The conventional wisdom today is that few individuals had the foresight to truly understand the subprime lending bubble while it was inflating. However, it did not take an MBA from an elite institution to understand intuitively that median home prices could not rise endlessly while median family incomes remained stagnant or that temporarily low teaser rates on zero down mortgages would end in tears unless home prices continued to rise. In fact, many ordinary Americans without any financial background could intuitively understand that a bubble was forming. However, while many understood the nature of the bubble, very few were able to profitably bet on the eventual crash.
If you are already cynical about the motives and practices of professional investors in the major Wall Street banks, chances are that you are not even half as cynical as Michael Lewis. In The Big Short, Mr. Lewis spins a tale that places very unlikely characters at the center of the subprime bubble. All of the individuals were either completely unknown or relatively small players, but they shared in common an insight into the bubble that resulted in spectacular profits. This book reads almost like a novel, at least for those who have a basic understanding of credit default swaps, collateralized debt obligations, and related terminology and concepts.
The Cast of Characters
The cast of characters in the book includes Michael Burry of Scion Capital, Steve Eisman of FrontPoint Partners, and Charlie Ledley and Jamie Mai of Cornwall Capital. Like many others, these men understood the nature of the bubble that was quickly forming, but they had the foresight to come up with ways in which they could place bets that would pay off in the event of a collapse in the worst CDOs. By purchasing credit default swaps (CDS) on CDOs comprised of the worst subprime mortgage bonds, all of these investors were able to realize huge payoffs when the collapse finally came. However, this required the ability to not only see the impending crash but to be willing to go against conventional wisdom for several years.
Did Michael Burry Make a Macro Call?
Michael Burry’s story is the most compelling when it comes to the price that must be paid for bucking conventional wisdom when managing other people’s money. Trained as a medical doctor, Dr. Burry had built a strong reputation for bottom up stock picking and attracted the interest of prominent value investors who realized excellent returns during the early part of the last decade. However, when Dr. Burry revealed his bet against the subprime mortgage market, nearly all of his investors strongly objected and many demanded their money back. It took nearly two years of gut wrenching conflict and short term underperformance before the strategy finally paid off.
One gets the sense that Dr. Burry was not the easiest person to deal with given his interpersonal issues related to Asperger Syndrome. And in some ways, the reluctance of the investors to accept what seemed like a major “macro call” from someone they thought was a bottoms up stock picker seems understandable. What the investors missed is the fact that Dr. Burry was not really making a macro call at all. He had studied the prospectuses for countless CDOs and identified the worst of the worst to bet against. He then convinced major investment banks to create CDS that would pay off in the event of default. Furthermore, he knew that the bonds in question were comprised of subprime mortgages with teaser rates that would expire in 2007 and the data made it obvious that defaults would rise at that time. From this perspective, the “macro call” looks less like a speculation and much more like a value investment, although Dr. Burry was never able to successfully convince his investors.
The Main Villains: Credit Rating Agencies
There is no shortage of villains in the book and the reader is repeatedly exposed to insane and distasteful behavior by many of the characters in the investment banks. However, the true villains and the “enablers” of the crisis are clearly the credit rating agencies that either naively or purposely rated subprime CDOs as AAA securities thereby giving cover to investors who abdicated their role as analysts and blindly paid up for seemingly “bullet proof” paper. Here is a quote from the book by Steve Eisman:
“They’re underpaid,” said Eisman. “The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for. There should be no greater thing you can do as an analyst than to be the Moody’s analyst. It should be, ‘I can’t go higher as an analyst.’ Instead it’s the bottom! No one gives a fuck if Goldman likes General Electric paper. If Moody’s downgrades GE paper, it is a big deal. So why does the guy at Moody’s want to work for Goldman Sachs? The guy who is the bank analyst at Goldman Sachs should want to go to Moody’s . It should be that elite.” (Page 156)
It becomes obvious that the ratings agencies had no real insight into the CDOs they were rating as AAA, nor did they really appear to care about improving their models. Given the fact that the banks creating the CDOs were paying the credit rating agencies, there was an inherent conflict of interest because if one agency refused to “play ball”, then another one would be willing to do so. Eventually, the agencies announced a change in the models used for subprime CDOs but inexplicably refused to make it retroactive by re-rating existing bonds.
Demise of the Partnership Model
While Mr. Lewis clearly believes that the ratings agencies were incompetent, he also places a great deal of blame on the demise of the partnership model of the investment banks. He believes that public share ownership of the banks allowed management to pursue risky strategies that would never have been tolerated in a partnership model. Those who have read The Partnership: The Making of Goldman Sachs can obtain a better understanding of how the partnership model worked and it may be a better approach. However, it must be noted that many of the investment bank CEOs did in fact lose the vast majority of their net worth in the crash.
If the partnership model has merit, it is more likely due to the culture of ownership that pervades the firm rather than simply exposure to loss. Public ownership comes with quarterly guidance, earnings estimates, analyst meetings, investor conference calls, short term thinking, and other dysfunction that would not exist in a partnership model. Still, it is not obvious that a partnership model is a panacea or that the subprime crisis would have been averted had the investment banks not opted for public ownership over the past two decades.
Entertaining and Worthwhile Read
Mr. Lewis, who first became famous for writing Liar’s Poker, is nothing if not a talented storyteller who can keep his audience enthralled by the drama (at least those with an interest in the subject). However, The Big Short cannot be considered a definitive history of the subprime crisis and does not come anywhere near the level of depth that Andrew Ross Sorkin delivered in Too Big to Fail, which we reviewed in January.
It may not be entirely fair to compare the two books. Mr. Sorkin gained access to some of the most important players in the major investment banks and in government to paint a broad picture of the financial crisis. Mr. Lewis, in contrast, took the stories of relatively unknown investors who were spectacularly successful in profiting from the crash. In reality, the books serve different purposes and are both worth reading. Those who are more interested in a behind the scenes account of the crisis from the perspective of “major players” should select Too Big to Fail while those who are looking for more insight into the minds of several very brilliant and contrarian investors should opt for The Big Short.