ACT Practice Tests

Here are six official ACT practice tests.

2018-19 ACT Practice Test

2016-17 ACT Practice Test (This is the test Compass Prep usually uses as a diagnostic tool.)

2014-15 ACT Practice Test

2011-12 ACT Practice Test

2008-09 ACT Practice Test

2005-06 ACT Practice Test

Since the ACT has slowly changed over time, start with the most recent version and work your way down the list.

I strongly suggest printing the tests out onto real paper. It's almost impossible to take notes, cross off answer choices, or double-check your bubbling unless you're working on paper!

If you need more practice tests, you can buy the Official ACT Prep Guide.

Have fun!

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Free Web Site Help AND a Free Tutoring Session

On January 28, the Contra Costa Small Business Development Center is offering a free three-hour seminar about building a Web site through Wordpress.

In the interest of helping students build an online presence, I'm offering a free tutoring session to any current or new student who attends. The link below has the seminar's location and time.

Web Site Building Basics: Building and Publishing Your Own Web Site

After the seminar, please contact me about tutoring and include the words "Web site building seminar." I'd be happy to help you with test prep, math, or chemistry. Alternatively, you can use the free session to learn how to use your new Web site to market yourself to colleges and potential employers.

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On Big Companies and Free Practice Tests

Big test prep companies offer free practice tests because it's a great way for them to make money.

They pay marketers, proctors, graders, administrative staff, bondholders, and shareholders - not to mention real estate costs - so you can get a score for free.

In exchange, you've become what salesmen call a warm lead: someone who's demonstrated interest in their product.

There's nothing wrong with this as long as you understand how the process works. Test prep companies offer practice tests, which are valuable to you, so they can get your attention, which is valuable to them.

They pay for this by charging $125-250 an hour for tutoring, ten sessions at a time, paid up front. Their tutors typically make $25-40 an hour, and the difference ($100/hour or more) is used to pay administrative costs and provide investors with a profit.

The breakeven point between teaching at a public school and working as an independent tutor is around $90/hour. Tutors who accept less than half of that amount typically have SAT scores of around 1400-1500. Those are good scores, but if you're paying $150/hour, your score target is probably already at or higher than 1500.

This is not going to change, as these tutors aren't being exploited. Test prep companies have large expenses every month that aren't going to go away if there's a recession. Most workers, including tutors, accept lower pay in order to have their employers shoulder that burden.

If you have time, it's best to take responsibility for your own education. Practice taking the SAT and ACT yourself, then compare the two scores. You can then choose SAT or ACT prep books and study on your own.

If you need a tutor, you have lots of options, including highly qualified independent tutors like myself. Go in with your eyes open, and you'll make a great choice.

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UC Schools Have Become More Selective

It's gotten harder to get into University of California schools: not just for your friends who were seniors last year, but for everyone.

I've included data below for the high school graduating classes of 2017 and 2018 with the information for UC Berkeley and UCLA highlighted.

While GPA ranges across the board have increased only slightly, test scores are consistently higher, and the percentage of applicants admitted has consistently moved lower from 2017 to 2018.

UC Data: Class of 2017

UC Data: Class of 2018

Audrey Slaughter was kind enough to share a Compass Prep article with me that breaks down ACT and SAT test score data from the past few years.

Compass finds that median scores haven't changed much, but more students are have been scoring at the high end of the range (1400-1600):

At the most competitive colleges, high test scores can be viewed as “necessary but not sufficient.” It is extremely difficult to gain admission to Stanford with a low SAT score, but getting a great score is far from a guarantee of admission. The net effect of the growth at the top ranges is to make a high score more essential but less sufficient.

After the dust settles each April, we often hear that “this was the worst year ever.” For 2018, that assessment feels fair. ACT and SAT scores at colleges have trended up over time, but it’s not simply higher scores that create anxiety — it’s also the added unpredictability. The combination of increased applicant numbers at competitive colleges and a higher percentage of top scores magnify the uncertainty that students experience.

So How Do I Get In?

In the end, grades, test scores, and a college degree itself are only imperfect measures of what really matters: your dedication, creativity, and life goals. Schools like Stanford know that, and they're looking for much more than just great numbers on your application.

Does your life thus far show that you have the potential to win a Nobel Prize or found your own company? That's what schools are looking for. Those are the things that get an alma mater noticed.

As a nation, we're obsessing more and more about the scoring well on the things that measure success without necessarily getting better at achieving success itself.

Test scores and grades matter because those are the things we've chosen to measure - but don't forget to live a life of dedication and meaning. It's that life that will get you involved in amazing extracurriculars and help you write essays that will get noticed.

Yes, UC schools have become more selective. Become the kind of person they would like to select.

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The Four Best Places to Find a Tutor

Update: I've added a link to Northgate High School's peer tutoring program.

Are you looking for a tutor? Our capitalistic economy provides a dizzying array of educational options, and part of my job is to help you sort through them, even if you end up working with someone else as a result.

Why would I purposefully direct you to tutor who's a better fit for you? Most of my business comes from word of mouth, and I believe that following the Golden Rule and giving to others will benefit me indirectly. (Check out this animation about win-win scenarios.) What's best for you is often what's best for me.

Full-time tutors start at $45/hour, and tutors with perfect SAT and ACT scores are $180-600/hour. Use the guide below to evaluate your options.

Peer Tutors

Most schools offer free or low-cost peer tutoring. I used to work as one of those tutors when I was in eighth grade. That's the lowest-end option and is suitable for help with homework, since those tutors are likely to be most familiar with the local curriculum.

If you go this route, you'll probably want to do sessions multiple times a week to stay caught up in school.

Using peer tutoring to get A's in math and English is an excellent way to prepare for the SAT and ACT and will reduce the number of sessions you'll need with a test prep specialist.

Similarly, you can get a peer tutor multiple times per week for an AP class and wait until March to hire a test prep specialist to help you prepare for the corresponding SAT Subject Test and AP exam.

You can find your school's peer tutoring page by searching Google for your school's name plus the word tutoring.

Northgate High School's peer tutoring program meets in the Multimedia Center.

I also have students with perfect SAT/ACT Math and Calculus BC scores who currently work as private tutors. They're good options at the high end of the peer tutoring spectrum.

Tutoring Companies

Medium-sized companies (JC Education, Lafayette Academy, Zenith Tutoring) and big companies (Kaplan, Princeton Review, Tried and True Tutoring, Compass Prep) charge two to five times what they pay out to tutors. They offer tutoring in the range of $45-250 an hour.

You'll be getting a lower-paid tutor, but the service is convenient, as those companies are one-stop shops for help in all subjects, including college admissions counseling.

In general, the larger the company, the more standardized its product will be. I personally go to huge corporations for commoditized services where I want predictability: gasoline (World Oil), book delivery (Amazon), and health food (Odwalla). Standardization is less of a benefit in situations where you have to learn a skill like swing dancing, writing, or math.

Mid-Tier Independent Subject Tutors

You can also hire independent educators through Web sites like Thumbtack and Wyzant, and you'll also find some advertising on NextDoor. You'll probably get more for your money than if you go through a big company.

A credentialed teacher who can tutor in most school subjects will run you about $70/hour, depending on the area you live in.

$70/hour is theoretically a bit low in California: the average high school teacher makes $75,000 a year. In order to be incentivized to tutor full-time, which is 20 hours a week of tutoring with 20 hours of driving and prep, the teacher needs to make around $75/hour AFTER paying business expenses and the extra taxes involved in being self-employed. That could end up being more like $90/hour gross of expenses, but I use $70/hour as an average because that's what I tend to observe in the market.

Of course, there are great tutors who charge less than $70/hour, just as there are great teachers who make less than $75,000 a year. (Un-unionized private school teachers - I used to be one - come to mind.) Just be aware that in general, you get what you pay for, and if you want something great at a relatively low rate, you have to be willing to evaluate a number of tutors to find the diamond in the rough.

Top-Tier Test Prep Specialists

Finally, there are independent specialists, each of whom focuses on one academic area and does it very well.

For example, I have a master's degree in chemistry from Stanford and perfect scores on most standardized tests, so I tutor mainly SAT/ACT, Math Level 2, calculus, and AP Chemistry. Audrey Slaughter specializes in college admissions counseling and spends a large portion of each year visiting college campuses and keeping up-to-date with changes in her field.

Specialized tutoring runs up to $600/hour and works best to address specific needs rather than as a long-term solution to raise grades. You may want to consider hiring a peer tutor to come multiple times per week and then supplement with a specialist two months before the AP test or four months before the SAT.

Tutors with perfect SAT and ACT scores are relatively rare, as they could be working at Google or founding startups instead of spending their weekends with high school students. They're usually high-value educators with multiple qualifications.

My own tutoring service compares favorably with other top-tier options. If you'd like to have ACT score gains of 5-10 points, SAT score gains of 180-350 points, or perfect scores on Subject Tests and AP tests, please contact me so I can help you create a study plan.

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Boomerang (Michael Lewis)

This week, we'll look at Boomerang by Michael Lewis. As usual, I've included representative quotes from the book along with finance-related lessons (in blue) that we can apply to markets today.

Lewis visits Europe to consider the aftermath of the 2008 financial crisis on Iceland, Greece, Ireland, and Germany.

Each of these countries took enormous financial risks it didn't understand. In each case, there were people who saw what was going on. Their voices were ignored until after the market began to collapse.

Iceland: The Carry Trade

For the past few years, some large number of Icelanders engaged in the same disastrous speculation. With local interest rates at 15.5 percent and the krona rising, they decided the smart thing to do, when they wanted to buy something they couldn't afford, was to borrow not kronur but yen and Swiss francs. They paid 3 percent interest on the yen and in the bargain made a bundle on the currency trade, as the krona kept rising. (p. 8)

Borrowing at a low interest rate and buying an asset that is expected to provide a higher return is known as the carry trade. It's a profitable strategy for traders who get in early. In this case, as other traders piled in - borrowing yen and buying the krona - the krona rose in value, providing those early traders with both positive carry (the difference between what they paid to borrow yen and what they made lending the krona) and the appreciation of the krona itself.

It must have seemed like a no-brainer: buy these ever more valuable houses and cars with money you are, in effect, paid to borrow. But, in October, after the krona collapsed, the yen and Swiss francs they must repay became many times more expensive. Now many Icelanders - especially young Icelanders - own $500,000 houses with $1.5 million mortgages, and $35,000 Range Rovers with $100,000 in loans against them. To the Range Rover problem there are two immediate solutions. One is to put it on a boat, ship it to Europe, and try to sell it for a currency that still has value. The other is to set it on fire and collect the insurance: Boom! (p. 9)

At some point, the carry trade runs too far, creating mispricings that will eventually be reversed. In this case, the krona became overvalued and the yen undervalued. Traders needed to exit their positions, buying yen and selling the assets they had bought, but some weren't able to because the assets they bought weren't liquid enough. If you borrow yen in the short term and buy long-term bonds to get a higher interest rate (or worse, buy houses and cars), you're counting on finding a willing buyer to eventually take that position off your hands.

That was the biggest American financial lesson the Icelanders took to heart: the importance of buying as many assets as possible with borrowed money, as asset prices only rose. By 2007, Icelanders owned roughly fifty times more foreign assets than they had in 2002. They bought private jets and third homes, in London and Copenhagen. They paid vast sums of money for services no one in Iceland had theretofore ever imagined wanting. "A guy had a birthday party, and he flew in Elton John for a million dollars to sing two songs," the head of the Left-Green Movement, Steingrimur Sigfusson, tells me with fresh incredulity. "And apparently not very well." They bought stakes in businesses they knew nothing about and told the people running them what to do - just like real American investment bankers! (p. 15)

Since the entire world's assets were rising - thanks in part to people like these Icelandic lunatics paying crazy prices for them - they appeared to be making money. Yet another hedge fund manager explained Icelandic banking to me this way: you have a dog, and I have a cat. We agree that each is worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners but Icelandic banks, with a billion dollars in new assets. "They created fake capital by trading assets amongst themselves at inflated values." (pp. 16-17)

The Danske Bank report alerted hedge funds in London to an opportunity: shorting Iceland. They investigated and found this incredible web of cronyism: bankers buying stuff from one another at inflated prices, borrowing tens of billions of dollars and relending it to the members of their little Icelandic tribe, who then used it to buy up a messy pile of foreign assets. "Like any new kid on the block," says Theo Phanos, of Trafalgar Asset Mangers, in London, "they were picked off by various people who sold them the lowest-quality assets - second-tier airlines, sub-scale retailers. They were in all the worst LBOs." (pp. 19-20)

You didn't need to be Icelandic to join the cult of the Icelandic banker. German banks put $21 billion into the Icelandic banks. The Netherlands gave them $305 million, and Sweden kicked in $400 million. UK investors, lured by the eye-popping 14 percent annual returns, forked over $30 billion - $28 billion from companies and individuals and the rest from pension funds, hospitals, universities, and other public institutions. Oxford University alone lost $50 million. (p. 23)

As a bull market ages, the deals that are done tend be less conservative, and the people participating in those deals tend to be less sophisticated.

Greece: A Subprime Government

In 2001, Greece entered the European Monetary Union, swapped the drachma for the euro, and acquired for its debt an implicit European (read German) guarantee. Greeks could now borrow long-term funds at roughly the same rate as Germans - not 18 percent but 5 percent. To remain the in euro zone, they were meant, in theory, to maintain budget deficits below 3 percent of GDP; in practice, all they had to do was cook the books to show that they were hitting the targets. Here, in 2001, entered Goldman Sachs, which engaged in a series of apparently legal but nonetheless repellent deals designed to hide the Greek government's true level of indebtedness. For these trades Goldman Sachs - which, in effect, handed Greece a $1 billion loan - carved out a reported $300 million in fees. The machine that enabled Greece to borrow and spend at will was analogous to the machine created to launder the credit of the American subprime borrower - and the role of the American investment banker in the machine was the same. The investment bankers also taught the Greek government how to securitize future receipts from the national lottery, highway tolls, airport landing fees, and even funds granted to the country by the European Union. Any future stream of income that could be identified was sold for cash up front and spent. As anyone with a brain must have known, the Greeks would be able to disguise their true financial state for only as long as (a) lenders assumed that a loan to Greece was as good as guaranteed by the European Union (read Germany), and (b) no one outside of Greece paid very much attention. Inside Greece there was no market for whistle-blowing, as basically everyone was in on the racket. (pp. 82-83)

Greece bundled up and sold off tomorrow's income in order to have cash today. That would have made sense if they had invested the money in assets that would have provided a higher return and allowed them to pay the money back. Instead, they spent the money - after having paid fat fees to do the borrowing.

Ireland: An Even Bigger Housing Bubble

Kelly saw house prices rising madly, and heard young men in Irish finance to whom he had recently taught economics try to explain why the boom didn't trouble them. And the sight and sound of them troubled him. "Around the middle of 2006 all these former students of ours started to appear on TV!" he says. "They were now all bank economists and they were nice guys and all that. And they all were saying the same thing: 'We're going to have a soft landing.' "

The statement struck him as absurd on the face of it: real estate bubbles never end with soft landings. A bubble is inflated by nothing firmer than people's expectations. The moment people cease to believe that house prices will rise forever, they will notice what a terrible long-term investment real estate has become, and flee the market, and the market will crash. It was in the nature of real estate booms to end in crashes - just as it was perhaps in Morgan Kelly's nature to assume that if his former students were cast on Irish TV playing the financial experts, something was amiss. "I just started Googling things," he says.

Googling things, Kelly learned that more than a fifth of the Irish workforce was now employed building houses. The Irish construction industry had swollen to become nearly a quarter of Irish GDP - compared to less than 10 percent or so in a normal economy - and Ireland was building half as many new houses a year as the United Kingdom, which had fifteen times as many people to house. He learned that since 1994 the average price for a Dublin home had risen more than 500 percent. In parts of Dublin rents had fallen to less than 1 percent of the purchase price; that is, you could rent a million-dollar home for less than $833 a month. The investment returns on Irish land were ridiculously low: it made no sense for capital to flow into Ireland to develop more of it. Irish home prices implied an economic growth rate that would leave Ireland, in twenty-five years, three times as rich as the United States. ("A price-earnings ratio above Google's," as Kelly put it.) Where would this growth come from? Since 2000, Irish exports had stalled and the economy had become consumed with building houses and offices and hotels. "Competitiveness didn't matter," says Kelly. "From now on we were going to get rich building houses for each other." (pp. 90-1)

Their real estate boom had the flavor of a family lie: it was sustainable so long as it went unquestioned and it went unquestioned so long as it appeared sustainable. After all, once the value of Irish real estate came untethered from rents, there was no value for it that couldn't be justified.... 

"There is an iron law of house prices... the more house prices rise relative to income and rents, they more they will subsequently fall." (pp. 91-2)

As it happened, Kelly had predicted the future with uncanny accuracy, but to believe what he was saying, you had to accept that Ireland was not some weird exception in human financial history. "It had no impact," Kelly says. "The response was general amusement. It was what will these crazy eggheads come up with next? sort of stuff." (p. 93)

Kelly wrote his second newspaper article, more or less predicting the collapse of the Irish banks. He pointed out that in the last decade the Irish banks and economy had fundamentally changed. In 1997 the Irish banks were funded entirely by Irish deposits. By 2005 they were getting most of their money from abroad. The small German savers who ultimately supplied the Irish banks with deposits to re-lend in Ireland could take their money back with the click of a computer mouse. Since 2000, lending to construction and real estate had risen from 8 percent of Irish bank lending (the European norm) to 28 percent. One hundred billion euros - or basically the sum total of all Irish bank deposits - had been handed over to Irish commercial property developers. By 2007, Irish banks were lending 40 percent more to property developers alone than they had to to the entire Irish population seven years earlier....

This time Kelly sent his piece to a newspaper with a far bigger circulation, the Irish Independent. The Independent's editor wrote back to say he found the article offensive and wouldn't publish it. Kelly next turned to the Sunday Business Post, but the editor just sat on the piece. The journalists were following the bankers' lead and conflating a positive outlook on real estate prices with a love for country and a commitment to Team Ireland. ("They'd all use the same phrase, 'You're either for us or against us,' " says a prominent Irish bank analyst in Dublin.) (pp. 94-5)

As a bubble inflates, there are always people who point out how irrational the market's behavior is, and they're almost always ignored. In practice, it's hard to tell if they're wrong or simply calling the end of the bubble too early. 

Objective quantitative approaches may help here: are valuations currently high relative to history, relative to other asset classes, and relative to other countries? Have trend-following indicators begun to suggest that the bubble may be popping?

A banking system is an act of faith: it survives only for as long as people believe it will. Two weeks earlier the collapse of Lehman Brothers had cast doubt on banks everywhere. Ireland's banks had not been managed to withstand doubt; they had been managed to exploit blind faith. Now the Irish people finally caught a glimpse of the guy meant to be guarding them: the crazy uncle had been sprung from the family cellar. Here he was, on their televisions, insisting that the Irish banks' problems had nothing whatsoever to do with the loans they'd made... when anyone with eyes could see, in the vacant skyscrapers and empty housing estates around them, evidence of bank loans that were not merely bad but insane. (p. 98)

It would have been difficult for Merrill Lynch's investment bankers not to know, on some level, that, in a reckless market, the Irish banks acted with a recklessness all their own. But in the six-page memo to Brian Lenihan - for which the Irish taxpayer forked over to Merrill Lynch 7 million euros - they kept whatever reservations they might have had to themselves. "All of the Irish banks are profitable and well-capitalized," wrote Merrill Lynch advisers. (p. 112)

"At the time they were all saying the same thing," an Irish bank analyst tells me. "We don't have any subprime." What they meant was that they had avoided lending to American subprime borrowers; what they neglected to mention was that, in the general frenzy, all of Ireland had become subprime. Otherwise sound Irish borrowers had been rendered unsound by the size of the loans they had taken out to buy inflated Irish property. That had been the strangest consequence of the Irish bubble: to throw a nation that had finally clawed its way out of centuries of indentured servitude back into indentured servitude. (p. 113)

Experts aren't always right. Do your own research, and turn off the financial news.

Germany: It's Risk-Free. Right?

The curious thing about the eruption of cheap and indiscriminate lending of money between 2002 and 2008 was the different effects it had from country to country. Every developed country was subjected to more or less the same temptation, but no two countries responded in precisely the same way. Much of Europe had borrowed money to buy stuff it couldn't honestly afford. In effect, lots of non-Germans had used Germany's credit rating to indulge their material desires. The Germans were the exception. Given the chance to take something for nothing, the German people simply ignored the offer. "There was no credit boom in Germany.... Real estate prices were completely flat. There was no borrowing for consumption. Because this behavior is totally unacceptable in Germany. This is deeply in German genes. It is perhaps a leftover of the collective memory of the Great Depression and the hyperinflation of the 1920s." The German government was equally prudent because, he went on, "there is a consensus among the different parties about this: if you're not adhering to fiscal responsibility you have no chance in elections, because the people are that way."

In the moment of temptation, Germany became something like a mirror image to Iceland and Ireland and Greece - and the United States. Other countries used foreign money to fuel various forms of insanity. The Germans, through their bankers, used their own money to enable foreigners to behave insanely....

They lent money to American subprime borrowers, to Irish real estate barons, to Icelandic banking tycoons, to do things to German would ever do. The German losses are still being totaled up, but at last count, they stand at $21 billion in the Icelandic banks, $100 billion in Irish banks, $60 billion in various U.S. subprime-backed bonds, and some yet-to-be-determined amount in Greek bonds. (pp. 145-6)

He'd created the bank when the market was paying higher returns to bondholders: Rhineland Funding was paid well for the risk it was taking. By the middle of 2005, with the financial markets refusing to see a cloud in the sky, the price of risk had collapsed: the returns on the bonds backed by American consumer loans had collapsed. Rothig says he went to his superiors and argued that, as they were being paid a lot less to take the risk of these bonds, IKB should look elsewhere for profits. "But they had a profit target and they wanted to meet it. To make the same profit with a lower risk spread they simply had to buy more," he says. The management, he adds, did not want to hear his message. "I showed them the market was turning," he says. "I was taking the candy away... instead of giving it. So I became the enemy." When he left, others left with him, and the investment staff was reduced, but the investment activity boomed. "One-half the number of people with one-third the experience made twice the number of investments," he says. "They were ordered to buy...."

As long as the bonds offered up by the Wall Street firms abided by the rules specified by IKB's experts, they got hoovered into the Rhineland Funding portfolio without further inspection. Yet the bonds were becoming radically more risky, because the loans that underpinned them were becoming crazier and crazier. After he left, Rothig explains, IKB had only five investment officers, each in his late twenties, with a couple of years' experience: these were the people on the other end of the bets being handcrafted by Goldman Sachs for its own proprietary trading book, and by other big Wall Street firms for extremely clever hedge funds that wanted to bet against the market for subprime bonds. The IKB portfolio went from $10 billion in 2005 to $20 billion in 2007, Rothig says, "and it would have gotten bigger if they had had more time to buy. They were still buying when the market crashed. They were on their way to thirty billion dollars."

By the middle of 2007 every Wall Street firm, not just Goldman Sachs, realized that the subprime market was collapsing, and tried frantically to get out of their positions. The last buyers in the entire world, several people on Wall Street have told me, were willfully oblivious Germans. That is, the only thing that stopped IKB from losing even more than $15 billion on U.S. subprime loans was that the market ceased to function. Nothing that happened - no fact, no piece of data - was going to alter their approach to investing money. 

On the surface IKB's German bond traders resembled the reckless traders who made similarly stupid bets for Citigroup and Merrill Lynch and Morgan Stanley. Beneath it, they were playing an entirely different game. The American bond traders may have sunk their firms by turning a blind eye to the risks in the subprime bond market, but they made a fortune for themselves in the bargain, and have for the most part never been called to account. They were paid to put their firms in jeopardy, and so it is hard to know whether they did it intentionally or not. The German bond traders, on the other hand, had been paid roughly one hundred thousand dollars a year, with, at most, another fifty-thousand-dollar bonus. In general, German bankers were paid peanuts to run the risk that sank their banks, which strongly suggests that they really didn't know what they were doing. (pp. 160-2)

The Germans were blind to the possibility that the Americans were playing the game by something other than the official rules. The Germans took the rules at their face value: they looked into the history of triple-A-rated bonds and accepted the official story that triple-A-rated bonds were completely risk-free....

Perhaps because they were some enamored of the official rules of finance, the Germans proved especially vulnerable to a false idea the rules encouraged: that there is such a thing as a riskless asset. After all, a triple-A rating was supposed to mean "riskless asset." There is no such thing as a riskless asset. The reason an asset pays a return is that it carries risk. But the idea of the riskless asset, which peaked about late 2006, overran the investment world, and the Germans fell for it the hardest. I'd heard about this, too, from people on Wall Street who had dealt with German bond buyers. "You have to go back to the German mentality," one of them had told me. "They said, 'I've ticked all the boxes. There is no risk.' It was form over substance...." 

IKB had to be rescued by a state-owned bank on July 28, 2007. Against capital of roughly $4 billion, it had lost more than $15 billion. As it collapsed, the German media wanted to know how many U.S. subprime bonds these German banks had gobbled up. IKB's CEO, Stefan Ortseifen, said publicly that IKB owned almost no subprime bonds at all - which is why he's now charged with misleading investors. "He was telling the truth," says Rothig. "He didn't think he owned any subprime. They weren't able to give any correct numbers of the amounts of subprime they had because they didn't know. The IKB monitoring systems did not make a distinction between subprime and prime mortgages. And that's why it happened." Back in 2005, Rothig says, he proposed to build a system to track more precisely what loans were behind the complex bonds they were buying from Wall Street firms, but IKB's management didn't want to spend the money. "I told them, You have a portfolio of twenty billion dollars, you are making two hundred million dollars a year, and you are denying me six point five million. But they didn't want to do it." (pp. 163-5)

People can be spectacularly wrong. It's a particularly bad sign when they can't make well-thought-out arguments for their views and ignore contradictory evidence.

At some point, you'll be tempted to capitulate and change your views because it feels like you're the only one in the world who's willing to stand against the crowd. As we've seen, it's good to question your beliefs and consider new evidence, but that evidence is probably not going to come from experts who are all trading in the consensus direction. Do your own research whenever possible.

ISBN 978-0-393-08181-7
Lewis, Michael. Boomerang: Travels in the New Third World. Norton, 2011.

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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.

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