The Big Short

by

Michael Lewis

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The Big Short: Chapter 3 Summary & Analysis

Summary
Analysis
In February 2006, Greg Lippmann shows up in the conference room of Steve Eisman’s hedge fund, where Vincent Daniel is also present. They treat Lippmann with suspicion, but Lippmann is a slick talker who doesn’t follow many of the standard “rules” of Wall Street. He tells them he isn’t loyal to Deutsche Bank; he just works there. Ultimately, he wants to sell Eisman on an idea he claims he came up with: betting against the subprime bond market.
Lippmann is interesting because he seems to be very honest—but that might just be a trick. This section emphasizes how much of business on Wall Street is based on interpersonal relations and how difficult it can be to find people you can trust, especially when large sums of money are involved.
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Quotes
The crux of Lippmann’s pitch is that, in order for his bet against the subprime bond market to be successful, home prices don’t have to fall—they just have to stop rising so rapidly. His plan is basically the same as Mike Burry’s and involves credit default swaps.
Though Lippmann’s manner is suspicious, his proposal lines up with what Eisman and his team already know. Once again this shows how difficult it is to make judgement calls about a person’s character when so much money is on the line.
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One of Lippmann’s most persuasive arguments is his work with Eugene Xu, a “quant” (meaning a quantitative analyst who uses math and statistics to provide information about investments). Xu is described as “a real Chinese guy—not even Chinese American—who apparently spoke no English, just numbers.” Everyone trusts Xu’s math because he finished number two in a national competition in China. As Lippmann notes, “How can a guy who can’t speak English lie?”
In an afterword to The Big Short published after the first edition, Lewis offers a clarification: despite what Lippmann says, Eugene Xu can in fact speak English. Though Lippmann is trying to emphasize a positive aspect of Xu’s character—that he’s good at math—he does so by falling back on racist stereotypes about the Chinese, emphasizing details about Xu that make him seem “exotic” and more like a number-crunching machine than a human.
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Quotes
Though Vinny remains suspicious, surprisingly, Eisman seems very interested. He asks questions but ultimately has no problem betting against subprime mortgages.
Vinny’s suspicion is warranted—deals that seem too good to be true on Wall Street usually are. Eisman, however, has done extensive research with Vinny and Danny on subprime mortgages, so he knows there may be truth to what Lippmann is saying.
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Meanwhile, Burry is able to buy $100 million in credit default swaps from Goldman Sachs. He guesses that Goldman isn’t the company taking on the risk if the mortgage debts default, and it turns out he’s right: it’s actually the financial products division of the insurance company American International Group (AIG FP).
One of the most important principles on Wall Street is to avoid taking on more risk than you can safely manage. Though Goldman Sachs makes some questionable decisions in the lead-up to the 2007 financial crisis, here the firm is smart to arrange things so that the risk falls to another company.
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AIG FP started taking on all sorts of complicated financial risks for other companies, initially for events that were very unlikely to happen. Though it was initially profitable, eventually AIG FP starts taking on the worst subprime mortgage bonds (triple-B rated) and becomes the world’s biggest owner of them.
The case of AIG FP shows how dangerous it is to get involved in big Wall Street trades without fully understanding the risks. Because the danger of subprime mortgage bonds isn’t widely known at this time, AIG FP is taking on much greater risk than it realizes.
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Greg Lippmann watches his peers at Goldman Sachs as they create multibillion-dollar deals where, in exchange for a few million dollars each year, they transfer all risk to AIG in the event that the worst bonds failed.
Transferring the risk to AIG suggests that, on some level, the people at Goldman Sachs are aware of the possibility that the bonds will fail.
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Goldman’s process is so complex that most investors and ratings agencies don’t understand it. It involves “synthetic subprime mortgage bond-backed collateralized debt obligation (CDO).” Basically, the process allows them to hide the fact that triple-B bonds are so bad by packaging them together in new bundles that get rated as triple A (which are easier to sell because they’re perceived as lower risk). Lewis calls CDO “a credit laundering service” for lower-middle-class Americans and a “machine that turned lead into gold” for Wall Street.
Again, Lewis attempts to demystify the deliberately complex processes that have been devised on Wall Street in order to make it seem like Wall Street firms are making more money than they actually are. The purpose of the complexity is often to hide the risk of investments, but Lewis seems to suggest that some firms are so good at hiding risk that they even fool themselves. The language Lewis uses here—“laundering” and “lead into gold”—suggests that he finds these practices to be both corrupt and a result of magical thinking.
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Wall Street firms like Goldman Sachs begin to want pessimists like Mike Burry to buy credit default swaps against triple-B bonds. They then create a “synthetic CDO” made of nothing but credit default swaps and take it over to a ratings agency like Moody’s or Standard & Poors. About 80 percent of synthetic CDOs are rated as triple-A bonds, and the remaining 20 percent are put through the same process again and again until they too are part of triple-A-rated bonds. By facilitating this complicated “synthetics” process, Goldman Sachs is able to skim a lot of money off the top without actually incurring the risk—this is why Goldman is so surprisingly helpful to Burry.
Big Wall Street banks like Goldman Sachs believe that they’re smarter than individual traders like Mike Burry, and this arrogance ends up being their downfall. In fact, it’s precisely because Burry is acting alone, without the pressures of being part of a major firm, that he is able to see the truth behind the bonds and the ratings agencies.
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Lippmann’s bosses ask him to do what Mike Burry is doing, creating as many credit default swaps as possible before AIG realizes how much risk they’re taking on. Though Lippmann is in an unusual position, he doesn’t protest, since it gives him the opportunity to make a lot of money. By November 2005, he realizes that the odds might actually be in favor of his gamble, and that it might be good to be short.
The cut-throat nature of Wall Street often leads to strange alliances. Though Lippmann is sometimes at odds with his bosses, they mostly allow him to do what he wants, and that’s the most important thing for him.
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Lippmann inspires mixed reactions from the people around him, many of whom find him scary and wonder if he has narcissistic personality disorder. He tries to sell other industry players on shorts like his, but they largely refuse him. When subprime mortgage bonds rise, decreasing the value of Lippmann’s credit default swaps, his bosses begin to wonder if he’s doing the right thing.
Though interpersonal relationships play a big role on Wall Street, Lippmann shows that you don’t have to be liked to make a lot of money. Despite being a controversial figure, Lippmann is still able to find success, largely because he’s very good at one skill you really do need on Wall Street: being able to convince people you can make them a lot of money.
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Lippmann decides that the best way to stop pressure from his bosses is to implode the market—because if AIG stops taking credit default swaps, the whole subprime mortgage bond market might collapse, making Lippmann’s credit default swaps much more valuable. He visits AIG FP in an attempt to persuade them and seems to succeed when AIG FP hint they might actually buy some credit swaps instead of sell. Lippmann thinks, for a brief period of time, that he’s changed the world.
Though Lippmann may seem like a simple narcissist, his scheming here shows that he is also strategic. Like Eisman, Lippmann also wants to change the world, although his motives are less altruistic—he simply wants to make a ton of money and prove to his bosses that he was right.
Themes
Outsiders vs. Conformists  Theme Icon
Wall Street’s Culture of Overconfidence Theme Icon
The Problems with Capitalism  Theme Icon
Pessimism vs. Optimism Theme Icon
Needless Complexity Theme Icon