The Big Short

by

Michael Lewis

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The Big Short: Chapter 7 Summary & Analysis

Summary
Analysis
Charlie and Ben get back from Las Vegas in early 2007 and are convinced that the whole financial system is on the verge of collapse. Despite the fact that the Las Vegas conference was created to boost confidence in subprime mortgage bonds, the price of a leading index of these bonds drops by over a point. Charlie worries that the crash will come too soon and that they haven’t bet enough on credit default swaps yet.
Charlie raises an important point: being able to predict a crash is worthless if they can’t also find a way to capitalize on it. Buying more credit default swaps means a chance for a bigger payoff in the future, but it also means more losses in the short-term. Additionally, it’s very clear that there’s a huge issue in the subprime mortgage market if the conference meant to boost confidence actually lowers their market value—it seems that even people who were sympathetic to the possibility of subprime mortgage bonds succeeding are now souring.
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Fortunately for Cornwall Capital, Wachovia is still willing to sell them credit default swaps. Cornwall now has a portfolio of less than $30 million, but they have $205 million in credit default swaps on subprime mortgage bonds. They are unsuccessful in buying more—even though the big banks are theoretically going long on the bonds, they are hesitant to sell more short positions. Charlie thinks the big firms might be slowly becoming aware of the impending disaster.
The fact that many banks are unwilling to sell credit default swaps suggests that some people in the industry aren’t as naïve as the subprime mortgage traders in Las Vegas seemed to be. Cornwall is heavily leveraged (meaning they’ve used the money they have to borrow more), so they are in danger of serious losses if their predictions about a crash don’t pan out.
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Major stock indexes of the subprime bonds begin to fall rapidly by early June, but surprisingly, it doesn’t lead to a collapse yet. Charlie, Ben, and Jamie suspect that Wall Street is artificially propping up the prices of CDOs so that they can dump losses onto clueless customers or make a little more money while they still can. By late March 2007, they know either everything is rigged or they they’ve gone totally crazy. They try to pitch the story to reporters at major papers, but there’s no interest.
It seems like the major players on Wall Street are rigging the game, doing everything they can to put off a crash until they’ve transferred the risk somewhere else. This highlights the danger of Charlie and Jamie’s investment strategy: even if they correctly predict a crash, there’s no guarantee they’ll be set up financially to profit off of it, especially because they’re not part of the inner circle of Wall Street that gets to make the rules.
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Cornwall’s biggest problem is that Bear Stearns, which sold them 70 percent of their credit default swaps, is in danger of going under. To help offset this, Cornwall bought credit default swaps from the British bank HSBC, betting on the collapse of Bear Stearns. A surprising announcement in February 2007, however, reveals that HSBC is also taking big losses from subprime mortgage loans.
Lewis shows how the so-called Big Short was not a one-time event. Firms like Cornwall were constantly changing their positions in order to avoid fallout from the impending crisis.
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Meanwhile, Eisman is feeling limited by the fact that his hedge fund is part of Morgan Stanley and that the risk management people don’t understand what he’s doing. Furthermore, throughout early 2007, the ratings agencies have yet to change their official positions on subprime bonds, even though lots of loans are going bad. Eisman confronts the CEO of the rating agency Moody’s directly during a meeting, telling him he’s delusional if he thinks their ratings will hold up.
Eisman faces similar issues to Cornwall, emphasizing the disadvantages of trying to succeed on Wall Street from outside of the inner circle.
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By early June, the subprime mortgage bond market is finally in decline and will stay that way. Eisman and his team are finally making money. They take out new short positions on the rating agencies. Eisman then learns that Merrill Lynch owns a large proportion of subprime mortgage securities. He sets up a meeting with them and, as with previous meetings, tells them to their faces that their models are all wrong. He shorts Merrill Lynch, believing that Merrill is always there during calamities and that it’s at the bottom of the food chain, below firms like Goldman Sachs.
Eventually, the market reaches a point where no amount of intervention can stop subprime mortgage bonds from tanking. Though Eisman trades with the intention of making money, he is usually also motivated by his politics and his personal opinions. He seems to prefer shorting companies that he would personally like to fail.
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Ben Bernanke, the chairman of the Federal Reserve, announces in July 2007 that the losses from the subprime mortgage market should be no more than $100 billion. Shortly after, Eisman hosts a conference call that attracts the interest of some industry insiders. Eisman tells them to throw all their preexisting models away, predicting trillions of dollars’ worth of losses.
Bernanke’s statement is an acknowledgment that things in the subprime market are dire, but he doesn’t (publicly) seem to realize the extent of the upcoming crash.
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Soon after, a newsletter that is well known among Wall Street insiders, Grant’s Interest Rate Observer (edited by Jim Grant), decides to investigate CDOs. Even with the help of his well-educated assistant, he can’t figure out what’s in them. He writes a series of pieces saying the rating agencies don’t know what they’re doing.
Though the Big Short traders were unique in some ways, they also weren’t alone. Jim Grant’s article shows that, particularly as the crash approached, other people were also starting to see the warning signs in the economy.
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Steve Eisman reads Jim Grant’s essay and feels that his own theories have been confirmed. He suddenly realizes that he owns “a gold mine.”
Grant provides validation by demonstrating that Eisman and his team aren’t simply delusional—something that many other people in the industry likely think.
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