October 26, 2018

The Big Short (Michael Lewis)

After introducing a quantitative finance course of study, I've decided to offer some brief comments on the finance-related books I've been reading.

This week, we'll be looking at The Big Short by Michael Lewis, who has a gift for telling stories about financial crises from the point of the view of the people who participated in them - in this case, the traders who made money from the crisis of 2008 by shorting subprime mortgage bonds.

Below, I've laid out some representative quotes from the book, each of which is followed by some practical lessons we can apply to today's markets.


"The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of a doubt, what is laid before him." - Leo Tolstoy

This is consistent with Lewis's message throughout the book: overconfidence in financial models can cause the people who use them (ratings agencies, traders at investment banks, and portfolio managers) to ignore the risks of events that those models say are impossible.


Nobody Wants to Take Smart Risks

Now, obviously, Meredith Whitney didn't sink Wall Street. She'd just expressed most clearly and most loudly a view that turned out to be far more seditious to the social order than, say, the many campaigns by various New York attorneys general against Wall Street corruption. If mere scandal could have destroyed the big Wall Street investment banks, they would have vanished long ago. This woman wasn't saying that Wall Street bankers were corrupt. She was saying that they were stupid. These people whose job it was to allocate capital apparently didn't even know how to manage their own. (p. xvii)

It was then late 2008. By then there was a long and growing list of pundits who claimed they predicted the catastrophe, but a far shorter list of people who actually did. Of those, even fewer had the nerve to bet on their vision. It's not easy to stand apart from mass hysteria - to believe that most of what's in the financial news is wrong, to believe that the most important financial people are either lying or deluded - without being insane. (p. xviii)

"Steve [Eisman]'s fun to take to any Wall Street meeting... because he'll say 'explain that to me' thirty different times. Or 'could you explain that more, in English?' Because once you do that, there's a few things you learn. For a start, you figure out if they even know what they're talking about. And a lot of times they don't!" (p. 23)

"That was a classic Mike Burry trade.... It goes up by ten times but first it goes down by half." This isn't the sort of ride most investors enjoy, but it was, Burry thought, the essence of value investing. His job was to disagree loudly with popular sentiment. (p. 46)

"If you're in a business where you can only do one thing and it doesn't work out, it's hard for your bosses to be mad at you." It was now possible to do more than one thing, but if he bet against subprime mortgage bonds and was proven wrong, his bosses would find it easy to be mad at him. (p. 81)

A smaller number of people - more than ten, fewer than twenty - made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market and, by extension, the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed. (p. 105)

A guy from a rating agency on whom Charlie tested Cornwall's investment thesis looked at him strangely and asked, "Are you sure you guys know what you're doing?" The market insiders didn't agree with them, but they didn't offer any persuasive counter-arguments. Their main argument in defense of subprime CDOs, was that "the CDO buyer will never go away." Their man argument, in defense of the underlying loans, was that, in their short history, they had never defaulted in meaningful amounts....

"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." (p. 147)

He went on about how the ratings agencies were whores. How the securities were worthless. How they all knew it. He gave words to the stuff we were just suspecting.... When he was finished there was complete silence. No one specifically attempted a defense. They just talked around him. It was like everyone pretended he hadn't said it. (p. 149)

"I do my best to have patience... but I can only be as patient as my investors.... The definition of an intelligent manager in the hedge fund world is someone who has the right idea, and sees his investors abandon him just before the idea pays off." When he was making huge sums of money, he had barely heard from them; the moment he started actually to lose a little, they peppered him with doubts and suspicions. (pp. 187-8)

"Nobody came back and said, 'Yeah, you were right....' It was very quiet." (p. 199)

The people in a position to resolve the financial crisis were, of course, the very same people who had failed to foresee it: Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke, Goldman Sachs CEO Lloyd Blankfein, Morgan Stanley CEO John Mack, Citigroup CEO Vikram Pandit, and so on." (p. 260)

Paper qualifications - degrees and job titles - don't say much about whether someone is capable of avoiding dumb risks and taking smart ones.

Risk, as measured by option prices, bond yields, and stock valuations, can get extremely overpriced or underpriced if everyone shares the same opinions. Trading against the crowd can be a smart risk, but it's difficult to do because investors pull their money out of managers' strategies at the worst possible time.


The Little Guys Lose

An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons. It was possible to get ripped off by the big Wall Street firms in the stock market, but you really had to work at it. The entire market traded on screens, so you always had a clear view of the price of the stock of any given company. The stock market was not only transparent but heavily policed. You couldn't expect a Wall Street trader to share with you his every negative thought about public companies, but you could expect he wouldn't work very hard to sucker you with outright lies, or blatantly use inside information to trade against you, mainly because there was at least a chance he'd be caught if he did. The presence of millions of small investors had politicized the stock market. It had been legislated and regulated to at least seem fair. 

The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they'd be reported to some authority. Bond traders could exploit inside information without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation - one reason why so many derivatives had been derived, one way or another, from bonds. The bigger, more liquid end of the bond market - the market for U.S. Treasury bonds, for example - traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn't know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.
(pp. 61-2)

Goldman Sachs stood between Michael Burry and AIG. Michael Burry forked out 250 basis points (2.5 percent) to own credit default swaps on the very crappiest triple-B bonds, and AIG was paid a mere 12 basis points (0.12 percent) to sell credit default swaps on those very same bonds, filtered through a synthetic CDO, and pronounced triple-A rated.... Goldman Sachs had taken roughly 2 percent off the top, risk-free, and booked all the profit up front. (p. 77)

According to the Bear Stearns analyst, double-A CDOs were trading at 75 basis points above the risk-free rate - that is, Charlie should ahve been able to buy credit default swaps for 0.75 percent in premiums a year. The Bear Stearns traders, by contrast, weren't willing to sell them to him for five times that price.... "I asked him, 'Are desks actually buying and selling at that price?' And he says, 'Gotta go,' and hung up." (p. 164)

As an independent investor, you're at a disadvantage trying to trade over-the-counter securities with investment banks. If you can even get them to talk to you, they'll set the terms and quote the prices at which trades take place. You're also exposed to counterparty risk: if your trading partner goes under, you may never get paid.

It's easier and safer to trade liquid, transparent contracts (like listed options) whenever possible.


Don't Make Trades You Don't Understand

Stage Two, beginning at the end of 2004 was to replace the student loans and the auto loans and the rest with bigger piles consisting with nothing but U.S. subprime mortgage loans. "The problem," as one AIG FP trader put it, "is that something else came along that we thought was the same thing as what we'd been doing." The "consumer loan" piles that Wall Street firms, led by Goldman Sachs, asked AIG FP to insure went from being 2 percent subprime mortgages to 95 percent subprime mortgages. In a matter of months, AIG FP, in effect, bought $50 billion in triple-B-rated subprime mortgage bonds by insuring them against default. And yet no one said anything about it - not AIG CEO Martin Sullivan, not the head of AIG FP, Joe Cassano, not the guy in AIG FP's Connecticut office in charge of selling his firm's credit default swap services to the big Wall Street firms, Al Frost. The deals, by all accounts, were simply rubber-stamped inside AIG FP, and then again by AIG brass. Everyone concerned apparently assumed that they were being paid insurance premiums to take basically the same sort of risk they had been taking for nearly a decade. They weren't. They were now, in effect, the world's biggest holders of subprime mortgage bonds. (pp. 71-2)

There were huge sums of money to be made, if you could somehow get [triple-B bonds] re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. Their - soon to be everyone's - nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from different subprime mortgage buildings (100 different triple-B-rated bonds), they persuaded the rating agencies that these weren't, as they might appear, all exactly the same things. They were another diversified pool of assets! This was absurd. The 100 buildings occupied the same floodplain; in the event of a flood, the ground floors of all of them were equally exposed. But never mind: the rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, pronounced 80 percent of the new tower of debt triple-A. 

The CDO was, in effect, a  credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold. (p. 73)

Goldman would buy the triple-A tranche of some CDO, pair it off with the credit default swaps AIG sold Goldman than insured the tranche (at a cost well below the yield of the tranche), declare the entire package risk-free, and hold it off its balance sheet. Of course, the whole thing wasn't risk-free; If AIG went bust, the insurance was worthless, and Goldman could lose everything. Today Goldman Sachs is, to put it mildly, unhelpful when asked to explain exactly what it did. (p. 77)

These supposedly diversified piles of consumer loans now consisted almost entirely of U.S. subprime mortgages. Park conducted a private survey. He asked the people most directly involved in the decision to sell credit default swaps on consumer loans what percentage of those loans were subprime mortgages. He asked Gary Gorton, a Yale professor who had built the model Cassano used to price the credit default swaps: Gorton guessed that the piles were no more than 10 percent subprime. He asked a risk analyst in London, who guessed 20 percent. "None of them knew it was 95 percent," says one trader.... In retrospect, their ignorance seems incredible - but then, an entire financial system was premised on their not knowing, and paying them for this talent. (p. 88)

The big Wall Street firms - Bear Stearns, Lehman Brothers, Goldman Sachs, Citigroup, and others - had the same goal as any manufacturing business: to pay as little as possible for raw material (home loans) and charge as much as possible for their end product (mortgage bonds). The price of the end product was driven by the ratings assigned to it by the models used at Moody's and S&P. The inner workings of these models were, officially, a secret: Moody's and S&P claimed they were impossible to game. But everyone on Wall Street knew that the people who ran the models were ripe for exploitation. "Guys who can't get a job on Wall Street get a job at Moody's," as one Goldman Sachs trader-turned-hedge fund manager put it. Inside the ratings agency there was another hierarchy, even less flattering to the subprime mortgage bond raters. "At the ratings agencies the corporate credit people are the least bad," says a quant who engineered mortgage bonds for Morgan Stanley. "Next are the prime mortgage people. Then you have the asset-backed people, who are basically like brain-dead...." Moody's and S&P didn't actually evaluate the individual home loans, or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools. (pp. 98-9)

"I called S&P and asked if they could tell me what was in a CDO... and they said, 'Oh yeah, we're working on that.' " Moody's and S&P were piling up these triple-B bonds, assuming they were diversified, and bestowing ratings on them 0 without ever knowing what was behind the bonds! There had been hundreds of CDO deals - 400 billion dollars' worth of the things had been created in just the past three years - and yet none, as far as they could tell, had been properly vetted. (pp. 130-1)

The CDO manager's job was to select the Wall Street firm to supply him with subprime bonds that served as the collateral for CDO investors, and then to vet the bonds themselves. The CDO manager was further charged with monitoring the hundreds or so individual subprime bonds inside each CDO, and replacing the bad ones, before they went bad, with better ones. That, however, was mere theory; in practice, the sorts of investors who... bought the triple-A-rated tranche of CDOs - German banks, Taiwanese insurance companies, Japanese farmers' unions, European pension funds, and, in general, entities more or less required to invest in triple-A-rated bonds - did so precisely because they were meant to be foolproof, impervious to losses, and unncessary to monitor or even think about very much. The CDO manager, in practice, didn't do much of anything, which is why all sorts of unlikely people suddenly hoped to become one. "Two guys and a Boomberg terminal in New Jersey" was Wall Street shorthand for a typical CDO manager. The less mentally alert the two guys, and the fewer the questions they asked about the triple-B-rated subprime bonds they were absorbing into their CDOs, the more likely they were to be patronized by Wall Street firms. The whole point of the CDO was to launder a lot of subprime mortgage market risk that the firms had been unable to place straightforwardly. The last thing you wanted was a CDO manager who asked lots of tough questions. (p. 141)

Chau explained to Eisman that he simply passed all the risk that the underlying home loans would default on to the big investors who had hired him to vet the bonds. His job was to be the CDO "expert," but he didn't spend a lot of time worrying about what was in the CDOs. His goal, he explained, was to maximize the dollars in his care.... Chau's real job was to serve was a new kind of front man for the Wall Street firms he "hired"; investors felt better buying a Merrill Lynch CDO if it didn't appear to be run by Merrill Lynch. (pp. 142-3)

"You know how when you walk into a post office you realize there is such a difference between a government employee and other people.... The ratings agencies were all like government employees." Collectively they had more power than anyone in the bond markets, but individually they were nobodies. "They're underpaid.... The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for." (p. 156)

Highly paid, putatively savvy experts took enormous risks they didn't understand. AIG went under because (1) they didn't question the models they were using to price extremely complicated contracts, (2) they believed what the rating agencies told them, and (3) they allowed other traders to take advantage of their ignorance.


Long-Term Options are Underpriced

The model used to by Wall Street to price LEAPS, the Black-Scholes option pricing model, made some strange assumptions. For instance, it assumed a normal, bell-shaped distribution for future stock prices....

It instantly became a fantastically profitable strategy: Start with what appeared to be a cheap option to buy or sell some Korean stock, or pork belly, or third-world currency - really anything with a price that seemed poised for some dramatic change - and then work backward to the thing the option allowed you to buy and sell.... People, and by extension markets, were too certain about inherently uncertain things... had difficulty attaching the appropriate probabilities to highly improbably events. (pp. 113-4)

What struck them powerfully was how cheaply the models allowed a person to speculate on situations that were likely to end in one of two dramatic ways. If, in the next year, a stock was going to be worth nothing or $100 a share, it was silly for anyone to sell a year-long option to buy the stock at $50 a share for $3. Yet the market often did something just like that. The model used by Wall Street to price trillions of dollars' worth of derivatives thought of the financial world as an orderly, continuous process. But the world was not continuous; it changed discontinuously, and often by accident. (p. 116)

Financial options were systematically mispriced. The market often underestimated the likelihood of extreme moves in prices. The options market also tended to presuppose that the distant future would look more like the present than it usually did. Finally, the price of an option was a function of the volatility of the underlying stock or currency or commodity, and the options market tended to rely on the recent past to determine how volatile a stock or currency or commodity might be.... The longer-term the option, the sillier the results generated by the Black-Scholes option pricing model, and the greater the opportunity for people who didn't use it. (pp. 121-2)

They were consciously looking for long shots. They were combing the markets for bets whose true odds were 10:1, priced as if the odds were 100:1. "We were looking for nonrecourse leverage.... We were looking to get ourselves into a position where small changes in states of the world created huge changes in values." (pp. 128-9)

This is a pretty accurate description of the way long-term options are priced. A trading technique called delta-hedging can be used to remove most of the impact of trending stock prices from an option's return. One-year and two-year options that are delta-hedged provide returns that are comparable to those of short-term bonds. When the delta-hedging is removed, options have high returns when markets makes large moves. They can be used to speculate on the possibility of these moves or to protect a stock portfolio from market corrections.

The opposite is true of short-term, or front-month, options, which are overpriced. Unlike longer-dated options, delta-hedged front-month options tend to have negative returns. Front-month options are the most heavily traded, and traders who buy them tend to lose money.

Buying a longer-dated option and selling a front-month option against it is called a calendar spread and is generally a profitable way to trade.


ISBN 978-0-393-07223-5
Lewis, Michael. The Big Short: Inside the Doomsday Machine. Norton, 2011.

0 comments:

Post a Comment