I read Michael Lewis’ The Big Short: Inside the Doomsday Machine months ago, and have been feeling guilty about not recommending it, because this material is sort of essential for anyone who would like to understand how our economy ended up in the toilet. Read on, not just for a (spoiler: positive) review, but for potentially time- and money-saving advice.

Sidebar: Michael Lewis · I should disclose that I’m a hopeless Michael Lewis fan; in my review of Moneyball I wrote “I suspect there may not be a greater living writer of reportorial non-fiction” and yes, I still suspect that. So you could either use my admitted bias to discount this review, or alternately join the club and next time you see a Lewis book in the airport bookstore, just grab it.

Sidebar: Maybe Don’t Read the Book · The book has its roots in a November 2008 piece in Portfolio magazine, The End. I’m not actually sure that the book is a better piece of work than the (much shorter) essay; and I am pretty sure that all the really important lessons of the book are there in The End.

Now if you enjoy Lewis’ narrative of this frankly-incredible-even-though-we-all-watched-it-happen story, you probably want to get the book, just because there’s room for more narrative and the rest is mostly just as good.

But considered as a work of the non-fiction writer’s art, I’d have to favor the shorter version for its ruthless focus and pace.

The Story · It’s simple enough; Lewis found individuals and partnerships (three in the book, one in the essay) who decided the mortgage bubble was bullshit far before most others did, and made gobs of money betting it would pop, and he walks us through their experience. Most of their time doing this was pretty stressful, because a lot of apparently-smart people were betting against them every step of the way and taking home millions doing so. Even when it all fell apart and they got paid it was stressful, because they understood the scale of the disaster before anyone else.

Anyhow, they’re interesting people, the financial tools used both for inflating the bubble and betting against it are interesting too, and Lewis can tell a story with the best of them. Unless you’re oblivious to recent economic history, you’ll like it.

Lesson 1 · It’s one we should have learned already, long ago: The business of Finance is 100% about making big money for people in the business of Finance. Everything else is irrelevant. The party line is that it’s about routing capital from those who have it to those who need it in a maximally-efficient market-driven way. Hah hah hah.

There’s another legend that it’s about making money for investors. Double hah hah hah. If you’re an investor, it’s about them making bets with your money and if they lose you lose, if they win you get a few scraps and they get a bigger vacation home.

This really should not be surprising. There is apparently no social or ethical force that will cause people to bypass a chance to shovel money into their own pockets, without regard for catastrophic costs to their fellow-humans no matter how predictable. This needs to be an axiom in the thinking of all future regulatory planners.

Lesson 2 · Of all the failures that led to the big meltdown, the most aggravating is the failure of the bond-rating agencies. These people took good money for pasting AAA credit ratings on piles of the most implausible shit imaginable, and what’s irritating isn’t that they did it, it’s that apparently they didn’t break any laws and thus there’s little prospect of the long prison terms that anything smelling of natural justice would require.

If you shared my blank, astonished “how could that happen?” reaction, you’ll probably enjoy Roger Lowenstein’s Triple-A Failure, published in April 2008 in the New York Times.

Once again, not surprising: having debt ratings paid for by the people issuing debt creates a huge conflict of interest, and per Lesson 1, any such conflicts will be taken advantage of by Finance insiders to fleece the sheep otherwise known as you and me.

Lesson 3 · Finance’s relationship to the economy should best be considered by policymakers as that of a dangerous parasite to its host. Any benefits offered at the margin by its market-making functions are dwarfed by the existential threats it is empirically observed to pose, on a regular basis, to the proper functioning of the real economy.

An earlier draft had the word “real” in the previous sentence enclosed in quotes. I took them away, because it really is real, as opposed to Finance which, on the evidence, is the mostly-toxic product of pure imagination, imagination fevered by a lethal illness that the rest of us are in danger of catching.

I’d say Finance should be regulated into utility status all over the civilized world, and if the community of hard-core financial engineers really wants to go on being a collective pathogen, they’ll be forced to acknowledge that what they do just isn’t civilized behavior, and do it somewhere else. We’ll be way better off without them among us.


Comment feed for ongoing:Comments feed

From: JulesLt (Aug 29 2010, at 12:14)

Well of course, we could properly jail them for what is effectively fraud. Or do what people did to kings of old when they led the country into ruin . . . .


From: James Abley (Aug 29 2010, at 12:40)

I remember you pointing at The End previously and I was in an apoplectic rage for a few days afterwards every time I thought about it. Hopefully the book won't induce a lengthier funk. I'd like to think that some of the recent things like BankSimple are a movement towards rebooting the system, but I somehow doubt it.


From: Don Marti (Aug 29 2010, at 13:05)

Somehow we have lost the norm that messing around with money for its own sake, whether in the form of "gambling" or "cheating people", is a low-reputation activity. The same goes for the bottom-feeding side of sales--convincing low or mid income people to buy things they couldn't afford used to be a low-reputation occupation, too.

There's lots of innovation, but many of our civilization's best mathematical minds are teaching computers to pitch pennies or tweaking the placement

of web advertisements. And we're all fine with that, for some reason. Can we re-grow our healthy contempt for this waste?

(Related article: Calvin Trillin:

http://www.nytimes.com/2009/10/14/opinion/14trillin.html )


From: hedgie (Aug 29 2010, at 13:26)

The events described in the Big Short are a disgrace.

Wall Street was engaged in a fraudulent conspiracy in which the buyer, the seller, the guaranty company, and the rating agency would willingly suspend disbelief so the buyer could get a 'AAA' security that miraculously paid a few hundred basis points over AAA corporates and count as AAA toward risk-based capital regulations, everyone got fees, and those 'lucky' subprime borrowers could suddenly access unlimited amounts of credit without adequate income or collateral.

Then when this created a giant bubble and it all blew up with catastrophic consequences, the banks got a giant bailout, went back to business as usual, and (so far) fended off meaningful reform. They said, who could have known, when the book shows many people did in fact clearly analyze the situation and foresee catastrophe.

That being said - there are countries that have only highly state-controlled finance sectors. A notable feature is that they don't have vibrant startup and VC sectors. The only reason capital is in large sums to start up companies like Google and Facebook is because of the possibility of rich IPO exits. Interestingly, some of those countries with regulated and state-owned banks, where the startup scene is nonexistent and the same 50 companies have dominated the stock market forever, did not escape reckless behavior and large losses in the banking sector.

This is still America, last I checked, and people should be free to take big risks and come up with innovative financial structures. That being said, consumer regulation must prevent toxic consumer products like the way certain subprime products were structured. Banks, which are systemically important, enjoy special privileges that make them a lot of money, and receive implicit and explicit government guarantees, cannot become giant extremely leveraged hedge funds.

So, you need to make a distinction between a highly regulated utility financial sector; and a speculative sector which can keep taking the risks and innovating in ways that create value, without the rest of us being on the hook to bail them out when things don't work out.


From: Robert Young (Aug 29 2010, at 13:58)

The truly underlying cause of the Great Recession is even simpler. Simpler, in the sense of motivation. Beginning with Reagan, the US government set off on a deliberate scheme to transfer income and wealth from the many to the few. Firing the PATCO folks was the first shot. Even the Reagan/Bushes governments released data showing the shift in wealth. It was not a secret, indeed, they were proud of it. Still are.

Reagan then set about selling the story: "you're OK, but your neighbor is Evil". In the end, from the beginning of Reagan to the end of BushII, median income in the US was either stagnant or a bit lower, depending on exactly what data you look at.

So, all while shifting wage income from the many to the few, there was great demand for some way to keep the economy from imploding. Greenspan invented it by dropping interest rates. This fact, in turn, dropped mortgage interest rates, which fact in turn again, caused house prices to rise. That house prices and interest rates are inversely correlated is well known, at least in the econ community.

With stagnant median income and stable interest rates, house prices would be stable; regs and prudent lending limited mortgage payment to about 33% of gross income (varies a bit from place to place, but is grossly stable over time within a place).

We therefore have two drivers of rising house prices: the falling interest rates from Greenspan, and the "exotic" mortgages (not just sub-prime) which mostly originated in mortgage companies, not banks as the Right Wingnuts would have you believe. These mortgages fiddled the rules such that ever larger house prices would be granted to the stagnant maximum mortgage payment which resulted from stagnant median income.

Those that already had mortgages (including those who bought up to 2006) substituted "home equity loans" for wage income, and thus gross demand was sustained during the Bush (I and II) years of stagnant income. The major winners in all this weren't the banks or mortgage companies, but the Pulte's. They shoved McMansions onto the landscape that couldn't possibly be supported by incomes.

That this would all end badly was obvious to any non-captive economist; most, alas, are captive, and mostly to the various actors in the Financial Services Sector. They pay for shilling better than anyone. The profession has devolved into that of attorney/advocate/mouthpiece; it's no wonder that the profession has so little credibility.


From: Dave Schlosnagle (Aug 29 2010, at 14:20)

Nice review Tim.

After reading the Vanity Fair excerpt "Betting on the Blind Side" [1] related to Michael Burry and his relentless analysis and research, I read _Liar's Poker_, then _The Big Short_ back-to-back. It is quite scary how the former is a setup for the latter given that _Liar's Poker_ leads up to the market crash of 1987 and _The Big Short_ covers the recent market crash some 20 years later. As a software engineer and finance outsider, it amazes me how little understanding and control these billion dollar investment firms have over their own and customers' investments. I found both books well worth reading.

[1]: http://www.vanityfair.com/business/features/2010/04/wall-street-excerpt-201004


From: Jeffrey Yassin (Aug 29 2010, at 14:32)

There is apparently no social or ethical force that will cause people to bypass a chance to shovel money into their own pockets


From: JK (Aug 29 2010, at 15:06)

I read the essay and loved it too.

Finance as it stands today seems to stand on purely "trust" currency with all the evil multiplication it brings when it is abused even ever so slightly. Any asset that is not backed by "tangibly barterable asset" (eg. gold or oil comes to mind) is sitting on a puff of air. Even the value of some of these asset classes are a byproduct of perception engineering.

I'd love to see Lewis tackle this for his next book.


From: Tony Fisk (Aug 29 2010, at 15:52)

It's what happens when markets are both de-regulated and closed. Markets get that way when supply-side spin doctors are given free reign to put their theories into practise.

And discover the concept of 'testing to destruction'.


From: Frog Nibble (Aug 29 2010, at 17:56)

The over investment in housing is one of the big causes of the Great Recession. We diverted resources from things that we need like health care to things that we don't need like McMansions. There's no way to recover the excess resources sunk into housing. These resources are gone forever.

The finance industry is only one of the contributors to the over investment in housing. The other is the government through tax breaks, policies, support for GSEs and so on.

I'd love to see a book about the government's role in all of this.


From: Mike (Aug 29 2010, at 18:18)

The details of mortgage this or bond rating that are unimportant. The economic downturn was inevitable. Financial cycles come and go in a big sine wave, and always have. Nobody's responsible for them, and nothing can stop them. If one cause is averted, another will pop up. It's just a law of nature. Human behavior in large populations insures these kind of cycles.


From: Al Lang (Aug 30 2010, at 03:35)

This is just silly: "Any benefits offered at the margin by its market-making functions are dwarfed..."

Have you not noticed the current economic troubles caused by the gumming up of markets, businesses' difficulty in issuing debt, etc?

Sensationalist writers of headlines and books love to talk up the "existential crisis", but that's a temporary disruption by comparison. Market-making is totally essential to the successful functioning of the while economy.


From: Robert Young (Aug 30 2010, at 08:36)

With regard to the inevitability of the Great Recession (and it being just another example of the Business Cycle), well, no. It's not just quantitatively different, it's qualitatively different.

The Business Cycle is the result of "friction" in markets, to the extent that there is any explicit explanation. What caused the Great Recession wasn't friction, but corruption, mostly on the part of mortgage companies (not banks, no matter what you may believe; and the CRA had nothing to do with it).

The Great Recession, on the other hand, is explicitly the result of wealth and income transfer from the many to the few, begun by Reagan and culminating with BushII. The same thing happened in 1929.

Do you know that Hoover had American soldiers attack poor Americans? It did happen. ( http://en.wikipedia.org/wiki/Bonus_Army ) And, of course, there's Kent State.

Historically, not just the USofA, the level of income inequality now in the USofA leads to armed revolt. Our GINI index is right there with your favorite banana republic. The Tea Baggers view themselves as the Oppressed; all the while being hoodwinked by the likes of Beck and Limbaugh. Stupid people act stupidly.

The economy hums along quite nicely when Recursive Economics(tm) is the rule. As it did under Clinton. The Right Wingnuts always run away from that inconvenient fact. It is also a fact that business, specifically, does better, too. Keeping the cash circulating, by reducing the urge or opportunity to hoard it, is what keeps an economy humming. Allowing the top 1% to hoard ever larger amounts of it leads to Depression, or present day Japan. Sometimes facts are just too difficult.


From: Mike (Aug 31 2010, at 03:36)

"What caused the Great Recession wasn't friction, but corruption..."

Which is inevitable in large human populations.

The desire to combat corruption is also inevitable. Measures and laws to combat corruption inevitably come into being. Subversion of those measures inevitably come into being. Self-satisfaction of the population during good times inevitably results in lax enforcement of anti-corruption measures, leading inevitably to an economic downturn.

Human beings in large populations behave not unlike plankton. We like to think we are in control of things, and as individuals in our own small world of our family and friends and career perhaps we are to an extent, but overall we're not. We're part of Gaia. We're Gaia's left big toe, actually. And for every me there is an anti-me.

So the big economic sine wave rolls on. The amplitude and frequency perhaps can be somewhat varied, but the wave remains.


From: Doug Ransom (Aug 31 2010, at 07:02)

The three "Lessons" ignore they key point of this meltdown - the main cause was the US Congress fueling subprime lending. They wanted it it happen and put the economic incentives in place to make it happen. Tim's Lessons 1 and 3 and incorrect. This was a public policy disaster with the financial companies responding to the US Government pushing the American Homebuilders Dream.

Here is a view on Canada's situation:

http://thetyee.ca/Opinion/2009/10/22/BubbleWillBurst/. Maybe the story isn't over.


From: Robert Young (Aug 31 2010, at 07:58)

Sub-prime lending was invented by Mortgage Companies. Congress had nothing to do with it.

The GSE's didn't either; they were late to the party, and were losing market share, so went a little nuts. That was stupid, but had nothing to do with Congress.

And, if you're going to blame Congress, remember that for the 28 years from the beginning of Reagan to the end of BushII, Republicans controlled either through majority or clouture for 28. Be careful who you blame, it may be Your Side.


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