The Big Short book reads like a behind the scenes telling of the movie (Steve Carroll was awesome). It still seems too fantastic to be true. Lewis captured a kind of “fantastical” element in his retelling of… a financial story. So that’s pretty impressive.
Below are my Kindle notes and highlights, exported with Bookcision.
The Big Short: Inside the Doomsday Machine
by Michael Lewis
Meredith Whitney, with news. Whitney was an obscure analyst of financial firms for an obscure financial firm, Oppenheimer and Co., who, on October 31, 2007, ceased to be obscure. On that day she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. It’s never entirely clear on any given day what causes what inside the stock market, but it was pretty clear that, on October 31, Meredith Whitney caused the market in financial stocks to crash.
Valerie, sick with the flu, had been awakened by a night nurse, who informed her that she, the night nurse, had rolled on top of the baby in her sleep and smothered him. A decade later, the people closest to Eisman would describe this as an event that changed his relationship to the world around him. “Steven always thought he had an angel on his shoulder,” said Valerie. “Nothing bad ever happened to Steven. He was protected and he was safe. After Max, the angel on his shoulder was done. Anything can happen to anyone at any time.” From that moment, she noticed many changes in her husband, large and small, and Eisman did not disagree. “From the point of view of the history of the universe, Max’s death was not a big deal,” said Eisman. “It was just my big deal.”
How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.
“Time is a variable continuum,” he wrote to one of his e-mail friends, one Sunday morning in 1999: An afternoon can fly by or it can take 5 hours. Like you probably do, I productively fill the gaps that most people leave as dead time. My drive to be productive probably cost me my first marriage and a few days ago almost cost me my fiancée. Before I went to college the military had this “we do more before 9am than most people do all day” and I used to think and I do more than the military. As you know there are some select people that just find a drive in certain activities that supersedes EVERYTHING else.
Burry had read Greenblatt’s book You Can Be a Stock Market Genius. (“I hated the title but liked the book.”)
He gave a talk in which he argued that the way they measured risk was completely idiotic. They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years. Real risk was not volatility; real risk was stupid investment decisions.
“It is ludicrous to believe that asset bubbles can only be recognized in hindsight,” he wrote. “There are specific identifiers that are entirely recognizable during the bubble’s inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud…. The FBI reports mortgage-related fraud is up fivefold since 2000.”
The short answer is, They are too near to the ground. More prone to flooding—the first to take losses—they bear a lower credit rating: triple-B.
Very confusing sentence
The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold.
The simple measure of sanity in housing prices, Zelman argued, was the ratio of median home price to income. Historically, in the United States, it ran around 3:1; by late 2004, it had risen nationally, to 4:1.
“Guys who can’t get a job on Wall Street get a job at Moody’s,” as one Goldman Sachs trader-turned-hedge fund manager put it.
Moody’s and S&P asked the loan packagers not for a list of the FICO scores of all the borrowers but for the average FICO score of the pool. To meet the rating agencies’ standards—to maximize the percentage of triple-A-rated bonds created from any given pool of loans—the average FICO score of the borrowers in the pool needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680.
Wall Street harvested his FICO score.
The catastrophe was foreseeable, yet only a handful noticed. Among them: a Minneapolis hedge fund called Whitebox, a Boston hedge fund called The Baupost Group, a San Francisco hedge fund called Passport Capital, a New Jersey hedge fund called Elm Ridge, and a gaggle of New York hedge funds: Elliott Associates, Cedar Hill Capital Partners, QVT Financial, and Philip Falcone’s Harbinger Capital Partners.
In Dallas, Texas, a former Bear Stearns bond salesman named Kyle Bass set up a hedge fund called Hayman Capital in mid-2006 and soon thereafter bought credit default swaps on subprime mortgage bonds. Bass had heard the idea from Alan Fournier of Pennant Capital, in New Jersey—who in turn had heard it from Lippmann. A rich American real estate investor named Jeff Greene went off and bought several billion dollars’ worth of credit default swaps on subprime mortgage bonds for himself after hearing about it from the New York hedge fund manager John Paulson. Paulson, too, had heard Greg Lippmann’s pitch—and, as he built a massive position in credit default swaps, used Lippmann as his sounding board. A proprietary trader at Goldman Sachs in London, informed that this trader at Deutsche Bank in New York was making a powerful argument, flew across the Atlantic to meet with Lippmann and went home owning a billion dollars’ worth of credit default swaps on subprime mortgage bonds. A Greek hedge fund investor named Theo Phanos heard Lippmann pitch his idea at a Deutsche Bank conference in Phoenix, Arizona, and immediately placed his own bet.
Looking into it a bit, Jamie found that the model used by Wall Street to price LEAPs, the Black-Scholes option pricing model, made some strange assumptions. For instance, it assumed a normal, bell-shaped distribution for future stock prices. If
It instantly became a fantastically profitable strategy: Start with what appeared to be a cheap option to buy or sell some Korean stock, or pork belly, or third-world currency—really anything with a price that seemed poised for some dramatic change—and then work backward to the thing the option allowed you to buy or sell.
They hired a PhD student from the statistics department at the University of California at Berkeley to help them, but he quit after they asked him to study the market for pork belly futures. “It turned out that he was a vegetarian,” said Jamie. “He had a problem with capitalism in general, but the pork bellies pushed him over the edge.”
“We spent a lot of time building Black-Scholes models ourselves, and seeing what happened when you changed various assumptions in them,” said Jamie.
Thinkering
One day on the phone with Ben, Charlie said, You hate taking even remote risks, but you live in a house on top of a mountain that’s on a fault line, in a housing market that’s at an all-time high. “He just said, ‘I gotta go,’ and hung up,” recalled Charlie. “We had trouble getting hold of him for, like, two months.” “I got off the phone,” said Ben, “and I realized, I have to sell my house. Right now.” His house was worth a million dollars and maybe more yet would rent for no more than $2,500 a month. “It was trading more than thirty times gross rental,” said Ben. “The rule of thumb is that you buy at ten and sell at twenty.” In October 2005 he moved his family into a rental unit, away from the fault.
They were consciously looking for long shots. They were combing the markets for bets whose true odds were 10:1, priced as if the odds were 100:1. “We were looking for nonrecourse leverage,” said Charlie. “Leverage means to magnify the effect. You have a crowbar, you take a little bit of pressure, you turn it into a lot of pressure. We were looking to get ourselves into a position where small changes in states of the world created huge changes in values.”
“We turned off CNBC,” said Danny Moses. “It became very frustrating that they weren’t in touch with reality anymore. If something negative happened, they’d spin it positive. If something positive happened, they’d blow it out of proportion. It alters your mind. You can’t be clouded with shit like that.”
“They didn’t know,” he said. “They didn’t know their own balance sheets.” Once, he got himself invited to a meeting with the CEO of Bank of America, Ken Lewis. “I was sitting there listening to him. I had an epiphany. I said to myself, ‘Oh my God, he’s dumb!’ A lightbulb went off. The guy running one of the biggest banks in the world is dumb!”
“We just shorted Merrill Lynch,” said Eisman. “Why?” asked Hintz. “We have a simple thesis,” said Eisman. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.”
Eisman is so quotable. This guy needs to write a book of aphorisms.
When, a few months later, Goldman Sachs announced it was setting aside $542,000 per employee for the 2006 bonus pool, he wrote again: “As a former gas station attendant, parking lot attendant, medical resident and current Goldman Sachs screwee, I am offended.”
Cornwall Capital, started four and a half years earlier with $110,000, had just netted, from a million-dollar bet, more than $80 million. “There was a relief that we had not been the chumps at the table,” said Jamie. They had not been the chumps at the table. The long shot had paid 80:1. And no one at The Powder Monkey ever asked Ben what he was up to.
Whenever Wall Street people tried to argue—as they often did—that the subprime lending problem was caused by the mendacity and financial irresponsibility of ordinary Americans, he’d say, “What—the entire American population woke up one morning and said, ‘Yeah, I’m going to lie on my loan application’? Yeah, people lied. They lied because they were told to lie.”
The line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet (you losing all of your money in hopes of making a bit more), and the wildest speculation has the salient characteristic of an investment (you might get your money back with interest). Maybe the best definition of “investing” is “gambling with the odds in your favor.”
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