This spring the US Congress will finally vote on legislation to address the weaknesses in the financial system that enabled the 2008 collapse. In that light, it is hard to imagine a stronger case for reform than the one implied by the brisk, illuminating story Michael Lewis (author of “Liar’s Poker”) tells in The Big Short, his chronicle of the three years leading up to the bursting of the subprime bubble.
Lewis’s account revolves around two men – Steve Eisman and Michael Burry – who as early as 2005 saw what few others on or off Wall Street did: that the entire subprime apparatus, from the million-dollar mortgages extended to minimum-wage workers, to the bonds manufactured from those mortgages, was a house of cards. It was each man’s eccentric personality, says Lewis, that led him to this contrarian insight. Eisman is described as a profanity-spewing fund manager whose hypersensitivity to the venality of others caused him to view his trades as a crusade on behalf of Americans suckered by the subprime hucksters. Burry, by contrast, is a recluse with Asperger’s syndrome and a glass eye, whose life circumstances had conditioned him to look at the world differently from everyone else.
In early 2005 Burry saw that what appeared to him to be very risky securities were being priced extraordinarily cheaply, as though they carried almost no risk at all. He went looking for a way to bet against subprime mortgage bonds, but quickly discovered that the nascent market had no mechanism by which to do so. Undeterred, he convinced Deutsche Bank and Goldman Sachs to create and sell him a type of insurance policy – the infamous credit default swap – that paid out if the subprime bonds went bad.
In addition to its improbably low cost, the most peculiar quality of this type of insurance was that Burry did not have to buy the underlying bonds in order to purchase the policy. It was roughly equivalent to owning fire insurance on your neighbor’s home. He cherry-picked the worst of the worst bonds (the ones comprising home loans most likely to be defaulted on) and to his surprise found that Wall Street was almost blithely eager to insure them. (Later, Burry discovered that Goldman and Deutsche Bank were only acting as intermediaries, taking a cut off the top and then passing the insurance through to the witless and now notorious financial products group at American International Group.)
A first bona fide of “The Big Short” is the lucidity with which Lewis explains credit default swaps and the other complex financial instruments behind the crash. He describes how Wall Street, when it ran out of subprime mortgage bonds to insure, invented a new way for speculators to gamble on the market called a collateralized debt obligation (or CDO). CDOs took the worst pieces of each subprime bond and recombined them into a new product that was meant to appear less risky than the sum of its parts. The gambit was like a meatpacker grinding together bits of bone and gristle and calling it top sirloin, and it worked because Moody’s and Standard and Poor’s – the meat inspectors of the financial world – were either asleep at the wheel or on the take, depending on your level of cynicism. Regardless, CDOs opened the possibility of an infinite regress of wagers – a bet on a bet on a bet – and enabled speculation in subprime mortgage bonds to reach the economy-destroying heights that it did.
As the book progresses, the bubble inflates and the trades get more complex, and it becomes evident that most of the traders and executives Burry and Eisman are dealing with either can’t understand what’s going on or – because of compensation incentives that encourage willful ignorance – don’t want to. “The Big Short” subtly but unambiguously upends the view – propagated with particular vehemence by deregulationists – that Wall Street is a place populated by grown-ups who understand their business better than the government ever could.
In one particularly telling moment, Eisman has dinner with a cheery, hopelessly unsophisticated fund manager named Wing Chau, after which Eisman tells an associate, “Whatever this guy [Chau] is buying, I want to short it.” Such was the small world of subprime finance where the limited number of players involved, combined with the opacity of the securities, created a market ripe for manipulation and exploitation. As Lewis puts it, “The world’s biggest capital market wasn’t a market.” At any given time it was nearly impossible to determine the exact value of subprime mortgage bonds – until, that is, it became clear that they were worth nothing at all.
The Americans who bought the homes that provided the foundation for this Wall Street speculation spree remain largely offstage throughout “The Big Short.” But their presence is felt. One of the first hints that Eisman had that the subprime market was askew came when the Jamaican woman who formerly looked after his kids told him that she was now a real estate mogul in Queens and the owner of six townhouses. Lewis also notes the representative case of a Mexican strawberry picker earning $14,000 a year who was loaned $724,000 to buy a home, no money down and few questions asked, at the height of subprime mania.
In Lewis’s estimation it is part of human nature to overreach – we shouldn’t expect people to turn down cheap money. Restraint, in his view, if there were to have been any at all, needed to come from the lenders and the underwriters who should have had a clearer picture of the risks involved. But such were the conditions in the middle of this past decade that even if the Jamaican real estate mogul from Queens defaulted on her loans – as she very likely would – everyone, from the bank issuing the loan to the Wall Street traders who speculated on it, stood to pick off some money before the body hit the floor. It was a clever game and it made a lot of undeserving people rich, that is, of course, until Wall Street realized that it was in free fall, too.