Wednesday, July 14, 2010

The Big Short

Michael Lewis has an outstanding ability to take the complex and opaque world of the capital markets and translate it into an immensely readable story. He’s done it again in The Big Short, the story of how sub prime mortgages became A rated mortgage backed bonds, those bonds became Collateralized Debt Obligations, and from those CDOs were created synthetic CDOs. If you wanted to hedge your exposure to the CDOs, you bought credit default swaps on them. And when that towering pyramid collapsed…well, this is the story of the people who saw it coming and shorted the subprime mortgage market.

The Big Short follows several characters who watched as more and more mortgages were issued to people who clearly had a limited ability to repay them, the sub prime borrowers. And how these characters, some Wall Street insiders and some on the edges, realized that the opportunity in front of them, to bet against the sub prime gong show, would make them huge amounts of money.

Being the capital markets nerd that I am, this book was a page turner for me. I'll happily choose this stuff over John Grisham any day. As I read on though, in addition to wanting to see how it worked out for the protagonists, and Mr. Lewis does manage to create some suspense about that, two thought provoking themes emerged.

The first was how the ability to make big money and walk away drove Wall Street to create more and more arcane instruments that were increasingly divorced from their underlying collateral. Fees were booked as each deal was done, and the outrageous compensation was paid out almost immediately. These people had no incentive to think about what would happen to these vehicles 3 months down the road, let alone three years. One of the more innovative ideas around managing risks from financial derivatives is to make the creator of the product keep some percentage of it, say 30%, on their books. That would certainly have forced the investment banks to take a closer look at the CDOs they were selling.

The second is that even though those who shorted the sub prime market made a great deal of money, they didn’t rejoice. They were saddened by the moral failure of the people working in the capital markets. One of the characters we follow through the book, a hedge fund manager, says “I have a job to do. Make money for my clients. Period. But boy, it gets morbid when you start making investments that work out extra great if tragedy occurs.” This is Michael Lewis’s angle, and perhaps one of the reasons I enjoyed the book so much – that people who run money have a moral obligation to society - “the truly profane event (is) the growing misalignment of interests between the people who trafficked in financial risk and the wider culture.”

This is an excellent book about risk and reward, clear and understandable, with themes that figures prominently in the hearts and minds of the SRI community.

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