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Debunking Michael Lewis' The Big Short

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The current number one non-fiction best seller, Michael Lewis' The Big Short: Inside the Doomsday Machine, addresses the question "Who got it right? Who saw the real estate market for the black hole it would become, and eventually made billions from that perception?" It is hailed as meeting the usual Lewis high standards of engaging story-telling and character depiction in combination with making a complex arena accessible to lay readers.

Lewis' tale is neat, plausible to a mass market audience fed a steady diet of subprime markets stupidity and greed, and incomplete in critical ways that render his account fundamentally misleading. It's almost too bad the book's so readable, because a lot of people will mistake readability for accuracy, and it's a pity that Lewis, being a brand name author, has been given a free pass by big-name media like 60 Minutes (old people) and The Daily Show (young people) to sell to an audience of tens of millions a version of the financial crisis that just won't stand up - not if we're really trying to get to the heart of the matter, rather than simply wishing to be entertained by breezy well-told stories that provide a bit of easy-to-digest instruction without challenging conventional wisdom.

The shortcomings of Lewis' superficially pleasing work bear out the concerns of traditional reporters who were discomforted by the success of Truman Capote's In Cold Blood: that turning a news report into a work of literature ran the risk of fitting facts to the Procrustean bed of a tidy, satisfying narrative.

The Big Short focuses on four clusters of subprime short sellers, all early to figure out this "greatest trade ever" and thus supposedly deserving of star treatment, bypassing the best known figure in this arena, John Paulson. The anchor is Steve Eisman, a blunt, unintentionally abrasive curmudgeon and money manager, who in his former life as an analyst put sell ratings on all the Gen One subprime lenders of the 1990s. Not only does most of the description of market chicanery and cluelessness come through him, but Eisman also serves as the main vehicle for depicting the shorts as noble opponents to a feckless industry.

Eisman's realization that the industry he once covered, consumer finance, was out to "fuck the poor," led a boyhood Republican to become, per Lewis, "Wall Street's first socialist." Eisman, plus his fellow colorful shorts, evoke comforting cultural cliches: Horatio Alger, Robin Hood, David v. Goliath (or as Eisman, would prefer to see it, Spiderman v. Carnage), Polonius' "To thine own self be true" in modern garb, and of course, the classic Campbellian hero's journey: a quest in the wilderness producing superior insight.

To make Lewis' Manichean perspective stick, he has to omit vital facts that would lead to a more accurate, but complicated, less crowd-pleasing tale. Lewis repeatedly and incorrectly charges that no one on Wall Street, save his merry band of shorts, understood what was happening, because everyone blindly relied on ratings and failed to make their own assessment. By implication, the entire mortgage industry ignored the housing bubble and the frothiness of the subprime market. This is simply false (although with Bernanke and the persistently cheerleading US business media largely missing this story at the time, the "whocouldanode" defense is treated more seriously than it should be). Many people in the credit markets were aware that the risks were increasing in the subprime and residential real estate markets. Every mortgage industry conference during this period had panels on this topic, every credit committee considered it throughout 2005-07.

Lewis completely ignores the most vital player, the one who was on the other side of the subprime short bets. The notion that "it's a CDO" is daunting enough to stop the non-financial reader in his tracks. The author is remarkably uncurious about who the end investors were for CDOs.

Listen up. Who really was on the other side of the shorts' trades is the important question. And the section in which Lewis finally gets around to that (more than halfway thought the book, reader sympathies to his key actors now firmly established) hides the fundamental flaw in his narrative in plain sight:

...whenever Eisman sets out to explain the origins of the subprime crisis, he'd start with his dinner with Wing Chau [a CDO manager]. Only now did he fully appreciate the central importance of the so-called mezzanine CDO - the CDO composed mainly of BBB rated subprime mortgage bonds - and its synthetic component, the CDO composed entirely of credit default swaps on triple-B rated subprime mortgage bonds. "You have to understand this," he says. "This was the engine of doom."...

All by himself, Chau generated vast demand for the riskiest slices of subprime mortgage bonds. This demand had led inevitably to the supply of new home loans, as material for the bonds.

Yves here. It wasn't all by himself, as we will see soon:

....the sorts of investors who handed money to Wing Chau, and thus bought the triple A rated traches of CDOs - German banks, Taiwanese insurance companies, Japanese farmer's unions, European pension funds, and in general, entities more or less required to invest in AAA rated bonds -did precisely so because they were supposed to be foolproof, impervious to losses, and unnecessary to monitor of think about very much.

Yves again. Note that these are the international equivalent of widows and orphans, but because they are exotic, presumably elicit less sympathy. But as we will discuss soon, by this point in the tale, January 2007, that list of prototypical chumps was out of date, which has further implications for the real significance of this trade.

Starting in mid-2005, when the creation of a standardized credit default swap on mortgages made it feasible to take large subprime short positions, a system quickly developed that overrode the normal checks and balances of the market and allowed the unscrupulous to 1. Profit from making bad loans, and 2. Force the creation of more bad loans, which would both increase their profits and make it more likely that their bet would be successful.

Most mortgage industry participants assumed there was a degree of rationality that would constrain reckless behavior. And this belief was not as naïve as it seems now. Past lending excesses, such as the late 1980s LBO craze, even the savings and loan crisis, had died under their own weight. The 1990s subprime boom ended precisely because investors started to shun the risky slices of CDOs, which made selling subprime bonds unattractive (CDOs had been a necessary outlet for selling less desired tranches of subprime bonds), which choked off demand for subprime loans.

A critical element of how this new system operated was by sending false signals to market participants. Imagine you are a doctor. You have a well established patient with a known heart problem and high cholesterol. He comes to his regular checkup looking simply wretched, with bad color, low energy, and complains of not feeling well. You immediately run all of your regular (thorough) tests, plus some additional ones related to his new symptoms. Yet all the results come back within normal bounds, save his known problems, and there you see no meaningful change from his previous history. You ask him to come in quarterly, rather than annually. He continues to look even worse, yet his test results continue to show nothing more amiss than before he started to look so awful. He drops dead of massive coronary blockage.

Now in our little fable, what happened was that someone saw the patient on the street and recognized he was a prime candidate for heart failure. He takes out ten life insurance policies on the patient and finds a way to alter the test results so everything looked normal. The doctor, conditioned to trust the tests, believes them rather than his lyin' eyes, and fails to take action.

Tom Adams, who has spent his career in the mortgage business, and was an executive at one of the major monoline insurers during the subprime mania, explains:

Starting in 2005, following the introduction of credit defaults swaps on mortgages, the spread for lending to risky borrowers fell. Normally, when risk becomes mispriced like this, the right approach is to step back and wait for sanity to return. And many cash investors did just that.

The problem this time was the market didn't correct.

By 2006, many companies in the risk business received pressure, in one form or another (investors, rating agencies, etc.), about how they were missing out on revenue opportunities. The market was booming, yet they were on the sidelines. No one I encountered wanted to take subprime mortgage risk (or Alt A mortgage) risk directly because the risks were considered too high and the premiums were way too low.

In a normal environment, this should have led to the mortgage market grinding to a halt - since no one wanted the BBB portions of any subprime or Alt A deal. Hundreds of people at conferences, in meetings and over the phone lines argued that the market for subprime was acting irrationally. Refusing to participate in the market at all would, in retrospect, have been the only solution, but this is easier said than done. A lot of people were told: "You're the expert in this area, find a way to make money in it - everyone else is."

How did this happen? By 2005, "cash" or traditional investors, were leery of subprime risk. Yet the interaction of increasingly synthetic CDO issuance, credit default swap spreads, and the resulting artificially low yields on BBB subprime bonds sent a powerful signal that the subprime patient was somehow still healthy. Presumably, a lot of someones were highly confident they could find gold within what looked to most like certain subprime dreck.

Back to Lewis:

The whole point of the CDO was to launder a lot of subprime mortgage market risk that the firms had been unable to place straightforwardly.....

"He 'managed' the CDOs," said Eisman, "but he managed what? .... I thought, 'You prick, you don't give a fuck about the investors in this thing....

"Then he said something that blew my mind," Eisman tells me. "He says, 'I love guys like you who short my market. Without you, I don't have anything to buy.' "

Say that again.

"He says to me, 'The more excited that you get that you are right, the more trades you'll do, and the more trades you do, the more product for me."...

That is when Steve Eisman finally understood the madness of the machine... There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. Wall Street needed his bets to synthesize more of them... "They were creating them out of whole cloth. One hundred times over! That's why the losses in the financial system are so much greater than the just the subprime loans. That's when I realized they needed us to keep the machine running."

Yves again. So what does Eisman do, our hero, vocal advocate of the poor and exploited, who now (along with Lewis) indisputably knows that he is an integral part of the problem?

"Whatever that guy is buying, I want to short it." Lippman took it as a joke, but Eisman was completely serious. "Greg, I want to short his paper. Sight unseen."

Eisman recognizes that the subprime market is a disaster waiting to happen, a monstrous fire hazard that, once lit, will engulf the housing market and financial firms. Yet he continues to throw Molotov cocktails at it. Eisman is no noble outsider. He is a willing, knowing co-conspirator. Even worse, he and the other shorts Lewis lionizes didn't simply set off the global debt conflagration, they made the severity of the crisis vastly worse.

So it wasn't just that these speculators were harmful, and Lewis gave them a free pass. He failed to clue in his readers that the actions of his chosen heroes drove the demand for the worst sort of mortgages and turned what would otherwise have been a "contained" problem into a systemic crisis.

The subprime market would have died a much earlier, much less costly death absent the actions of the men Lewis celebrates. They didn't simply keep the market going well past its sell-by date, they were the moving force behind otherwise inexplicable, superheated demand for the very worst sort of mortgages. His "heroes" were aggressively trying to find toxic waste to wager against. But unlike short positions in heavily-regulated equity markets, these wagers, the credit default swaps, had real economy effects. The use of CDOs masked the nature of their wagers and brought unwitting BBB protection sellers to the table, which lowered CDS spreads (and as in corporate bond markets, CDS dictate, via arbitrage, interest rates for bond issues) and pushed down the interest rates on the cash bonds backed by those same loans, which in turn made it perversely attractive for lenders to generate mortgages with the worst characteristics. And it isn't surprising that weak-credit borrowers were enticed by this once in a lifetime "opportunity".

Lewis misses an even more stunning part of this picture. His colorful band, although engaged in damaging conduct, were comparatively small fry, beneficiaries of the strategies of even more clever and lethal actors. Chapter 9 of ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism discusses how a single hedge fund, Magnetar, which has heretofore been missed in every major account of the subprime crisis, was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader's wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar's CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006. Apparently unbeknowst to Lewis, his shorts were riding the slipstream of Magnetar's trade, with a significant percentage of their credit default swaps coming from its and its imitators' CDOs.

And who stepped in on the other side of these short bets? Who were the investors in the CDOs? For the riskier slices of the CDO, it was a bizarre combination: chumps, almost entirely foreign, and supposedly sophisticated correlation traders, (Lewis discusses one at length, Howie Hubler of Morgan Stanley). Across the board, they suffered spectacular losses.

But as Lewis stresses, the ruse at the heart of this great trade was that the shorts were betting against BBB subprime trash, which when packaged into CDOs, had roughly 80% rated AAA. So who were the fools taking toxic BBB risk for mere AAA returns?

For the most part, the dealers themselves. Without going into mind-numbing detail, the apparent risklessness of an AAA instrument hedged by an AAA counterparty (in this case, a monoline) substantially reduced the capital a dealer needed to support a position. As a result, holding AAA CDOs hedged by AAA guarantors was treated, on a profit and loss basis on the relevant dealing desks, as vastly more attractive than finding investors to take the other side of the trade. In other words, this was massive gaming of the banks' own bonus systems.

So what was the dealers' big mistake? When the subprime market started hemorrhaging losses, the Magnetars and the smaller subprime shorts wanted to be paid on their successful bets. For the AAA investors, that meant ponying up cash. They went to the monolines, only to be rebuffed. Even though the insurers would likely have to pay out on their subprime guarantees, the provisions of their contracts assured would be a VERY long time, often decades, before their check would be in the mail. So the dealers themselves, due to their own poor incentives and inattention, were faced with unexpected losses and caught in a liquidity crisis. They suddenly had to cough up lots of money to Lewis' supposed heroes. Wall Street took multiple hits: writedowns, downgrades, and a cash drain when funding was increasingly scarce.

So who was ultimately on the other side of these lionized trades? When Wall Street could no longer pay the Magnetars, the biggest chump of all, taxpayers in the US and abroad stepped into the breach. We are the ones bearing the enormous cost of state sponsored bailouts and real economy damage, the wreckage this "greatest trade ever" hath wrought.

Lewis' need to anchor his tale in personalities results in a skewed misreading of the subprime crisis and why and how it got as bad as it did. The group of short sellers he celebrates were minor-leaguers compared to the likes of Goldman Sachs, Deutsche Bank and John Paulson. But no one on the short side of these trades, large or small, should be seen as any kind of a stalwart hero and defender of capitalism. Circumstances converged to create a perfect storm of folly on the buy side, beginning with essentially fraudulent mortgage originations at ground level, which the short-sellers - whether trading at the multimillion or multibillion dollars level - took advantage of. That they walked away with large profits may be enviable, but there was nothing valiant about it. In the end, Main Street, having been desolated by a mortgage-driven housing bust, now found itself the buyer of last resort of Wall Street's garbage.

Lewis' desire to satisfy his fan base's craving for good guys led him to miss the most important story of our age: how a small number of operators used a nexus of astonishing leverage and camouflaged risk to bring the world financial system to its knees and miraculously walked away with their winnings. These players are not the ugly ducklings of Lewis' fairy tale; they are merely ugly. Whether for his own profit or by accident, Lewis has denied the public the truth.