Important Vocabulary

  • Short: To bet against something
  • Long: To bet for something
  • Security: A place to put your money so it grows
  • Default (of a mortgage bond): When a bond becomes worthless because a large enough percentage of the homeowners within it stop paying their mortgages.
  • Tranched Mortgage Bonds: Tranches protect an investor from premature removal from their investment. This is really important for mortgage bonds because there is the very real possibility that a homeowner will pay back their mortgage early. In this case, the investor will have all their money returned to them early and now they are sitting on a big pile of cash with nowhere to put it. Tranches solve this. They allow investors to get a guarantee on how long their investment will last. They can almost be thought of as layers on a cake. The bottom layer tranche will be made up of the mortgages that will end up getting paid back the fastest. They have the highest interest rates for their investors and the shortest lifespan. In the higher tranches, as homeowners pay back their loans slower, investors can have the peace of mind that their investment will last longer, albeit at lower interest rates for taking less risk.
  • Subprime mortgage loan: A mortgage loan made to a person that has a poor credit history. Essentially firms were giving large sums of money to people who had no business having large sums of money.
  • CDO: A group of the worst of the worst mortgage bonds, reparceled into a more appealing package. Often, large banks would buy mortgage bonds from the mortgage lenders that they were not able to sell to people; usually because the bonds (rated BBB) sucked and were not likely to be paid back. The banks would parcel these poor bonds into one package and then get that package rerated by a major rating agency (Moody's or S&P) for a small fee as an A or AAA. They could then sell these CDOs to investors as if the bonds were high quality. It is virtually impossible to see what actual mortgage loans are inside a CDO — it was purposely kept opaque so that the true garbage inside them could not get sniffed out. The banks were so good at this that they fooled even themselves and began holding and buying these CDOs.
  • Synthetic CDO: A CDO made up of bits and pieces of other CDOs. Often there were cycles where CDO A would be part of CDO B, CDO C would contain parts of CDO B, and CDO A contained parts of CDO C; meaning CDO A contained multiple versions of itself. Synthetic CDOs were created for banks to generate assets out of thin air, giving them more securities to sell.
  • Credit Default Swap: A form of insurance. The buyer pays a regular premium as long as a mortgage bond or CDO is still alive. If the bond defaults, the issuer of the insurance must pay a large lump sum. In the context of this book, credit default swaps were like buying fire insurance worth $10 million for $100 a month on a house soaked in gasoline with a lit match right next to it. Because no one in the industry saw this coming, you could buy them cheap with huge upside, and they were practically guaranteed to cash out.
  • Adjustable Rate Mortgage: A mortgage that has a low initial teaser rate. After a few years, the "true" rate kicks in and is much higher than the teaser rate.

Historical Context

At this time large banks were screwing over everyone (including themselves) and no one knew. Eventually everything blew up. The banks made their money by selling securities and taking a small fee on every transaction. Eventually one man named Lewis Raineri from Salomon Brothers created a security based on mortgages, mortgage bonds, that provided a way for investors to get theoretically stable returns on their investments.

The underlying assumption: houses are assets that only increase in value. This assumption is false. Just because something increases historically does not mean it will continue to do so. Adjustable rate mortgages became increasingly popular. The idea was that as long as home prices go up, you have an incentive to pay your mortgage as you build equity. Adjustable rate mortgages had a couple of large benefits for the bank:

  • They allowed people who would not otherwise qualify, to buy a home. Because the teaser rate is so low, people could make the initial payments. This includes people who did not fully understand that the initial rate was not permanent.
  • When the higher floating rate kicked in, the person had an incentive to refinance, which generated yet another fee paid to the bank.

The system worked like this:

  • Large mortgage lenders made loans to ordinary people, often encouraging them to lie and qualify for loans they had no business receiving. The lenders had no skin in the game. They just sold the loans to banks.
  • Large Wall Street banks bought these loans and pooled them into tranched mortgage bonds.
  • Large hedge funds bought up mortgage bonds, CDOs, and synthetic CDOs. The banks also held some of these bonds themselves.
  • Investors, other banks across the world, and anyone with enough capital could start putting money into the securities.

Major Themes

Greed/Lack of accountability

Pretty much everyone from the rating agencies, banks, mortgage lenders, and CDO managers were obsessed with their own short-term profit. They lacked the ability to think critically about how their actions would affect others or how they were shifting risk onto others. Nowhere is this more prominent than in the epilogue. When the author talks to his old boss Gutfreund and asks why he turned Salomon Brothers into a corporation (from a partnership), his answer was simply that it shifted the risk to the shareholder. At the culmination of the housing collapse, that risk was ultimately shifted to the common, everyday American who bore the brunt of the greed at the top.

Stupidity

The big banks were too stupid to even realize what they were holding. They didn't know what was inside their own CDOs. This stupidity permeated every single level of the financial world.

Two-Layered Society

It is clear from this book that the people at the top face no repercussions. The end of the book is harrowing and disheartening. The ones who caused the problem made the rest of the world live with the consequences. The government did nothing to intervene. They actually bailed out the banks and allowed them to keep running business as usual. In fact, CDOs are now being sold again.

Character Breakdown

  • Michael Burry: A nerd with Asperger's who predicts the crisis first. He does not listen to the mainstream and instead follows the data. He creates the credit default swap to hedge the market.
  • Greg Lippman: Hears about Burry's trade and begins selling credit default swaps too. He is cynical, eager to exploit the inefficiencies he sees in the market.
  • Steve Eisman: A hotheaded Wall Street skeptic. He sees the effect this will have on the average person and the deep injustice being committed.
  • Wing Chau: A CDO manager more interested in his own profit than his investors. Represents greedy, short-term self-interest.

Plot Summary

  • See Historical Context before reading this section.
  • Michael Burry does deep analysis in 2005 and realizes these mortgages are being given to anyone and everyone with no ability to repay them. Once the adjustable rates hit their floating levels, everything will default.
  • Burry goes to Goldman Sachs and gets them to create the credit default swap so he can bet against the housing market.
  • Greg Lippman hears about Burry's trade, investigates, and begins selling credit default swaps.
  • Steve Eisman and partners learn about the swaps and begin buying them.
  • We learn about the other side of the trade: AIG FP is the reinsurance firm actually putting up the collateral to pay the swaps in the event of default.
  • AIG figures out the bonds are garbage and stops backing the swaps.
  • Steve and Greg attend the Subprime Conference in Vegas. They meet Wing Chau and confirm the market is going down.
  • Mass defaults occur.
  • Bear Stearns collapses.
  • Every large bank is revealed to be holding enormous amounts of CDOs.
  • The government bails out the big banks — without banks, all commerce stops, which is catastrophic for the entire world.
  • The CEOs and management responsible are untouched. They keep their bonuses and salaries. Business as usual resumes.
  • By 2015, synthetic CDOs are back and being sold again.

Strengths

Super engaging. Lewis is a great teacher. He explains complex securities and terms without being boring. Each character brings a radically different perspective. While they all arrive at the same conclusion (the housing market is going to bust), they approach it differently. Burry is analytical and data driven. Eisman is loud and justice-seeking.

Weaknesses

Swiches between perspectives pretty frequently. Wish it followed each narrative for longer before switching to another.

What did this book teach you?

This taught me a lot about human nature. People are self-interested, especially when there is no accountability for their actions. It also taught me about appearances. The slick, polished financiers look the part but are actually sadistic, self-interested, and greedy.

In one sentence

An incredible look at how the 2008 housing market crash occurred and what caused it.

Score

9/10