Michael Lewis "The Big Short"

[pdmunro]

fascinating

http://www.bloomberg.com/apps/news?pid=new...id=aUpBrUJ.pIiA

[Al_U_Card]

Its not a conspiracy so much as its a way of life....

[mike777]

fascinating

http://www.bloomberg.com/apps/news?pid=new...id=aUpBrUJ.pIiA

I dont fault short term greed.

 

 

 

My best guess is a recession caused bad things to happen.

 

 

I dont know what caused the recession.

 

Recessions cause bad things to happen.....

 

I read this book.

 

--------------------

 

 

too put this another way....even if short term greed caused this...what causes short term greed? Please explain!

 

-----------------------

 

 

Too put this another way if mankind is by NATURE short term greedy.....only the supernatural can change the NATURE Of MANKIND

[kenberg]

May I take a representative quote and ask about it?

In the case of one of my other main characters, Charlie Ledley and Jamie Mai of a tiny little firm called Cornwall Capital, they had a view that the financial markets made a systematic intellectual error. And it’s the Black Swan error. It’s underestimating the likelihood of unlikely events. That yes, an event, some catastrophe, some event is unlikely, but it’s not as unlikely as your pricing these way out of the money options.

 

Does this mean something?

 

That is: You are discussing finances, someone says "I priced these way out of the money options", and this means something to you?

 

Reading the interview was tough (I haven't finished). I would read a paragraph and realize that I have no idea what I just read.

 

I am not so much asking you to tell me what it means (there are many many things in there that mean nothing to me) I am just asking if it means anything at all to you. It sounds like babble to me.

[pdmunro]

an excerpt re Michel Burry from "The Big Short"

http://www.vanityfair.com/business/feature...?printable=true

[Al_U_Card]

Thanks for the excerpt. A primer on why the economy is in the dumpster.

 

Banksters. Machiavelli would have been proud but we will be the poorer for it.

[Winstonm]

My best guess is a recession caused bad things to happen.

 

I think you are dead wrong. This "Great Recession" as it has been termed has not been your garden variety business cycle inventory-driven recession. This has been a deleveraging of epic proportions, a debt-deflation recession not seen since the Great Depression.

 

This recession was not the "cause" of bad things but a "result" of bad things done previously.

[kenberg]

The second reference reads much better. I particularly liked:

 

The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. You, the homebuyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principal balance. It wasn’t hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn’t understand was why a person who lent money would want to extend such a loan.

 

Burry came to the sensible conclusion that if a banking practice that, once you got through the obfuscation, sounded nuts then there was a good chance it was nuts. Hiding the nuttiness was the purpose of the complicated phrasing. "interest-only negative-amortizing adjustable-rate subprime mortgage" means the loan isn't paid off, in fact the principal grows. But I am still working on "I priced these way out of the money options". Can I say, for example, "Now that Starbucks charges over two bucks for coffee I think that that have priced it out of the money option"? But Burry took the essential next step: He figured out how to make this nonsense work for him. Congratulations to him.

[y66]

May I take a representative quote and ask about it?

In the case of one of my other main characters, Charlie Ledley and Jamie Mai of a tiny little firm called Cornwall Capital, they had a view that the financial markets made a systematic intellectual error. And it’s the Black Swan error. It’s underestimating the likelihood of unlikely events. That yes, an event, some catastrophe, some event is unlikely, but it’s not as unlikely as your pricing these way out of the money options.

 

Does this mean something?

 

That is: You are discussing finances, someone says "I priced these way out of the money options", and this means something to you?

 

Reading the interview was tough (I haven't finished). I would read a paragraph and realize that I have no idea what I just read.

 

I am not so much asking you to tell me what it means (there are many many things in there that mean nothing to me) I am just asking if it means anything at all to you. It sounds like babble to me.

That last sentence in your quoted excerpt does not make sense to me either. Although Michael Lewis thinks and speaks more clearly about this stuff on zero hours of sleep than I do on my best day, I think he may have meant something like:

 

some catastrophe, some event is unlikely, but it’s not as unlikely as the price structure of available hedge bets suggests.

from which I infer he means that in some dark corners of financial markets, the markets simply do not work efficiently, even though very large parts of the world's financial system operate as if they do.

 

Gretchen Morgenson has an interesting story in this morning's NY Times about once such corner of the market. I thought this part was esp. good:

DAVID J. GRAIS, a partner at Grais & Ellsworth, represents the plaintiff. He said the Federal Home Loan Bank is not alleging that the firms intended to mislead investors. Rather, the case is trying to determine if the firms conformed to state laws requiring accurate disclosure to investors.

 

“Did they or did they not correspond with the real world at the time of the sale of these securities? That is the question,” Mr. Grais said.

 

Time will tell which side will prevail in this suit. But in the meantime, the accusations illustrate a significant unsolved problem with securitization: a lack of transparency regarding the loans that are bundled into mortgage securities. Until sunlight shines on these loan pools, the securitization market, a hugely important financing mechanism that augments bank lending, will remain frozen and unworkable.

 

Sometimes I wonder if what's really going on is that the pirates, arsonists, bankers and even major health care players have figured out how to rig the game by exploiting non-correspondences between the real world and the modeling assumptions of various insurance underwriters. And that the heroes of ML's new book somehow managed to avoid getting sucked in by the prevailing wisdom that efficient markets protect against this.

 

Enjoyed the interview in OP's link.

[pdmunro]

Interview of Michael Lewis on "60 Minutes"

http://www.cbsnews.com/video/watch/?id=629...entBody;housing (Part 1)

http://www.cbsnews.com/video/watch/?id=629...entBody;housing (Part 2)

http://www.cbsnews.com/stories/2010/03/12/...in6292458.shtml ("60 mins" text)

 

Michael Burry's investment company:

http://www.scioncapital.com/ (Scion)

http://scioncapital.com/index__letters.html (early Scion letters)

http://www.scioncapital.com/PDFs/Scion%202...20and%20FAQ.pdf (Scion Primer)

 

************* Excerpt from Michael Burry's Primer ************

"Credit default swap contracts on asset-backed securitizations have several features not common in other forms of swap contracts. One feature is cash settlement. Again, examining PPSI 2005-WLL1 M9 - the BBB- tranche - we see it has a size of $5,894,000. Because credit default swaps on mortgage-backed securities are cash-settle contracts, the size of the tranche does not limit the amount of credit default swaps that can be written on the tranche, nor does it impair ultimate settlement of the contract in the event of default.

 

By cash-settle, I mean that the tranche itself need not be physically delivered to the counterparty in order to collect payment. An investor with a short view may therefore confidently buy more than $5,894,000 in credit default swap protection on this tranche.

 

As well, these credit default swap protection contracts are pay-as-you-go. This means the owner of protection on a given tranche need not hand over the contract before full payment is received, even across trustee reporting periods. For instance, if only 50% of the PPSI 2005-WLL1 M9 tranche is written down in the first month, the owner of $10,000,000 in protection would collect $5,000,000 and would not need to forfeit the contract to do so."

 

Source: http://www.scioncapital.com/PDFs/Scion%202...20and%20FAQ.pdf (Scion Primer)

 

My paraphrase

If I read this correctly, it's saying that if there are mortgagee defaults and subsequent writedowns occur, then

 

1) we don't have to wait for the whole debt instrument to be written down for our bet to pay off - if part of the debt intrument is written down, we get a payout on that part. Say, our yearly insurance premiums are 2% of a 10 million dollar tranche. The mortgage tranche might have a 30 year lifetime, but we don't expect to be paying premiums for 30 years. In fact, we expect there to be a significant number of defaults in 2 years when the variable interest rates go from, say, 6% to 12%. So if we wait 2 years, paying 2 x 2% = 4% premiums, we expect to get paid whatever the size of the writedown is. If the whole, say, $10 mill is written off, we make $9.6 mill for our $0.4 mill outlay.

 

2) we get money if writedowns occur, rather than getting the original property. We won't be burdened with property in a falling market - we get cold, hard cash.

 

Now these CDS (insurance policies) were taken out with the biggest banks, (Deutsche, Merrill Lynch, ...). They weren't taken out with the lesser players like Lehman Brothers. Michael Burry wanted the institutions taking the bets to be able to pay up when the day of judgement came.

 

Also the bets were made on tranches where bad lending decisions had been made, such as zero requirement to pay back the loan in the initial years, the interest could just accumulate. And loans were given to people with very low incomes. Defaults were guaranteed to occur.

 

*******************************************************

 

Examination of CDO's in Harvard 2009 thesis:

http://www.thefacultylounge.org/2010/03/th...ard-thesis.html (Faculty Lounge))

http://www.hks.harvard.edu/m-rcbg/students...CDOmeltdown.pdf (Anna Katherine Barnett-Hart's, March 2009, thesis)

[Winstonm]

This is the best quote from the Bloomberg article:

 

And what I find outrageous is that the people who were in positions of influence and power when the crisis occurred were by definition people who didn’t see it coming. They were, by definition, ignorant of what was going on right under their noses.

 

That there has been so little change in that regime is a little outrageous to me.

 

So much hype - So little change - and that you can believe in.

[y66]

Just read this excerpt in Vanity Fair. Will read the book.

Late one night in November 1996, while on a cardiology rotation at Saint Thomas Hospital, in Nashville, Tennessee, he logged on to a hospital computer and went to a message board called techstocks.com. There he created a thread called “value investing.” Having read everything there was to read about investing, he decided to learn a bit more about “investing in the real world.” A mania for Internet stocks gripped the market. A site for the Silicon Valley investor, circa 1996, was not a natural home for a sober-minded value investor. Still, many came, all with opinions. A few people grumbled about the very idea of a doctor having anything useful to say about investments, but over time he came to dominate the discussion. Dr. Mike Burry—as he always signed himself—sensed that other people on the thread were taking his advice and making money with it.

 

Once he figured out he had nothing more to learn from the crowd on his thread, he quit it to create what later would be called a blog but at the time was just a weird form of communication. He was working 16-hour shifts at the hospital, confining his blogging mainly to the hours between midnight and three in the morning. On his blog he posted his stock-market trades and his arguments for making the trades. People found him. As a money manager at a big Philadelphia value fund said, “The first thing I wondered was: When is he doing this? The guy was a medical intern. I only saw the nonmedical part of his day, and it was simply awesome. He’s showing people his trades. And people are following it in real time. He’s doing value investing—in the middle of the dot-com bubble. He’s buying value stocks, which is what we’re doing. But we’re losing money. We’re losing clients. All of a sudden he goes on this tear. He’s up 50 percent. It’s uncanny. He’s uncanny. And we’re not the only ones watching it.”

 

Mike Burry couldn’t see exactly who was following his financial moves, but he could tell which domains they came from. In the beginning his readers came from EarthLink and AOL. Just random individuals. Pretty soon, however, they weren’t. People were coming to his site from mutual funds like Fidelity and big Wall Street investment banks like Morgan Stanley. One day he lit into Vanguard’s index funds and almost instantly received a cease-and-desist letter from Vanguard’s attorneys. Burry suspected that serious investors might even be acting on his blog posts, but he had no clear idea who they might be. “The market found him,” says the Philadelphia mutual-fund manager. “He was recognizing patterns no one else was seeing.”

[mike777]

The most interesting part of all of this is how we could buy insurance on say 100 million bucks of bonds for prices of 500,000 to 2.5 million per year.

 

 

If roughly 8-16% of the bonds default we get 100 million bucks.

If 8% default we get 100million minus whatever the salvage value of the house and land....If 16% we get the whole 100 million.

 

On top of this we get to pick the worst of the worst pools of bonds to buy the insurance on. :blink: The price on all pools....good or bad borrowers was the same price.

 

This was as if you bought flood insurance and one drop of water hits your house you get full payment.

 

Keep in mind people were buying a 750,000$ house on 14,000 of stated income and people were defaulting on the very first mortgage payment, the very first one.

[Winstonm]

The most interesting part of all of this is how we could buy insurance on say 100 million bucks of bonds for prices of 500,000 to 2.5 million per year.

 

 

If roughly 8-16% of the bonds default we get 100 million bucks.

If 8% default we get 100million minus whatever the savage value of the house and land....If 16% we get the whole 100 million.

 

On top of this we get to pick the worst of the worst pools of bonds to buy the insurance on. :blink: The price on all pools....good or bad borrowers was the same price.

 

This was as if you bought flood insurance and one drop of water hits your house you get full payment.

 

Keep in mind people were buying a 750,000$ house on 14,000 of stated income and people were defaulting on the very first mortgage payment, the very first one.

Keep in mind these transactions occurred in non-regulated markets.

[kenberg]

I was listening to Michael Lewis (He gets around, clearly) on the Diane Rehm show. Lewis's analogy for the insurance envisions people buying high levels of fire insurance on low cost homes. It gives you good motivation to torch the neighborhood.

 

Here is where I am stuck. I read about Lewis' main characters. Very smart, very high energy, pretty strange. Maybe I fit the strange part but the rest isn't me, not nearly to the same degree. So I will never understand this at the level of Lewis and his heroes. I think of it as bring like the Wiles proof of Fermat's Last Theorem. Perhaps, if I started now, I could actually understand the proof of FLT before I die but if that's my plan I had better get started today, not next week. It will take some time. Somehow I have to grasp enough about this financial mess to vote properly and support the proper course of action, but without devoting all of my waking hours to it.

 

The truly frightening part, to me, is that quite possibly the people in the top positions actually do not understand what they are doing. For someone who spent his professional life among mathematicians, this is very disorienting. There are many areas of mathematics that I don't know much about. But I know who does know, and I have every reason to believe that I can trust them completely. If a^n+b^n=c^n for positive integers a,b,c,n then n is 1 or 2. This claim will not need a bailout next year.

[PassedOut]

The truly frightening part, to me, is that quite possibly the people in the top positions actually do not understand what they are doing. For someone who spent his professional life among mathematicians, this is very disorienting.

In addition to sensible regulations on leverage and disclosure, I would like to see anti-trust laws in place to break up the large financial institutions into small pieces. Otherwise the "too big to fail" thing will hit us in the face again in a few years. People who don't understand what they are doing should be allowed the luxury of failure.

[hrothgar]

As part of my job, I spend a fair amount of time talking to folks down on Wall Street. I've been involved in some very scary conversations.

 

One of the scariest (and most common) involves random number generators.

 

The conversation usually goes something like this:

 

"I just used your product to generate 100,000 random numbers with mean = 0 and standard deviation = 1. When I checked mu and sigma, the mean was .0023 and the standard deviation was .9978 (or some such). I need mean = 0 and sigma = 1. Make it work..."

 

This conversation is terrifying on multiple levels

 

1. The customer's request violates the basic definition of "Random Number Generator". (If you are constraining the system, such that you are producing a known mean and standard deviation, you aren't generating random numbers.)

 

2. The transforms necessary to turn a vector of random numbers with mu = X and sigma = Y into one with mu = 0 and sigma = 1 are trivial. This is high school math type stuff.

 

3. In general, the reason that you need random numbers is for Monte Carlo simulations. You want to find out what's going to happen if something unexpected happens and if you're always feeding nice, well behaved numbers into your simulation, you're never going to stress test your system. If your model only works when you feed the "right" set of numbers into it, there's something very wrong with your model...

[Winstonm]

I may have posted this link before, but it is pertinent to this conversation about math and Wall Street: Recipe for Disaster: The Formula That Killed Wall Street

 

http://www.wired.com/techbiz/it/magazine/1...currentPage=all

 

Over-reliance on mathematics seems to be a recurring theme in Wall Street disasters.

[kenberg]

I just took a quick scan, I am going to bed, but I will read it. Love potions, gas stoves and mathematics all come with warning labels about the necessity for proper use. It's best to heed the warnings.

[mike777]

I just took a quick scan, I am going to bed, but I will read it. Love potions, gas stoves and mathematics all come with warning labels about the necessity for proper use. It's best to heed the warnings.

I doubt most of us who buy love potions and gas stoves read in full or understand the operating manuel.

 

As for math....we must not only understand the math but use math properly hmmmm...ok got it.

 

 

One story that over the years really stuck with me was a woman who bought a $10,000 personal computer for the times. When she complained about it she was told she needed to read the manuel. She yelled:

 

1) I payed 10,000 bucks

2) and also must read and understand some stupid 500 page manual?

 

 

The story being the seller thought the woman an idiot for not reading the manuel for this really basic question.

 

The customer thought the seller was an idiot for expecting such .....

 

( See Richard's post)

edit: ( reading Richard's post I just wonder if there is a business opp. for his company, to teach people how to use the software properly, to expect the end users to not read the manuel).

[hrothgar]

reading Richard's post I just wonder if there is a business opp. for his company, to teach people how to use the software properly, to expect the end users to not read the manuel.

That market niche is filled by colleges and universities.

 

We have a very good training program that is very good at showing users how to use our software. By this, I mean that they will show you

 

how to use a random number generator to generate numbers

how you can control the seed

how to parallelize the process most efficiently

how to store the results compactly

...

 

What we don't do is to teach people how to apply Monte Carlo methods, how to apply quantitative methods, what have you.

 

As an analogy, our products make it possible for users to get to where they want to go quickly and easily; however, users still need to know where they want to travel to...

[helene_t]

2. The transforms necessary to turn a vector of random numbers with mu = X and sigma = Y into one with mu = 0 and sigma = 1 are trivial. This is high school math type stuff.

Yes but then you get a t-distribution rather than a normal distribution. :)

[hrothgar]

2.  The transforms necessary to turn a vector of random numbers with mu = X and sigma = Y into one with mu = 0 and sigma = 1 are trivial.  This is high school math type stuff.

Yes but then you get a t-distribution rather than a normal distribution. :)

Depends on just what you do, but in the most obvious case, yeap...

[kenberg]

I apologize if I have nudged this off in an unintended direction but since amthematics now plays such a role in finance it may be worth talking a bit about it.

 

Richard's post presents an example which any mathematician recognizes if he has dealt at all with Real World People. I recall a talk many years ago by the applied mathematician Richard Bellman. He said that what happens too often is that the RWP gives the M a mathematical formulation of a problem, the M gives the RWP the solution, and it doesn't work. The reason is that the RWP doesn't know enough about mathematics to formulate the problem correctly, and the M doesn't know, or maybe doesn't care, what the RWP is trying to do. For the collaboration to work effectively, the mathematician has to ask the RWP what it is that he really wants to do, the RWP has to explain it, and the M has to take the time and make the effort to understand the explanation.

 

In those infrequent times when I have actually had to deal with the real world I have generally acted on Bellman's advice and when I have not done so I have usually found that I end up wasting a lot of time solving a mathematics problem that is of no use to the real world problem.

 

 

The people that work in the mathematics of finance are very smart people and they know all of this stuff that I just said. Still, it seems possible that at least some of the current difficulty springs from a very sophisticated version of the same basic issue.

[helene_t]

In my completely uninformed opinion the problem is more about lack of ethics and social responsibility than it's a about lack of mathematics.

 

Those managers that arrange for themselves to be awarded with options rather than futures on their company are perfectly aware that this creates a situation in which managers are risk-seeking while shareholders (and most other interest groups) are risk-averse. It may take some math to assess the nett present value of the black swans correctly but it doesn't take any math to see that the black swans are more attractive to managers than to shareholders (or to employees or savers or to society in general for that matter).