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The Big Short: Inside the Doomsday Machine by Michael Lewis

May 11, 2011

Everyone knows about the subprime mortgage crisis in 2006, but few can explain the mechanisms behind the meltdown. Even fewer could explain it in a way that makes for a compelling narrative. The Big Short is that and more. It’s the story of a handful of people who, while everyone else was enjoying what appeared to be a healthy market, pulled back the curtain and saw not the man behind the machine, not a false wizard, but something even more shocking—that there was nobody there at all.

Falling interest rates, deregulation of the markets, a belief that home ownership is a requisite part of the American Dream and good ol’ fashioned greed led to an environment where Wall Street banks were getting more and more creative (and reckless) with their financial instruments. Mortgage debt was packaged into collateralized debt obligations (CDOs), where investors could buy packaged debt, earning money as long as the borrowers on the other end of that debt could maintain payments. Those CDOs were then combined and repackaged over and over to disguise the lower-rated securities (those built on sub-prime mortgages most likely to default) until the situation was so obfuscated that nobody—not the regulators, nor the bankers, nor the CFOs—knew what the heck anything was made of. For many of the banks, it didn’t matter—they just wanted to move the products. Add to this mess the credit default swaps (CDS), another lightly-regulated financial instrument that allowed companies to profit by providing what amounts to a financial insurance policy against the collapse of another company. Again, not a bad bet unless the company you’re covering happens to collapse. Furthermore, because collapse of some of the companies involved seemed so unlikely, the purchasers of the CDS often weren’t required to have the capital to back their bets.

It was in this environment that a handful of savvy financial characters with the brains and patience to study and understand the market (and the open-mindedness to see that no ship was unsinkable) realized that it was a house of cards with a faulty foundation. That foundation, they discovered, was built of sub-prime mortgages with a “teaser rate” that, in two-years’ time, could increase by a factor of two. For homeowners to start defaulting on their loans, home values wouldn’t even have to drop. They’d just have to level out. Of course, housing prices did drop, right off a cliff.

The guys who saw this coming started by shorting the market—betting against the toxic funds built on these toxic mortgages. Then they bet against the banks peddling the funds. Then they bet against the companies holding the CDS on the banks—mostly other banks. Then they waited for the crash.

In the end, they made what is technically called a “buttload of cash” (BOC). For example, two guys who ran a hedge fund out of their Berkeley garage started shorting the market with $100,000. They made $120 million on the collapse. Other characters—a Deutsche Bank trader, an anti-social hedge fund manager and a half-blind ex-neurologist with Asperger’s syndrome did as well, if not better. It was an odd group of semi-misfits, and they were mocked by an establishment who chided their “sky is falling” predictions, until the sky did fall. These guys could have snubbed their noses and run around saying “I told you so.” It was obvious how right they’d been. But for the most part, as fat as their wallets got, they didn’t feel like winners. They’d profited from tragedy and they knew it. But they had tried to warn people. And compared to the bad guys in the story, they look like saints.

Now for the bad guys. Every short needs a long, and this is the part of the story that gets your blood boiling. On the other side of this mess, a combination of criminal greed, neglect and ignorance led to some of the biggest losses in history: Merrill Lynch’s CDO manager lost $300 million; Morgan Stanley’s Howie Hubler has the dubious distinction of making the worst single trade in history (he lost $9 billion!); and AIG lost over $99 billion. The real losers, of course, were the  American taxpayers who sponsored the bailout of these idiots. The fallout? Nobody’s gone to jail. Little has been done to improve oversight of the system. And Howie Hubler? He walked away from Morgan Stanley with his own BOC, tens of millions of dollars in back pay.

This story might have a semi-satisfactory outcome for the good guys, but the fate of the bad guys sure does feel like a kick in the nads.

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