The Big Short

by

Michael Lewis

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The Big Short: Chapter 9 Summary & Analysis

Summary
Analysis
Howie Hubler is an ex–college football player who, in 2004, runs Morgan Stanley’s asset-backed bonds trading, effectively putting him in charge of subprime mortgage bets. During this period, quants at Morgan Stanley invent the credit default swap specifically to protect Hubler from risk—but Hubler and his traders steal the idea as their own.
The fact that Hubler steals one of his big ideas suggests that he isn’t honest and isn’t creative enough to come up with his own ideas. His central involvement in the bond industry in 2004 suggests that he hasn’t been able to spot the warning signs of the upcoming crash.
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Hubler’s credit default swap is so tilted in Morgan Stanley’s favor that they essentially predict that it would pay off no matter what—it’s like buying flood insurance that pays out the entire value of the house, even if the house only got dusted with rain. They need to find really clueless traders to take such a bad deal, and by early 2005, Hubler has found enough of them to have $2 billion in credit default swaps. By spring of 2005, Hubler wants more credit default swaps, but it’s getting harder because more traders like Mike Burry and Greg Lippmann are buying them.
At first, Hubler’s strategy isn’t so different from what Greg Lippmann, Mike Burry, and Steve Eisner are doing. Because he works at Morgan Stanley, he’s able to get particularly good terms on the deals he offers.
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Hubler becomes a powerful force at Morgan Stanley, making up about 20 percent of the firm’s profits by April 2006. He expects that his $2 billion in credit default swaps will soon yield $2 billion in profits. Because of pressure to make a profit, however, he sells off some of his credit default swaps on triple-A-rated subprime CDOs (which are supposedly less risky than lower ratings). Basically, Hubler is betting that some triple-B-rated bonds will go bad but not all of them. As Lewis puts it: “He was smart enough to be cynical about his market but not smart enough to realize how cynical he needed to be.”
Though Hubler makes his reputation on shorting, he eventually starts to go long on the highest-rated bonds, suggesting that he doesn’t realize what people like Burry realize: that the highest grade of bonds is often just as risky as the lower grades.
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Hubler is taking a huge risk, perhaps without realizing it, by essentially betting on the same CDO tranches that Cornwall Capital are betting against and the same bonds that FrontPoint Partners and Scion Capital are betting against. Hubler trusts the bond ratings and considers the bets he’s making to be risk-free.
Hubler does not do the same level of research as FrontPoint or Cornwall, and as a result, he finds himself in a dangerous financial position.
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From early February to June 2007, the subprime mortgage market is being propped up by a few Wall Street firms, but starting in June, they all begin to quietly change their minds.
Again, it seems that Wall Street’s ability to put off the crash is limited and that the crash is, ultimately, inevitable.
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In April 2007, Hubler second-guesses his large gamble but ultimately decides to keep some of his subprime position rather than take a loss of tens of millions of dollars. The decision ends up costing Morgan Stanley almost $6 billion.
Hubler succumbs to the sunk-cost fallacy—he doesn’t want to take the loss, even though it would prevent him from taking more losses in the future. It seems like Hubler was never a very savvy trader—he was just operating in a market that was, for a while, rigged in his favor.
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By May 2007, Hubler is in conflict with Morgan Stanley management, but not over credit default swaps. He threatens to quit but is offered more money, which he takes.
The web of relationships on Wall Street can get complicated. Once again, the higher ups at a Wall Street firm don’t seem to know how to manage a trader.
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It takes another month before Morgan Stanley starts asking what would happen if large numbers of lower-middle-class Americans began defaulting on their debt. They are frightened by the possible answers, but they continue to believe that such a thing would never happen.
Jamie and Charlie first made their fortune by betting on bad events that people didn’t want to imagine could happen. Here, it seems like history is about to repeat itself. This is also another example of how the culture of optimism on Wall Street blinds traders to risk, whereas people like Eisman who are more pessimistic have a clearer view of reality.
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In early July 2007, Morgan Stanley gets a call from Greg Lippmann at Deutsche Bank: Hubler and his team owe them $1.2 billion, since the credit default swaps have moved in Lippmann’s favor. Morgan Stanley and Deutsche Bank dispute the value of the credit default swaps. Ultimately, Morgan Stanley wires over $600 million to Deutsche Bank.
Because Hubler didn’t cut his losses earlier (and because Morgan Stanley made such an effort to hold on to him), Morgan Stanley now owes a huge amount of money to Deutsche Bank.
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As time passes, Hubler and his team keep refusing to make deals and ultimately lose money for Morgan Stanley. He doesn’t understand that the triple-B bonds in a CDO are 100 percent correlated, meaning if one goes bad, they’re all bad. Hubler loses billions for Morgan Stanley—the single worst trade in the history of Wall Street—and he also loses his job. Other major banks lose even more money.
Hubler seems to be either too proud or too short-sighted to realize what a disastrous position he holds. His refusal to back down ultimately leads to a historic loss for Morgan Stanley.
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In December 2007, Morgan Stanley holds a call with investors to explain the year’s extreme losses. The CEO of the company is asked to explain the loss and gives a jargon-filled response that leads Lewis to conclude “the CEO himself didn’t really understand the situation.”
Once again, a major player on Wall Street tries to cover up a bad situation by using complex, jargon-filled language and hoping that others won’t be able to understand. This shows how jargon often isn’t a mark of sophistication—it can actually hide that someone doesn’t have a clear enough understanding of a topic to explain it clearly.
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By August 1, 2007, the last buyer of subprime mortgage bonds finally stops purchasing more. Shareholders bring a lawsuit against Bear Stearns, which frightens Cornwall Capital, since many of their credit default swaps are through Bear Stearns. They also stand to lose money if the U.S. government steps in to guarantee all subprime mortgages.
As the markets head for a crash, no one is safe. Though Cornwall Capital have a smart position, they could still take a huge loss, emphasizing how all trades have some level of risk.
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Ben, currently living in England, is put in charge of reducing Cornwall’s exposure if Bear Stearns were to go down. On Friday, August 3, he calls several places and only gets interest from one bank, UBS. But by Monday, August 6, people at Citigroup, Merrill Lynch, and Lehman Brothers are also clamoring for a deal. By Thursday, Ben has completed a deal with UBS, turning their initial million-dollar bet into over $80 million.
Unlike Hubler, Ben knows when to cash out, and he helps Cornwall turn their theoretical profits into real profits before it’s too late. The big Wall Street firms are also finally realizing that they need to change their strategies, but for some it will be too late.
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Later, on August 31, 2007, Mike Burry takes his own credit default swaps out of the side pocket and begins to unload them. By the end of the year, his portfolio of less than $550 million will have earned profits of more than $720 million. He shoots off an email to Greenblatt’s firm that simply says, “You’re welcome.” Burry buys them out of his company.
Burry’s controversial strategy has been proven correct. His email and subsequent buyout of Greenblatt suggest that Burry holds grudges. While his behavior might get him fired in another industry, because he makes so much money, he has leeway to act how he wants.
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Burry reflects on the role Asperger’s has played in his life. Like many with Asperger’s, Burry uses his intense interests as a way to escape from the real world. His therapist helps him identify the role that “ego-reinforcement” plays in his mental health—and the stress that his interest in the financial markets is causing for him. Eventually, he loses interest in the markets altogether and picks up guitar, even though he didn’t previously have any particular talent for it or interest in it.
Though Burry first uses his victory as an opportunity to gloat, he eventually uses it as a time for self-reflection. His realization that the money itself isn’t what’s important is spurred partly by what he learned about autism from his son’s diagnosis and his own research.
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Six months after Burry gives up finance, the International Monetary Fund estimates that U.S. subprime-related assets have lost a trillion dollars. Every major Wall Street firm is negatively affected in some way.
Despite Wall Street’s attempt to put a positive spin on things, hard numbers reveal that the subprime mortgage meltdown was catastrophic.
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