Sunday, April 18, 2010

Review of The Big Short: Inside the Doomsday Machine by Michael Lewis

I finished reading The Big Short: Inside the Doomsday Machine, the new Michael Lewis book on the credit bubble. Since the story of the credit bubble is pretty familiar to me, it's the little tidbits that made this book worth reading.

I liked Michael Burry, and his value investing concept of "ick" investments, which means "taking a special analytical interest in stocks that inspire a first reaction of 'ick.'" Our investment in Callon Petroleum debt was an "ick" trade, and I'm working on some other deep value situations that I hope to share with readers soon.

I love the story about Steve Eisman and Lomas Financial, where he says

"I put a sell rating on the thing because it was a piece of shit. I didn’t know that you weren’t supposed to put a sell rating on companies. I thought there were three boxes—buy, hold, sell—and you could pick the one you thought you should."
One of the first things I did when getting into investing was to figure out the real story with sell side analysts, by reading books like Confessions of a Wall Street Analyst. Steve is not kidding when he says that sell ratings are frowned upon. How are you going to get any debt or equity underwriting business from a company that you have a sell rating on? Bad marketing!

As I noted in my review of Investment Fables: Exposing the Myths of "Can't Miss" Investment Strategies, a study from 1999 that found that "stock prices for recommendations made by nonunderwriters do significantly better than the market, but the stocks recommended by underwriters (in those stocks) tend to do poorly (p466)." A phenomenon which is relevant to our Grubb & Ellis (GBE) short!

One of the funds in the book has the same CNBC policy that I do: "We turned off CNBC. It became very frustrating that they weren't in touch with reality anymore. If something negative happened, they'd spin it positive. If something positive happened, they'd blow it out of proportion. It alters your mind. You can't be clouded with shit like that."

Yves Smith wrote a review of The Big Short saying that the "shorts Lewis lionizes didn't simply set off the global debt conflagration, they made the severity of the crisis vastly worse." That is totally off base!

In fact, you could argue that the reason the housing bubble lasted so long is that it was so hard to express a negative view by shorting. Is it a coincidence that the bubble didn't end until a method of shorting the worst mortgages was developed and implemented?

Yves does raise a fair point about how the taxpayer was forced to pay for some of the CDS trades by bailing out one of the key counterparties, AIG. It turns out that a naive person didn't worry about the big banks making good on CDS trades, a smart person worried enough not to buy any CDS, but a really smart person didn't worry. Maybe some people knew that Goldman Sachs' man in the Treasury would bail out certain insolvent counterparties?

I don't think the final chapter has been written on the credit bubble. Over the coming decades, we'll find out what people knew and when they knew it. What actually happened is sure to be even worse and more corrupt than we can imagine.

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