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1-Page PDF Summary of The Big Short

The Big Short: Inside the Doomsday Machine takes us inside the madness, corruption, and greed at the heart of the 2007-2008 financial crisis. It tells the story of an eccentric collection of investors who saw the folly of the subprime mortgage-backed securities market—and found a way to bet against it. By focusing on individuals who saw these worthless securities for what they truly were, The Big Short explores the complexities and irrationalities of modern capitalism and forces us to seriously question the wisdom (and motivations) of the financial elites who wield so much power over our economy, society, and politics.

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In just a few years, these poorly understood financial products spread like a virus throughout the financial system, exposing both Wall Street and Main Street to catastrophic risk. Major players—including the big investment banks, the ratings agencies, insurance companies—all contributed to the creation and proliferation of these dubious financial innovations because they were enormously profitable.

Ordinary homebuyers weren’t inexcusable either—many took on mortgage terms that they had little chance of being able to meet, and some bought multiple houses on meager salaries. While the deceptive nature of how mortgages were marketed played a part in this behavior, consumers were also clearly trying to cash in on skyrocketing housing prices.

In short, all major stakeholders in the ecosystem were fueled by the desire for profit, which made it easy to overlook the other systemic problems below.

Inscrutably Complex Financial Instruments

The sheer complexity of the mortgage-backed securities is what enabled the risk from subprime mortgage bonds and CDOs to spread like wildfire throughout the financial system. No one seemed to understand how these convoluted financial products worked or how to properly evaluate what they were truly worth. Even the big investment banks themselves were confused as to how much of these toxic assets they actually owned.

The ratings agencies were particularly susceptible to these sorts of miscalculations. They were supposed to evaluate the riskiness of these products by assigning ratings to them—these ratings would then be used by investors to determine whether or not they were good investments. Thus, the ratings agencies had enormous influence over the prices that CDOs would command in the marketplace. But the agencies’ ignorance and lack of sophistication led them to assign undeservedly high ratings to the CDOs.

Corruption and Fraud

Explicit corruption and fraud also played a powerful role in creating the crisis. In many cases, the lenders who created the original bad loans that were to be packed into the CDOs deliberately misrepresented the terms of the mortgage to the borrowers. They lured these borrowers in with “teaser rates”—low initial interest rates on their mortgages which then ballooned into exorbitant rates after a few years. This acted as a ticking time bomb in the financial system, triggering a moment where millions of mortgages would fail at the same time.

There were also blatant conflicts of interest that made the subprime mortgage bond market dysfunctional. The ratings agencies already had a poor understanding of the financial products they were meant to be evaluating. But they were also corrupt—they were essentially paid by the big investment banks to issue rosy ratings to the dodgy financial products that the banks were cooking up. The banks were paying clients of the agencies, and the agencies risked losing the banks’ future business if they issued poor ratings to the CDOs.

Profits Encourage Short-Term Thinking

The agencies weren’t the only players who had short-term incentives that encouraged behavior which would be destructive in the long-term. Major insurance companies like AIG prioritized short-term greed over long-term financial stability, because it was highly profitable for them to do so. AIG, for example, insured billions of dollars worth of subprime CDOs, because they were raking in a fortune in insurance premiums. Few at the company bothered to think about what would happen if the underlying bonds failed, because the business was so lucrative in the short-term.

Bad Incentives Drive Bad Behavior

People faced perverse incentives at every level of the subprime mortgage disaster.

Borrowers had an incentive to borrow more than they could ultimately afford because they thought that (with ever-rising home prices) they would always be able to refinance and take out new loans to cover the old ones, using their homes as collateral.

Lenders were motivated to shower uncreditworthy borrowers with cash because they knew that they would just be bundling the loans into subprime mortgage bonds and pass them off to other investors.

The ratings agencies, likewise, had every reason to give their blessing to the whole process because they were being paid by the big investment banks to do so.

And, of course, the big banks themselves got bailed out by the federal government to the tune of $700 billion when the whole market collapsed. This raises another question: did the big banks know that they were too big to fail and that they would receive a bailout no matter what kind of irresponsible risks they took? If so, this would be a powerful incentive to take wild financial risks. After all, it’s easy to gamble when you know you’re playing with the house’s money.

Outsider Perspectives Can See Through the Smoke

Given the madness into which Wall Street had descended, it took a true outsider perspective to see through the smoke and mirrors. It is no coincidence that the group of investors who saw the crisis coming and found a way to profit from it were a collection of cynics, pessimists, oddballs, and neophytes who held no reverence for the supposed wisdom of the market. They were able to see how irrational and chaotic the subprime mortgage bond market was because they had always looked askance at Wall Street’s conventional wisdom. This gave them the necessary perspective to see a once-in-a-lifetime opportunity where no one else could.

Some of them, like Steve Eisman, were morally aghast at Wall Street’s fleecing of ordinary Americans. For others, like Michael Burry, betting against the housing market was simply an extension of the eccentric investing strategy they’d always pursued. But they all had in common the fact that they were iconoclasts and nonconformists who zigged when the rest of Wall Street zagged.

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PDF Summary Chapter 1: An Untapped Asset—The Home

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Many investors at this time, in fact, shied away from them because the cash flows were undesirable. During this era, the bonds were made up of rock-solid mortgages to creditworthy homeowners who were in little risk of default. Ironically, this was the original problem that investors had with these securities. Borrowers could always pay off their mortgages any time they wished, and it was usually easiest for them to do so in a low-interest environment.

Buyers of mortgage-backed securities at this time weren’t concerned about default: they were worried about being paid back too quickly. As an investor, you want to be sitting on cash when interest rates are high so that you can reinvest that money and earn even greater returns. The basic nature of mortgage-backed securities seemed to cut against this basic investing principle. Because people were paying off their mortgages when interest rates were low, the holder of a mortgage-backed security received their money back precisely when it was least valuable to them.

Specialty Finance

Wall Street, however, had a workaround to this problem.** Instead of buying the whole bundle, investors could purchase a...

PDF Summary Chapter 2: Placing the Bet

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The success of his blog established Burry as an acknowledged authority on value investing. Eventually, he quit medical school to pursue a career in finance. Joel Greenblatt of Gotham Capital offered Burry a million dollars to start his own fund, Scion Capital.

Scion was quickly delivering for its clients, no doubt due to Burry’s keen insights about true value and risk. He knew how to beat the market. In 2001, the S&P index fell by nearly 12 percent, but Scion was up 55 percent. In 2002, the S&P fell by over 22 percent, but Scion was up 16 percent. Burry believed that incentives were the driving force behind much of human behavior—and that his rival fund managers had poor ones. Most other managers simply took a 2 percent cut of the total assets under their portfolio, which they earned regardless of how their actually performed. Thus, their incentive was simply to hoard clients’ money, not to take the time and energy to grow that money.

Burry believed this to be inherently unfair. Scion took a different tack, only charging customers for the actual expenses incurred running the fund. Burry insisted on profiting only when his clients profited first.

The...

PDF Summary Chapter 3: Doubling Down

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He also showed Eisman the powerful compelling logic behind the credit default swap bet. You wouldn’t have to pay premium costs for long—most of these nominally 30-year mortgages were really designed to be refinanced and paid off within six years. 30 years became six when low-income Americans couldn’t afford their mortgages after the teaser rate ended and they were forced to refinance. Because the ability to refinance depends on the home’s value, ever-rising home prices meant homeowners would always be able to refinance and borrow more money. If you purchased swaps on $100 million in subprime bonds, your maximum losses would only be the fixed annual premium costs of $2 million per year—$12 million total for six years. But if the default rate rose from 4 to 8 percent, you stood to reap the full face value of the original bond—$100 million.

Finally, despite his skepticism, Eisman did the trade with Lippmann. The logic was sound. Premiums on even the worst subprime bonds were less than two percent of the face value of the referenced bond per year. This was a minor cost compared to what he would earn when the subprime market imploded, which was a certainty. It was spending $2...

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PDF Summary Chapter 4: Bubble Nation

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The lending standards Eisman saw were obscene. Homeowners with no credit and no proof of income were issued mortgages with no money down. In one instance, a strawberry picker earning $14,000 per year was loaned the money to buy a house worth over $700,000. Eisman even saw the bubble affecting people within his own personal circle. His housekeeper was offered an adjustable-rate, no money down-mortgage to purchase a townhouse in Queens. His daughters’ baby nurse somehow managed to purchase six townhouses in Queens through easy credit. One of his partners even knew a stripper who had five separate home equity loans.

In Eisman’s view, the willingness of borrowers to take out these kinds of loans wasn’t the shocking part. Borrowers had always tried to get as much as they could from creditors. But it had traditionally been the rigid adherence to strict lending standards that had stopped lenders from giving money to obviously un-creditworthy borrowers. Why were they suddenly now so eager to lend money like this?

The answer, of course, lies in the fact that lenders were just repackaging these loans off to the big banks to be sliced and diced into CDOs to be sold...

PDF Summary Chapter 5: Event-Driven Investing

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Cornwall’s first test of this theory was with Capital One, a credit card company specializing in issuing credit cards to Americans with poor credit scores. In the early 2000s, their stock had tanked amid fears that they had insufficient capital reserved as collateral to cover the risky credit cards they’d issued. The company soon got into a regulatory dispute with the federal government. The market smelled fraud and investors fled in droves. Despite this, Capital One wasn’t posting unusual losses. Upon speaking with a mid-level corporate manager at Capital One (the only person who would return their phone call), Ledley and Mai discovered that he was buying stock in his own company—not the behavior they’d expect to see from officers at a company engaged in fraud. They determined that Capital One was more or less a sound company, the regulatory dispute was trivial, and that the market was irrationally penalizing them.

For Cornwall, the stock was clearly underpriced at $30-per-share. The best way to profit off this was not to buy the stock itself, but to buy the right to buy the stock at a fixed price for a defined period of time. And the options to buy Capital One...

PDF Summary Chapter 6: House of Sand

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And, to Eisman’s disgust, Chau was paid obscenely for doing nothing more than shuffling around stacks of useless debt. He received a 0.01 percent fee off the top of the total CDO portfolio he managed, before any of the investors he theoretically served got paid anything (the opposite, if you’ll recall, of Michael Burry’s client-first business model at Scion Capital). This, of course, gave the CDO manager every incentive to grow the pile of CDOs as large as he or she could, no questions asked about the quality of the underlying loans. And 0.01 percent was a lot when you were talking about billions of dollars. In just one year, a CDO manager like Chau could take home $26 million.

Lippmann knew that a figure like Chau embodied everything that Eisman hated about Wall Street. He was arrogant, mediocre, wildly overcompensated, and had his clients’ worst interests at heart. He was a living representation of the dumb wealth that Eisman found so appalling. Meeting Chau was just the sort of boost that Steve Eisman needed to continue shorting the subprime market. Not only did Eisman stand to make lots of money, but he would do so at the expense of the Wing Chaus of the...

PDF Summary Chapter 7: Payday

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Side-Pocketing

So what did Burry do? He told his investors, no, they couldn’t have their money back. He exercised a rarely used provision in his contracts with the investors that enabled him to lock up their money if it was invested in assets for which there either was no market or that could not be freely traded. He argued that credit default swaps were just such an asset and that the market for them was either fraudulent or totally dysfunctional. In doing this, he “side-pocketed” his investors’ money, keeping it invested until his bet had fully played out.

But as the aforementioned downturns in the subprime market began in 2007, Scion’s fortunes began to shift, just as Burry had told investors they would. In the first quarter of 2007, Scion was back up by 18 percent. The loans were going bad and borrowers were getting slammed with higher interest payments. The bill was finally coming due for Wall Street.

In just one pool of mortgages that Scion bet against, delinquencies, foreclosures, and bankruptcies rose from 15.6 percent to 37.7 percent from February to June 2007. More than a third of borrowers had defaulted on their loans. The bonds were suddenly worthless....

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