Before Crisis, Wall Street Knew

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The Big Short: Inside The Doomsday Machine by Michael Lewis. 288 pp. W.W. Norton and Company. $15.95

Some of us are still trying to figure out how the leading causes of the ongoing U.S. economic crisis went unnoticed before it began in 2008.  Author Michael Lewis, however, in his book, The Big Short: Inside The Doomsday Machine, focuses on Wall Street traders who not only foreshadowed the problem, but also made a fortune in the hope that the U.S. economy would fail.

Lewis tells the story through individuals who knew exactly where the U.S. economy was headed in the years leading up to the 2008 crash.  He describes their journeys, from how they began knowing little about finance to ended being the among largest gainers. Lewis guides the reader with humor to understand the subject of how mortgages work, and how these individuals saw the situation coming and profited from it.

Lewis begins by breaking down the complex process of creating a mortgage bond. This becomes key to how his characters in the book made their money. “A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages,” Lewis writes.

Some investors understood the stock market really well, but others depicted by Lewis were newcomers who simply studied the markets.  Take Michael Burry. A neurology resident, he spent late nights reading and blogging about investing. It was not until after his father died that Burry, who lost an eye when he was younger, changed his career and became a money manager.

In 2005, in his new position, Burry quickly saw that a lot of “mortgage lenders were extending easy credit,” writes Lewis. Seeing that this was going on, Burry believed this idea that since mortgages were bundled into bonds, they then are sold to banks, and other financial institutions. The problem, however, is that if homeowners couldn’t pay back the mortgages, the bonds would be no good, and therefore could not be paid back, creating a toxic situation.

Seeking to make a profit from this, Burry went to various investment banks to see if they would sell him what is known as a “credit default swap,”–an insurance policy that allows a buyer to be compensated if a loan defaults–in exchange for the subprime mortgage bonds. Burry was persistent, casting a net out to a wide range of banks. “Whoever sold him a credit default swap on a subprime mortgage bond would one day owe him a great deal of money,” Lewis wrote.

It didn’t take long before Burry got a taker. Deutsche Bank, one of the first of many banks, agreed to sell him subprime mortgage bonds. By July, Burry owned a lot of “credit default swaps,” which became $750 million in bonds.

Steve Eisman had reached a similar conclusion.  Though his parents were brokers, Eisman became a lawyer instead.   “I hated being a lawyer,” Eisman told Lewis. Soon, he quit and joined the career of his parents. It was not until years later he understood the new world of Wall Street, thanks to Vincent Daniel, another Wall Street investor who was self-taught.   Eisman decided to open up his own hedge fund in 2004, thanks to help from Morgan Stanley who sponsored him. Instead of choosing the route that Burry makes, Eisman decided to short debt, which is back up by mortgages.

Lewis’ story is an example of how a complicated issue can be made easy to understand.  One wishes that other writers could be so adept in giving us step-by-step guides into many of the complexities of finance. But then, Lewis is no stranger to that world.  He worked at an investment bank in the 1980s, an experience that formed the backbone of his bestseller, Liar’s Poker.  The Big Short takes a totally different tact by following a group of intrepid investors who had their own rebel view of how another part of Wall Street works.

 

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