Book review: The Big Short by Michael Lewis (nonfiction)

The Big Short is a fascinating look at the evolution of the trillion-dollar market in subprime mortgage debt, the arcane derivatives built upon it, and the greatest financial disaster of the first decade of the new millennium, whose tremors had an international impact.

At the center of the subprime crisis were novel new financial instruments devised by trading departments of large investment banks on Wall Street.  One is the "credit default swap", which is simply an insurance policy indemnifying its buyer from the risk of default upon a bond issued by another agency, at the cost of a fixed annual premium based upon the assessed risk of default. The other is the mortgage bond, a pool of mortgage loans of various levels of risk; it was these bonds that some institutions wanted to buy insurance for and to make a market, other institutions would step up to the plate to accept the premiums and contract to provide insurance.  One of the insurers was AIG Financial Products.

The curious aspect about the credit default swap though is that the buyer didn't have to own the insured debt.  All they had to do was pay the premiums, and if the "insured" bonds were to lose value the insurer was on the hook to pay up.  So why would anyone want to take the "sell" end?  Simple:  everyone thought the real estate market had only one way to go, and that was up.  On this assumption, the likelihood of a default was so low ― or so was the belief on the Street ― that being the insurer brought easy income in the form of premiums at next to nonexistent risk.  A cash cow.

The entire system was set up to make the securities as opaque as possible.  This made the analysis of the true risk of ownership next to impossible.  Ratings agencies Moody's and S&P were snowed as well and grossly underrated the risk of default.  Only a handful of savvy players delved deeply enough into the byzantine market to conclude what know one else knew (or was willing to let on that they knew).

The complexity takes a bit of work to follow, but you too can learn what a credit default swap on a AA tranche of a sub-prime-backed collateralized debt obligation is, and have an entertaining time following the adventures of several "little guys" as they went toe-to-toe with the titans of the bond market, culminating in the demise of Bear Stearns, Lehman Brothers, and other firms who played with fire and paid dearly.

Among other titles authored by Michael Lewis is the revealing Liar's Poker, chronicling the meltdown on Wall Street during the 1980s.

Reviewer's note:  The Big Short may disappoint those who wish to pin the financial crisis of 2008 upon either political party.  The simple fact is that although the stage may have been set by federal legislation, it was the scheming of big players in the U.S. fixed-income markets that built an unsustainable house of cards from the products of unscrupulous lenders and their foolish and naive customers.