The Big Short

The Big Short, Michael Lewis' new book on the subprime mortgage crisis, was already timely.  The recession caused by subprime mortgages and the multiple bets for and against the bonds created from them is only now officially lifting, and the impact is still being felt with high unemployment and struggling markets.

Then the SEC filed fraud charges against Goldman Sachs this week, and the whole book looks a little different.

The Big Short is about some investors, mostly small hedge funds, who made money by going "short" or betting against the success of bonds created from subprime mortgages.  The fraud charges against Goldman Sachs came from transactions similar to those described in the book, although the specific Goldman trade is covered more thoroughly in Gregory Zuckerman's The Greatest Trade Ever, which I haven't read (yet). 

The ins and outs of the trades can be better described by professionals, but the short (no pun intended) version is that banks like Goldman Sachs packaged groups of mortgages into bonds so that they could be sold and traded.  The thought on Wall Street was that the bonds were not terribly risky because they were made of many different mortgages (or pieces of mortgages) from different areas of the country, meaning they were diverse.  A few investors thought, correctly, that the housing market was being fueled by inflated house valuations, and if house prices didn't continue to go up, people with adjustable rate subprime mortgages wouldn't be able to refinance when their rates went up.  Those investors essentially took bets that the mortgages would fail with the Wall Street banks, and the banks either took the "long" side of the bets or passed that risk along to companies like AIG or other investors, often organizations (like pension funds) that were required to make conservative investments.

The fraud charges from the SEC give the stories from Lewis and Zuckerman another dimension.  One way you can read The Big Short is as the story of plucky underdogs who saw that disaster was imminent and unavoidable and figured out ways to make money from it, enduring mockery until their bets paid off.  The other way is to see it as people who made money at the expense of less sophisticated investors, possibly due to criminal activity.  While Wall Street firms lost a lot of money being long on subprime mortgage bonds, the charges from the SEC say that once Goldman Sachs realized that they were on the wrong side of the crisis, they dumped massive amounts of risk onto less sophisticated investors by deceiving them about the origin of those soon-to-be toxic assets.  What's interesting is the "shorts" who made money as a result of these transactions are not under investigation; Goldman Sachs is in trouble for allegedly lying to their investors about how the specific mortgages were chosen and weren't upfront that the asset was being put together solely so John Paulson could bet against it. 

I really enjoyed The Big Short, and I think I'd like to read The Greatest Trade Ever.  I would recommend picking up one or the other if you want to better understand subprime mortgages, collateralized debt obligations, and credit default swaps.  The Amazon ratings are higher on TGTE, but a lot of that seems to be caused by a bunch of low ratings frankly whining that TBS isn't available on Kindle*.  What I do believe from reviews I've read is that TBS less scholarly and more character driven, while TGTE is an in-depth, investigative report on one trade by one man--the one trade being the one that the SEC is now alleging was fraudulent.  I'll agree that TBS is not big on technicalities and skims over some of the negative impact, but it's very readable and I definitely understand more about the crisis that sunk the economy worldwide, resulted in billions in bailouts to banks, and led to the unemployment of friends and family.  I think the recession was personal to everyone, and it's important to learn more about how it happened. 

*I highly recommend reading the 1 star Amazon ratings for entertainment value.  Some are legitimate concerns (not technical enough, too sympathetic to opportunistic investors), some are personal (Lewis is honest that he is not an investment advisor, but some reviews criticize him for contradicting something he said a few years ago about derivatives), but many are about the lack of a Kindle edition.  People complain that the lack of a Kindle edition is tantamount to segregation in the American South, that bookstores should set up garbage cans so people can throw away hard copy Michael Lewis books in protest, and that it might as well be published on post-its, written in crayon.  Which then leads to joke bad reviews that it is not published in Na'vi or serially in a magazine like a Dickens novel.  The interweb is funny.