Tuesday, July 13, 2010

The Big Short, Inside the Doomsday Machine – A Book Review

The latest book on my summer reading list is The Big Short, Inside the Doomsday Machine, Michael Lewis’s amazing book about the hedge fund investors who managed to find a way to bet against the U.S. subprime mortgage market before it blew up in spectacular fashion. If you are looking for a book that simplifies and explains many of the derivative mortgage products that are now part of the vocabulary of any investor, then this is the book for you. Part of Lewis’s genius as a storyteller is his ability to explain complicated financial stuff, and this book doesn’t disappoint. If you’ve had a secret longing (come on…admit it) to understand Residential Mortgage Backed Securities (RMBS), Credit Default Swaps (CDS), Collateralized Debt Obligations (CDOs), synthetic CDOs, etc., this is a way to learn by being engrossed in a fantastic story about compelling people.

What is the real story of the book? For me it is a story of the type of investors who are true value investors. These are people who look at the world in a different way and have the ability to disagree with the consensus. In this case, the hedge fund managers that Lewis introduces us to basically reach the conclusion that the consensus is wrong about U.S. residential real estate, the U.S. mortgage origination and distribution system of underwriting mortgages, the level of risk in mortgage-backed securities and their derivatives, and the entire Wall Street apparatus of the world’s largest investment banks who ultimately packaged and sold hundreds of billions of dollars worth of subprime and Alt-A mortgages. In short, these hedge fund managers reached the conclusion that they were right, and virtually everyone else was wrong about the state of finance around the world. Not only do they reach the most amazing contrary opinion of the century, but they then risk everything they own to invest their view. I suppose when you can buy insurance on subprime mortgages (a way to sell-short or bet against the value of the mortgages) for 3 cents on the dollar, the value characteristics of the trade seemed obvious…to them.

And what is the defining characteristic of these genius hedge fund managers who bet it all and made hundreds of millions of dollars when the U.S. residential real estate market fell in value and the underlying mortgage products imploded? They were social misfits. One was eventually diagnosed with Asperger’s disease, although he attributed his inability to get along with people to having a glass eye. Here is Mike Burry, one of the heroes of the book, describing his struggles to get along with people: “When trying his best he was often at his worst. ‘My compliments tended not to come out right,’” he said. “I learned early on that if you compliment somebody it’ll come out wrong. For your size, you look good. That’s a really nice dress: it looks homemade.” Burry is one of many characters that are so socially inept that apparently their only recourse was to lose themselves in finance. I never thought that I would meet such interesting characters in a book about the subprime mortgage market, but there is a lot to learn from them if you aspire to be a value investor, or want to better understand value investing. This is a great book that’s easy to read. If you have some time left this summer, take a shot at it. Next on my reading list: This Time its Different, Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff.