Saturday, January 30, 2016

Book Review: The Big Short – Inside the Doomsday Machine

The Global Financial Crisis (GFC) has been as much a mystery to public in general as to the ones responsible for it. The cost of GFC to the world economy is estimated to be around USD 15.0 trillion and affected lives of millions.

There were people who could understand the folly of the markets as early as 2003 and put bets in favor of doomsday. These contrarians earned millions eventually, but were as perturbed by the possible destruction of the whole financial system as all of us.
Michael Lewis in The Big Short: Inside the Doomsday Machine shares three stories where contrarians shorted the sub-prime mortgage bonds market and bought CDS (a type of insurance) betting that the sub-prime borrowers wouldn’t be able to repay the mortgage loans.

Before venturing in these amazing stories lets understand what exactly a Mortgage Bond is. A typical bond is a form of large debt – the mortgage bond basically is a pool of mortgages. Innovative Salomon Brothers further divided mortgage bonds into pieces of tranches which could be traded in the market. These mortgages were extended to credit worthy borrowers and guaranteed by government agencies.
Everything was hunky dory till the time mortgage bonds were put to new use – making loans to the borrowers who didn’t qualify for the government guarantee a.k.a sub prime borrowers. Wait, why would anyone lend to low quality borrowers? It doesn’t make any sense. The answer lies in social justice – income inequality was increasing and institutions took over the great task of social justice by lending to sub-prime borrowers.

Now is the time to meet characters of the story and unfolding of unbelievable turn of events.
Steve Eisman was a great proponent of subprime lending during initial years but was shocked by the malicious accounting practices of subprime lending firms. Eisman was brazen man and always looked for big kill. He became crusader against Household Finance Corporation – largest subprime borrower at the time for its corrupt practices which was later acquired by HSBC!

Next in line is Dr. Michael Burry, a blue blood value investor who could garner USD 1.0 million from Gotham Capital as his first investable capital. He was a recluse and rational fanatic who let go residency in neurology at Stanford University for money management. This was year 2000 and by year 2004 Dr. Burry was managing USD 600.0 million! Dr. Burry found subprime lending unsustainable and side pocketed his clients’ money to buy CDS of mortgage bonds.
The third is about accidental capitalists by the name of Cornwall Capital Management – a company floated by two amateur investors aged 30 with no reason to claim investing talent.

One most important character who single handedly made pitches to hundreds of investors to bet against the mortgage market was Greg Lippiman. Greg strengthened Eisman’s beliefs and motivated Cornwell Capital to bet against subprime mortgage bonds. On other hand, Greg gave headaches to Dr. Burry by his strenuous and noisy talks against subprime bonds. Dr. Burry didn’t want the world to know this once in lifetime idea to make tonnes of money.  
Michael Lewis had intriguingly explained the roles of financial institutions in creation of CDS market for mortgage bonds.

AIG FP was the first seller of subprime bond’s CDS in the market & took short positions of USD 50.0 billion. AIG bosses couldn’t fathom how someone can buy CDS and bet for defaults by sub-prime borrowers!
Moody’s and S&P models to rate the mortgage bonds were riddled with errors. These agencies were rating these subprime loans as AAA bringing capital to this crystal sheen market. No due diligence was being done on loans under mortgage bonds and system was throwing out AAA ratings basis ridiculous data points.

Most of the Wall Street firms looked out and out stupid to Eisman. Many of these firms earlier acted as intermediary between AIG and CDS buyers. Later they started housing the risk in their balance sheets rather than offloading it. Morgan Stanley, Goldman Sachs, Bear Sterns, Meryl Lynch valorously sold billions of dollars of CDS in the market. HSBC took huge losses in subprime lending business through Household finance which they had bought. Eisman, Dr. Burry, Cornwell and few others kept buying CDS from these sellers.
Eisman saw another opportunity – he started shorting shares of institutions like UBS, Citigroup, Lehman brother and few others.

All three protagonists were deep in the money in 2007 when borrowers started defaulting. The biggies of Wall Street took losses of billions of dollars by 2008 nudging many of them close to insolvency.
GFC left indelible mark for the world economy. What lessons did India take from the crises? We experienced a mini-storm in micro-financing sector a few years back when institutions pushed loans to people at bottom of pyramid without doing proper due diligence. Indian banking system is now at an inflection point. The rapid credit growth of previous years has led to tonnes of bad loans for banking system. Financial Institutions has now shifted their focus to retail lending by towing inline with government’s push for financial inclusion. I hope Indian institutions don’t repeat the past mistakes and lend with great sense of responsibility.  

This beauty from Michael Lewis is a good read for all who believe there are opportunities even in adversity.
Read it, devour it!

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