Eighteen Things I Learned from The Big Short by Michael Lewis
- Investment banks won’t take you seriously if you aren’t serious money. I had first heard this from a person I knew who had sold his company for $100 million. He described being treated like an afterthought by the big brokerage houses. They preferred to spend their time catering to those who controlled *real* wealth. And this isn’t just a case of preferring working with billionaires to millionaires. It’s preferring to work with people who aren’t necessarily all that wealthy themselves but instead manage the pooled wealth of hundreds of other disparate millionaires. To spell out the consequence, investment banks have a lot of interactions with people who aren’t putting their own wealth at risk.
- There are a lot of ways things can break. Holding a credit default swap that serves as insurance on terrible bonds seemed like a great thing, but what if your counterparty is Bear Stearns? There are a lot of possible points of failures. Even a thesis that is 99.9% correct can lose you money.
- At an intellectual level, I knew that most trades usually involve at least one party doing something that will work out against them. Lewis demonstrates this in dramatic fashion. It is very, very easy to be the dumb money. There are professionals who are dumb money. They probably aren’t actually dumb people, but they aren’t paying attention to the right things. In some ways, trading seems to be like dropping into on online gaming platform where you are matched against an opponent you know nothing about. How much money are you willing to bet on your winning? For me, the answer is “basically, nothing”, but that is analogously what I’ve been doing this whole time when investing.
- The system can make paying attention to the right things difficult. Getting the required information to evaluate the underlying bonds seems to have been very difficult for the heroes of the book despite this being the most important thing about the bonds. Does this mean that the factors that are most important to a company you are investing in are not readily found in the company’s SEC filings? Quite possibly.
- “Due diligence” should be accompanied by an eye roll. Practically speaking, “due diligence” means that you went through the minimum steps required so that an outsider will consider you to have done your job. Anytime you hear someone say “we did our due diligence” you should automatically substitute in “You can’t technically prove that we were willfully negligent.” This is something less than an unwavering commitment to finding the truth no matter what.
- The pension managers that bought subprime bonds felt they did their due diligence by not just buying whatever the investment banks told them to buy. Practically speaking though, this meant they were just buying from an intermediary whose primary incentive was to maximize the volume of business they did. The best way to do this was to just push through whatever the investment banks were able to send. In trying to be responsible, all the pension managers succeeded in doing was increase their own costs.In turn, the investment banks did their due diligence by making sure everything they sold was rated by an independent agency, either Moody’s or S&P.
S&P and Moody’s did their due diligence by using models that predicted the probability of default. If a crisis ever occurred, they could still prove in court if needed that they did their due diligence in rating the bonds issued. When the idea of suing S&P and Moody’s was floated, it was laughed at with an analogy made to suing Road & Track because their car recommendations didn’t work out well.
The cover offered by “due diligence”, more than any other factor, seems to be how no one went to prison.
- Did it seem capricious and random to you how some banks were saved by one method and others by a completely different one and others not at all? Sometimes only bondholders were saved while shareholders were wiped out. Sometimes both bondholders and shareholders were wiped out. Sometimes the government just poured in billions to save both bondholders and shareholders. If there was a justification for this disparate treatment, it doesn’t seem known to Michael Lewis. I wish there were a villain this could be pinned on because the alternative explanation is that no one really ever knew what the right thing to do was, so they made up everything on the fly.
- Options can be mis-priced, even in cases where an event that is likely to significantly influence the stock price is known and has a timeline. This makes sense to me. There are a lot of people who sell covered calls, for example. They pat themselves on the backs for earning extra income above whatever appreciation they might make on the stock. This is the perfect setting for people who want to be arbitrarily picky with what calls they buy.
- Apparently, no one reads the fine print on purposefully abstruse legal documents except one very obsessive guy with Aspergers.
- Despite however much Warren Buffett is admired, few of his most successful admirers seem to have been able to fill his exact same niche.
- Agency costs are hard to avoid. You can pay someone handsomely to manage your money and incentivize them to do well as long as you do well too, but even this doesn’t prevent them from putting you in a situation that will cost you in the long term. By the time the consequences have arrived, they may have taken home millions. The heroes of The Big Short who correctly predicted the subprime crisis don’t seem to have ended up as well off as many of the villains. The Big Short is a tragedy, and that’s its most tragic scene.
- Taking ideas seriously is hard. Lippmann, a Deutsche Bank managing director widely circulated his beliefs about the impending crash. This was a person whose primary job was to sell people on ideas, and he failed to sell hardly anyone on his idea. I can imagine that a lot of slide decks from a lot of banks are floating around all the time. Why believe this particular one? Can you accurately differentiate between investment bank slide decks that are conveying important, truthful information and those that are trying to sell you on something that will screw you? It seems to me that most investment professionals must not even trust themselves with that task, and thus did Lippmann fail in his crusade.
- Don’t do a deal with an investment bank whose parameters are drawn up by the investment bank. They are almost certainly smarter than you. Yes, you hired lawyers to protect yourself, but their lawyers are smarter than your lawyers. Of course, this probably is true of any deal in which you are less of an expert than the other party, but The Big Short let’s us know that the non-experts can include multi-billion-dollar pension funds. Don’t think you know something just because it is your day job. Especially when there are people whose day job is to know that same thing better than you do.
- The investment banks seem to be in the best position to exit at the first hint of a crash. They are information brokers as well. Not everything that is important first appears in some company’s annual report. The banks can thus participate in bubbles while ensuring they get out before their portfolios are worthless.
- Don’t trust investment banks to provide accurate pricing. Michael Burry had deals with investment banks that required them to front capital when the contract he bought went his way and for him to front money when the contract went their way. Accordingly, the bank claimed all news that went his direction was irrelevant and all information that went their way required him to front capital. This seems to have been kept up for about a year. Without staying power, Burry could have been badly taken advantage of. In a book that discusses a lot of slimy behavior, I find this to have been the most disgusting and unfair story. Your nicely written fair contract might be implemented in a deeply unfair way.
- Don’t trade in markets where there isn’t accurate, publicly-available pricing. If you trade illiquid assets without public pricing, you are either someone whose job is making money off the fact that no one knows what the fair price is or you’re someone who is getting screwed.
- A price is only accurate if you can both buy and sell near that price. If someone says their car is worth $10k, one way to determine she is lying is to offer to sell her an identical car for $9k. If the $10k is accurate, she ought to leap at the chance.
All analyses are at least somewhat superficial. Someone might have evaluated a company’s balance sheet and feel they have done a great job of it by examining what assets should be assigned what ratings, but this only works if you believe the ratings. Now, it might seem obvious that you shouldn’t, but it was wholly non-obvious at the time. However little respect anyone had for ratings agencies, few would have guessed that bonds they rated as AAA would ever be in question.
Next time it won’t be this problem. The analysis will fail along with one of the other 500 unstated assumptions, which will seem equally stupid in retrospect as trusting rating agencies. Does that mean you should just give up on the idea of detailed analysis of complicated things? I wish I could say “yes”, but the heroes of The Big Short figured out what would happen in advance through detailed analysis of a complicated thing. There doesn’t seem to be a substitute.