SUMMARY - The Big Short_ Inside the Doomsday Machine - Michael Lewis

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Here is a summary:

  • Michael Burry was diagnosed with bipolar disorder by psychiatrists, but he disagreed with the diagnosis.

  • He had an intense drive and obsessive personality that led him to work extremely long hours studying topics that interested him, like the stock market.

  • While working as a neurology resident, Burry started posting his contrarian stock analyses online late at night, going against the prevailing consensus picks of the dot-com bubble era.

  • Word spread in the finance community and people started following his picks, making him something of an expert through his blog.

  • By the time he moved to Stanford Hospital, his side investing activities had become significant though he kept them secret from medical colleagues enthralled by dot-com stocks.

  • Burry eventually quit neurology to manage money full-time and apply his intensive analytical approach to understanding markets.

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  • Greg Lippmann was a bond trader at Deutsche Bank who took a sizable short position against subprime mortgage bonds in 2005, growing it to over $1 billion by the end of the year.

  • As the position lost money initially while housing prices remained high, Lippmann faced pressure from Deutsche Bank executives questioning his negatively leveraged bet.

  • To validate his views, Lippmann held presentations in 2006 arguing that underwriting standards were poor, hidden prepayment penalties would cause defaults when rates reset, and fraud was rampant based on diligent research by his team.

  • While still skeptical, some hedge funds were convinced by Lippmann's analysis and data showing cooling home prices did not need to trigger defaults on riskier loans for subprime bonds to suffer losses. FrontPoint Partners was one fund that began shorting subprime mortgage markets based on his pitch.

  • By 2007, Lippmann's foresight was proven correct as defaults rose sharply in the collapsing US housing market, generating enormous profits for those who had established short positions like Lippmann based on his early warnings.

    Here is a summary of the key details:

  • Cornwall Capital was a small hedge fund run by Charlie Ledley and Jamie Mai that operated out of an art studio space.

  • Through a friend named Ben, they were able to obtain a crucial legal agreement (ISDA) from Deutsche Bank that allowed them to trade credit default swaps (CDS).

  • However, Deutsche Bank initially raised questions during their review process about Cornwall Capital's small office space in an artist's studio.

  • Obtaining the ISDA gave them access to trade CDS with major banks like Goldman Sachs and Deutsche Bank.

  • They saw an opportunity to short subprime mortgage bonds using CDS, which they believed were incorrectly priced too low given signs of distress in the subprime market.

  • To better understand the vehicles (CDOs) that were impacting CDS pricing, Cornwall Capital conducted research to learn what CDOs were and how they related to subprime mortgage bonds.

In summary, the key challenges they overcame were gaining the legal access to trade complex derivatives as a small fund, and then educating themselves on CDOs to take advantage of trading opportunities.

Here is a summary:

  • FrontPoint Partners, led by Steve Eisman, conducted extensive research into the subprime mortgage market and ratings agencies in 2007 as they grew increasingly concerned about risks.

  • Their research uncovered troublesome details about how subprime loans were structured with low initial rates that would later spike, and how ratings models assumed home prices would always rise. The agencies lacked data on individual loans.

  • Based on this analysis, FrontPoint took significant short positions in subprime bonds, ratings agencies' stocks, and banks exposed to the mortgage market.

  • As subprime bonds started to decline, FrontPoint realized their bearish bets were paying off. However, meetings with ratings agencies like Moody's showed a disturbing denial of any problems on their part.

  • New evidence emerged that even reputable banks like HSBC faced subprime losses, contrary to FrontPoint's assumption that risks had been fully offloaded. This confirmed to Eisman the securitization bubble was collapsing and would take down parts of the financial system.

    Here is a summary:

  • In 2007, Morgan Stanley suffered huge losses from Howie Hubler's proprietary subprime mortgage trades, totaling over $9 billion. This was the largest trading loss in Wall Street history at that time.

  • William Tanona, head of trading at Goldman Sachs, called Morgan Stanley CEO John Mack to inquire how such a large loss could have occurred from one trader's positions.

  • Mack acknowledged the loss but claimed it was due to an "error in judgment" by one particular trading desk, implying it was an isolated incident.

  • However, Tanona suspected the losses simply reflected the market accurately repricing risk, not extraordinary market conditions. The underlying subprime assets were performing very poorly as defaults increased sharply.

  • Tanona believed Morgan Stanley had taken on far too much exposure through Hubler's bets without properly understanding the risks. The heavy losses were inevitable once the true risk of their subprime holdings became clear.

  • While Mack portrayed it as a trading mishap, Tanona saw it as a much broader failure by Morgan Stanley to comprehend the risks accumulating in their mortgage portfolios and hedge funds from the subprime boom.

    Here is a summary:

  • Morgan Stanley suffered an $8 billion trading loss in 2007 related to subprime mortgage investments. John Mack was called by regulators to explain.

  • Mack answered evasively about recognizing the loss in their accounts but admitted risk management failed to properly stress test for potential losses.

  • Tanona questioned why Morgan Stanley's trading VaR did not dramatically increase given the large loss. Mack had no clear answer and said he needed to investigate further.

  • This revealed that as a former trader, Mack did not truly understand the risks Morgan Stanley was taking or how such a large loss could occur. It showed a lack of oversight and risk management that allowed the $8 billion loss.

    Here is a summary:

  • A hedge fund called North Shore Energy collapsed after losing $6.8 billion betting on natural gas prices in early 2006.

  • Alt-A loans made up $3 trillion in mortgages from 2004-2008 and had default rates similar to subprime loans, despite Alt-A borrowers having slightly better credit scores that were still poorly documented.

  • "Silent second" mortgages concealed from the first lender make repayment of both loans less likely.

  • People involved in the crisis are reluctant to discuss what they saw due to legal agreements and fears over past actions.

  • Firms had conflicts of interest when making proprietary bets while also brokering trades, giving incentive to use customers to benefit their own positions.

  • Selling credit default swaps on assets carries the same risks as owning the assets directly.

  • There is debate over key events and risk warnings at Morgan Stanley and Goldman Sachs' exact subprime exposures and exit timing.

  • No one fully understood the structured bond risks taken by Morgan Stanley trader Howie Hubler.

  • If AIG had assumed all subprime risk, it may have redirected blame away from Wall Street onto just AIG.

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