The Big Short by Michael Lewis

I just finished reading The Big Short, Inside the
Doomsday Machine, by Michael Lewis. It's an
intriguing story about how the whole subprime
mortgage crisis developed, and who some of the
players were who actually could see ahead to
the ugly crash.

Michael Lewis is also the author of The Blind Side,
on which the movie that earned Sandra Bullock
an Academy Award is based. He does a great job
of involving you with the major players and telling
the story through them.

The Big Short refers to a position in the stock
market where investors bet against the success
of a company, or a segment of the market and
in this case the investors bet against the success
of subprime mortgage bonds.

While the mortgage industry was behaving as
if property values would always go up, and that
borrowers could always refinance their loans
when they became intolerable, Lewis shows us
some of the people who were on the other side
of that bet.

Lewis is able to take some technical and arcane
information and explain it in terms that anyone
with an interest can decipher.

He takes the reader through some of the basics
of the subprime lending world, where loan orig-
inators marketed the loans to the consumers.
These loans in turn were taken by the lender
and put into subprime mortgage bonds and sold
to investors through Wall Street.

The bond traders on Wall Street then "sliced and
diced" these mortgage bonds into layers called
tranches, and rating agencies like Moody's and
Standard and Poors were supposed to use their
analytical prowess to properly assess the risk and
grade them accordingly.

The Wall Street firms then created new investment
instruments called Collateralized Debt Obligations
(CDO's), which gave them further opportunities to
sell positions in the same underlying bonds and
actual mortages. Some of these Wall Street firms
included Lehman Bros., Bear Stearns, Merrill
Lynch, Goldman Sachs, Deutsche Bank and
Morgan Stanley.

The investors who were betting against the success
of the subprime bonds, who wanted to be short in
the market, needed a way to make this work. They
needed a way to insure their position and were able
to buy Credit Default Swaps (CDS's) to do so. AIG
was the major player who provided this insurance.

I'm sure that I do not have a comprehensive under-
standing of how all of these pieces fit together. But
it finally became clear to me how it all started to
unfold.

The Greenspan era with the Federal Reserve was
notorious for providing a lot of liquidity at very
attractive terms. It provided the fuel and the
insatiable appetite for the subprime binge.

This incredible supply of liquidity meant that the
Wall Street firms needed to find a market that
could put that money to work. Mortgage-backed
securities (MBS's) traditionally filled some of that
market, because they were usually filled by first
trust deeds that conformed to well-understood
and conservative underwriting standards.

But these types of loans could not longer satisfy
the investment beast. It wanted to be fed, and
instead of holding firm to MBS product that
were filled with conservative first trust deeds,
it was willing to accept, at first, wilder versions
of first trust deeds. These became known in
the market as Alt-A loans, and they usually
commanded a slightly higher rate to compensate
for the risk.

Once the standards started slipping, it wasn't
incredibly long before investors were willing
to accept MBS product that were filled with
interest-only first loans, or stated-income and
no-doc loans, or negative amortization loans,
or stated-income and no-doc negative amort-
ization loans. Investors also rationalized that
the loans with teaser rates for the first two
years and then adjust to a higher rate would
be a good thing too.

And since these still didn't satisfy the demand,
investors were willing to buy MBS product
that included second loans. These second loans
could be fixed-rate or HELOCs (home equity
line of credit loans). A prudent investor may
want to limit their exposure to 80% of value,
but since property values were always going to
go up (right?), they thought: let's create second
loans that go all the way to 100% of the value,
let's do them on a no-doc basis, and to make
things easier, let the interest accumulate on
these without requiring payments.

The rating agencies did not do a good job at all
of assessing the risk in these MBS pools. Investors
were duped into thinking that they were buying
AAA rated bonds when in fact they were buying
into something of substantially higher risk of BBB
quality.

Inside the Wall Street firms, there may have been
only a handful of people that truly understood
what was being created, marketed and sold. Also,
there was a very limited understanding of how
highly leveraged this business had become. There
was one trader at Morgan Stanley that had
accumulated $16 billion of subprime positions
that were poised to go to zero when the eventual
crash came. As Lewis tells it, management at
Morgan Stanley had no clue as to the financial
risk that the company was in because of this one
trader.

We all know that the crash came. And with it
came the demise of Bear Stearns, Lehman Brothers,
and Merrill Lynch's absorption by Bank of America.
AIG received a massive bailout from the Federal
Reserve to stay solvent. Morgan Stanley and Gold-
man Sachs were tanking also, and the government
stepped in to prevent a total collapse.

Amazingly, almost everyone who was integral in
this house of cards was paid handsomely through
the process. People were richly rewarded for doing
the wrong things. And no one really cared who
was going to end up the big loser as long as they
got their piece of the action along the way.

If you want to see the process from the inside,
and maybe answer some questions for yourself
as to how we got into this mess, I highly recommend
reading The Big Short.