Eighteen Things I Learned from The Big Short by Michael Lewis

  1. Investment banks won’t take you seriously if you aren’t serious money. I had first heard this from a person I knew who had sold his company for $100 million. He described being treated like an afterthought by the big brokerage houses. They preferred to spend their time catering to those who controlled *real* wealth. And this isn’t just a case of preferring working with billionaires to millionaires. It’s preferring to work with people who aren’t necessarily all that wealthy themselves but instead manage the pooled wealth of hundreds of other disparate millionaires. To spell out the consequence, investment banks have a lot of interactions with people who aren’t putting their own wealth at risk.
  2. There are a lot of ways things can break. Holding a credit default swap that serves as insurance on terrible bonds seemed like a great thing, but what if your counterparty is Bear Stearns? There are a lot of possible points of failures. Even a thesis that is 99.9% correct can lose you money.
  3. At an intellectual level, I knew that most trades usually involve at least one party doing something that will work out against them. Lewis demonstrates this in dramatic fashion. It is very, very easy to be the dumb money. There are professionals who are dumb money. They probably aren’t actually dumb people, but they aren’t paying attention to the right things. In some ways, trading seems to be like dropping into on online gaming platform where you are matched against an opponent you know nothing about. How much money are you willing to bet on your winning? For me, the answer is “basically, nothing”, but that is analogously what I’ve been doing this whole time when investing.
  4. The system can make paying attention to the right things difficult. Getting the required information to evaluate the underlying bonds seems to have been very difficult for the heroes of the book despite this being the most important thing about the bonds. Does this mean that the factors that are most important to a company you are investing in are not readily found in the company’s SEC filings? Quite possibly.
  5. “Due diligence” should be accompanied by an eye roll. Practically speaking, “due diligence” means that you went through the minimum steps required so that an outsider will consider you to have done your job. Anytime you hear someone say “we did our due diligence” you should automatically substitute in “You can’t technically prove that we were willfully negligent.” This is something less than an unwavering commitment to finding the truth no matter what.
  6. The pension managers that bought subprime bonds felt they did their due diligence by not just buying whatever the investment banks told them to buy. Practically speaking though, this meant they were just buying from an intermediary whose primary incentive was to maximize the volume of business they did. The best way to do this was to just push through whatever the investment banks were able to send. In trying to be responsible, all the pension managers succeeded in doing was increase their own costs.

    In turn, the investment banks did their due diligence by making sure everything they sold was rated by an independent agency, either Moody’s or S&P.

    S&P and Moody’s did their due diligence by using models that predicted the probability of default. If a crisis ever occurred, they could still prove in court if needed that they did their due diligence in rating the bonds issued. When the idea of suing S&P and Moody’s was floated, it was laughed at with an analogy made to suing Road & Track because their car recommendations didn’t work out well.

    The cover offered by “due diligence”, more than any other factor, seems to be how no one went to prison.

  7. Did it seem capricious and random to you how some banks were saved by one method and others by a completely different one and others not at all? Sometimes only bondholders were saved while shareholders were wiped out. Sometimes both bondholders and shareholders were wiped out. Sometimes the government just poured in billions to save both bondholders and shareholders. If there was a justification for this disparate treatment, it doesn’t seem known to Michael Lewis. I wish there were a villain this could be pinned on because the alternative explanation is that no one really ever knew what the right thing to do was, so they made up everything on the fly.
  8. Options can be mis-priced, even in cases where an event that is likely to significantly influence the stock price is known and has a timeline. This makes sense to me. There are a lot of people who sell covered calls, for example. They pat themselves on the backs for earning extra income above whatever appreciation they might make on the stock. This is the perfect setting for people who want to be arbitrarily picky with what calls they buy.
  9. Apparently, no one reads the fine print on purposefully abstruse legal documents except one very obsessive guy with Aspergers.
  10. Despite however much Warren Buffett is admired, few of his most successful admirers seem to have been able to fill his exact same niche.
  11. Agency costs are hard to avoid. You can pay someone handsomely to manage your money and incentivize them to do well as long as you do well too, but even this doesn’t prevent them from putting you in a situation that will cost you in the long term. By the time the consequences have arrived, they may have taken home millions. The heroes of The Big Short who correctly predicted the subprime crisis don’t seem to have ended up as well off as many of the villains. The Big Short is a tragedy, and that’s its most tragic scene.
  12. Taking ideas seriously is hard. Lippmann, a Deutsche Bank managing director widely circulated his beliefs about the impending crash. This was a person whose primary job was to sell people on ideas, and he failed to sell hardly anyone on his idea. I can imagine that a lot of slide decks from a lot of banks are floating around all the time. Why believe this particular one? Can you accurately differentiate between investment bank slide decks that are conveying important, truthful information and those that are trying to sell you on something that will screw you? It seems to me that most investment professionals must not even trust themselves with that task, and thus did Lippmann fail in his crusade.
  13. Don’t do a deal with an investment bank whose parameters are drawn up by the investment bank. They are almost certainly smarter than you. Yes, you hired lawyers to protect yourself, but their lawyers are smarter than your lawyers. Of course, this probably is true of any deal in which you are less of an expert than the other party, but The Big Short let’s us know that the non-experts can include multi-billion-dollar pension funds. Don’t think you know something just because it is your day job. Especially when there are people whose day job is to know that same thing better than you do.
  14. The investment banks seem to be in the best position to exit at the first hint of a crash. They are information brokers as well. Not everything that is important first appears in some company’s annual report. The banks can thus participate in bubbles while ensuring they get out before their portfolios are worthless.
  15. Don’t trust investment banks to provide accurate pricing. Michael Burry had deals with investment banks that required them to front capital when the contract he bought went his way and for him to front money when the contract went their way. Accordingly, the bank claimed all news that went his direction was irrelevant and all information that went their way required him to front capital. This seems to have been kept up for about a year. Without staying power, Burry could have been badly taken advantage of. In a book that discusses a lot of slimy behavior, I find this to have been the most disgusting and unfair story. Your nicely written fair contract might be implemented in a deeply unfair way.
  16. Don’t trade in markets where there isn’t accurate, publicly-available pricing. If you trade illiquid assets without public pricing, you are either someone whose job is making money off the fact that no one knows what the fair price is or you’re someone who is getting screwed.
  17. A price is only accurate if you can both buy and sell near that price. If someone says their car is worth $10k, one way to determine she is lying is to offer to sell her an identical car for $9k. If the $10k is accurate, she ought to leap at the chance.
  18. All analyses are at least somewhat superficial. Someone might have evaluated a company’s balance sheet and feel they have done a great job of it by examining what assets should be assigned what ratings, but this only works if you believe the ratings. Now, it might seem obvious that you shouldn’t, but it was wholly non-obvious at the time. However little respect anyone had for ratings agencies, few would have guessed that bonds they rated as AAA would ever be in question.

    Next time it won’t be this problem. The analysis will fail along with one of the other 500 unstated assumptions, which will seem equally stupid in retrospect as trusting rating agencies. Does that mean you should just give up on the idea of detailed analysis of complicated things? I wish I could say “yes”, but the heroes of The Big Short figured out what would happen in advance through detailed analysis of a complicated thing. There doesn’t seem to be a substitute.

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63 thoughts on “Eighteen Things I Learned from The Big Short by Michael Lewis

  1. Sometimes I think all of life is just making it up on the fly until you are old and/or dead.

    This was an excellent but depressing summation. I’m reminded of Margin Call where the Bear Sterns-esque entity terminates their Chief Compliance Office and then one of his aides discovers how damned they are. The solution was to sell off all the risk on unsuspecting clients. The junior employees who did this were compensated and told that they would probably be out of the industry for one or two years.

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      • A leash implies that the regulators know where the banks ought to go. Rather than a leash, perhaps a rope with which they tie their own noose. The goal of the regulators then it to make sure that the only one the rope hangs is the single bank.

        We can agree, perhaps, that this last episode gave us neither leashes nor rope, and if the last stress test shows anything, nor protection from dominoes.

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      • I call your attention to this bit:

        Don’t do a deal with an investment bank whose parameters are drawn up by the investment bank. They are almost certainly smarter than you. Yes, you hired lawyers to protect yourself, but their lawyers are smarter than your lawyers.

        So unless the government regulators are even smarter (unlikely), this seems like a recipe for regulatory theater.

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        • The “smarter lawyers” thing regarding regs has never really impressed me. Regulators can regulate pretty well if they have power to get the regs they want. The problem with the gov regulators seems more that the pols who direct them are bought and sold and sometimes that the regulators will want jobs from those they regulate. Smart doesn’t play into those things.

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          • Not really. Regulators are a lot like the police, in that we could get perfect compliance if we gave the police absolute authority to enforce it. Give regulators everything they want to enforce regs and the regulated industry will die under the weight of compliance in much the same way that we’d all be a lot more miserable if the police had all the power they needed to enforce compliance with the law.

            So police have to (ideally) do things like respect our rights, and regulators have limits as well. But even then, even if regulators had every power they could get while still respecting rights, the fact is that you have a small number of regulators attempting to regulate a large number people who have a powerful incentive to find ways to keep away from the regulator. It will never be possible for the regulator to be effective except to hammer on the nail that sticks out too far, and that is even before we get to your salient point about political interference making sure they don’t hammer too hard.

            Trusting to regulators is not the answer to systemic issues. This is a Hanley rule (the structuring incentives & policies one).

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            • The thing is I don’t’ hear the same arguments being made about other kinds of regulations. EPA regs to keep water or air clean or the FAA as examples. I don’t here people say that big corps will just hire smarter lawyers or Chemists so why bother regulating what they put in the air or water. Not an exact analogy but nothing is or it wouldn’t be an analogy. Finance seems to held out as a special case where the poor helpless regulators will always be outmatched. But in some places ( states and other countries) there has been effective regs that prevented some problems. One example that comes to mind is banks in TX which, if i remember, had more stringent requirements so the housing crunch didn’t hit them as hard. I think finance can be regulated and the smart lawyer problem is more a projection of the attitudes of big finance.

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              • ” I don’t here people say that big corps will just hire smarter lawyers or Chemists so why bother regulating what they put in the air or water. ”

                Of course not. Because it’s easier to work with the regulators if you’re a large company. Regulatory capture and all that. You always want a pleasant relationship with your regulators, but that doesn’t mean that you can make decisions and policies that GO RIGHT UP TO THE LEGAL LIMIT or are subject to smart interpretation of the rules. That’s where the action is and that’s where someone skilled is worth what the companies pay them for.

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              • Texas doesn’t allow home equity loans. You can take out a second mortgage, but you can’t borrow from equity in your home.

                It was a law from the last housing crash here (the 80s, I think) and one of the two reasons (the other being the jump in oil prices) that saw the ‘Texas Miracle’.

                It’s not that much of a miracle when you realize it’s based on one particularly relevant law that prevented a bubble and the fact that a huge chunk of the Texas economy runs stronger if oil is in high demand.

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              • This is is a part of the Homestead bankruptcy exemption in Tx. 100% of your primary residence is exempt from being taken away during bankruptcy. This actually dates from the Republic of Texas constitution. This effectively forces the no cash out feature, as one could in theory take the money out of the house, spend it, and then file for Bk and the bank could not get the house back.

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        • The regulators are plenty smart. It isn’t like the Federal Government can only pick from lower tier law schools. A lot of Federal lawyer jobs pay six figure salaries in order to attract good talent.

          The problem is the so-called revolving door of going back and forth between government work and private industry for many people as admins change.

          To use another example, a lot of law firms pay top dollar for former Supreme Court clerks and these former clerks end up being the ones who write most briefs and do most arguing before the Courts of Appeal and Supreme Court in the United States. The majority end up at Corporate Defense firms and those that don’t end up as judges or academics. Maybe once in a blue moon, you will find one who stays in the Civil Liberties or Crim Defense world.

          The other problem is resources. Goldman Sachs more or less has infinite resources for dealing with government regulators and/or lawsuits from individuals and/or criminal prosecution. Everyone else has very limited resources in comparison including the government. Manhattan’s DA does spend a lot of time and effort going after white-collar crime but he or she still needs to deal with all the other crime in Manhattan and numerous banks and institutions.

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          • The problem is the so-called revolving door of going back and forth between government work and private industry for many people as admins change.

            This is the other point I agree with & you about.

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          • The issue where the regulator knows that, if he plays his cards right, he can get a job at the regulated after a dozen years or so has a lot of incentives baked into it.

            The regulated will, of course, want someone who has an established relationship the regulators to facilitate communication, someone who knows the regulations (hell, the regulator should be all over that stuff), and who won’t need to be spun up but who should be able to dive into the deep end on day one.

            And, of course, knowing that, after you pay your dues as a regulator, you’ll have a good job making (a lot) better money if you play your cards right is one hell of an incentive to play your cards right.

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            • True but I don’t necessarily always see this as bad. The best criminal defense lawyers have some time or a lot of time has prosecutor’s and have the same insider info/contacts.

              Some of the best plaintiff’s lawyers spend a while on the defense side, maybe they even make partner.

              This is a problem but it is not a wholesale reason to scrape regulations as Greginak pointed out.

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        • At the same time, do we really want the economic well being of tens of millions or even hundreds of millions of people at the hands of investment bankers? They are capable of doing a lot of damage when they get too greedy or mess up.

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  2. I think the lesson is somewhat simpler: look at who is getting rich + nothing is too good to be true.

    Here, it was a bunch of hustlers at places like Countrywide who made $X per issued mortgage while carrying no risk. The banks made money (primarily because the volume got so huge) but also retained exposure and some lost money overall because they didn’t cynically shed that exposure (or make enough on the ramp-up). The ratings agencies made money, and did so by competing against each other to offer friendlier-and-friendlier ratings. That ought to tell you the ratings are BS, the mortgages are BS, and no matter how clever the packaging, it won’t spin that BS into DRAMATICALLY better returns than any other AAA-rated product.

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      • But nothing there was too good to be true (except the idea that Gates invented DOS). He had a wildly popular consumer product that sold a lot of copies against very little competition. That’s a pretty reliable and standard business model that you would expect to get the head of the company rich.

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        • Truth that. Just sayin that it isn’t always too good to be true.
          Most wealth, though, most wealth was stolen.
          From the Carnegies through the Rockefellers down to the Kochs, people have stolen from the little guy.

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            • notme,
              You do realize I know businessmen?
              Smart businessmen find it easy to make money from the middle class.
              Making new businesses is easy for them…

              Do you want to reward smart people, or toadies?
              I’d think the choice would be clear.

              But on the subject of refugees, I’m all for you buying the children a home in Mexico rather than the United States, and I can send you a link for you to buy their wares. Because I don’t think you need to give charity, when you can support working teenagers so they don’t need to come to the United States and live off of the dole.

              See? Live your beliefs — if you want to help privately, just do it already.

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  3. A price is only accurate if you can both buy and sell near that price. If someone says their car is worth $10k, one way to determine she is lying is to offer to sell her an identical car for $9k. If the $10k is accurate, she ought to leap at the chance.

    I get what you’re actually saying, but the car metaphor doesn’t work well, because no two cars are identical. The market price of used cars in various conditions is pretty easy to find out. If the seller is cheating you, it’s probably by hiding nonobvious information about the car’s condition.

    Actually…maybe it does work better than it first appears to, given the point about counterparty risk. My original thought was that an option to buy a ton of pork bellies at $200 in December is an option to buy a ton of pork bellies at $200 in December, but I guess counterparty risk is the equivalent of a hidden engine defect.

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  4. I take from this, amongst other things, that I don’t understand rich people. If I had sold my business for $100 Million, what need would I have of dealing with investment bankers who treat me like I am small change? If I stuff the money under my mattress and live a very comfortable $250K per year lifestyle, my money will last me four hundred years. The only problem is that I might know people living a more lavish lifestyle, and be so distressed by this that I feel a need to burn through my money faster. Sure, I get that there are always more ways to spend money, but not everyone needs to spend like a lottery winner.And you don’t have to treat money like it is how you keep score to see who wins.

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    • Richard Hershberger: If I had sold my business for $100 Million, what need would I have of dealing with investment bankers who treat me like I am small change?

      I asked that. He said that at least up to that point the bank had thrown him some minuscule number of shares of the IPOs they underwrote. This was easy, guaranteed great returns for at least some portion of his overall portfolio. He said the larger tracks were reserved for larger investors. I have no idea if he’s still with them or if he’s moved on to other things.

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  5. To spell out the consequence, investment banks have a lot of interactions with people who aren’t putting their own wealth at risk.

    And they have a constitutional right to use that wealth (i.e. other people’s wealth) to influence elections, according to the Roberts Court.

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  6. I wish there were a villain this could be pinned on because the alternative explanation is that no one really ever knew what the right thing to do was, so they made up everything on the fly.

    This was an unprecedented situation, so of course they were making it p on the fly. Unfortunately, the result of the recent AIG lawsuit means that next time they’ll have fewer tools and much less flexibility.

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  7. All investing is risky. Otherwise it wouldn’t create wealth. And it is not as though we don’t know how to put a price on risk.

    Maybe the problem is that people bought the wrong investment products. I guess if you want a solution you could say that investment managers should be willing to refuse to execute transactions they think are inappropriately risky (or when they believe that their clients fail to appreciate the true risk) but that’s such a hugely subjective thing that it would be impossible to enforce. And, ultimately, you are there to do what the client asks, no matter how dumb it actually is.

    “However little respect anyone had for ratings agencies, few would have guessed that bonds they rated as AAA would ever be in question.”

    That’s also the case. Maybe the criminal prosecutions ought to be happening at the ratings agencies who said that what the banks were doing was a good idea…

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  8. Point 2 raises the fearsome spectre of trading with Bear Stearns and then argues “There are a lot of possible points of failures. Even a thesis that is 99.9% correct can lose you money.” This is true. Bear Stearns probably knows a lot more than you do. But then Point 3 argues “It is very, very easy to be the dumb money. There are professionals who are dumb money. They probably aren’t actually dumb people, but they aren’t paying attention to the right things.”

    So why is it that Bear Stearns is necessarily paying attention to the right things and I am not? Point 13 argues precisely this: Bear Stearns’ lawyers are always smarter than my lawyers, no matter how smart my lawyers are. Indeed, wasn’t the crash caused precisely by houses like Bear Stearns, run by smart people with smart lawyers, maybe seeing the right information that was there for everyone to see all along, telling them that the bubble was inflated to its maximum-tension point, but willfully ignoring that information? Indeed, point 12 recapitulates the story of a Cassandra who did read the right signals and interpreted them the right way but no one listened to him.

    It seems to me that the real message the extract here is that the market, being composed of a great many people, none of whom have complete access to information, behaves such that over the long run it repetitiously inflates and then bursts bubbles in capital. Such appears to be the long term history of the monied economy and it doesn’t matter how smart you are, you can’t stop it from happening: it is as inevitable as winter. The depressing lesson here is that for all but a very select and very clever few, and maybe not even them, not only can’t you stop it, you probably can’t even profit off of it personally.

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    • “point 12 recapitulates the story of a Cassandra who did read the right signals and interpreted them the right way but no one listened to him.”

      It’s easy to dig up doomsayers after the fact, because there are always people predicting a crash. I remember people in 1994 talking about how all these stupid internet companies were gonna crash real soon because they were obviously based on nothing, and you’d need a pretty expansive definition of “real soon” for them to have been right. The fact that a stopped clock is right twice a day does not mean that we should pay attention to it because sometimes it’s right.

      What Bear Stearns has is a big bank account that can eat losses. They’re a frog that jumps up five feet and falls back three, whereas the rest of us are frogs that jump up two feet and fall back one. We see them jumping higher, but if we fall three feet we’ll break our ass when we land.

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  9. But the longer answer is – for the vast majority – unfortunately.
    Make a point not to succumb to pressure tactics or even to seemingly polite persuasion. While trading
    trends can be extremely profitable, the odds are unfortunately staked
    unfavorably against the directional traders, even more so
    for directional option traders due to time decay.

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