Book Review: The Big Short

Not often do I read a book after seeing the movie - usually it’s the other way around. I thought The Big Short movie actually did quite a nice job explaining the mechanics of the financial crisis of 2008 for a major film. After watching the movie a few times, I figured the book could dig into the details of the 2008 financial crisis a bit more that the movie may have not expanded on.

From a pure entertainment value, Michael Lewis does not disappoint. I previously read Moneyball (another book-turned-movie) and was a fan of both Lewis’s prose and content. In The Big Short, He keeps a solid cadence throughout the book, explaining complicated financial movements in laymen’s terms. His books rarely have dry spells, and I never wanted to but the book down. He strikes a nice balance between character “development”, the road to the conditions of the 2008 situation, and the movements of the big financial players.

Lewis is mostly able to describe the financial landscape of the time quite elegantly. There were a few times where I required an external source to explain the details of a specific financial instrument or the reasoning behind why a financial instrument was used - these included why do banks buy mortgages? and mortgage backed securities. He traces the start of the crisis to Soloman Brothers being taken public in the 1980’s, which made the company beholden to shareholders and thus financial performance. Other firms followed suit, and increasing growth was expected to keep stock prices rising. This enticed firms to make risker financial bets to capture higher returns. Mortgage-backed securities (MBS) have existed since the 1970’s and Collateralized Debt Obligations (CDOs) have existed since the 1980’s, and in the early 2000’s mortgages became the bulk of collateral in CDOs. This encouraged mortgage originators to create more and more subprime mortgages to risky lenders. Individually these mortgages were risky but when combined into CDOs, the risk was thought to be diversified and thus given quality credit ratings. Banks increasingly relied on these financial instruments to book profits, even when the underlying securities were becoming risker.

Separately, a Credit Default Swaps (CDS) can be thought of as an insurance product on a loan - for a premium, the seller will compensate the buyer in the event of a credit event. Synthetic CDOs are composed of CDSs, which modeled the behavior of the bonds that CDSs were based on. In what proved to be a major cause of the financial crisis, the underlying content of the Synthetic CDOs was hard to discover, and ratings for these assets were inflated due to the perceived notion that these were “diversified” assets. These Synthetic CDOs appeared to be a safe money maker for firms - they were able to sell these to market pessimists and receive a premium. The mortgage market seemed infallible - home ownership was an integral part of the American Dream, why would homeowners stop paying their bills? Unfortunately, most of these mortgages had a lower teaser rate, but ballooned after 2 years - this meant that homeowners taking out these mortgages may be able to afford the initial rate, but could not afford the higher rate for the duration of the loan. Additionally, silent seconds (a second mortgage that the primary lender did not know about) left the homeowner without any financial interest in maintain mortgage payments.

Michael Burry, a fund manager that Lewis follows, notices that subprime mortgage bonds were being given inflated credit ratings. He convinces Goldman Sachs to sell him a CDS on CDOs that consist of crappy mortgage bonds, but appear to be safe investments due to their AAA rating - a CDS on mortgage-backed CDOs had not been done before. It’s later discovered that this risk was transferred to AIG’s Financial Products group for a lower premium than what Sachs had sold them for, essentially locking in guaranteed profits for Sachs. This beings a wave of buying and selling CDSs on crappy mortgages between firms and market pessimists.

Skipping much of the details that are described in the book, a web of Synthetic CDOs, CDSs and CDOs being bought and sold on subprime mortgage bonds appeared to generate large profits for firms, but ultimately led to firms being overleveraged into high-risk scenarios. When the subprime mortgages start to go bad, the risk is realized - firms become insolvent, stock prices drastically drop, and the market pessimists Lewis follows emerged begrudingly wealthy - each knowing that there were betting against the economy and that there financial gain was beget from the financial losses of others.

There’s a lot of information to digest - I certainly reread parts, and I’m still not sure if I can completely describe all the factors that led up to the crisis. I’m sure I’ll reread the book in the future and understand more of the complicated workings of the financial system, and the conditions that caused Wall Street to erupt in panic. I’m also excited to pick up more of Lewis’s work - it was an enjoyable and informative read.