The Big Short - Michael Lewis

The nominator for this book was Jeff C, so he led our discussion. He began by asking everyone what we personally and professionally remembered from the financial crisis of 2007 to 2008. A few of us were aware of the crisis only through news reports; some of us were involved in tangential economic or business fields, and a few worked in the financial services industry (including Bear Stearns), and were on the ship so to speak, if not in the boiler room. The mortgage and re-fi engine pushed a lot of real estate activity, which in turn drove many other business activities. Our office witnessed energetic economic forces in urban settings that were otherwise deserts of economic opportunity, and we fully bought into the 'Home Ownership is Good for America' pitch while that run lasted. But we were also skeptical of a new system that led many people into debt obligations well beyond their ability to re-pay. Even on Main Street, the math didn’t seem to work. Jeff C recalled how home ownership is not necessarily right for many people: those who are a broken dishwasher away from a missed mortgage payment. With 0% down, nor did m any of the Alt-A and other sub-prime borrowers have any equity at risk, skin in the game.

Several of us have read other Michael Lewis stories about the financial services business, including Liars Poker and Flash Boys. Lewis has an extraordinary knack for explaining somewhat complicated financial issues in ways that most readers can understand. He also spent time on Wall Street before becoming a full-time writer, so his understanding is experiential, not academic.

Early discussions centered around blame for the crisis, veering from details in the book. There is no shortage of blame, and broadly blame can be cast to five categories: government policy, the rating agencies, the financial institutions, the mortgage brokers and the borrowers themselves. Government regulations including new interpretations of the 1977 Community Reinvestment Act, which established quotas for lending to lower income groups and in lower income neighborhoods. Continued pressure into lower and lower rated borrowers was a large contributor. Jeff C felt that the failure of the rating agencies to rate the portfolios accurately should take the greatest blame. The systematic destruction of a broadly competitive rating agency business, to the few agencies favored by Government Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac was another, leading to only a few remaining rating agencies preferred by those institutions. Those businesses became more about getting the business than rating the business.

The book assesses the greatest blame to the financial institutions themselves. At one point in the book, one of the risk managers asks rhetorically what the effect could be if housing prices did not continue to rise, and was told that the model couldn't calculate negative growth. Does anyone think that a multi-billion dollar financial business couldn't have found a programmer who could model using a negative number? The 35 year decline in interest rates has provided a 3% average annual tailwind to home values over these past three and a half decades. Did anyone consider what could happen when that trend slowed, or reversed? There were simply too many people who were making money off the mortgage brokerage machine and the repackaging and securitization machine, to think to pursue those questions. 'Get this year's bonus' was the overriding theme on Wall Street. Nor were regulators at the SEC were not up to the task of regulating the complicated securities that facilitated the securitization machines. Many of the people working in these oversight capacities were agling for the far higher paying jobs in the institutions they oversaw.

We mostly agreed that the political class has abrogated economic leadership in the US, leaving the sole quasi-governmental economic leadership at the Federal Reserve. Today the Fed exerts outsized influence on stock and other assets values. Our historically low interest rates have been good for owners of capital (we read Thomas Pikkety, Capital in the 21st Century), and those in the financial services business, but not so much for retirees, or savers. We mostly agreed there is a coordinated effort to keep US interest rates low (monetary policy) to help manage fiscal policy, as a broad rise in interest on dollars would balloon the debt service needs, and place government in an ability-to-pay corner. But we digressed once again.

We drifted into whether there is a solution to the dysfunction, incompetence and false leadership in government, but eventually came to the conclusion that no, we cannot count on government to lead, create positive incentives or useful regulations: it is the nature of the beast. The real question is what can we do to prepare for the unknown future, possibly crash, possible abyss.

As asset classes are more and more correlated, even drifting into real estate is subject to tremendous downside risk. Geoff offered that owning a profitable small business, where one relies heavily on your own efforts, is one way. Investible assets are a challenge today.

Back to the book, we had varying opinions on the level of known fraud that was committed during the run-up. Chuck placed us all on the board room, where the Chief Risk Officer makes observations, asks a few questions, while the guys who are delivering huge corporate profits are seated at the table knowing that they delivered the bonuses. The C-suite of all these institutions had to have a sense of the fraud in pricing (as illustrated by the failure of Credit Default Swaps prices to move after the first big wave of non-performing loans), in credit ratings, and in the assembly of the Collateralized Debt Obligations to mask the true risks. If not the details of the fraud, certainly the top leaders knew the impact of small fraud at many levels.

Some of us had also seen the movie, which was good. The movie was better at character development and personal drama, but the book was better in its explanations of the financial details.

We returned to one of the main points of the book: hindsight is 20-20, but why was the clarity of the problem so unimaginable to so many people in the business? Why were there so few people who knew to “Short the Housing Market”, when the signals appear (20-20) so clear?