The Biggest Lesson From The Big Short
Investors should understand how to profit from up and down markets... This book tells you exactly how smart investors did this in 2007 - 08
What Is The Big Short?
The Big Short: Inside the Doomsday Machine is a non-fiction book by Michael Lewis about the build-up of the housing and credit bubble during the 2000s. The book focuses on several investors who recognized the potential for the bubble to burst and bet against the housing market. This position that these investors took in 2007 - 08 was referred to as "the big short."
The book tells the story of these individuals and the events leading up to the financial crisis, explaining complex financial concepts in an accessible way for a general audience. It also explores the role that greed, hubris, and a lack of oversight played in the crisis. The Big Short was a best-seller and was made into a successful movie in 2015.
It follows Michael Burry (Christian Bale), Mark Baum (Steve Carrell), Jared Vennett (Ryan Gosling) and Charlie Geller, Steve Eisman and Jamie Shipley (Brad Pitt) as they discover the poorly structured high-risk loan securities that have been given AAA ratings by credit rating agencies, repackaged and resold in highly questionable ways.
All investors should read and understand this story. It's an important lesson in spotting bubbles and unfettered manias in investment markets. And most importantly, how to take a reasonably sized bet with an asymmetric payoff. This trade is the quintessential Barbell Alpha investment. These guys risked a little to make a lot.
Understanding The Big Short
The housing market bubble that led to the global financial crisis was fueled by a number of factors, including excess speculation and the creation of complex financial instruments that made it easier for people to speculate on the housing market. Here are a couple examples from The Big Short that illustrate excess speculation in the housing market:
The creation of mortgage-backed securities (MBS): One key factor that contributed to the bubble was the creation of mortgage-backed securities. These are financial instruments backed by bundles of mortgage loans. These securities were created by banks and sold to investors, who believed they were low-risk investments because they were backed by real estate. However, the securities were actually quite risky because they were often backed by subprime mortgages, which were given to borrowers with poor credit. As housing prices began to decline, many of these borrowers defaulted on their loans, leading to the collapse of the mortgage-backed securities market.
The rise of subprime lending: Another factor that contributed to the bubble was the rise of subprime lending. This is the practice of giving mortgage loans to borrowers with poor credit. These loans often had high interest rates and risky terms. As expected, many borrowers were unable to make their payments. As the subprime mortgage market grew, housing prices soared, leading to excess speculation in the market. When the housing market eventually collapsed, many subprime borrowers defaulted on their loans, leading to the collapse of the mortgage industry.
Michael Lewis showed the excess in borrowing in a couple ways. But perhaps the most vivid example from the book was the adult entertainer from Miami. While at a gentlemen's club, the entertainer told the investor (I think it was Burry, but I can't remember for sure) that she bought 5 houses and was able to get loans for each of them.
Also rampant during the time were what are called NINJA loans. These are No Income, No Job Applications. The borrower inevitably defaulted under an enormous load debt. But banks made these loans because they figured they'd make more on the upside of the underlying real estate during a foreclosure sale.
But like all good bubbles, things come to an end.
Michael Burry of Scion Capital and Jared Vennett realize the housing bubble will burst, leading to the collapse of the US economy. Charlie Geller and Jamie Shipley make a fortune on their bets against mortgage-backed securities when the housing market collapses.
Burry produced nearly 500% returns for investors who stay with him through the duration of the housing market's collapse.
How Burry Did It
He paid close attention to credit default swaps. CDS's offered fixed terms of repayment that allowed investors to potentially make much greater returns than their initial investment should the company in question go into debt within the given period. We can think of these as an insurance contract against mortgages defaulting.
At the start, when Burry got involved in this, no one could purchase credit default swaps on subprime mortgage bonds. They weren't a thing. But Burry got investment banks to create these for him.
Burry was cautious when selecting credit default swaps from banks not as prone to the mortgage bond market's collapse, so he had a lower risk of them becoming insolvent and being unable to make payments when those bonds went bad. One bank in particular he selected was Deutsche Bank.
And this proved prescient as the bank was able to buy back the CDS from him at much higher prices. And as we mentioned above, his payoffs were huge.
The End Game
I'm sure most of us remember the carnage brought upon the markets from the housing collapse. It ended well established investment banks Bear Stearns and Lehman Brothers. These banks unwittingly became to levered up on MBS and other instruments like collateralized debt obligations (CDOs). And when the subprime mortgage bond market collapsed, these institutions collapsed with it.
Michael Lewis's The Big Short is a great reminder that Wall Street greed always ends poorly - with investors and banks losing billions of dollars.
But the more impressive lesson comes from following the central characters in the book. People like Michael Burry, Steve Eisman, and John Paulson. These guys all saw the impending housing market crash in the marking and positioned themselves to profit from it.
These guys are all smart people, but it didn't take a genius to know that excess growth in subprime loans and the huge derivative markets surrounding these new financial instruments would blow up. We saw this last year with the cryptocurrency markets. The money was coming too easily. And now we know why... it was all a house of cards. And anyone shorting crypto last year also made a lot of money.
Spot the bubble, make money from the trend on the upside, but then use some of those profits to position yourself for the bubble bursting. It is possible to make money when the markets go up AND down.
To fully learn these lessons, I highly encourage everyone to read the book. And if you'd like to support the blog please purchase the book through this link.
Who Is Michael Lewis
Michael Lewis’s 1989 book Liar’s Poker cast a lurid light on Wall Street bond-trading house Salomon Brothers. In his new book The Big Short, Lewis presents the division in financial markets between two character types: the bull and the bear. The Big Short is an account of the greatest financial fraud since the 18th century, which occurred when the market Wall Street created in housing debt of very poorest Americans fell to bits in 2007 and all but engulfed the world in 2008.
Michael Lewis is a journalist who has made a name for himself by exposing the inner workings of Wall Street. His book The Big Short, which was later adapted into a movie, detailed the events leading up to the 2008 crash and the people who profited from it. Lewis' work has been praised for its ability to make complex financial concepts accessible to readers without sacrificing accuracy.
In his New York Times bestseller Panic: The Story of Modern Financial Insanity, Lewis examines five major financial upheavals and their underlying causes. Through anecdotes and humor, he paints an accurate picture of what happened before each event and analyzes what actually happened in hindsight. Greed is identified as the first deadly sin when it comes to markets, as it leads to underpricing of risk and eventual catastrophe. Michael Lewis' work serves as an important reminder that Wall Street should not be trusted blindly; instead, we must remain vigilant in order to protect ourselves from another financial crisis.
The 2008 global financial crisis was a devastating event that shook the world economy and left many people reeling. The cause of the crisis was largely attributed to Wall Street firms turning subprime mortgages into toxic financial products, enabled by ratings agencies that were supposed to police risk. While most financial institutions and government regulators failed to foresee the meltdown, there were a few investors who managed to anticipate it and make a fortune off it.