The Big Short by Michael Lewis

Key Insights

There is a great disparity between what those who work in finance know and what is accessible to the average American: and this can be a huge detriment for American’s in successful financial planning. In fact, even something as seemingly small as the lack of knowledge the average American has about financial terminology played a key role in something huge: the historical financial crisis of 2008. In Michael Lewis’ The Big Short, he chronicles the reasons behind the financial collapse, and how much of it had to do with those who preyed on low-income American’s with a lack of foresight or financial awareness. The book also details the experiences of those who managed to profit off of the economic downturn: those individuals who bet against the housing bubble and won. These outsiders included Greg Lippman, a trader: Steve Eisman, an investor: Charlie Ledley and Jamie Mai, founders of Cornwall Capital: and Ben Hocket, a former investor. Each one profited from the collapse of the housing market by “shorting” big bankers and the like: meaning they invested against credit default swipes, which would only become profitable if the housing market failed. Read on to learn more about the circumstances that lead up to this historical crisis, why those who caused the collapse didn’t bear the brunt of the financial burden (and who did) and why these seemingly random folks were able to profit.

Key Points

Unchecked optimism was a big problem for sellers and bankers

There were many factors that lead to the 2008 financial crisis. One of which was unchecked optimism on the part of those who were selling the houses. Many of those who were selling houses like crazy were doing so because they had two unchecked beliefs. First, they assumed that since the housing market had never failed in the past, it couldn’t possibly fail now. Second, they held onto the belief that there was no way that all of the people who had taken out loans could possibly default at the same time, which would cause a financial crisis. Both beliefs didn’t have much data to support them but were widely held anyway. Bankers, investors, and others made the mistake of assuming that since they hadn’t ever experienced the housing market crash, it was not going to happen. This lapse in logical reasoning is called the optimism bias. This bias is the tendency for people to underestimate risk in a situation because they can’t remember any recent experiences showing that this sort of a risk would end in an undesirable result. Sellers had no recent experience of a housing collapse to draw on: so it seemed like an impossibility while they were selling houses and profiting.

Overconfidence and manipulation ruled sales tactics

In combination with underestimating just how risky giving out those loans was, financial analysts also indulged in another bias: overconfidence. They were overconfident in their ability to predict whether they had the abilities, skills, and judgment to accurately predict the future. Overconfidence was illustrated in the way that lenders gave almost anyone loans, whether they could afford them or not. Low-level lenders were motivated to sell the most expensive homes they could, even if the people they were selling to only had a moderate income. These lender’s would go as far as falsifying paperwork, particularly by inflating applicant’s incomes. For instance, a Mexican immigrant made roughly $9 an hour and was sold a home that would require 100% of his income after taxes. His income was listed at $156,000 a year: grossly dishonest and negligent. Dishonesty went in both directions. For those with high credit scores, lenders would list an applicant’s credit score as lower than it really was, so their loans would have higher interest.

Credit rating agencies accommodated brokers, and let accuracy fall to the wayside

While the financial crisis was building, credit rating agencies were incredibly incompetent. They used outdated models, hired subpar employees, and their systems were so transparent they were being manipulated by brokers at major banks. They were pressured to give CDO’s triple-A ratings (the highest rating possible). They also knew that if they didn’t supply these false ratings, companies would go somewhere else to get them and they would miss out on profits. The system for incentives changed in the 1970s. Their original system of servicing those who bought debt obligations (and profiting from those transactions) shifted to being paid by how many sellers per rating they serviced. Eventually, there were very few brokers calling the shots, which meant credit rating agencies bent to their will, rather than risk losing huge chunks of business. This means giving great ratings to fraudulent companies. Unfortunately, this issue with credit rating agencies accommodating brokers is still a common one. Agencies still haven’t received an incentive to provide accurate ratings, in spite of many attempts at reform.

Confusing Jargon was also used to manipulate buyers

When you hear the word “Securitization”, what do you think it means? If you have a background in finance, you’d know that it means an aspect of finance that is based on risk or debt. If you didn’t have that background, you might think it means “security”. It's through misleading words like this that people who work in finance were able to trick and manipulate those who are less familiar with financial jargon into making ill-informed decisions. Fortunately, since the crisis, many American’s have brushed up on their understanding of finance. John Lanchester, a writer of How to Speak Money, conflates ignorance with complicity, stating that it is essential for people who do not understand finances to become financially literate, at the very least, to prevent another financial crisis.

Buyers sights were set on short term goals rather than long term implications

When presented with something we truly desire, waiting can feel like an impossible chore. Sellers knew this, and capitalized on it to sell homes to short-sighted, low-income buyers… who made illogical choices that caused them to purchase homes they simply could not afford. Though they were often partially blamed for buying these homes, there’s a psychological phenomenon at play. Often people who are low income have a hard time seeing past their immediate financial needs: which makes sense. If you have barely enough money to eat, your focus will be on getting food that will last until your next paycheck, not planning for retirement. This tendency in combination with the fact that most people generally aren’t good at planning for the distant future (because it seems so intangible) can culminate into a financially lethal duo. This tendency to only plan for one’s immediate future is called “temporal discounting”, and leads to decisions like the one made by many American’s not to plan for retirement. The future doesn’t quite seem real enough to plan for. A strategy to curb this tendency is to make a focused effort to make the future more tangible, to prevent yourself from making irresponsible decisions.

Those who were too close to the crash couldn’t see it coming. 

Unfortunately, those who were directly causing the crash weren’t aware it was happening: that was up to the outsiders who had just enough knowledge about finance that they worked out what was about to happen, and prepared to profit. This group of individuals was unique for a variety of reasons. For instance, Michael Burry believed his glass eye gave him special insight and intuition. Charlie Ledley and Jamie Mai, who also predicted and profited off the crash, had peculiar business practices. Finally, Ben Hockett had willingly removed himself completely from the industry prior to making his prediction.

Michael Burry, one of those who saw it coming, was an autistic doctor. He left the medical field to start a hedge fund and became fixated on dense financial documents. Eventually realizing that the US housing market was likely to fail. Once he came to this realization, he invested all of his money in credit default swaps, which would only become profitable once people defaulted on their mortgages. Then, he waited. During this time, Gregg Lipmann a Deutsche who worked for a bank that was underwriting bad mortgages started selling credit default swaps: willing to save himself since he could not prevent his bank from underwriting these mortgages. Lipmann created FrontPoint, and a man named Steve Eismann became interested. He had seen the housing bubble but didn’t know how he could profit off it. He invested heavily in Lipmann’s credit default swaps. Far away in California, Charlie Ledley and Jamie Mai came across a presentation from Lipmann and acknowledged it's imminent truth. They didn’t have the financial know-how to gain access to Wall Street, so their neighbor, self-exiled ex wall street native Ben Hocket showed them the ropes.

After making their investments, they all waited for the housing market to collapse. Burry dealt with clients hounding him about his investment strategy, while others simply waited with intense nerves. Eventually, it happened. They profited, but also dealt with the negative impact and fears of the collapse.

Why the economists couldn’t predict it

After the housing market collapsed, many were appalled at the inability of economists to predict the collapse. Franklin Allen, a professor at Wharton, explains that those who are educated economists focus heavily on mathematical models, while often failing to take into account the significance of changes in the open market system. Another professor, Stephen J. Kubrin, stated that academia tends to lean away from supporting regulation, generally favoring less government involvement in businesses. Alan Greenspan, the former chairman of the Federal Reserve, stated that in order to predict an occurrence like this, someone would have to be enough of an insider to understand investing, but would benefit significantly from being an outsider, much like those who profited from the collapse.

In the aftermath, the irresponsibility of those who caused the crash was rewarded - not punished 

There were many consequences of the 2008 housing market crash: though they are difficult to measure. Roughly 9 million Americans lost their homes, and about 8 million lost their jobs. A 2017 issue of the economist indicates that the effect of the crash wasn’t limited to those who live in America, there was also a global impact. Repercussions of the 2008 crash can be seen in violent nationalist revolts around the world.

In comparison to those who felt the heat from the collapse, Wall Street executives were doing just fine - they were on the receiving end of a bailout from the government. In 2009, those who had the highest level positions at banks received $114 billion dollars in government bailout money. Many of the other financial burdens were unwittingly taken on by American taxpayers and those in the global market. A significant number of folks were negatively impacted by the crash, except those whose gross negligence caused it.

Summary

There is a great disparity between what those who work in finance know and what is accessible to the average American. In fact, even something as seemingly small as the lack of knowledge the average American has about financial terminology played a key role in something huge: the historical financial crisis of 2008. In Michael Lewis’ The Big Short, he chronicles the reasons behind the financial collapse, and how much of it had to do with those who preyed on low-income American’s with a lack of foresight or financial awareness. The book also details the experiences of those who managed to profit off of the economic downturn: those individuals who bet against the housing bubble and won. Read on to learn more about the circumstances that lead up to this historical crisis, why those who caused the collapse didn’t bear the brunt of the financial burden (and who did) and why these seemingly random folks were able to profit.