The Big Short

by

Michael Lewis

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The Big Short: Chapter 5 Summary & Analysis

Summary
Analysis
Eisman is not alone in investing in investing in credit default swaps. Lippmann pitched them around and got about a hundred interested buyers, although many use them only as a hedge rather than as a full bet against the markets. Only about 10 to 20 people bet on the whole subprime mortgage market going down.
Lewis once again emphasizes how the protagonists of his book were exceptional. Many other investors had enough information to engage in similar trades, but only a small minority of people with this information used it to its full potential.
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In 2003, Jamie Mai and Charlie Ledley are two 30-year-old men from Berkeley, California who form a company called Cornwall Capital. It’s based out of a shed and has only $110,000 of their own money in it.
Like many of the other protagonists of the book, Jamie and Charlie are independent self-starters. The fact that they go into business with their own money suggests that they have a decent tolerance for risk.
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Jamie and Charlie decide to look for inefficiencies in the market and they come across the credit card company Capital One Financial. Capital One seems to be a solidly run business to them, but in July 2002, its stock dropped after the company disclosed that it was in a dispute with government regulators over how much capital the company needed to keep in reserve. After the dispute, Capital One continued to be profitable, but its stock stayed down around $30 a share. Jamie and Charlie wonder whether the company is good at what it does (and therefore worth more like $60) or if it’s committing fraud (and therefore worth nothing).
Though Jamie and Charlie aren’t afraid of risk, they’re smart about the way they manage it. They start with a relatively conservative investment, looking into a company that, historically, has performed well.
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Jamie and Charlie research Capital One. They decide to buy options on the stock, meaning they can pay about $3 in order to have the option to buy the stock at $40 at any time in the next two and a half years. Soon after, Capital One resolves its issues with regulators, and the stock price goes way up, making Jamie and Charlie a lot of money.
Like Eisman’s team and Burry, Jamie and Charlie are shrewd researchers. Their use of options demonstrates a sophisticated knowledge of how to limit their exposure in case their predictions are wrong.
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Jamie and Charlie use the same technique to make money with lots of other companies and commodities around the world. They call their strategy event-driven investing and often do deals with an “administrative complexity” way out of proportion for how much money they are dealing with. They want to build a closer relationship with a big Wall Street firm, so they transfer their account to Bear Stearns, where their brokerage statements come back with “Ace Greenberg” at the top (a former CEO of Bear Stearns and a Wall Street legend).
Because they come from outside the mainstream of Wall Street, Jamie and Charlie have to get creative to make money. Even after they find success, however, they struggle to get recognized. Their experience shows how hard it is to break into the insular community of Wall Street, especially if you aren’t already spectacularly wealthy.
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Despite multiple attempts to contact Ace Greenberg, the most Jamie and Charlie ever get is a 30-second meeting with him before being led out. As private investors, they feel like a “second-class citizen” on Wall Street. They seek help from Jamie’s new neighbor in Berkeley, Ben Hockett.
Even two people as persistent as Jamie and Charlie can’t break into the inner circle of Wall Street on their own. The fact that Jamie ends up living next door to Ben Hockett shows that, for all the strategy and planning that go into a successful hedge fund, there is also a substantial element of luck.
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Ben Hockett is a Deutsche Bank employee who tried to quit his job, but the company kept him on by allowing him to work remotely. Jamie and Charlie keep asking Ben questions about Wall Street before finally convincing him to quit Deutsche Bank and join Cornwall Capital with them. Ben is even more pessimistic than Jamie and Charlie, constantly preparing for an apocalypse.
Ben’s pessimism makes him similar to other Big Short traders, like Eisman and Burry. Also like Eisman, he has some experience with mainstream Wall Street but finds the culture alienating.
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Ben, Jamie, and Charlie begin trading in such a way that they have a lot of little losses but a few extremely large gains that make the losses trivial. They figure out that this is because options on Wall Street are underpriced. Their once-small company, Cornwall Capital, begins to seem more legitimate. But before they can make deals with some of the biggest institutions, they need an ISDA (an agreement from the International Swaps and Derivatives Association), which is like a “hunting license” to make big deals.
Ben, Jamie, and Charlie show a sophisticated understanding of statistics. They know that in order to make money, they don’t have to succeed all the time—they just need to succeed enough times on bets that pay off well. The ISDA is an example of Wall Street gatekeeping and shows how the mainstream tries to keep out outsiders like Cornwall Capital.
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Even with $30 million in capital, Cornwall has a hard time getting an ISDA. Eventually, Ben is able to get them one with Deutsche bank, which usually requires $2 billion in capital, but Ben uses his industry connections. The ISDA is tilted heavily in Deutsche Bank’s favor, but Ben, Charlie, and Jamie are excited about being able to buy credit default swaps from Greg Lippmann—even as they remain suspicious that his deal is too good to be true.
The fact that it takes well over $30 million to get an ISDA shows just how exclusive the inner circle of Wall Street is. Still, Ben demonstrates the value of connections, securing them an ISDA even though on paper they would not be eligible.
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Ben, Charlie, and Jamie research the bond market and conclude that it uses so much confusing terminology because it’s designed to be confusing. Once they get up to speed, they end up doing something slightly different than what Mike Burry and Steve Eisman do. Instead of betting against the worst tranches of bonds (triple-B-minus), they bet against a higher tranche (double-A)—a move that ultimately ends up being more profitable. This is because Cornwall is always looking for long shots.
Though the intricacies of Wall Street are confusing, Lewis shows that the details aren’t impenetrable and, with enough determination, even an outsider can figure out what’s going on. Cornwall continues their strategy of trying to bet smart on long shots.
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The more Ben, Charlie, and Jamie look into collateralized debt obligations (CDOs), the more they think the whole system is crazy. As Lewis puts it, “it was also a stunning opportunity: The market appeared to believe its own lie.” Even after a lot of research, it is extremely difficult for them to tell what all is in a CDO, but they try to identify the worst of them and make deals. The big banks don’t take them seriously and begin to call them “Cornhole Capital.”
Lewis once again shows how banks used complicated concepts and terminology to obscure what was really going on. Even experienced researchers like Cornwall Capital have a difficult time sorting through the data.
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Ben, Charlie, and Jamie hear about a major conference in Las Vegas that will draw every bigshot in the subprime mortgage market. At the event, Bear Stearns is organizing an outing at a shooting range, and Charlie and Ben make plans to fly into Las Vegas for it.
Lewis often includes little details like the shooting range to give an insight into Wall Street culture. Perhaps Bear Stearns was trying to project a macho image with the event.
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