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Lewis - The Big Short (2010) - Synopsis

Lewis - The Big Short (2010) - Synopsis

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Published by Mark K. Jensen
Synopsis of Michael Lewis, The Big Short: Inside the Doomsday Machine (New York and London: W.W. Norton, March 2010). -- Discussed at Digging Deeper (www.ufppc.org) on May 10, 2010.
Synopsis of Michael Lewis, The Big Short: Inside the Doomsday Machine (New York and London: W.W. Norton, March 2010). -- Discussed at Digging Deeper (www.ufppc.org) on May 10, 2010.

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Published by: Mark K. Jensen on May 09, 2010
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UFPPC (www.ufppc.org) Digging Deeper CXXII: May 10, 2010, 7:00 p.m. 
Michael Lewis,
The Big Short: Inside the Doomsday Machine
(New York andLondon: W.W. Norton, March 2010).
 [
Thesis.
 The "doomsday machine" of the subtitle is the asset-backed bondbusiness of Wall Street banks thatresumed the discredited practice of selling subprime mortgage-backed bonds(CDOs), then invented credit defaultswaps based on them, destabilizing thefinancial system. These derivativecontracts latter were ways to bet against,or "short," the CDOs, devised in a murkyversion by financial engineers at MorganStanley in 2003 and then by otherinvestors. Other banks soon got into theaction, especially Merrill Lynch, which"created twice as many . . . as the nextbiggest Wall Street firm" and "easily theworst" (142) of the "engines of doom":CDO[s] composed entirely of creditdefault swaps on triple-B-rated subprimemortgage bonds" (140).]
Dedication.
"To Michael Kinsley/Towhom I still owe an article" [vii].
Epigraph.
"The most difficult subjectscan be explained to the slow-witted manif he has not formed any idea of themalready; but the simplest thing cannot bemade clear to the most intelligent man if he is firmly persuaded that he knowsalready, without a shadow of a doubt,what is laid before him." —Leo Tolstoy,1897 [ix].
Prologue: Poltergeist.
When writing
Liar's Poker 
, Lewis thought the financialirresponsibility of the 1980s, in which hehas participated at Salomon Brothers,would appear in retrospect as anaberration (xiii-xvi). In late 2008, Lewisdecided to write about individuals whoforesaw the coming collapse (xvi-xviii).
Ch. 1: A Secret Origin Story.
SteveEisman graduated from Harvard LawSchool, then moved into the securitiesindustry at Oppenheimer securities (1-2).He earned a reputation as an offensive,obnoxious truth-teller (3-6). Mortgagebonds extended to subprime marketwere at first an example of "smallmarkets in bonds funded by all sorts of strange stuff: credit card receivables,aircraft leases, auto loans, health clubdues," creating a "growing interfacebetween high finance and lower-middle-class America" (8; 9; 6-10). Accidentaldeath of Eisman's infant son Max (12).Vincent Daniel, working for Eisman as anaccountant, concluded in 1997 thatsubprime lending companies "weregrowing so rapidly, and using such goofyaccounting, that they could mask the factthat they had no real earnings, justillusory, accounting-driven ones. Theyhad the essential features of a Ponzischeme"; Eisman issued a report to thateffect (14; 10-15). Less than a year later,in the Long-Term Capital Managementcrisis, "the early subprime lenders weredenied capital and promptly wentbankrupt en masse" (15; 15-16). In 2002Eisman undertook "a single-mindedcrusade" against the deceptive lendingpractices of the Household FinanceCorporation, but HFC evaded anappropriate regulatory response (16-18).Eisman, fascinated by comics (19; 152-53), became convinced "the system wasreally, 'Fuck the poor'" (20; 19-20). Hispolitics "drifted left" (20). In 2004 he setup a hedge fund called FrontPoint withMorgan Stanley but had difficulty raisingmoney; an insurance company "stakedhim to $50 million" (22). Danny Mosesalso worked for him (22). By 2005 "[t]hesubprime mortgage machine was up andrunning again, as if it had never brokendown in the first place," and in evenmore unsustainable ways (e.g withfloating-rate mortgages), to the tune of $625bn (23). Those making subprime
 
loans learned they had to keep them off their books (23-24). Stocks increasinglydepended on the bond market; "Justabout every major Wall Streetinvestment bank was effectively run byits bond department" (25). [NOTE: Onthe bond market, see ch. 2 of NiallFerguson's
The Ascent of Money 
(2008)
,
pp. 65-118: The bond market allowsgovernments and large corporations toborrow money from a broader range of people than banks alone, and isimportant both because retirementsavings end up there and because it setslong-term interest rates for the economyas a whole, thus influencing the value of all other assets. Investing in a bond isbetting against future inflation. The bondmarket dominated 19th-century finance;its hegemony was ended by World War I,but since the 1970s, the bond markethas recovered its preeminence.]
Ch. 2: In the Land of the Blind.
A San Jose investor, Michael Burry, looking forways to bet against subprime mortgagelending, solicited the interest of GoldmanSachs, Morgan Stanley, Deutsche Bank,Bank of America, UBS, Merrill Lynch, andCitigroup in credit default swaps onsubprime mortgage bonds (26-31). Alonely, obsessive, reclusive characterwith a glass eye (31-34). A doctor, hefound his own approach to "valueinvesting" (35-37). His blog becamewell-known; he quit medicine andsuccessfully founded Scion Capital (37-47). Burry's investing in credit defaultswaps on subprime mortgage bondsrevealed that their "market made nosense"; banks were indifferent at hischerry-picking the worst bonds to betagainst (47-54). But investors wereskeptical of his strategy when theylearned about it (54-57). Then, inNovember 2005, Deutsche Bank (GregLippmann) and Goldman Sachs showedan interest in buying his positions (58-60).
Ch. 3: "How Can a Guy Who Can'tSpeak English Lie?"
Because the bondmarket is largely unregulated, involvesinstitutional investors, and is mostlyopaque, "[a]n investor who went fromthe stock market to the bond market waslike a small, furry creature raised on anisland without predators removed to a pitfull of pythons. . . . The bond marketcustomer lives in perpetual fear of whathe didn't know" (61-62). Greg Lippmann,a shockingly frank bond trader,approached Steve Eisman (62-68). Theparty on the other side of the creditdefault swap transactions was AmericanInternational Group (AIG), which came upwith a way to "insure . . . subprimemortgage loans . . . without having todisclose to anyone what it had done" (69;68-70). "In a matter of months, AIG FP,in effect, bought $50 billion in triple-B-rated subprime mortgage bonds byinsuring them against default.. And yetno one said anything about it" (71).Goldman Sachs devised a collateralizeddebt obligation (CDO) "to disguise therisk of subprime mortgage loans," thusallowing them to be "re-rated as triple-A"(72-73). The essence of this sleight of hand was that "By assuming that one pileof subprime mortgage loans wasn'texposed to the same forces as another—that a subprime mortgage bond withloans heavily concentrated in Floridawasn't very much like a subprimemortgage bond more concentrated inCalifornia—the [financial] engineerscreated the illusion of security (74; 74-78). Instead of feeling qualms, otherbanks felt "something like shame thatGoldman Sachs had been the first to findthis particular pay dirt" (78). InNovember 2005, Greg Lippmann of Deutsche Bank briefly convinced AIG thatthey were being played for fools (79-84).
Ch. 4: How to Harvest a MigrantWorker.
Gene Park figured out that thecredit default swaps AIG was bying were95% subprime, but the dictatorial CEO of AIG, Joe Cassano, resisted the news (85-
 
89). Deutsche Bank was demanding thatin order to be allowed to keep hisexpensive short position, Greg Lippmannhad to prove other investors wereinterested, so approached Steve Eisman(90-95). It took Eisman and Danielmonths to figure out how the ratingagencies were being gamed by tacticslike manipulating borrowers' FICO scores(creditworthiness ratings) (95-103).
Ch. 5: Accidental Capitalists.
GregLippmann's pitching the idea led 10-20people "to bet against the entiresubprime mortgage market and, byextension, the global financial system"—including John Paulson, a New York hedgefund manager (105; 104-06). Paulsonmarketed the idea as "a cheap hedgeagainst the remote possibility of catastrophe" (106). The people who sawwhat was happening "were, almost bydefinition, odd. But they were not all oddin the same way" (107). The sardonicallytold story of the three odd people behindCornwall Capital's success in "event-based investing" (108-25). Withoutreally being able to understand whatthey are doing, they took a $110 millionposition in CDOs (125-35).
Ch. 6: Spider-Man at The Venetian.
In Las Vegas in January 2007, Eismanmet Wing Chau, a CDO manager, andrealized his credit default swaps werebeing used to synthesize more CDOs(143; 136-44). Charlie Ledley and BenHockett of Cornwall Capital at the LasVegas event sensed that the collapse of the market would be soon and try to bymore credit default swaps (144-50). There were 7000 people making moneyoff subprime mortgages at theconference (151). Eisman and hisassociates wondered at the absurdity of the situation and at the mediocrity of theratings-agency personnel (151-57).Unsure of the proportions of morons tocrooks, they subsequently doubled theirshort position in subprime mortgagebonds to $550 million and also shortedstock in Moody's (157-59).
Ch. 7: The Great Treasure Hunt.
When Cornwall Capital tried to increasetheir short position, they ran intoinstitutional resistance, though $50billion more in new CDOs were createdand sold between February and June2007—a final squeeze from a rottenorange (160-66). Then Bear Stearnscollapsed (166-67). Eisman discoveredthose running both ratings agencies andbanks were delusional—or even "dumb"(167-74). Eisman shorted Merrill Lynch(175). To contradict Ben Bernanke'sSenate testimony, Eisman hosted aconference call predicting larger losses;an article in
Grant's Interest RateObserver 
confirms his belief (175-78).
Ch. 8: The Long Quiet.
Dr. Burry, thefirst to understand the subprimemortgage problem, discovered he hadAsperger's Syndrome when his sonstarted displaying the same symptoms(179-83). Being right proved to be anordeal for Burry, but one that finally paidoff in 2007 (183-99).
Ch. 9: A Death of Interest.
In thischapter, Lewis goes back in time anddescribes the development of the CDOsin Morgan Stanley's asset-bonddepartment (on their early history see254) and the creation of essentiallyfraudulent credit default swaps by HowieHubler (who was allowed to set up a"proprietary trading group" called GlobalProprietary Credit Group, or GPCG); thesecredit default swaps were designed to bebets almost certain to pay billions of dollars; the essence of the scheme beingthat "[t]he pretense that these [subprimemortgage] loans were not all essentiallythe same," and thus not all likely todefault at the same time —Huber, wholost more money than any trader in thehistory of Wall Street (about $9 billion[215]) actually "trusted the ratings" of the ratings agencies, and gambled that

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