“The Big Short” tackles the financial meltdown as seen by four relatively minor, but colorful players. (Minor means running only hundreds of millions, not billions.) All of them were voices in the wilderness. All of them bet heavily against the subprime real estate bubble that, for a while, fueled huge gains.
This book will help nourish the healthy debate that is going on right now about the financial industry, its maladies and possible cures. It can do that because it is such a great read and many people will read it, and because it is replete with interesting, on-the-scene revelations.
Do not, by the way, be dissuaded from reading the book because of the average three-star rating on amazon.com (out of five stars). The torrent of one-star ratings were merely a protest that the book’s digital version wasn’t made available immediately. They have nothing to do with the quality of the book.
But there is a problem
Buried among the negative reviews, though, there is a possibly valid criticism. It is related to, but not the same as, a criticism of my own.
I’ll get to those later. Let me hasten to say that I don’t really believe these to be valid criticisms of the book per se. They complain about what the book didn’t say and perhaps should have said. But for a work to be seminal, it needn’t say everything. It must only trigger a productive debate.
The cast of characters
The protagonists (all men) look like a cross-section of the entire industry to people who know it:
- a geeky guy with laser focus and Asperger’s syndrome;
- a guy who is habitually, unconsciously crude, but seems not to realize it and doesn’t care;
- a guy who says up-front that he intends to screw you, though you might benefit from it;
and for good measure,
- a group of relatively modest nice guys with ordinary common sense who assume the experts must know better, yet stick with their common sense when not convinced otherwise.
These four protagonists, their personal characteristics aside—whether at a posh dinner in New York or an industry conference in Las Vegas—come off like Alice in Wonderland at her trial: clear-headed, sane people surrounded by raving maniacs.
So of course you root for them. You know they’re going to turn out to be right. Yet you thrill to the fact that while they know they’re surrounded by fools who are there for the taking, there’s always the possibility that something will go wrong.
The evidence
Lewis’s book is an exciting story, not a scientific inquiry. It is not obliged to give us objectively convincing data to prove the heroes were right. We just assume it, because they are the heroes. History is written by the victors, and these were the victors. And also, they were the Davids to the industry’s Goliaths.
There is enough evidence here, however, taken from what the protagonists saw and experienced, to make a very convincing case—even for the most skeptical observer—that anyone with his or her eyes open should have known that real estate-backed securities were in a bubble bound to collapse.
One of the heroes discovered that his Jamaican baby nurse owned six townhouses in Queens. A stripper another one met in Las Vegas had five separate home equity loans. A Mexican strawberry picker with an income of $14,000 who didn’t speak English was loaned enough to buy a $750,000 home.
Not only anecdotes but statistics showed it too. Early, before the crisis became apparent, one of our heroes discovered that people whose homes had risen in value between one and five percent had defaulted at a rate almost four times as high as people whose homes had risen by more than 10 percent. They could repay their mortgages only if their home values increased by enough to borrow more. What would happen, then, if all the values went down—or even went up, but just barely?
Then there was the search to find out why so many people were taking the other side of their bets. Initially some of the heroes expected to hear rational arguments why their bets might be wrong.
But all they found was people on the take, scraping off their golden crumbs and passing off the risks to others. They weren’t even thinking about whether they were good risks. Why bother? We’re making money aren’t we?
We don’t get very far into the story before we can plainly see that the heroes are people with clear vision surrounded by a world gone mad.
A quibble
An objection to Lewis’s portrayal has been that he lionized players who contributed just as much to igniting the crisis as anyone else. This complaint is lodged, for example, in a column by commentator Yves Smith. The complaint rests on a technical detail.
Here is a little background. The protagonists in Lewis’s story mostly bet against subprime collateralized debt obligations, or CDOs. A CDO is formed by pooling a large number of mortgages and “tranching” the pool; that is, imposing a seniority structure on it.
In an ordinary pool of securities, a mutual fund for example, there is no seniority structure. Everybody gets an equal share of the revenues. But in a CDO, there are levels of seniority. For example, the super-senior tranche might get 80 percent of the revenues before anyone else gets anything; then the senior tranche might get the next 10 percent of the revenues before anyone else gets anything; then the mezzanine tranche gets the next five percent before the last tranche gets anything; and the last tranche, the equity tranche, gets whatever is left over—five percent, if all the revenues (e.g., mortgage payments), come through.
The super-senior tranches and often the senior tranches too were rated AAA by S&P and Moody’s. Sometimes the lower-rated mezzanine tranches were re-pooled and re-tranched into new CDOs and their super-senior tranches were rated AAA too.
Lewis’s heroes wanted to short the wobbliest of these CDOs. But initially there was no way to do it. Then a new invention was offered to them, credit default swaps (CDSs). CDSs on CDOs were essentially insurance on the CDOs. For a very small premium as a percentage of the face value of the CDO, paid quarterly, you could buy insurance that would make your investment whole if your CDO tranche defaulted, in whole or in part. And you didn’t even need to own the CDO to buy the insurance.
The heroes bet against subprime CDOs chiefly by purchasing the credit default swaps that insure them. The CDSs’ values would go up as the CDOs’ values went down.
Now here’s the thing. The CDO seller, who has promised to make good up to the face value of the CDO, can now pool the premiums received on the sell-side of a bunch of these CDSs, tranche them and turn around and sell this to someone else. To the buyer, it’s virtually indistinguishable from having bought a mortgage CDO. You make your investment, and you get periodic payments in return. These tranched pools of CDSs that simulated CDOs were called “synthetic CDOs”.
And the more CDSs our heroes bought, the more the fiends who sold them the CDSs could create synthetic CDOs. It’s for this role in the drama that the quibblers vilify Lewis’s heroes.
As accessories to the crime the heroes may have been a trifle negligent, but I would vote not guilty.
But were they so smart?
Here is my quibble. Maybe the heroes of the story shouldn’t be indicted as villains. But were they just lucky?
Plenty of investors are convinced they’re onto a sure thing. Many of them can show you solid and convincing evidence why they’re so sure. And many of them think those who don’t see it are fools.
Sure, they’ll say, if something really crazy happens it won’t work. But would it make sense to plan on that? No.
Lewis’s heroes did worry at times that something crazy could happen. They worried at one point that the Fed would bail out the mortgagors, who would then be able to make their payments and the CDOs would be good as gold. Then the CDSs—the insurance against the CDOs going bad—would be worthless.
But the Fed didn’t do that. In fact, the Fed wound up bailing out CDS owners, not mortgagors.
Was that a sure thing? Heck, no. There were big risks here.
Why, then, were the heroes of Lewis’s story any smarter than, say, the Long-Term Capital Management folks back in the ‘90s, who we all now know were bonkers.
The LTCM gang were blindsided when Russia defaulted on its debt. Why was it so stupid to have fallen into that trap, but so smart to have avoided the trap of the Fed bailing out mortgagors?
The answer is obvious: one was unlucky enough to fail, and the other was lucky enough to succeed. History is written by the victors.
The big question
This leaves us with the really big question, which Lewis touches on in his epilogue.
All of the heroes made tens of millions when their bets turned out to be right. But as Lewis points out, those who were wrong made tens of millions too. In many cases hundreds of millions. “The CEOs of every major Wall Street firm were also on the wrong end of the gamble. All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the United States government. They all got rich, too.”
But this is America, where we don’t mind people getting rich if it enriches us too. Bill Gates is richer than all the guys on Wall Street, and Steve Jobs is richer than almost all of them too. But most people would agree (there are exceptions) that Bill Gates and Steve Jobs haven’t gotten rich on our backs. In fact, we would probably say that what they created enriched us all.
Not so with the Wall Street guys. Most of us would agree (with exceptions) that what gained them their wealth—including even the heroes of Lewis’s story—did not enrich the rest of us. It was a zero-sum game. What they gained, we lost. And it’s even worse when they cause a general collapse of market values on top of it.
So here is my question. From whom, exactly, was extracted the billions that the titans of the financial industry were paid for their failures?
Here’s an example of how the accounting could be done. The mutual fund industry collects $90 billion annually in fees. Vanguard has shown that the number could be $10 billion, yield the same net result for the client on average, and still pay the managers handsome—though not regal—sums, as compared with workers in other industries. Let’s add $5 billion for a few thousand stock-pickers to keep prices honest. (A shrunken industry of stock-pickers would probably keep market prices in aggregate at least as honest as the bloated industry does now.)
So clearly, $75 billion flows every year out of the pockets of mutual fund investors and into the pockets of managers and advisors: a zero-sum game that the high-cost managers always win and their clients, in aggregate, always lose. The accounting is cut and dried.
What about the credit derivatives game? If there was a zero-sum game going on—as I think there was—who, exactly, won it? How much, exactly, did they win? And who lost it to them? I’d like to see the accounting done. It shouldn’t be that hard.
Once we do that, maybe we can find out who the pigeons are, why they are pigeons (perhaps they want to be and are happy to be, like Las Vegas gamblers, but I doubt it), and what should be done about it.
Michael Edesess is an accomplished mathematician and economist with experience in the investment, energy, environment, and sustainable development fields. In 2007, authored a book about the investment services industry titled The Big Investment Lie, published by Berrett-Koehler.
Read more articles by Michael Edesess
