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Credit default Swap: A kind of bet on whether a bond would default. A and B bet on the bond. A pays B a percent of bond value (premium) in N years. If in N years, the bond defaults, B have to pay A the whole Bond’s value. Else, A lose his premium. It’s more like an insurance on a bond. But neither A nor B needs to really own the bond.
For subprime mortgage “They were making loans to lower-income people at a teaser rate when they knew they couldn’t afford to pay the go-to rate, They were doing it so that when the borrowers get to the end of the teaser rate period, they’d have to refinance, so the lenders can make more money off them. Thirty-year loans were thus designed to be repaid in a few years.”
This is like ARM loan. It offers you low interest rate in a beginning period and then adjust the rate every N years. The most common one now is 5/1 2/2/5 ARM loan which has a fixed rate in first 5 years and then adjusts the rate every year. The maximum cap of the rate change every year is 2 percent and no more than 5 percent in total.
I have friends buying house with ARM loan because of incredible house price in bay area. But I think the arm loan is still risky given that your maximum interest rate could be 6% after 5 years with large amount of remaining loan to be calculated based on.
So maybe after 4 – 5 years there could be house prices drop in bay area.
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Golden Sachs bundle triple B rated subprime mortgages into a complicated bond package and get the package rated as triple A and then sell it to AIG. AIG just looked at the rate and blindly buy it. That cause the bubble. Golden Sachs even put credit default swap into the package to amplify its size so that they can create more such triple A package without creating more subprime mortgage. They pay a much smaller amount of credit default swap premium to AIG than they received from Mike Burry to make money. Lippman’s Chinese quant Xu find that the subprime mortgage default rate will grow higher even when the house price rise slower. So it is highly possible that it will default. To make his decision sound correct to other, Lippman even visited AIG and told them how unreliable the package is to persuade AIG stop buying the package and credit default swap. This behavior is weird because it hurts other departments’ profit in the same company in D bank….
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AIG insured a lot of bad subprime mortgage. This is somehow caused by its leader Cassano.
Cassano is a guy:
1. Has little background in finance.
2. Don't like to listen to different opinion
3. Easy to direct his angry to his employee in the meeting and daily life
4. Though he doesn’t treat his employees well in daily work, he gives them good pay. That’s why his employees can bear his bad mood and don’t leave the company or fight againt.
“Even by the standards of Wall Street villains whose character flaws wind up being exaggerated to fit the crime, Cassano, in the retelling, became a cartoon monster.”
AIG finally stopped to insure those subprime mortgages because the appointed leader of mortgage department didn’t want to take the position and fairly stated his opinion in front of Cassano.
Greg Lippmann tried to persuade Steve Eisman to buy credit default swap. Eisman know subprime mortgage has problems. But he doesn’t believe Lippmann. Because Lippmann is from D bank which sells huge amount of subprime mortgage. And now Lippmann is asking him to short it. That’s weird. Eisman questioned Lippmann a lot but cannot find out how Lippmann could cheat them. So Eisman decides to buy the credit default swap first then he could know how Lippmann could fuck him…..
Subprime mortgage got high credit rate from rating company because there are many defects in the rating model. The one who can’t get a job from Wall street’s hedge fund company go to rating company. So the rater’s quality is bad. And those hedge fund company finds many defects and bugs in the model and cheat it. For example, the model rates a mortgage package AA based on its average credit score instead of lowest credit score. And the threshold of average credit score is so low.
There are also corruption inside rating company. For example, one rater says she submit a list of hundreds of mortgage to be downgraded but her supervisor only approved 25 of them.
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Chapter 5:
Most institution investor bought this credit default swap on subprime mortgages not as an outright bet against them but as a hedge against their implicit bet on them
The main characters in this chapter is Charlie Ledley and his 2 partners. Their primary strategy is to seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening.
Charlie and his 2 partners had done this often enough, and had had enough success, to know that the markets were predisposed to underestimating the likelihood of dramatic change.
They made money from their strategy because many “long term options” are underpriced. These options’ long term risk is underestimated so that these options are priced close to short term options. Therefore, their betting cost is small. They lost more bet than won. But when they won, they made much more money.
Before betting against something, they usually hire an analyst and try to gather as much information as possible from different source and people. For example, before they bet on Capital One, they called Capital One, pretended to be large investor and had a meeting with its top management team to gather information about the company.
They also bet against subprime mortgage bonds. Different from others, they bet on triple-A rated subprime mortgage bond package. Because they think its cost is much lower than triple-Bs while many of triple-A might just be a repackage of triple-B.
They were rejected to buy credit default swap from big financial institution at first because their investing company was too small. They only had 3 people with $30 million. Ben, one of their 3 people, was working in large bank. So he built the bridge for them and enable them to buy these things.
One interesting note is that in financial area, products and terms are usually named weirdly. Because seller doesn’t want people to understand their real meaning. And they want to create some illusion for it.
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C6
This chapter is mainly about things happened during a subprime mortgage conference in Las Vegas. Steve Eisman attended this conference. In other to encourage his customer to short more on subprime mortgages, Lippman (the Credit Default Swap broker) arrange a meal for his customers. He invited both Eisman and other fund manager who buy subprime mortgage. He didn’t tell the other fund managers Eisman is a shorting guy. His intention was to show how stupid those fund managers were. Then Eisman would understand why these managers are still willing to buy subprime mortgages and why shorting it makes sense.
And during the conference, after communicating to different people in subprime mortgage market, Eisman understood how problematic those people are.
Some funny words from the book:
Of course, the safest way to expense to one’s Wall Street firm a day of playing Full Metal Jacket was to invite some customer along. And, of course, the most painless customer to invite was one whose business was so trivial that his opinion of the festivities didn’t actually matter.
“Usually, when you do a trade, you can find some smart people on the other side of it,” said Ben. “In this instance we couldn’t.”
These people believed that the collapse of the subprime mortgage market was unlikely precisely because it would be such a catastrophe. Nothing so terrible could ever actually happen.
This book has so many detailed narration including the conversation between different people, how Eisman plays golf, what conversation took place during that meal e.g. I don't know how the author gathered all those details.
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From 2006 – 2007, mortgage loan started to go bad. Subprime mortgage bonds’ prices dropped a lot. But CDO which is subprime mortgage’s derivative was still high. Because large Wall Street firms propped the CDO’s price. However these brokers stopped selling Credit Default Swap. Eisman discovered that these firms also bought a lot of CDO themselves with borrowed money. And rating company didn’t even know the detail of CDO. Before if they request the detail, the Wall Street firms will go to another rating company. So the rating company didn’t downgrade the CDO.
Funny words from the book
“Credit quality always gets better in March and April,” said Eisman. “And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. And they sort of did. But they let the credit spreads tighten. We just thought that was moronic. What are you, fucking stupid?”
A lot of these loans were now going bad, but subprime bonds weren’t moving—because Moody’s and S&P, disturbingly, still hadn’t changed their official opinions of them.
One of the reasons Wall Street had cooked up this new industry called structured finance was that its old-fashioned business was every day less profitable. The profits in stockbroking, along with those in the more conventional sorts of bond broking, had been squashed by Internet competition.
Wall street CEOs don’t know their own balance sheet.
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This chapter mainly describes Mike Burry’s life from 2005- 2007. At first, his fund lost a lot of money because he paid a lot of premium for Credit Default Swap. At that time, he faced a lot of pressure from his investor and he was very difficult at that time. Then in early 2007, subprime mortgages started to default. At the beginning of the default, Golden Sachs which Burry bought CDS from didn’t mark correct position for his CDS. Because Golden Sach itself sold a lot of CDS to Burry instead of just being a broker. But till middle of 2007, the subprime mortgage dropped so much that Golden Sach cannot keep cheating Burry. They had to mark CDS correctly.
Some funny facts from this Chapter.
1. “I think these personal foibles of mine were tolerated among many as long as things were going well,” he said. “But when things weren’t going well, they became signs of incompetence or instability on my part—even among employees and business partners.”
2. Burry’s son was diagnosed of Asperger syndrome which is a developmental disorder affecting ability to effectively socialize and communicate. At first, Burry cannot believe that because Burry himself was same in childhood. But finally he admitted that it was a syndrome and painfully realized that his special behavior since childhood was more of a common syndrome than a talent.
When he thought of it that way, he realized that complex modern financial markets were as good as designed to reward a person with Asperger’s who took an interest in them. “Only someone who has Asperger’s would read a subprime mortgage bond prospectus,”
For this story, my understanding of disease changed a little bit. I think disease is just some uncommon syndrome/facts/changes occurring on one’s body. Is it really bad? That depends on if it affects your life length instead of on how different it is comparing to others. A lump in your body is bad only when it continue growing and makes you weaker. Some lumps may quietly stay in your body for your whole life. And we shouldn’t discriminate people with such disease. Mike Burry’s son was rejected by most of schools because of Asperger syndrome and has to go to some special school. I think that is bad. Though Asperger syndrome may make Burry’s son difficult to make friends with classmates, sending him to a special school full of irregular kids may hurt him even more.
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C9:
Howie Hubler is a Morgan Stanley bond trader. In 2005, he stole an idea and all related work from some quants and started to bet against subprime mortgages by creating and buying Credit Default Swap for triple-B rated CDO. CDO is a group of subprime mortgages. To reduce the risk of people paying off the mortgage by refinancing it, Hubler put a sentence in the CDS that if any mortgage in CDO defaults, insurer should pay full CDO value to him. Then he find some fools to buy such CDS from. At the very beginning, to offset the premiums he paid to the insurance, he even sold triple A rated CDO’s CDS at a much lower price. His actual bet was that triple B CDO would go bad while triple A CDO wouldn’t. But that’s not true. For more than twenty years, the bond market’s complexity had helped the Wall Street bond trader to deceive the Wall Street customer. It was now leading the bond trader to deceive himself.
I think that’s the penalty for stealing CDS idea from quants. Because Hubler doesn’t know as much about the model as quants do. If he could get these quants’ help, he might figure out even triple A CDO is risky. It is like copying code from stackOverflow is fine as long as you understand how it works.
In 2007, Hubler’s triple-A CDO went bad. His CDS customer (D bank) claimed its win over the bet and gave Morgan Stanley several options to pay for the loss. At first, Hubler didn’t admit the loss because he didn’t understand his own CDO. But finally he admitted and cause trillion of loss for Morgan Stanley. Then he was fired while he still got millions of dollars Morgan Stanley promised him. An interesting facts is that Morgan Stanley’s CEO couldn’t explain how that loss happened to his customer though the CEO was also a bond trader before.
In 2007, many CDOs went bad and subprime mortgage market crashed. Charlie Ledley decided not to keep holding CDS until it completely goes bad because there could be 2 potential risks:
1. Government could intervene the market and prevent CDO from completely going bad. Then Charlie Ledley would lose their bet with their CDSs.
2. The financial companies which sold a lot of CDS to Ledley could bankrupt so that they can’t pay the loss.
So instead of waiting for full rewards of the bet, Ledley sold his CDS to other companies which held a lot of CDO and wanted to offset the loss of CDO. Finally Ledley made a profit of 80:1. One interesting facts was that to sell their CDSs, Ledley had to ask his partner Ben to do that. Because only Ben had a broker background and could use correct vocabulary when talking with potential buyer.
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C10：
This chapter mainly describes the 3 fund manager’s ending after 2008 crash.
Charlie Ledley and his partners had quadrupled its capital. They are anxious on how to preserve their money.
The more sure you were of yourself and your judgment, the harder it was to find opportunities premised on the notion that you were, in the end, probably wrong.
The long-shot bet, in some strange way, was a young man’s game.
They spent a surprising amount of their time and energy thinking up ways to attack what they viewed as a deeply corrupt financial system.
Michael Burry also made lot of money for his fund. But maybe due to his lack of ability to communicate with others and impolite words in his emails to his investors, many of his investors still quit his fund though their money in it grew a lot. And they don’t even say thanks to Burry. Burry is the first guy who help to create Credit Default Swap and short the subprime mortgages but no one recognized his achievement. He was still unknown to public. All these thing made him really unhappy and depressed. So finally he decided to close his fund.
Steve Eisman became famous. He also behaved nice for a while. Here is an explanation from his wife about why that happened:
“There was a void after everything happened,” she said. “Once he was proved right, all this anxiety and anger and energy went away. And it left this big void. He went on an ego thing for a while. He was really kind of full of himself.”
Epilogue:
Summary:
Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed. The incentives on Wall Street were all wrong; they’re still all wrong. This is caused by turning a partnership of a Wall Street firm into a public corporation. The main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders.
Citation：
Maybe the best definition of “investing” is “gambling with the odds in your favor.” The people on the short side of the subprime mortgage market had gambled with the odds in their favor. The people on the other side—the entire financial system, essentially—had gambled with the odds against them. Up to this point, the story of the big short could not be simpler. What’s strange and complicated about it, however, is that pretty much all the important people on both sides of the gamble left the table rich.
The moment Salomon Brothers demonstrated the potential gains to be had from turning an investment bank into a public corporation and leveraging its balance sheet with exotic risks, the psychological foundations of Wall Street shifted, from trust to blind faith.
In Eisman’s view, the unwillingness of the U.S. government to allow the bankers to fail was less a solution than a symptom of a still deeply dysfunctional financial system. The problem wasn’t that the banks were, in and of themselves, critical to the success of the U.S. economy. The problem, he felt certain, was that some gargantuan, unknown dollar amount of credit default swaps had been bought and sold on every one of them.
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