The Big Short

by

Michael Lewis

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The Big Short: Chapter 4 Summary & Analysis

Summary
Analysis
But the people at AIG FP quickly forget their meeting with Lippmann. It’s Gene Park in AIG FP’s Connecticut office who figures out that all the subprime mortgages AIG FP owns are dangerous, since the company doesn’t have enough to cover the losses in the event of a default. For bringing the problem up, he gets yelled at by his boss, Joe Cassano.
The story of Gene Park and Joe Cassano may seem like a departure, but in fact, it is a microcosm of the whole industry that shows how the higher-ups at big financial firms enforce conformity and refuse to listen to obvious warning signs.
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Cassano is a dictator in the office who demands strict obedience. He is upset at Park for daring to contradict him, although by early 2006, he ultimately comes around to the same position Park was trying to convince him of.
Cassano seems to have a fragile ego; he can only come to the correct conclusion once he believes that he thought of it himself, rather than listening to his employee.
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Meanwhile, Lippmann is confused that AIG FP keeps refusing to take his advice. Surprisingly, the subprime market keeps growing, and in April 2006, Lippmann is asked by his bosses at Deutsche Bank to explain himself. They compromise: Lippmann can keep his expensive shorts if he can prove there are other investors who might take them off his hands. This means he has to create a credit default swap market.
Though Lippmann’s bosses also put up resistance and try to encourage conformity, they are smart enough to know that Lippmann might be on to something. This contrasts with the previous case of Cassano and Park.
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Lippmann’s initial attempts to sell credit defaults are unsuccessful, but ultimately, he meets Steve Eisman. At first, Eisman doesn’t take the bet. Later, Danny Moses (Eisman’s new head trader) and Vinny Daniels call Lippmann back and ask him to explain everything all over again. Danny and Vinny keep mistrusting Lippmann, even as he keeps answering their calls and answering their difficult questions. They treat Lippmann like a witness to crack under interrogation, but he doesn’t slip up.
Lewis emphasizes how thoroughly Eisman, Danny, and Vinny vet Lippmann to see if he’s telling the truth. Unlike what Cassano does to Park, they don’t dismiss what Lippmann is saying outright. Their approach is based on data, and though they listen to their intuitions, ultimately, they act based on hard information.
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Ultimately, Lippmann sells credit default swaps to a different investor, and two pieces of breaking news change the whole situation. First, in May 2006, Standard & Poor’s announces it’s changing its model for rating subprime mortgage bonds. This stirs up fear, suggesting that, on some level, even the big Wall Street firms knew they were creating overrated bonds. Second, the ratio of housing prices to income has been going up, from 3:1 to 4:1, with some markets going as high as 10:1. Still, even these major pieces of news didn’t disrupt the subprime bond market.
Though major Wall Street firms have been keeping upbeat about the mortgage bond market, warning signs are beginning to show that no amount of positive spin can hide what’s really going on in the markets. One of the enduring questions is how much the major players on Wall Street really knew: if they were ignorant of the consequences of their actions, or if they were deliberately trying to play a fraudulent game.
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Finally, Eisman makes a deal with Lippmann. He, Danny, and Vinny remain skeptical of the deal, so Vinny and Danny fly down to Miami to investigate more about the housing market. They find “empty neighborhoods built with subprime loans.” The best targets for shorts (i.e., “the bonds ultimately backed by the mortgages most likely to default”) are primarily in states like California, Florida, Nevada, and Arizona, where housing prices soared in the boom—and are most vulnerable to a fast crash. These states also have “dubious” mortgage lenders who make lots of fraudulent loans, such as one extreme example where a Mexican migrant worker with an income of $14,000 was lent enough to buy a $724,000 house.
By actually flying down to Miami, Danny and Vinny demonstrate that sometimes they need more than just models and predictions—they need to see things with their own eyes. They fact that the situation is so dire in Miami, and that anyone who goes there can see it, suggests that all the fancy financial mechanisms Wall Street has concocted are helping to obscure the situations real people are faced with.
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These fraudulent loans are possible in part because the regulatory agencies, Moody’s and S&P, are easy for the big Wall Street firms to exploit. This is because they don’t look at individual home loans, just loan pools. Wall Street learned to manipulate these pools by bundling together borrowers with low FICO ratings (also known as credit scores) with borrowers who have higher credit scores. This hides the fact that a pool contains many low-credit-score borrowers who are very likely to default.
Lewis consistently portrays the ratings agencies as either incompetent at their basic roles or complicit in helping Wall Street firms to engage in risky behavior. The implication may be that free markets don’t work correctly without proper oversight.
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Wall Street further manipulates the pools by seeking out so-called “thin-file” FICO scores, or FICO scores from borrowers who have only a short credit history. This is why firms target people like migrant workers—because their short credit history sometimes enables them to have a high FICO score that could be used to offset low FICO scores in a pool, even though they’re not all that likely to be able to pay off a house.
This section shows how Wall Street firms can be tactical and ruthless—they don’t mind targeting vulnerable groups like migrant workers if it ends up being a convenient way to turn a profit.
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Eisman and his team don’t know the full details of what Wall Street investment banks are doing, but they know they have a dedicated staff whose whole job is to game the rating agencies. They set out to learn more. Danny and Vinny speak to a woman at Moody’s who answers some of their questions. They find out that to get more information, they’ll have to go to Las Vegas.
Once again, Eisman and his team reach the limits of what they can find out researching from a distance. As always, they aren’t afraid to get up close and do some unconventional research. Their plan to go to Vegas once again reinforces how much they value seeing things with their own eyes.
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