Book Summary: The Big Short by Michael Lewis

Book Cover for The Big Short by Michael Lewis

This summary of The Big Short: Inside the Doomsday Machine by Michael Lewis explains what exactly went down during the 2007 Global Financial Crisis (GFC), the causes of the crisis, and how a few people managed to profit from it.

Note that my summary differs from the book, which is more narrative and focuses on the journeys of the characters who actually shorted the market. My summary, by contrast, focuses more on the facts of what happened, and refers to some of the stories to illustrate.

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Key Takeaways

  • What happened in the GFC?
    • Thousands of borrowers took out home mortgages when they did not have the incomes to repay them.
    • These loans were bundled up together into collateralised debt obligations (CDOs) and sold to other investors. In other words, the banks making the loans passed on the risk of default to other people.
    • The ratings agencies gave the CDOs higher credit ratings than they should have. In some cases, they even gave AAA ratings (the highest rating possible, generally only available to ‘riskless’ investments like government bonds).
  • The problems:
    • Moral hazard. Mortgage lenders didn’t bother doing due diligence on the borrowers because they just passed the risk onto other investors.
    • Complexity. CDOs were very complex, and few people — including the ratings agencies — understood how they really worked. The investors who bought CDOs put too much faith in the ratings.
    • Conflict of interest. The ratings agencies earned fees from the banks selling the products, so were incentivised to give them good ratings.
    • Correlated risk. The instruments were much riskier than their ratings suggested, because the ratings agencies did not appreciate that underlying risk was all correlated. That is, the circumstances that lead one borrower to default (e.g. rising interest rates or falling house prices) are likely to lead other borrowers to also default.
  • A few actors — Michael Burry, Steve Eisman and Cornwall Capital (Charlie, Ben and Jamie) — realised what was happening and tried to “short” these mortgage bonds. Lewis takes us through their journeys in detail.
  • It took a long time for everything to collapse:
    • It took a while for borrowers to default. The underlying mortgages had low interest rates for the first few years before increasing. When house prices were rising, borrowers could refinance when their low ‘teaser’ rate expired.
    • The market for credit default swaps was very opaque and illiquid, so banks stayed in denial for months even as defaults mounted.
  • Many people did not end up bearing the costs of their bad decisions.
    • The traders and CDO managers buying the subprime assets made a lot of money before everything collapsed — and often got to keep that money when they did.
    • Wall Street firms and AIG did suffer losses, but the government also bailed out many of them.
    • The CEOs and staff of the big firms didn’t end up paying much of a price for their risky gambles, which effectively meant the taxpayer ultimately bore the cost.

Detailed Summary of The Big Short

What happened in the GFC?

Basically, thousands of borrowers took out loans that they could never really afford to repay. The lenders never did their due diligence on the borrowers because they managed to pass the risk of default onto other investors.

Mortgage bonds would pool together a bunch of home loans and carve up the loan payments into tranches. The bondholder with the first tranche would get hit with the first wave of defaults, so would receive the highest interest rate. The bondholder with the second tranche took the next wave of defaults and would get the second highest interest rate, and so on.

Wall Street banks then took the riskier tranches from various mortgage bonds and repackaged them into collateralised debt obligations (CDOs). The ratings agencies didn’t really understand what was underlying these CDOs and gave them much higher ratings than they should have — in some cases, AAA (the highest rating).

Eventually, a lot of borrowers did default, and the house of cards tumbled down. As explained below, however, this took quite a while to unravel.

What were the underlying causes of the GFC?

There were many:

  • Moral hazard;
  • Complexity of the mortgage bonds and CDOs;
  • False confidence as a result of the high credit ratings;
  • Conflict of interest; and
  • Lack of regulation.

[Note that while Lewis does address all of these causes throughout his book, he doesn’t list them out like I do here. There is some overlap between these causes and you could sensibly categorise them in different ways.]

Moral hazard

“Moral hazard” is just a fancy term for when the person taking a risk doesn’t actually bear the costs of that risk. They therefore have the incentive to take bigger risks.

The subprime lending industry was fraught with moral hazard. Because the lenders sold many of the loans they made to other investors in the form of mortgage bonds, they didn’t have to worry about whether the borrowers would repay the loans. Lewis gives the example of a strawberry picker who didn’t speak English, with an income of $14,000, managed to borrow $724,000 to buy a house.

The fact that Wall Street firms were public corporations that took risks with other people’s money also created a moral hazard. Before 1981, all the investment banks were private partnerships. When Salomon Brothers became Wall Street’s first public corporation in 1981, the partners/managers of the firm transferred the ultimate financial risk from themselves to the firm’s shareholders. But the shareholders didn’t really understand what risks the firms took.

The focus then shifted from servicing customers or allocating capital to productive businesses to making complicated bets that would only pay off in the short-term.

I doubt any partnership would have sought to game the rating agencies, or leapt into bed with loan sharks, or even allowed mezzanine CDOs to be sold to its customers. The short-term expected gain would not have justified the long-term expected loss.
— Michael Lewis in The Big Short


Few people really understood the mortgage bonds and CDOs they sold or bought. Bond market terminology seemed designed to bewilder outsiders. For example, the bottom tranche of a CDO (the riskiest floor) was the “mezzanine” or “mezz”. The most creditworthy borrowers got the designation “A”. “Alt-A” then referred to crappy mortgage loans that didn’t even have documents to verify the borrower’s income.

Every mortgage bond had a 130-page prospectus, but hardly anyone read the fine print. CDOs were even more complex and opaque, as each CDO contained pieces of a hundred different mortgage bonds (which in turn held thousands of different loans).

The information that was available were just high-level, aggregate measures. Even the ratings agencies had no view of the individual loans. For example, an individual’s FICO score is a measure of their creditworthiness. The ratings agencies just looked at the average FICO score for a pool of mortgages, and didn’t distinguish between “thin-file” and “thick-file” FICO scores. A “thin-file” score meant only a very limited credit history was available, but immigrants or young people could have surprisingly high FICO scores even if they weren’t actually very creditworthy.

False confidence as a result of the high credit ratings

Complexity by itself may not be such a problem if everyone knew what they didn’t understand. However, Moody’s and S&P gave AAA ratings to roughly 80% of all CDOs. The high credit ratings gave everyone a false sense of security.

Getting the ratings agencies to re-rate risky securities as AAA was very profitable. Wall Street firms apparently employed people whose entire job was to game the rating agencies’ models. And they were ripe for exploitation. For example, the models assumed that the default risk was not affected by whether the interest rate was 8% or 12%.

Somehow, roughly 80 percent of what had been risky triple-B-rated bonds now looked like triple-A-rated bonds. The other 20 percent, bearing lower credit ratings, generally were more difficult to sell, but they could, incredibly, simply be piled up in yet another heap and reprocessed yet again, into more triple-A bonds.
— Michael Lewis in The Big Short

Another major blind spot in the models was that they saw the default risks as only about 30% correlated. This was why CDOs, which comprised the riskiest tranches from various mortgage bonds, got such high credit ratings. In reality, the subprime mortgage loans were all exposed to largely the same risks — correlation was closer to 100% than 30%.

Conflict of interest

The rating agencies earned fees from the Wall Street banks based on the number of products they rated for them, so their incentive was to increase the number of products rated. This got in the way of them demanding the information they needed to properly rate the bonds. S&P seemed worried that if they demanded too much information, the banks would just go to Moody’s for their ratings.

It wasn’t a fair fight, either. Wall Street traders were graduates from top Ivy League schools, making 7 figures a year. Rating agency analysts’ salaries were in the high 5 figures. They were timid, fearful, and risk-averse. Those who could get a job on Wall Street did; those who couldn’t worked for the rating agencies.

Several of the players who shorted the market wondered whether the people in the rating agencies were “morons” or “crooks”. One (Vinny) concluded there were more morons than crooks, but the crooks were higher up.

Lack of regulation

While the stock market was heavily regulated because there were millions of small investors in the stock market. The bond market was much bigger, but operated like the wild west:

An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons.
— Michael Lewis in The Big Short

This was because the bond market mainly consisted of large institutional investors. As a result, the populist pressures pushing for regulation did not exist.

People who saw it coming

Lewis takes us through the personal journeys of several people who saw the GFC coming and profited greatly from it. The key ones were: Michael Burry, Steve Eisman, and the people at Cornwall Capital. [I’m going to focus on Burry and Cornwall Capital.]

But, first, let’s talk about how they actually pulled off the “short”.

How they did the short

“Shorting” a security or a market means betting against it — i.e. you expect its price will fall. When Michael Burry first saw the risks that subprime mortgages posed, he didn’t have a way to short them. He had to pester the big Wall Street banks into creating credit default swaps on the subprime mortgage bonds.

Credit default swaps were like insurance policies and already existed in other markets, usually for corporate bonds. This is how they worked:

  • You pay, say, $200k each year to maintain a 10-year credit default swap on $100 million of General Electric bonds.
  • If General Electric defaults on its bonds anytime in the next 10 years, the credit default swap would make up for the default. So the maximum upside was $100 million, if GE defaulted completely.
  • If General Electric does not default at all, you got nothing. So the maximum downside was $200k per year for 10 years = $2 million.

The initial purpose of swaps was to hedge risk, but they soon became tools for speculation.

Michael Burry and Scion Capital

Michael Burry, the first guy who got wind of what was happening in the mortgage bond market, was originally a doctor. He started blogging about financial markets whilw he was working 16-hour shifts during his medical residency.

Eventually, he started his own investment firm, Scion Capital, with his own money and some of his family’s. Burry made sure to structure his compensation so that his incentives aligned with his investors’. Hedge fund managers usually took 2% off the top of assets under management, meaning their compensation didn’t depend on how the investments performed. Scion, by contrast, charged investors its actual expenses (typically well below 1% of assets) and only made profits if they could grow investors’ money.

Scion Capital’s record was impressive:

  • 2001 (the first full year): Scion was up 55% while the S&P 500 fell 11.88%.
  • 2002: Scion was up 16%, while the S&P 500 fell 22.1%.
  • 2003: Scion was up 50% while the S&P 500 rose 28.69%.

By the end of 2004, Burry was managing $600 million and turning away investors.

Burry’s general investment strategy was a pretty vanilla “buy and hold” strategy. He just read financial statements and bought common stocks. He didn’t use leverage and avoided shorting stocks. It was just one guy in a room, poring over publicly available information and data. The credit default swaps were a departure from this usual strategy.

Burry’s short

Burry bought credit default swaps on the BBB-rated bonds and tranches. He started buying swaps in May 2005. By July, he had swaps on $750 million in subprime mortgage bonds.

To maintain the swaps, Burry needed to make regular premium payments to keep them — just like a regular insurance policy. The problem was that it took a while for the loans to go bad, and he had to keep paying premiums in the meantime. During 2006, Scion lost 18.4%, while the S&P had risen by more than 10%. Scion’s investors weren’t thrilled.

Unlike most hedge funds, Scion didn’t let investors remove their money on short notice. Initially, Burry also told investors very little about what he was up to. But when returns started faltering, investors started demanding monthly and even fortnightly reports. Despite Scion’s impressive track record, investors doubted the wisdom of Burry’s bets and questioned whether he should stick to buying stocks.

Because Scion didn’t charge the usual 2% management fee, there was no buffer when they didn’t make a profit. To keep his credit default swaps, Burry had to fire half of his small staff. He then changed his fee policy — which made investors angry with him again. Eventually, he took the drastic step of restricting investors’ ability to withdraw their own funds until the swaps paid off. Some investors then threatened to sue.

Burry’s bets started paying off in the second half of 2007. By June 30, 2008, any investor who had stuck with Scion Capital from its beginning, had a gain (after expenses) of 489%. The S&P 500 had returned just 2% over that same period.

Despite all this success, none of the investors came back or apologised. In fact, investors clambered to request back their money as soon as they could, and no new investors called. On 12 November 2008, Burry wrote to investors explaining that he’d decided to close down Scion.

Cornwall Capital Management (Charlie, Jamie and Ben)

Cornwall Capital was the plucky underdog who struggled to be taken seriously by the big firms. They started with just $110,000 in capital, and grew this to $30 million. But that was still not enough for Wall Street, where you need at least $100 million to be taken seriously.

General investment strategy

Cornwall Capital made use of options and looked for opportunities where the market substantially mispriced risk. This often occurred because the Black-Scholes option pricing model favoured by Wall Street contained some strange assumptions.

For example, the model assumes future stock prices follow a normal, bell-shaped distribution. If Capital One traded at $30 a share, the model assumed that, over the next two years, the stock was more likely to get be worth $35 than $40, and so on. But sometimes, that stock was much more likely to be worth $60 than $40, because the value of a stock hinged on some upcoming event (e.g. a court date) that would make the stock worth either $60 or $0. So the model may price the right to buy Capital One’s shares for $40 at $3, which would be an incredible bargain.

Buying options allowed Cornwall Capital Management to take big bets with limited potential downside. Their strategy was to look for long shots — cases priced like 100:1, with true odds of 10:1. In the Capital One example, they bought 8,000 options for $26,000, which later became $526,000. They called this “event-driven investing”.

Of course, not all their bets paid off and overall, they had more losers than winners. But when they did win, the size of the winners dominated the losses.

They shorted double-A CDOs

Cornwall Capital bet against the least risky tranches of the CDOs, in line with their general strategy to look for “long shots”. Initially, Cornwall Capital they thought the odds of default might be 10:1, though the market was pricing it like 200:1.

Their strategy was a lot more profitable than Burry and Eisman’s, because insurance on a “safe” AA tranche was cheaper. Instead of paying 2% a year in ‘premiums’, they paid around 0.5%.

Cashing in on the bets

Bear Stearns sat on the other side of 70% of Cornwall Capital’s $205 million of credit default swaps. So Cornwall had a lot of exposure to risk of Bear Stearns failing.

Cornwall Capital did two smart things here:

  • In March 2007, they bought insurance from HSBC against Bear’s collapse. The risk seemed so farfetched that they got a very good rate for it — less than 0.3%. They’d put down $300,000 to make $105 million.
  • On 1 August 2007, shareholders in the subprime-backed hedge funds brought their first lawsuit against Bear. Cornwall then rushed to offload their credit default swaps. They had paid about $1 million to hold $205 million in credit default swaps. Banks were now offering $60 million, and did not seem to price the risk of Bear Stearns failing at all.

The collapse

Time lag before defaults start

The subprime mortgage loans that went bad in 2007 had been made years earlier. Although the loans were unaffordable from the start, it took a while for defaults to happen because:

  • Most loans were fixed at an artificially low ‘teaser’ interest rate for the first 2-3 years, before it became a floating rate.
  • Borrowers could also refinance after the teaser rate expired, as long as house prices kept rising.
  • The mortgage bonds went bad months after the underlying loans went bad, after a lot of foreclosures and forced sales. With CDOs, there was an extra delay as the trustee sorted out the funds from the various bonds.

Time lag after defaults started

Lewis also points out that it took some time for Burry, Eisman and Cornwall Capital to cash in their short positions, because there wasn’t a liquid market for credit default swaps. The investment banks could dictate the “market price” for the swaps, and the banks lived in denial for a long time. All bad news about the housing market or economy was dismissed as irrelevant. The Wall Street firms would also make excuses, blaming systems failures, staff sickness, etc.

At the end of every month, for nearly two years, Burry had watched Wall Street traders mark his positions against him. That is, at the end of every month his bets against subprime bonds were mysteriously less valuable. The end of every month also happened to be when Wall Street traders sent their profit and loss statements to their managers and risk managers.
— Michael Lewis in The Big Short

Even after defaults started, there were huge discrepancies between the prices at which banks were willing to sell new credit default swaps and their quotes for existing swaps. There were similarly large discrepancies between what banks sold CDOs for (par value), what an index comprised of the same CDOs traded for on the market (half par), and what the underlying subprime bonds making up the CDOs traded or.

One view was that the banks were trying to prop up the price of CDOs to give themselves enough time to offload their own exposure onto unsuspecting customers, or make a last few billion before the market collapsed. Between February and June of 2007, Wall Street created and sold $50 billion in new CDOs.

Another view was that the banks genuinely misunderstood their own trade. For example, Morgan Stanley refused Deutsche Bank’s offer to exit its $4 billion bet several times on the way down. At first, they offered Howie Hubler (discussed below) the chance to exit at a loss of $1.2 billion. The second time, the price had risen to $1.5 billion. Each time, Hubler or one of his traders argued about the price, and didn’t take the opportunity to exit. They did this all the way down.

Eventually, of course, the defaults got too large to ignore, and everything crumbled.

The size of the collapse

From the end of 2005 until the mid-2007, Wall Street firms created between $200 and $400 billion in subprime-backed CDOs. Much of it was held off balance sheets.

The ability to make “side bets” on the market via financial derivatives meant that the gains and losses associated with subprime mortgage lending could exceed the actual loans made. To make a billion-dollar bet, you didn’t need a billion dollars’ worth of actual mortgage loans. You just had to find someone willing to take the other side of the bet.

The IMF put losses on US-originated subprime-related assets at a trillion dollars.


The US Government stepped in to bail out some of the firms that had made dumb bets:

  • Bear Stearns — the government provided financial incentives to encourage JP Morgan to buy it (e.g. guaranteeing Bear Stearns’s riskiest assets).
  • Fannie Mae and Freddie Mac — these government-sponsored entities were promptly nationalised.
  • AIG — the Federal Reserve gave it a loan of $85 billion (later expanded to $180 billion). It did charge a lot for the loans, though, and took most of the equity.
  • Washington Mutual — the government took control of it and wiped out its creditors and shareholders.
  • Wachovia — the government encouraged Citigroup to buy it, again by providing financial incentives.

By late September 2008, US Treasury Secretary Henry Paulson persuaded Congress to give him $700 billion to buy subprime mortgage assets from banks, pursuant to his proposed Troubled Asset Relief Program (TARP).

However, Paulson abandoned this strategy once he got the money and instead, as Lewis puts it, “essentially began giving away billions of dollars to [the banks]”. One example is the government paying off a $13 billion loan that AIG owed to Goldman Sachs in full. Another is the government giving Citigroup $45 billion and guaranteeing over $300 billion of its assets, without asking for a piece of the action or demanding management changes. According to Lewis, the Treasury never even clarified exactly what the crisis was, and just referred to Citigroup’s “declining stock price”.

Later, it became clear that even $700 billion was not enough. The US Federal Reserve then took the unprecedented step of buying subprime mortgage bonds directly from the banks. In doing so, they transferred the risks and losses of over a trillion dollars’ worth of bad investments from Wall Street firms to US taxpayers. Henry Paulson and Timothy Geithner (who were Treasury Secretaries at different points of the crisis) both claimed that the chaos and panic caused by Lehman Brothers’ failure proved that the system could not tolerate another big financial firm failing.

Soon, the events were reframed as a simple “crisis in confidence”, triggered by the collapse of Lehman Brothers. However, Lewis argues this was not a simple, old-fashioned financial panic. The problem wasn’t that Lehman Brothers had been allowed to fail, but that they’d been allowed to succeed.

Many people did not bear the costs of their bad decisions

CDO managers

In theory, CDO managers vetted the mortgage bonds that went into a CDO. They claimed to represent the interests of the investors holding the CDOs because the CDO manager owned the “equity” or “first loss” piece of the CDO. That is, when the subprime loans in the CDO defaulted, the CDO manager would bear the first loss.

However, CDO managers’ incentives were more aligned with the Wall Street trading desks’. CDO managers got a fee of around 0.01% off the top, before investors saw any returns. They received a similar fee off the bottom when their investors got their money back. So CDO managers got paid regardless of what happened to the CDOs.

Lewis talks about one CDO manager, Wing Chau. In one year as a CDO manager, Chau had made $26 million for doing practically nothing. He contributed to the false confidence that investors had in the CDOs — investors felt better buying a Merrill Lynch CDO if it didn’t appear to be run by Merrill Lynch. When the collapse happened, Chau’s CDO managing business went bust. But he still walked away with tens of millions of dollars.

Wall Street firms — and their staff

The story of the Wall Street firms was more complicated. In theory, they were supposed to be middleman, without any skin in the game. From 2006 to early 2007, Burry sent his list of credit default swaps to the banks believing that they’d show the list to potential buyers.

However, it transpired that many of these firms ended up taking positions on Burry’s lists themselves. The higher-ups in these firms didn’t even seem to know this. I found the example of Howie Hubler at Morgan Stanley to be a very interesting case that highlighted just hwo badly Wall Street misunderstood its own risks.

Morgan Stanley and Howie Hubler

Howie Hubler’s mortgage desk at Morgan Stanley made a lot of money creating mortgage-backed securities. As part of this process, Morgan Stanley had to “warehouse” home loans, temporarily holding them on its balance sheet before the loans could be repackaged into securities and sold off.

To mitigate the risk of warehousing loans, Hubler’s desk held around $2 billion in “bespoke,” credit default swaps. These credit default swaps were one-off insurance contracts, opaque, illiquid, and difficult for anyone but Morgan Stanley to price. They were virtually guaranteed to pay off — a full payoff only required losses of around 4%, which subprime mortgage loans experienced even in good times.

But the premiums on Hubler’s $2 billion credit default swaps ate into their short-term returns. So Hubler decided to sell some credit default swaps on AAA-rated CDO tranches, to earn some offsetting premiums. Of course, AAA-rated CDO tranches were believed to be much less risky than BBB-rated ones. The premiums of AAA-rated tranches were around 1/10th of the BBB-rated ones, so Hubler needed to sell roughly 10x the amount of credit default swaps in AAA-rated CDO tranches. By January 2007, Hubler had sold credit default swaps on roughly $16 billion worth of AAA-rated CDO tranches.

Morgan Stanley didn’t really question whether Hubler should be allowed to take such a big risk — because they didn’t see it as a big risk:

  • In Morgan Stanley’s risk reports, the swaps were just shown as “triple A” — i.e. they looked as safe as US Treasury bonds.
  • The firm’s value at risk (VaR) calculations didn’t catch them either, because VaR only measured a security’s past volatility, and the AAA-rated CDOs had never fluctuated much in value before.
  • Internal stress-tests only required testing subprime losses of up to 6%, the highest losses in recent history. When the market started turning and they were asked to stress test 10% losses, the result changed from a projected profit of $1 billion to a projected loss of $2.7 billion.

Losses in the relevant pools eventually reached 40%, leaving Morgan Stanley with a over $9 billion in losses. This was the single largest trading loss in the history of Wall Street. (Other firms such as Citigroup and Merrill Lynch lost more, but more as a byproduct of warehousing CDOs in the process of generating them. Hubler’s loss was the result of a simple bet.)

Despite these enormous losses, Hubler walked away largely unscathed. He lost more money than any single trader in the history of Wall Street, yet was permitted to keep the tens of millions of dollars he had made before then.


American International Group, Inc (AIG), an insurance company, sold lots of credit default swaps (i.e. they took the other side of Burry and Eisman’s bets).

AIG Financial Products, a unit within AIG, had sold credit default swaps on corporate bonds since 1998. It was well-suited to do so because of two characteristics:

  • AAA-rated. One problem with swaps is that they require each party to take on the credit risk of the counterparty. With its excellent credit rating, AIG could stand in the middle of such transactions and smooth out the risks.
  • It was not a bank. Banks were more closely regulated and had to reserve capital against risky assets. AIG in contrast could bury lots of risks on its balance sheet without any regulators noticing.

Initially, the consumer loans that Wall Street (led by Goldman Sachs) asked AIG FP to insure only had around 2% subprime mortgages. In just a matter of months, this rose to 95% subprime mortgages. AIG FP rubber-stamped $50 billion of such deals.

Lewis largely lays the blame for this at the feet of Joe Cassano, the boss of AIG FP. Under the previous CEO, debate and discussion was common. Cassano, by contrast, was a bully with a high need for obedience and control. He ran AIG FP like a dictatorship. When someone brought up at a meeting that the consumer loans AIG FP was insuring were much riskier than previously thought, Cassano screamed that he didn’t know what he was talking about.

Cassano did eventually change his mind. By early 2006, AIG FP decided not to sell any more credit default swaps. At the time, traders inside AIG FP thought this would shut down the subprime mortgage market completely, but Wall Street was able to find other investors to insure the loans.

Moreover, despite AIG FP’s changed stance, it didn’t offload the $50 billion worth that it had already sold. As a result, it suffered large losses in the collapse and would have failed had the US Government not bailed it out.

The CEOs

The CEOs of every major Wall Street firm ended up on the wrong side of the bet, but none of them paid a price for it. A few were fired for their roles in the subprime mortgage failure, but most remained in their jobs. These same CEOs later worked with government officials to try to figure out how to solve this mess.

When Eisman met with Wall Street CEOs, he’d ask them the most basic questions about their balance sheets. He soon discovered they didn’t know their own balance sheets, and decided to short the shares of Bank of America, UBS, Citigroup, Lehman Brothers, and Merrill Lynch, among others.

The big Wall Street firms, seemingly so shrewd and self-interested, had somehow become the dumb money. The people who ran them did not understand their own businesses
— Michael Lewis in The Big Short

Even the CEO of Morgan Stanley, John Mack, widely regarded as being relatively well informed about his bond firm’s trading risks, didn’t fully understand how Hubler had lost $9 billion, even after the fact.

Government officials

Lewis also blames government officials for two things:

  • being asleep at the wheel, not knowing what the Wall Street firms were doing early on. He points out the irony that the people in a position to resolve the financial crisis were the very same people who had failed to foresee it.
  • bailing out the Wall Street firms. He claims that without government intervention, every single one of the CEOs would have lost their jobs. Instead, those CEOs just used the government to enrich themselves.

In particular, he names Treasury Secretary Henry Paulson, future Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke, along with the CEOs of some of the Wall Street firms (Lloyd Blankfein, John Mack, and Vikram Pandit).

Other Interesting Points

  • Some of the warning signs included delinquencies and defaults in other types of consumer loans:
    • In the second quarter of 2005, credit card delinquencies hit an all-time high, even as house prices boomed.
    • “Involuntary prepayments” in the “manufactured housing” sector were very high. (An “involuntary prepayment” is a euphemism for when a borrower has defaulted on their loan, and their collateral is repossessed and sold off to repay the debt. “Manufactured housing” is a euphemism for a mobile home.)
  • Wall Street had a pecking order. Goldman Sachs was the big kid who ran the games in this neighbourhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things.
  • Credit quality usually improves in spring, when people get their tax refunds. So in March and April 2007, the subprime mortgage bond market had actually strengthened a little.

My Thoughts

I wasn’t a big fan of the movie adaptation of The Big Short. I watched it around the time it first came out and revisited it again recently, but both times I found it disjointed and hard to follow. The movie focused more on the collapse—specifically, when defaults started to mount up but banks still refused to reprice the credit default swaps. This was a dramatic period and it looked like some massive fraud was going on. But, in the grand scheme of things, that was really just a minor wrinkle that sorted itself out over time.

Michael Lewis’s book did a much better job of addressing the underlying issues that caused the GFC. Even though I already had a decent understanding of the crisis beforehand, I still came away with a deeper appreciation of what happened. For example, before reading the book, I mostly blamed the rating agencies and their careless ratings. But when Lewis pointed out how the rating agencies were grossly outmatched by the Wall Street firms who actively gamed their models, it made me more empathetic towards them.

I also found the book easier to follow than the movie because Lewis spends enough time with each character for us to get to know them. By contrast, the characters in the movie just felt like a bunch of interchangeable men in suits (my mild form of face blindness likely didn’t help with his).

My main problem with The Big Short was that it is clearly written to provoke a sense of outrage and invites you to blame specific people — namely CEOs and government officials. I generally find this sort of attitude to be counterproductive and divisive. I mean, yes, there were serious failures, but what kind of constraints were those people operating under? Actors like Wing Chau were apparently fully aware of what they were doing but, even on Lewis’s account, most CEOs and government officials seemed guilty of negligence at most. People often hold these unrealistic expectations that leaders and public officials be omniscient when, in reality, they’re just humans at the top of extremely large organisations and they rely on other people to accurately report to them. .

That’s not to say that I think Lewis’s take on the crisis is wrong. I don’t particularly like the idea of bailouts, and the suggestion that the relationship between regulators and regulatees in the US finance sector is too cozy sounds plausible to me. But Lewis’s account just felt unbalanced. It made me sceptical and keen to seek out alternative accounts, such as those written by Henry Paulson or Timothy Geithner.

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What do you think of The Big Short? Do you think Michael Lewis’ portrayal was fair? Share your thoughts in the comments below!

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4 thoughts on “Book Summary: The Big Short by Michael Lewis

  1. Interesting. I read this a long time ago and really enjoyed it, but what I really enjoyed most was the description of the short-sellers’ process and insights. That to me was much more interesting than the approbation distributed out. I really enjoyed following Michae Burry’s investments after the book. If I recall correctly, he invested in things like almond orchards as a way of betting on water rights becoming more valuable, and when I checked that had done really well.

    One interesting thing that came out after the book was published was that TARP actually made money. From wikipedia: “Through the Treasury, the US Government actually booked $15.3 billion in profit, as it earned $441.7 billion on the $426.4 billion invested.”

    (This seems like a very small return over quite a long time period with a huge amount risk, but still – interesting).

  2. Yeah, I started listening to Timothy Geithner’s audiobook after this (not sure if I’ll finish it, at least in audiobook form) and he made that point about TARP too. He also used a firefighting analogy to counter the “moral hazard” arguments – i.e. if a house is on fire, you don’t let it burn down to teach the occupants a lesson about smoking in bed – which I found reasonably compelling. So, arguably, teaching people lessons is more the job of the criminal system than the Federal Reserve – but there are lots of issues bringing criminal cases against white collar criminals. (As an aside – I did a brief internship at an international HK law firm once, and one of the partners shared that the most lucrative areas to get into were maritime law and criminal law, because of the prevalence of white collar crime there. I found that interesting, because criminal law is one of the *least* lucrative areas back home…)

    That’s interesting about Michael Burry’s investment – thanks for sharing. Yeah I liked the part about their strategies as well, particularly Cornwall Capital’s option-based strategy. I might look into options a bit more – I’d always thought of them as being high risk because of their leverage but, in a way, the leverage makes them *lower* risk in that you can make aggressive bets with just a tiny part of your portfolio.

  3. If you are interested in investment stuff, a great book (and one mentioned in The Big Short) is the terribly named *You can be a stockmarket genius* by Joel Greenblatt:

    Several of the characters in the book (the Cornwall capital guys, plus Burry himself I think) got started by reading this book, which, despite the title, is incredibly insightful about how hedge funds etc. actually make money. It covers the mispriced option example you give in the summary (binary outcome mispriced by models that assume a normal distribution).

    Greenblatt himself (as I’m sure you remember) was one of the agitating customers of Burry, asking for his money back. I actually think that the book does him a disservice. He invested with Burry because Burry was a bottom up financial analysis guy, looking at small and midsized companies. If I invested with a guy like that and then he starts telling me the entire US housing market is in a bubble and he’s buying these weird CDSs, I would probably (sensibly) ask for my money back too!

    On options being low risk: you’re right if you size purchases small, but note that a very well-established finding is that deep out of the money options (that is, options that are very cheap but have a high payout, because they require the underlying to move significantly before the option is “in the money” (profitable)) are systematically overpriced.

    That is, if you just blindly buy deep out of the money options, you expect to lose money at a very high rate. Of course, that raises the issue of whether you should sell them. And yes, selling them is profitable, but it’s very risky, because you are collecting very small premiums most of the time, and then having large losses on some of them, so you have to be very careful with size allocation.

    But if you’re interested in that stuff, the Greenblatt book is a great and fun read to see if you’d like to learn more about it.

    1. Thanks for the recommendation! Greenblatt’s book is actually already on my list but I’ve just moved it up now.

      And point taken about blindly buying deep out of the money options. I have no idea if I’ll be any good at options trading at all – either the financial analysis side or the putting aside your emotions side – and I don’t know if I’ll actually do it. But, yeah, I think Greenblatt’s book will be worth reading in any case.

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