In The Big Short Michael Lewis tells the story of the financial meltdown of 2007-2008 from the point of view of several people who saw it coming and tried to find ways to profit from it. The story involves complex financial contracts and activities such as asset-backed bonds, collateralized debt obligations (CDOs), credit default swaps, and short selling. Lewis skillfully integrates the explanation of these concepts with his tale of individuals who recognized that bonds backed by subprime mortgages (mortgages made to people with poor credit scores) would fail. As a result, the reader is not overwhelmed with technical details of complex concepts.
After reading how those who bet against the market were vindicated, several messages should remain with readers. The experts and very smart people at the center of this market had no clue as to what would happen even though the end outcome was obvious in hindsight. When those making the loans no longer had to worry about whether the loans would be repaid, the smart people should have recognized that loan originators no longer had an incentive to worry about loan quality, and thus quality would inevitably fall, ultimately resulting in high defaults. Their assumption that housing prices would only rise was reckless. It was not the smart insiders and experts who first recognized that the market was flawed. Outsiders, people often on the fringes of investing, like a California MD with Asperger's syndrome, were the first to understand the situation. Although Lewis does not explore why the insiders were so blind, it seems obvious that group thinking and wishful thinking played huge roles. The insiders had found a way to make vast amounts of money and they wanted to believe that it was sustainable, so they did. Being smart does not immunize one from self deception--rather the hubris of smart people may make them more susceptible.
The pessimists of the story, who were the realists, wanted to bet against subprime mortgage-backed securities, but they struggled to find a way to do so. Eventually they discovered credit default swaps, which in simple terms are insurance policies on bond. As long as the bond is alive, the holder of the insurance policy must pay premiums. When the bond dies or is severely injured, the owner of the policy can collect. One does not need to actually hold the bonds to have an insurance policy on them. Further, it does not seem that this way of "shorting" the market has any corrective effect, unlike in the stock market, where shorting a stock helps drive the price down.
Why were large financial institutions willing to sell these insurance policies? Again, the experts on Wall Street did not realize how risky these bonds were. In part that was because the rating agencies--Moody's, S&P, and Fitch--said they were safe. They rated the bonds based on models, and those models were based on the assumption that pooling assets reduces risk because though some will fail, most will not. That assumption is valid when the performance of assets is uncorrelated, that is, when what happens to one is independent of what happens to others, the way a second coin flip does not depend on the results of a first coin flip. When the assets are correlated, so that they tend to move together, diversification may not reduce risk. The models were flawed and the very smart people on Wall Street gamed them to get alchemy: lead was certified as gold.
When the subprime mortgages finally crashed the world-wide financial markets, those who had bet against the subprime bonds walked away rich. But so too did those who had been originating, packaging, and selling the toxic financial instruments that had wreaked havoc. The U.S. government, fearful of total economic collapse, bailed out poorly run institutions and those who had caused the carnage walked away whole. Lewis does not blame the debacle on a lack of government regulation--if those at the center of the market did not understand what was happening, there is no chance that government bureaucrats would have. Rather he stresses the importance of incentives. When investment banks were organized as partnerships, the partners would suffer huge financial losses if the firm failed, so they worried a great deal about risk. When stockholders own the financial institution, managers have incentives to worry about the short run and not so much about risk and the long run. Top managers can and do walk away from companies that they have ruined with their wealth intact; life is not fair.
The Big Short views the collapse of the market for mortgage-backed securities from a narrow perspective. Yet it is one of the best books I have read on the episode and certainly the most entertaining.