DeepakBhalla

The Big Short: Inside the Doomsday Machine

By Deepak Bhalla Sun 10 July 2016 5 min read

In the last book I read by Michael Lewis, Liar's Poker, he had set the scene for a financial world run by greedy traders where greed and bravado were valued over sense and forethought. Ultimately the book was the story of the Salomon Brothers and its merciless rise to the top of the bond sales market. An excellent read, the learning points can be found here. Lewis himself details how he was tainted by the experience, always seeming to maintain some dis-attachment he writes about how he had a certain knack for selling, hurting a few of his clients in the meanwhile.

In the Big Short, Lewis doesn't present the same sense of build up. It seems to be quite opposite, if Liar's poker told you how a Wall Street King was made, The Big Short told you how crown were toppled. It presents the market Solomon brothers and Lewie Raneiri helped start. Now, mortgages and their CDO's were sold to the very poorest Americans. A mortgage is an inherently risky debt obligation, that is the reason they're so expensive to own. When the poor have no skin in the game, yet they are given access to seemingly endless amounts of mortgage credit, things can go wrong.

The book never vilifies the poor, it does the opposite. In typical Michael Lewis fashion he gives details the industry where common sense and financial gain can clash heads. The poor were not the reason the crash occurred, that was the result of collusion between those that sold debt and those that rated it. It was the derivatives (contracts that base their value on an actual asset)1 that were misrated that caused the crash. The mortgages themselves were called "sub-prime", or below acceptable levels of risk. With no standards credit held by the industry could easily build up, with risk of default rising in lock step. When defaults did begin to occur it was a small group of well known financiers that were able to benefit.

Lewis tells the stories of three groups of financiers and one Deutsche Bank bond salesman, who ended up selling short (in effect betting that the price would go down)2 several hundreds of millions of dollars of sub-prime mortgage securities.

The Big Short

Trades occurred through a contract called a Credit Default Swap (CDS) - as the name suggests, upon a default a swap would occur. A swap is simply a trade of one financial instrument for another. Even if that swap was for an equivalent stake in a bond with a LIBOR coupon rate and a 25 year maturity, it would still beat holding a defaulting mortgage. In effect a CDS as a form of insurance.3. CDSs were a pivotal instrument in helping our protagonists beat the market.

In the book we learn that the merchant bankers knew as early as 2006 about the rising default rate on sub-prime mortgages but engaged in elaborate ruses to hide that reality from ratings agencies and investors. We also learn of the scary world of structured financial objects which were used when the lure of cheap credit ran dry. One such structured financial object is a "synthetic" mortgage-backed security, which used CDSs to bet on the performance of mortgages. You could essentially sell billions of sub prime mortgages and then go on to sell trillions of synthetic objects based on their performance. A house of cards if there ever was one.

The Big Short is the greatest example of financial fraud this side of the South Sea Bubble. Lewis, who now lives in Paris, spares no expense in denigrating the greed of the merchant bankers, the book is the equivalent of popping a balloon, its loud and unpleasant. It's certainly not as thrilling as Liar's Poker but it is far more important.

  1. Interestingly, in the days of the long gone Gold Standard where money was based on gold, all currency was by definition a derivative.
  2. Someone who sells short will borrow an equity or bond and sell it at its current price "opening" their short position. When they decide to close their position they do so by buying the equity or bond at the going market rate. If there has been a decrease in price the short seller is able to pocket the difference. The catch being, if the price rose significantly, their house would suddenly become for sale
  3. I do not believe any of the traders held CDSs to maturity. That was something only someone who held Collatoral Debt Obligations needed to do. They just sold them post-meltdown pocketing the difference in selling price.
Deepak Bhalla