutions were oblivious to the huge risks they were taking.

Then there was the concern that maybe even if they were right, they’d never get paid because the behemoths on the other side of the wagers would be unwilling or unable to pay when they lost. Maybe they’d find a way to cheat. Or maybe there was some loophole they could exploit to get out of paying that wouldn’t technically constitute cheating. Or maybe they’d go under and then there would be no one left to collect from. (Again all of this is very familiar in the sportsbetting world. Just because you find one of those rare angles where you have the edge against a sportsbook, that’s no guarantee you’ll be paid in the end. Not if they pull a fast one, or simply disappear into the night, ceasing operations and taking their customers’ money with them.)

As they explored further, they also came to realize that a large number of the entities that were most important to the economy were horribly overextended on the wrong side of these wagers, and thus in effect these bettors were betting on—and implicitly hoping for—potential economic Armageddon that would pauperize countless of their fellow citizens and lead to who knows what calamities worldwide.

So they were left thinking “Can we possibly be right about this? Do we want to be?”

Of course it turned out they were very much right. And as I say, at least as spelled out in The Big Short, the foolhardiness of these subprime mortgage bundles should have been pretty obvious all along. Assuming that’s true, it’s worthwhile to ask why certain people could see that and certain people couldn’t, to try to ascertain if perhaps there were perverse incentive structures that steered so many people in positions of influence toward being wrong.

That’s an assumption I mostly buy but not entirely, by the way. Speaking again as a total non-expert in these things, I can’t rule out the possibility that Lewis has oversimplified with the benefit of hindsight, and that if you really looked at all the relevant factors at the time it was not at all predictable which was the smart side of these bets. Yes, these folks predicted it and bet accordingly, but is that because they were brilliant (and/or the people on the other side were moronic) or because they got lucky? I mean, you can always find someone after the fact who predicted anything that happens—a stock market crash, a certain team winning the world series, the death of a celebrity, whatever—but if the opposite had happened instead there would have been someone else who predicted that, and turning out to be “right” in this way in and of itself doesn’t prove anything.

But I’m willing to say it’s more likely Lewis is not being misleading here, even if I don’t know for sure.

I think at least part of the explanation for why these banks and such made such dumb bets of such a monstrous size is that they had succeeded in positioning themselves such that they really don’t lose when they lose.

In sportsbetting there’s the concept of the “airport bet.” Let’s say a crooked sportsbook is considering closing up shop, or at least is open to it. They’re holding a lot of their customers’ money—since unlike street bookies they generally make their customers post up funds in advance rather than bet on credit—and are not above just pocketing that if the time comes when it’s in their self-interest to do so. (Or maybe that money is already long gone and they’re in the hole.) So they hang a line on a major event like the Super Bowl that is slightly off the consensus of other sportsbooks, meaning almost all the bets they take will be on one side of the game. If the side that favors them wins, they cash in big time, and if they choose to they can remain in operation. But they also have all their bags packed and the cars running and the route to the airport planned, because if the other side wins, they can disappear and never pay anyone off. If they win their “airport bet” they win; if they lose, they don’t really lose.

That’s not to say that all these firms knew the subprime mortgage bundles could blow up, and that in that event they were planning to go under in an advantageous way, but the similarity is that once you reach a certain level of wealth and power, you know that when you win you get to keep your winnings, and when you lose there will be one way or another to avoid the consequences. So there’s really no incentive to reduce risk (assuming you’re a crook, which is a safe assumption when we’re talking about the wealthiest and most powerful folks); you can focus solely on maximizing your potential gain.

When you’re too big to fail and you know it, you don’t have to include potential failure in your calculations the way regular people do.

The way it all played out, yes these maverick investors at the heart of The Big Short mostly ended up big winners, but it’s not like the people on the other side of these wagers were correspondingly humiliated and ruined. They lived like kings before they lost their wagers, and they lived like kings after they lost their wagers. Even if what they did crossed the line from stupid to illegal, of course they never went to prison. Even if they lost their jobs, they received massive compensation in exchange for leaving. Even if their firms went bankrupt, they were bailed out by the government.

Or as it’s said, when you’re rich the winnings are privatized and you get to make believe you’re some Ayn Randian super genius who has earned everything you have, while the losses are socialized and picked up by the taxpayers.

So really it is indeed all rigged. (But as long as there’s Fox News and their ilk to tell the rubes that it’s all the fault of liberals facilitating lazy, shiftless black people taking out mortgages they can’t afford, nothing will ever change.)

By keeping things on a human level and focusing on certain personalities involved in the larger events of the subprime mortgage crisis, Lewis makes the story a lot less dry and a lot more interesting and readable than it could have been, and he makes the technical stuff as understandable as one can reasonably ask. Lewis is a skilled writer, and The Big Short is a solid book of its kind.

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