The Big Short, and the Enormity of the World Economy Explained by Pop Culture References

There’s a trick they do with one pea and three cups which is very hard to follow, and something like it, for greater stakes than a handful of loose change, is about to take place.

The text will be slowed down to allow the sleight of hand to be followed.

Mrs. Deirdre Young is giving birth in Delivery Room Three. She is having a golden-haired male baby we will call Baby A.

The wife of the American Cultural Attache, Mrs. Harriet Dowling, is giving birth in Delivery Room Four. She is having a golden-haired male baby we will call Baby B.

Sister Mary Loquacious has been a devout Satanist since birth. She went to Sabbat School as a child and won black stars for handwriting and liver. When she was told to join the Chattering Order she went obediently, having a natural talent in the direction and, in any case, knowing that she would be among friends. She would be quite bright, if she was ever put in a position to find out, but long ago found that being a scatterbrain, as she’d put it, gave you an easier journey through life. Currently she is being handed a golden-haired male baby we will call the Adversary, Destroyer of Kings, Angel of the Bottomless Pit, Great Beast that is called Dragon, Prince of This World, Father of Lies, Spawn of Satan, and Lord of Darkness.

Watch carefully.

I read Michael Lewis’s The Big Short: Inside the Doomsday Machine, and I recommend it.

It was a quick read and, like all Lewis stories, half character story and half an examination of some trend or event in society. I already had a comfortable grasp of mortgage backed securities, collateralized debt obligations, and credit default swaps, so the technical details were (mostly) easy reading.

That said, I hit one point a third of the way through that I had to read three times before it clicked, and when I could finally say that I understood what I’d just read, I felt I’d wandered into a story about an ancient sunken city that will rise again when the stars are aligned.

The most merciful thing in the world, I think, is the inability of the human mind to correlate all its contents. We live on a placid island of ignorance in the midst of black seas of infinity, and it was not meant that we should voyage far. The sciences, each straining in its own direction, have hitherto harmed us little; but some day the piecing together of dissociated knowledge will open up such terrifying vistas of reality, and of our frightful position therein, that we shall either go mad from the revelation or flee from the light into the peace and safety of a new dark age.

To wit:

In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. […]

There was a third, even more mind-bending, way to think of this new instrument: as a near-perfect replica of a subprime mortgage bond. The cash flows of Mike Burry’s credit default swaps replicated the cash flows of the triple-B-rated subprime mortgage bond that he wagered against. The 2.5 percent a year premium Mike Burry was paying mimicked the spread over LIBOR that triple-B subprime mortgage bonds paid to an actual investor. The billion dollars whoever had sold Mike Burry his credit default swaps stood to lose, if the bonds went bad, replicated the potential losses of an actual bond owner.

On its surface, the booming market in side bets on subprime mortgage bonds seemed to be the financial equivalent of fantasy football: a benign, if silly, fascimile of investing. Alas, there was a difference between fantasy football and fantasy finance: When a fantasy football player drafts Peytom Manning to be on his team, he doesn’t create a second Peyton Manning. When Mike Bury bought a credit default swap based on a Long Beach Savings subprime-backed bond, he enabled Goldman Sachs to create another bond identical to the original in every respect but one: There were no actual home loans or home buyers. Only the gains and losses from the side bet on the bonds were real.

And so, to generate $1 billion in triple-B-rated subprime mortgage bonds, Goldman Sachs did not need to originate $50 billion in home loans. They needed simply to entice Mike Burry, or some other market pessimist, to pick 100 different triple-B bonds and buy $10 million in credit default swaps on each of them. Once they had this package (a “synthetic CDO,” it was called, which was the term of art for a CDO composed of nothing but credit default swaps), they’d take it over to Moody’s and Standard & Poor’s. […]

The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lower-rated of the remaining bonds and turned most of those into triple-A CDOs. And then, because it could not extend home loans fast enough to create a sufficient number of lower-rated bonds – it used credit default swaps to replicate the very worst of the existing bonds, many times over. […]

The market for “synthetics” removed any constraint on the size of risk associated with subprime mortgage lending. To make a billion-dollar bet, you no longer needed to accumulate a billion dollars’ worth of actual mortgage loans. All you had to do was find someone else in the market willing to take the other side of the bet.

I find it a stretch to call this the “subprime crisis.” Yes, subprime mortgages were involved, but in the way of the chicken’s – not the pig’s – involvement in a breakfast of ham and eggs. Bear Sterns didn’t blow up because it found itself holding too many defaulting mortgages – it blew up because it found itself guaranteeing unrelated third parties’ mortgages, and income streams not from mortgages but indexed to the mortgages of unrelated third parties, and income streams from the income indexed to the mortgages, and so on. And it was doing this many times over.

I’ve seen arguments that the subprime crisis was caused by Federal pressure to expand lending to minorities and thus Fannie Mae taking on excess risks. I thought this argument implausible – subprime mortgages were the loans that didn’t meet Fannie Mae’s underwriting requirements. Subprime mortgages were a way around Fannie Mae and its underwriting requirements. Synthetics were a way around the subsequent lack of demand for new mortgages.

It turns out this reply isn’t relevant, because the Fannie Mae claim isn’t even wrong. The subprime mortgage crisis isn’t about the implosion of a pool of bad mortgages – it’s about the implosion of a pool of no mortgages.

For a specific example, consider Abacus 2007-AC1 – the security Goldman Sachs is accused of inappropriately marketing to its clients. Abacus 2007-AC1 is being described as a mortgage security; but it appears to contain no mortgages, just side bets. Calling it a mortgage security gives the impression there’s something backing it, but it’s just a gamble on someone else’s (mis)fortune.

And if you’re wondering how this didn’t show up on anyone’s radar:

[…] Goldman would buy the triple-A tranche of some CDO, pair it off with the credit default swaps AIG sold Goldman that insured the tranche (at a cost well below the yield on the tranche), declare the entire package risk-free, and hold it off its balance sheet. […]

As a risk mitigation strategy, this makes about as much sense as the scene in Sunshine where a man stands in the equilibrium between a thermonuclear bomb explosion and the core of the Sun. It’s very pretty, and theoretically interesting, but it makes no sense and you know he’s getting nuked in short order.

To summarize:


For maybe a hundred thousand years or more, grownups have been waving tangles of string in their children’s faces…. No wonder kids grow up crazy. A cat’s cradle is nothing but a bunch of X’s between somebody’s hands, and little kids look and look at all those X’s…. No damn cat, and no damn cradle.

The Big Short has its protagonists and antagonists. By the end, I couldn’t sympathize with either camp. They were all playing a game no one should have been playing, and even the “losers” were making a bundle doing so.