The Book Report - The Big Short: Inside the Doomsday Machine

The book I chose to read for my report was The Big Short: Inside the Doomsday Machine by Michael Lewis. I was nine years old when the market crashed in 2008 and wasn’t fully aware of the impact that it had on the United States and the rest of the world. As I grew older and learned more about how bad the situation was, I wanted to learn the details of how Wall Street could allow something like that to happen. This book provided clarity over how the situation unfolded and taught me more about what trading on Wall Street is like, the attitudes of people on Wall Street, and the amount that people are willing to forego ethical decisions in order to gain the most profit for themselves, specifically in regards to the mortgage bond situation within the book.

Before reading this book, I knew some stereotypes of brokers on Wall Street such as their arrogance and loud, cutthroat personalities. One of the characters who fit this personality was Steven Eisman, who was originally a corporate lawyer before he went to Wall Street as an analyst. He was quoted by Lewis as saying “the only way to be paid as an analyst is being right and making enough noise so that people noticed it” and further described the chaos that would unfold every day on Wall Street during trading periods. This behavior reminds me of the in-class game where we experienced a trading simulation. My group was quieter and less sure of our decisions, but the loudest and most aggressive groups got the attention and the deals they wanted because they acted quickly and confidently. Trading is very hectic, so you need to be loud to get attention and secure the deal you want.

With this background knowledge, it was interesting to learn more about Michael Burry because he didn’t fit the mold of the typical Wall Street investor. I was intrigued by how he remained confident with his discovery in the housing market, even while he was faced with doubt from large corporations. Michael Burry was a smart guy who started out as a regular stock market investor before he decided to immerse himself in the bond market. However, before he even began to explore the stock market, he was a physician. He was awkward in social interactions and lacked social skills, but had an incredible sense of concentration, deep learning, and thorough processing of information. He blamed his lack of social skills on the fake eye he used after losing one to cancer in his childhood, but he later learned that he had Asperger’s syndrome. This diagnosis explained his awkwardness and fixated concentration on certain concepts or ideas. He used this to his advantage while learning about finance and investments in the bond market. Burry was one of the first to discover the subprime mortgage crisis that was about to strike the United States before corporations on Wall Street were even aware of the situation. Once he had decided to pursue his interest in the bond market, he created the hedge fund Scion Capital and achieved great financial success for his investors in the early 2000s. He began to focus on the subprime mortgage market around 2005 and realized if he could bet against the housing market at this point when people were accepting loans with fixed rates that would inflate exponentially in two years, that he would see success around 2007 when he assumed the housing market would collapse.

Initially, I thought that the housing crisis was something that happened suddenly without a clear explanation. As I read further, I learned that the subprime mortgage crisis which struck the United States in 2008 had been building up for many years--since the 1980s and 1990s. The book explained the situation in complicated financial terms, but this helped me learn more about the correct terminology for investments I didn’t even realize existed. As stated by the author, “the biggest fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all. The pool of loans underlying the mortgage bond conformed to the standards, in their size and the credit quality of the borrowers, set by one of several government agencies. If the homeowners defaulted, the government paid off their debts” (Lewis). Later on, the mortgage bond was “put to a new use: making loans that did not qualify for government guarantees. This would extend credit to less and less creditworthy homeowners, not so they might buy a house but so they could cash out whatever equity they had in the house they already owned” (Lewis). This new change was one of the reasons the housing market crashed. Greedy Wall Street investors wanted to help their own organizations’ bottom lines, so they encouraged people to take out loans to pay for houses that they both knew the individuals couldn’t afford. These loans were enticing because Wall Street brokers presented them with a “teaser” rate. This strategy offered a low fixed rate for the first two years of the loan which would then become a much higher floating rate for the rest of the loan period. People bought into the low fixed payment and were fooled into believing it would remain low over the entire period of the loan. Of course, the real crisis erupted when they began to fall behind on their payments.

Another piece of the puzzle was the risks of mortgage bonds from their structure. As the book explains, “mortgage bonds created from subprime home loans extended the logic invented to address the problem of early repayment to cope with the problem of no repayment at all: the investor in the first tranche (first floor) would be exposed to actual losses, not prepayments. He took the first losses until his investment was entirely wiped out, whereupon the losses hit the guy on the second floor, and so on” (Lewis). The author went into further depth by explaining how higher rated mortgage bonds were on higher tranches, while lower-rated bonds were on lower tranches. Of course, most people wanted the “safest” bonds, so Wall Street chose to package low-rated bonds with high-rated bonds to increase the average in the pool and then sell it as something with a higher rating than it actually was. Michael Burry noticed that the overall pool of mortgages being issued, packaged, and sold off was worsening in quality “because for the same FICO scores or the same average loan to value, you were getting a higher percentage of interest-only mortgages” (Lewis).

After considering how these poor quality bonds were being sold off at much higher ratings, it was concerning to learn how the rating agencies Moody’s and S&P were run. From the novel, it was clear that “wall street firms had the same goal as any business: to pay as little as possible for raw material (home loans) and charge as much as possible for their end product (mortgage bonds)” (Lewis). The key element here is that the price of the end product was driven by the ratings assigned to it by the models used by Moody’s and S&P’s. Unfortunately, the people at these rating companies were easily taken advantage of. They didn’t intentionally mislead people with their ratings, but often were too lazy to check the quality of the bonds that they were rating. The author confirms that “Wall street traders knew that these rating people didn’t look at each individual home loan, but rather evaluated the general characteristics of loan pools” (Lewis). In addition, the use of FICO scores was something that misled the agency ratings because these scores didn’t account for a borrower’s income. I learned that Moody’s and S&P didn’t ask for a list of the FICO scores of all of the borrowers, but rather asked for the average FICO score for the pool. This was dangerous because the agencies allowed loans to be made as long as the borrower with a high FICO score could be found to compensate for the risky borrower with a much lower rating, who would also most likely default. If those weren’t enough, the agencies found another loophole. Thin file FICO scores were high for immigrants because they had little to no credit history and had never borrowed money before, which would have been an opportunity to determine their risk of default. According to Lewis, “the more egregious the rating agencies’ mistakes, the bigger the opportunity for the Wall Street trading desks”, which is exactly what they capitalized on. After reading about all this, I couldn’t believe that the capitalistic structure that the United States runs on was so easily corrupted. These loopholes leave room for enormous error which is exactly what happened in this situation from 10 years ago. I assume most Americans would want to trust the financial institutions that are holding the wealth of our nation, but it is extremely worrying that the very agencies who are responsible for rating the value or risk of certain bonds are not even assessing these correctly and are easily manipulated to benefit the big wall street corporations and hurt the rest of the American population.

I had no idea that the cause for the market crash was caused by something that sounds so corrupted and unethical. Beyond that, I was shocked at how Wall Street got away with this technique of misleading people about their loans and selling off highly rated bonds that weren’t really deserving of their ratings for years before it began to crash and burn. I always assumed that corporations would be more ethical in the way that they treated their customers when it was real money (and lots of it) on the line. This book exposed how the corporations’ main focuses were their own benefit and not the greater picture of how this behavior would hurt each individual customer and eventually the entire market. Brokers were willing to take advantage of low-income Americans who already were in financial debts, which is a really sad reality that this novel captured. By taking advantage of these people, the market crashed and also affected plenty of other hard-working Americans, many of which weren’t even involved in the buying or selling of subprime mortgage bonds. It is a dark reality of finance that I was not prepared to read about, but that I found interest in learning more about.

Another lesson I learned about finance by reading this book was the importance of transparency between corporations and the public. One character, Vincent Daniel aka “Vinny” was detail-oriented and wanted to know the merit behind the bond rating and numbers that Moody’s and S&P were presenting to the public. Companies also chose to disclose their growing earnings to the public, but not much else in regard to their operations or investments. Vinny taught himself what mortgage-backed securities were and learned that these companies failed to disclose the delinquency rate of the home loans that they were making, which was a very important part in determining how much risk was associated with this investment. These companies were able to sell off the loans to people who packaged them into mortgage bonds so that “the risk was no longer theirs” (Lewis), even though this was untrue and the risk was still very much theirs. All the companies “retained some small fraction of the loans they originated, and the companies were allowed to book the expected future value of those loans as profit” (Lewis). The accounting rules allowed the companies to assume that these loans would be repaid, which Lewis claimed became “the engine of their doom”. This reminded me of something we discussed in class while considering how to report financing of companies. Finance is important because it focuses on the actual cash flows of a company, not just the promised cash flows. It is important to focus on the actual cash flows because these are the transactions that are supporting the organization’s operations. Promised cash flows can easily be misleading because they do not represent the liquid assets that are necessary to support the organization.

After reading this book and taking in the main points I mentioned above, I have become much more interested in investing my money into the stock and bond markets. However, as the author states towards the end, “the line between gambling and investing is artificial and thin” (Lewis). It was informative to learn in class about the ways one can increase this risk so that investing is less like gambling and more strategic. It would be helpful to have a diverse portfolio with some negatively correlated stocks in order to profit in a time of crisis, similar to if another housing crash tanked the market. I have grown more interested in researching investment strategies and trying to discover trends like the characters in the books did but on a much smaller scale. I don’t plan on going into finance, but this background information on what wall street is really like when major situations unfold is something I will remember now when I think about where to put my money.