Monday, March 7, 2016

Maybe the best definition of "investing" is "gambling with the odds in your favor"

My dad has been telling me I should read The Big Short ever since it was first published. This past Thanksgiving I finally agreed, in large part because I wasn't in the mood for Let The Right One In which was sitting on my Kindle and he had a copy to lend me. I was around 1/2 way through when I sent him the following email:
I'm enjoying the book and I think I can confidently say I'm even understanding a full quarter of what's going on.
That said, I will have questions. I just need to figure out what those questions are. So please, be prepared for an onslaught.
I was not coming at this with a lot of prior knowledge. As I started to come up with said inquiry attack I realized how little I really knew, which was actually why I wanted to write out all of my questions rather than have him try to explain it. Because before quizzing him, I wanted to see what I could find online. And then I started with Googling "subprime mortgage" which you might notice is pretty much what the entire book is about. I mean, I had an idea of what it was, context clues at all, but realized if pushed, I can't really define it confidently. I moved on from there to Google "mortgage bond" and then just "bond" and yeah. Just to paint the picture of how little I knew going into this.

Lewis manages to make the story a character driven one, which certainly helps with readability. He focuses on a group of men who realized long before the cracks began to show that the way banks were handling these subprime mortgages and bonds and CDOs that things were going to crash and crash big. They're the characters we're rooting for but they're not exactly heroes. They didn't cause the crash, but they certainly did nothing to prevent it. And, given the way they were investing, it was in their best interest for the crash to happen. They may have been (or said they were) disgusted by it, that it was fraud, etc. But they didn't alert anyone. That's not to say that anything they could have done would have made a difference,  but just an attempt would have been nice. I'm sure people that lost their houses are happy that these guys saw the crash coming and made a LOT of money off of it.

It's never entirely clear if the things that happened were because people were purposefully trying to screw people to get rich, or if they were just stupid. It seems like both, though leaning slightly more towards the "stupid" side, with people legit not understanding that things could get that bad.
How did the bet perform, for instance, using the assumption of losses generated by the most pessimistic Wall Street analysis? Up to that point, Hubler's bet had been "stress tested" for scenarios in which subprime pools experienced losses of 6%, the highest losses from recent history. Now Hubler's traders were asked to imagine what would become of their bet if losses reached 10%..."If losses go to ten percent there will be, like, a million homeless people." (Losses in the pools Hubler's group had bet on would eventually reach 40%.)
Then again, they talk about lending giant Household Finance Corporation offering fifteen-year, fixed-rate loans "bizarrely disguised as a thirty-year loan." It essentially would say, in theory, if you were making the same dollar payments over thirty years that you're actually paying over fifteen years your "effective rate" would be something WAY LOWER than what they were actually offering. They use the example of an effective rate of 7% that's actually something like a 12.5% rate.

Or, using my handy dandy excel formula, let's say someone decides to buy a $250K house with 5% down, take a look at the difference is in monthly payments:
30-year, 7% loan: $1,580.09
15-year, 7% loan: $2,134.72
15-year, 12.5% loan: $2,927.24
So yeah, this makes a bit of a difference in what you're actually paying each month. And by the way, I read this paragraph describing it in laymen's terms at least 20 times AND had other people read it and I'm still not 100% sure I'm following everything it's saying. Imagine some asshole lender who is purposefully trying to hide what they mean.

Obviously, this is still a confusing book, but Lewis manages to make it readable. It makes you pretty angry at banks and lenders and hedge funds, so be prepared for that.

Gif rating:

Title quote from page 256

Lewis, Michael. The Big Short: Inside the Doomsday Machine. Norton, 2010