Sunday, January 9, 2011

Michael Lewis: The Big Short: Inside the Doomsday Machine

In finance, short selling (also known as shorting or going short) is the practice of selling assets, usually securities, that have been borrowed from a third party (usually a broker) with the intention of buying identical assets back at a later date to return to the lender. It is a form of reverse trading. The short seller hopes to profit from a decline in the price of the assets between the sale and the repurchase, as the seller will pay less to buy the assets than the seller received on selling them. Conversely, the short seller will incur a loss if the price of the assets rises. Other costs of shorting may include a fee for borrowing the assets and payment of any dividends paid on the borrowed assets. "Shorting" and "going short" also refer to entering into any derivative or other contract under which the investor profits from a fall in the value of an asset. Going short can be contrasted with the more conventional practice of "going long", whereby an investor profits from any increase in the price of the asset.

“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 sell ratings on companies. I thought there were three boxes—buy, hold, sell—and you could pick the one you thought you should.”

- Steven Eisman in The Big Short: Inside the Doomsday Machine by Michael Lewis

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"Wall Street actually forgot that they rigged the market."

- Michael Lewis tells Jon Stewart on The Daily Show

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“The single greatest line I ever wrote as an analyst was after Lomas said they were hedged: ‘The Lomas Financial Corporation is a perfectly hedged institution: it loses money in every conceivable interest rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.”

- Steve Eisman, on his time at Oppenheimer as a lead analyst.

The Big Short: Inside the Doomsday Machine is a 2010 non-fiction book by Michael Lewis about the build-up of the housing and credit bubble during the 2000s. It describes several of the key players in the creation of the credit-default-swap (CDS) market that sought to bet against the bubble and thus ended up profiting from the financial crisis of 2007–2010. The Big Short also highlights the eccentric nature of the type of person who bets against the market or goes against the grain. The book follows people who believed the bubble was going to burst. The Michael Lewis book was shortlisted for the 2010 Financial Times and Goldman Sachs Business Book of the Year Award. The The Big Short spent 28 weeks on the New York Times Bestsellers list for non-fiction.

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"I felt like I am heading towards a short life. I have been pushed repeatedly to the brink by my own actions, the Fund’s investors, business partners, and even former employees. I have always been able to pull back and carry on my often overly intense affair with this business. Now, however, I am facing personal matters that have carried me irrefutably over the threshold, and I have come to the sullen realization that I must close down the Fund."

- Dr. Michael Burry in a final letter to Scion Capital Investors

Michael Burry was born in 1972. He is the founder of the Scion Capital LLC hedge fund. Burry ran the fund from 2000 to 2008, when he closed Scion for various reasons. Burry was one of the first investors to recognize and invest in the impending subprime mortgage crisis. Author Michael Lewis profiled him in his 2010 book The Big Short: Inside the Doomsday Machine. Burry was also featured in Gregory Zuckerman's 2009 book The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History. Michael Burry left work as a Stanford Hospital neurology resident to become a full-time investor and start his own hedge fund. He had already developed a reputation as an investor by demonstrating astounding success in "value investing," which he wrote about on a message board beginning in 1996. He was so successful with his stock picks that he attracted the interest of such companies as Vanguard and White Mountains Insurance Group, as well as prominent investors such as Joel Greenblatt. In November 2000, Michael Burry shut down his website and discontinued posting to the message board. He did this in order to focus completely and exclusively on launching Scion Capital, which he funded with a modest inheritance and various loans from family members. The company was named after The Scions of Shannara, a favorite childhood book. Burry quickly earned extraordinary profits for his investors.
"[In] his first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55 percent. The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion was up again: 16 percent. The next year, 2003, the stock market finally turned around and rose 28.69 percent, but Mike Burry beat it again—his investments rose by 50 percent. By the end of 2004, Mike Burry was managing $600 million and turning money away."

- Michael Lewis, The Big Short: Inside the Doomsday Machine

“I said to my mother, ‘I think we might be facing something like the end of democratic capitalism.’ And she just said, ‘Oh, Charlie,’ and seriously suggested I go on lithium.”

- Charles Ledley co-founder of Cornwall Capital Management

Cornwall Capital is a New York City based private financial investment corporation. Cornwall played a primary role in the story of The Big Short: Inside the Doomsday Machine by Michael Lewis. The firm was one of a handful in the world that correctly foresaw and profited from the subprime mortgage crisis of 2007. Charles Ledley and James Mai were 30 years old when they launched Cornwall Capital in a house garage in Berkeley, California. The fund was seeded with $110,000 from various relatives and family members. In the fund’s first 2 years, they had grown their capital from $110,000 to $15 million by shorting stocks and other investments that they believed were incorrectly valued due to the inability of the market to account for sudden and unexpected change. In other words, option prices (“strikes”) were set according to a stock or set of stocks’ historical data (past performance), and did not take into account unusual or "Black Swan" events that may occur in the future. By finding potential Black Swan events, Charles Ledley and James Mai were able to make stunning returns of 100:1 or greater in extremely short periods. Charles Ledley and James Mai pinpointed and shorted stocks and other financial instruments accordingly, correctly positioning Cornwall Capital against the subprime mortgage crisis before most other people saw the crash coming. Charles Ledley and James Mai have garnered some attention, largely due to the Michael Lewis book, The Big Short. In 2010, Cornwall Capital was estimated to be worth $200 to $300 million.

“They were stuffing the channel, getting as much shit out so that it could be rated by the old model.”

- Vincent Daniel, regarding the May 2006 announcement of Standard & Poor’s new model for rating subprime mortgage bonds

In March 2010, Andrew Leonard wrote “Bringing subprime sexy back” for If you wanted to summarize "The Big Short" in just one line, it might be: the most lucid explanation yet offered to readers as to the importance of a credit default swap on a double-A tranche of a subprime collateralized debt obligation. Which might not sound like a whole lot of fun, but turns out to be a blast. As someone who has struggled for years to penetrate the obtuse world of structured finance and the role it played in blowing up Wall Street, I must give credit where credit is due. "The Big Short" is superb: Michael Lewis doing what he does best, illuminating the idiocy, madness and greed of modern finance. Even though I have long been a huge Michael Lewis fan, dating all the way back to "Liar's Poker," his hilarious and enlightening account of life as a bond broker in the go-go '80s, I did not anticipate something this good, something capable of carrying its weight as a bookend to "Liar's Poker's" delights. My heart actually sank when the galleys of "The Big Short" arrived in the mail. A library of books exploring the financial crisis has already been published, with many, many more yet to come. My bedside table groans under the weight of their unfinished tomes. What could Michael Lewis have to say that hadn't already been said a million times over? But then I made the mistake of glancing at the first chapter and literally could not put "The Big Short" down. Michael Lewis achieves what I previously imagined impossible: He makes subprime sexy all over again. The secret to Lewis' success is a mixture of strategy and craft. Most books on the financial crisis find their locus inside the Wall Street firms at the heart of the action. The general theme: Hubristic banksters are oblivious to what they've wrought until it is too late. Chaos ensues. Michael Lewis takes a different tack. "The Big Short" tells the stories of an odd collection of brilliant misfits who recognize that Wall Street is wearing no clothes, become convinced a massive calamity is nigh, and seek feverishly to profit off of their understanding. They are, in Wall Street parlance, the "shorts" -- speculators who bet that the price of a given stock or bond or commodity or any derivative thereof will fall, rather than rise. Most shorts pick on a single company, or have a dour view of the direction of the price of corn or pork bellies. "The Big Short" is a little more ambitious: It's a bet on financial sector collapse.

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