In the prologue to The Big Short: Inside the Doomsday Machine, Michael Lewis explains that he envisioned his first and perhaps most famous work, Liar's Poker, as a grim obituary for an industry that rewarded inexperience and greed. However, the byzantine banking industry continued to flourish, and young readers wrote Lewis to ask how they, too, could get into the game. His disappointment is palpable. In his new book, he may have replicated the mistake of glorifying a troubled industry.
The premise of the book is simple: A few investors had the foresight to see that the sub-prime-mortgage loans at the heart of a vast bubble in the bond markets were destined to default and made fortunes betting against them. The Big Short, then, is the story of those counter-investors and in turn, an illustration of what was (and is) wrong on Wall Street.
In narrative, Lewis, as ever, doesn't disappoint: He gets inside the heads of his fascinating characters and vividly describes the complex financial structures they built and destroyed. Unlike many other recountings of the crisis -- I'm thinking of Andrew Ross Sorkin's Too Big To Fail or David Wessel's In Fed We Trust -- Lewis captures both the broader macroeconomic currents at work and those struggling to ride them to profit.
Anyone who looked closely at sub-prime mortgages could see trouble coming: They were destined to fail when their teaser interest rates jumped, or because they were non-amortizing, or simply because the borrowers never had the means to pay them in the first place. As early as 2004, the FBI warned that fraud was endemic in the mortgage markets. Lewis managed to find the few investors who tapped into this knowledge early; indeed, Steve Eisman, one of the money managers at the center of the book, had seen an earlier generation of sub-prime lenders fail.
The investors' problem was that, by definition, you cannot invest in a catastrophe you see coming. To monetize their insight about the housing market, the investors in Lewis' book needed to bet against the bonds they knew would fail -- to short them. Their aim was pure speculation, and to speculate in this way, they, too, had to invent a new financial instrument and a new investing strategy. What they created was at least as damaging as the bubble it was built to bet against.
Lewis credits Dr. Michael Burry, another of his prescient investors, with figuring out how to do it. Credit-default swaps had existed for a while; they were insurance policies that would pay out if a bond failed. No one had ever put a CDS on a mortgage-backed security before -- no one had wanted to -- and in 2005, Burry had to aggressively lobby Wall Street banks to sell him insurance on mortgage bonds. Soon a market for these instruments existed, driven at first by Eisman, Burry, and a small fund started by a couple of guys in a Berkeley garage.
It wasn't long, though, before the financial establishment picked up on the game, beginning with a walking stereotype of a bond trader named Greg Lippmann. Lippmann, a trader at Deutsche Bank, got into the CDS game against the prevailing winds in the market. He didn't make any bones about being a white knight, telling a skeptical colleague, "Fuck you. I'm shorting your house." He would even make T-shirts with the slogan.
That's all you really need to know, really: The Big Short was a bet against your house; whether or not you had a sub-prime mortgage. The devaluation these investors were counting on -- with hundreds of billions of dollars -- affected everyone. To their credit, some of the investors Lewis profiles tried to warn journalists, ratings agencies, even the Securities and Exchange Commission. They weren't heard -- their explanations were too complicated, the conventional wisdom too ingrained, the profits too large.
Inevitably, the signs of disaster became too large to ignore. Teaser interest rates on mortgages began resetting, bringing mortgage defaults along with them, and banks began to write down the value of their bonds. By 2007 Wall Street's biggest players, from Goldman Sachs to Morgan Stanley, were jumping over themselves to make their own bets against the housing market. Disconcertingly, these banks still sold mortgage bonds to clients -- especially an even more complex version called a collateralized debt obligation -- while they bet these same instruments would eventually default.
The spread of these CDS throughout the market amplified the volume of the eventual crash. The investors recognized that their aggressive bet helped keep the bubble expanding. Indeed, the collapse of American International Group, whose bailout by the federal government continues to be controversial, was due to these derivatives. After the bailout, AIG would pay off the bets banks took out against their own bonds -- up until the last minute, no one realized that AIG was at the center of that market -- at 100 percent of their stated value.
Lewis shows there was very little recognition among these traders that their speculation had anything to do with the real world. "Being short in 2007 and making money from it was fun, because we were short bad guys," Eisman says in a telling quote. "In 2008 it was the entire financial system that was at risk." But in shorting the bad guys, aka Wall Street, Eisman was also shorting the underlying mortgages. By the time he realized the financial system was at risk, Eisman wasn't too concerned about the regular economy, either: He worried that failing banks might not pay him back, that the government might ban short-sales, or even step in to guarantee mortgages -- that is, for the investors to make money, those mortgages had to fail.
Ultimately, the investors of The Big Short made out like bandits. Most of the smart Wall Street banks did as well, thanks to the government's aggressive response to the crisis. Barring a broad financial overhaul emerging from Congress in the coming months, the financial sector will continue as it did before. And even though Lewis perceptively identifies many causes of this crisis -- in particular the decision of private investment partnerships to become public companies -- he still remains bewilderingly agnostic about the industry he recognizes to be a rigged casino.
"The line between gambling and investing is artificial and thin," Lewis writes. "Maybe the best definition of 'investing' is 'gambling with the odds in your favor.'" This is too cute by half. Investment, like gambling, involves risk and uncertainty, but there is a difference. You don't underwrite a poker hand -- nor did mortgage brokers properly underwrite the loans that brought down the housing market. The Big Short was no investment; it brings no benefit and conveys no ownership. You no more invest in a default than you invest in roulette.
In the end, The Big Short does too much to convince us that the contrarian investors it chronicles are laudable: When the rogue investors compare themselves to "Spiderman," or "a crusader, a champion of the underdog"; Lewis does nothing to contradict them. He praises their foresight, at times portraying their work as noble. What will keep another generation from taking their derring-do as a model? Understanding how to win a rigged game is different from understanding not to play. After all, these traders weren't stopped by their consciences. As Steve Eisman, one of the money managers whose tale Lewis recounts, puts it: "We fed the monster until it blew up."
