52 Book Reviews: The Big Short

I’ve decided that I want to read and review one book a week for all of 2017. My first book, The Big Short: Inside the Doomsday Machine, was a tantalizing dip into the world of hedge funds and global finance that left me with countless questions even as it entertained me with a cast of real, interesting characters and filled me with no small amount of despair about the global economic environment.

The plot of the novel is what countless speculators and investors—and eventually, the American people—found out after the fact. Moody’s and S&P, two private companies, are responsible for rating the credit-worthiness of institutions from individual companies to national governments. Their methods for rating credit default swaps, while deliberately opaque to the outside world, could be gamed (for example, collateralized debt obligations, which housing mortgages were stuffed into, were rated on the average credit rating of its individual borrowers, so that allowed banks to include both high- and low-rated borrowers so long as the average was maintained). These holes—along with a blind trust in the ratings of these vehicles, and the tendency for every single trading desk to not look too closely at them—allowed the banks to overextend their debt obligations orders of magnitude more than the cash they had on deck.

A group of “underdogs”, hedge fund managers and just plain private citizens with an interest in trading, realized that despite the organization of these vehicles—where defaults in payment could be tiered to protect higher credit-rated tiers—were all, in fact, based on a single economic factor: the ability for all house owners in the US to pay their mortgages. These mortgages were underwritten with insane terms and expectations of borrowers to repay their debts: workers making 17,000 dollars a year purchasing 400,000 dollar houses were not unheard of.

You can probably see where this is going. If many, many borrowers went into default, the entire investment vehicle would become worthless overnight. These underdogs all realized the same thing, and began shorting these vehicles: essentially betting against their success, against the banks who were betting for their ability to finance their debts.

When defaults start occurring, investors start asking for their money back, under the terms of the debt obligation. But there is no money, because the vehicles are worthless, because no one can pay their mortgages. The banks tank. The US government steps in. Some banks are deemed “too big to fail”, and are essentially nationalized. Some banks fail, some get absorbed into larger ones. Every idiot at every trading desk responsible for the untenable situation in the first place walks away with multimillion dollar payouts. The underdogs are rewarded for their stalwart opposition and long bets. The American taxpayers foot the bill.

The author, Michael Lewis, seems to understand that most readers would be out of their depth in terms of the terminology and processes involved in hedge fund management, and, depending on the foundational knowledge required, either describes the jargon as quickly and specifically as he can, or else relies on metaphors to get his point across. I’d have rather he done the former much more, because his metaphors seem either overly simplistic, or still couched in how financial managers think about their work.

For example, the nature of how credit default swaps are arranged is usually depicted as a “tower” whose floors flood in order of their proximity to ground level, which is analogous to the amount of risk each “floor” contributes to the agreement. Halfway through the novel, however, this metaphor is discarded because it’s much easier to think of credit default swaps as having three basic categories of risk. The tower metaphor loses its usefulness then, and it’s unclear why it was introduced in the first place.

The “underdogs” in the story are deep and sympathetic characters, and since the reader probably knows the outcome of the story, have the advantage of being able to root for them the whole time (or not, as it were; Greg Lippmann of Deutsche Bank is portrayed as a canary in the coal mine in this book, but is considered a piece of shit in German-based analyses of international finance who brought an unrealistic American culture to Deutsche Bank and “bet against his own products”, walking away with a tidy sum). Lewis’ domain expertise and colorful prose bring these underdogs to life. I found myself wanting a tenth of their gumption, cynicism, and intelligence.

So, yeah. If you love well-researched retrospectives on global catastrophes, and are willing to walk away with a depressed outlook on the market’s ability to correct for the greed of banks and investors, I’d pick it up.