'The Big Short' Book Review

A Lesson In The Power of Incentives - 15 Minute Read

Maybe it was the recent tariff tantrums and subsequent doomy economic outlook, or maybe it was just pure happenstance, but either way, when I walked past a copy of ‘The Big Short’ in Waterstones recently I felt the urge to buy it and have a leaf through. I thoroughly enjoyed the film a few years back despite only having a superficial understanding of the financial instruments underpinning the crisis, and found the book illuminating in explaining what forces were at play within these derivatives.

My main takeaway from the book is just how powerful incentives can be in eroding and corrupting a system. If you have a structure where there is significant misalignment between what benefits the individual, and what fundamentally benefits the system as a whole, then people will tend to act in a way that satisfies their own interest to the detriment of the overall system. Complacency becomes commonplace as no one asks questions while everyone is making good money. This allows the problems to gather momentum and scale until eventually a trigger exposes the latent instability and the whole thing comes crashing down. This observation is unashamedly unoriginal as it is of course the same conclusion that the author reaches in the epilogue of the book. Lewis notes; ‘What are the odds that people will make smart decisions about money if they don’t need to make smart decisions - if they can get rich making dumb decisions? The incentives on Wall Street were all wrong; they’re still all wrong’. This notion brings to mind some timeless Charlie Munger advice, who has famously always advocated for the importance of a correct incentive structure as the foundation of any successful system. He is famous for saying; ‘Show me the incentive, and I will show you the outcome", as well as; "I think I've been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. Never a year passes that I don't get some surprise that pushes my limit a little farther."

In the case of the Global Financial Crisis, the scale of the incentive misalignment was proportional to only that to the scale of the calamity itself. In other words they were both enormous, and I don’t think that correlation is in any way a coincidence. What I hope to highlight in this summary is how, at every step along the food chain - from the homeowners receiving the loans at one end to the money managers buying the bonds at the other - everyone was benefitting in some way from feeding this giant machine and keeping it rolling.

At the bottom of the chain, the home buyers were being given these huge mortgages they likely knew they could never repay but were getting access to an incredible amount of capital in relation to their income which brought with it both an amazing house and lifestyle. What's more, the machine kept generating more and more loans, increasing demand and pushing up the value of their homes, giving the illusion they were getting rich and also allowing them to spin loans out from the value of one property into the purchase of others. The looseness of the lending was so extreme, with zero down payments, zero interest repayments (it just accumulated on the principal loan), and extremely initially low teaser rates, that they almost had no equity in the property and therefore next to no risk as they had very little to lose if they declared for bankruptcy. Lewis highlights that a strawberry picker with a $14,000 a year salary was paid every penny to get a house worth $725,000! Who wouldn’t want to obtain a far greater lifestyle with almost no downside if things go awry?

Next are the loan originators. These were typically smaller banks in the origination and sell business. Like the name suggests, these banks would offload loans almost as soon as they created them. As such they carried almost none of the risk for the mortgages they were underwriting and therefore had no incentive to carry out any real checks and balances on these loans. They often didn't require any proof of income from borrowers and actually advised borrowers on how to game the system to get the biggest loans. These businesses benefited by simply making as many loans as possible and profiting from the fee on each one. They wrote the loans and then sold them, getting them off their balance sheets as quickly as possible. The employee made a small commission with each loan they sold and the bank made a fee when these loans were sold off to the bigger banks ready to packaged up into the subprime mortgage bonds.

Further up the food chain were the big Wall Street Banks who packaged up these loans into subprime mortgage bonds. These banks were able to make big gains on the sale of these bonds - which once packaged and organised into complex tranches - were able to glean better ratings from the agencies giving them the allure of safety through diversification and subsequently a higher price tag. The risk of the underlying bond was then quickly shipped off their own balance sheets and onto that of the investors purchasing them, allowing them to book big profits whilst having little carrying risk. The Wall Street banks had managed to play the regulators into giving the bonds higher ratings than what they deserved by manipulating consumer credit ratings and using the obscurity of the instruments to mask their true risk. (One thing I was initially unsure of, is if these banks didn't actually own these subprime mortgage bonds themselves then why did they eventually go belly up? Later in the book Lewis notes they created so many of these loans, that they couldn't sell them quickly enough so had to 'warehouse' them until they could find a buyer and thus held some risk. In addition, whilst many Wall Street Banks were expecting the lowest quality bonds to go sour, there was an element of self delusion at play regarding the higher rated bonds which the banks had left themselves heavily exposed to after they also went pear shaped).

There was so much money to be made that the Wall Street banks got even more creative and made things called CDOs where they repackage the worst of the loans into this other derivative, giving the underlying loans the illusion of diversification and lower risk in order to be able to sell them as investment grade to buyers. Once they had depleted this idea, they continued to feed the machine by using CDSs (credit default swaps) to artificially inflate the size of the market through what became known as synthetic CDOs. A point that Lewis makes in the book, is that for all intents and purposes, selling a credit default swap was very much the same as buying a bond. Whereas buying a bond meant laying out money initially in order to get a future stream of interest payments, selling a CDO was the equivalent of selling an insurance policy, where you collected a stream of premium payments upfront, with the obligation of paying a claim if the bonds defaulted. The Wall Street banks could sell these Credit default swaps to people betting against the market like Burry, or they could just create them themselves, and then package them into synthetic CDOs and sell them. For the investors buying them, they were a near-perfect replica of the bonds they had previously been buying. This gave the system a huge amount of leverage and was the key contributor to the enormity of the crisis. Through the synthetic CDO, the market has been able to grow far larger than the size of the underlying housing market. The market had become like a line of dominos, where a defaulting bond was just the first domino to fall.

At the end of the food chain we have the funds buying the bonds. From what I understand these were largely big pension funds, managing and investing capital on behalf of their clients. In the book, this role is brought to life by a guy named Wing Chau, who was the CDO manager at an investment firm called Harding Advisory. At his now infamous Las Vegas meeting with Steve Eisman he laid out the misalignment of incentives between the fund managers and their investors. Similar to that of the O&S banks and the Wall Street banks, the CDO managers were incentivised purely by volume and not risk. They got richer from just having as many assets under management as possible, irrespective of the quality of those assets. They skimmed a 0.01% fee off the top and bottom whilst also having no skin in the game and therefore no exposure to any of the bond risk. They were supposed to be vetting the risk of the bonds and CDOs but they had no incentive to turn any down. Maybe the most outrageous revelation was that these fund managers actually loved people shorting the bonds (through CDSs), as it just created more and more synthetic CDO assets to buy. His main fear was the economy strengthening as it may stem the flow of the synthetic CDOs.

However, It was the deceitful triple-A ratings these bonds carried that gave the big investors the excuse to ignore the risk and fundamentally allowed this scandal to take place. The rating agencies, who were supposed to bring some level of policing to the market to call out any foul play but fundamentally failed to do so again due to incentives. Moody's and S&P - the two dominant rating agencies - were supposed to be giving the bonds issued by the big Wall Street banks ratings corresponding to the level of underlying risk they carried. However, these rating agencies operated under an 'issue-pays' model, which means they were directly compensated by the Wall Street banks who's CDOs they were rating. As such, and as Eisman figured out, their principal concern was that if they asked too many unwanted questions about the bonds, or if they threatened to lower the ratings of the bonds, the banks would just go to a competitor to get a higher rating on the bonds. The Wall Street banks wanted these high ratings of course as it allowed them to to increase the value of these low quality loans they were packaging up and sell them at higher prices to investors. This opened up all sorts of ways in which the Wall Street banks were able to game the regulators as they could frame information about these bonds that they had created in whatever way they wanted. As long as this information made it plausible that these bonds could be rated highly, to make the ratings seem explicable, the rating agencies were incentivised to turn a blind eye and not dig deeper or think independently. An example of this was FICO scores. A FICO score is the equivalent of a consumer's credit rating in the US. Wall Street banks were able to game the regulators as the regulators didn't ask for FICO scores for individual borrowers but instead for the average of the pool of loans. It was hard for the banks to find enough borrowers with the required average score to fill a full bond so instead they filled them with half very low scores and half very high scores. For the bonds to default, a relatively low number of the underlying loans had to default (15% which is a lot less than half) so they were almost designed to fail. Whatsmore, an oversight in the FICO rating system meant people who hadn't defaulted before typically were given a high FICO score, as a sort of ‘innocent until proven guilty’ type model. This meant a lot of migrant workers, often on low incomes, had high FICO scores because their credit history was short (called thin-file FICOs). As such, the Wall Street banks harvested the high FICO scores of consumers who were actually less creditworthy than the borrowers whose FICO scores they were balancing, allowing the creation of high rated bonds with really low quality borrowers.

Overall, I found this to be a really entertaining book with a lot of interesting nuggets and in particular an example of the catastrophic consequences of a system where incentives are not balanced or aligned. It's a vivid reminder of some important factors to look for in the management and cultures of businesses when looking to make an investment. Does the management eat their own cooking? I.e do they win when you win and lose when you lose? Are incentives organised in an intelligent way throughout the corporation? I.e. is a type writer compensated for the number of words they write and not the earnings of the business? And finally, as the investor, do we really understand the nature of the underlying assets driving profits? I.e. While profits look strong, are we working hard enough to understand what's driving this or is complacency creeping in?

I hope you enjoyed this short book review. It’s been a bit of a departure from the more typically value investing books I typically read, but I still found some real value in putting this write up together so thanks for reading. I hope to catch you again for some more book reviews on the feed.