The Big ShortNotes from The Big Short by Michael Lewis

My Rating: 9/10

My guess is that the movie will likely dumb down the events to make them easier to understand. My guess is also that Michael’s book also dumbs it down quite a bit. So if you are looking for a more sophisticated look, the book is a really good read.

Below are the things that stood out to me while reading.

Wall Street’s essential function was to allocate capital: to decide who should get it and who should not.

The accounting rules allowed them to assume the loans would be repaid, and not prematurely. This assumption became the engine of their doom.

“A Home without Equity Is Just a Rental with Debt,”

“we do more before 9am than most people do all day

If you wanted to predict how people would behave, Munger said, you only had to look at their incentives.

He used no leverage and avoided shorting stocks.

He went looking for court rulings, deal completions, or government regulatory changes—anything that might change the value of a company.

He’d found it searching for the word “accepted” in news stories.

Financial markets are a collection of arguments. The less transparent the market and the more complicated the securities, the more money the trading desks at big Wall Street firms can make from the argument.

The closer you were to the market, the harder it was to perceive its folly.

A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place.

Apparently the agencies didn’t grasp the difference between a “thin-file” FICO score and a “thick-file” FICO score. A thin-file FICO score implied, as it sounds, a short credit history.

the markets were predisposed to underestimating the likelihood of dramatic change.

Both sensed that people, and by extension markets, had difficulty attaching the appropriate probabilities to highly improbable events.

“The rule of thumb is that you buy at ten and sell at twenty.”

Financial options were systematically mispriced. The market often underestimated the likelihood of extreme moves in prices. The options market also tended to presuppose that the distant future would look more like the present than it usually did. Finally, the price of an option was a function of the volatility of the underlying stock or currency or commodity, and the options market tended to rely on the recent past to determine how volatile a stock or currency or commodity might be.

Black-Scholes

They were combing the markets for bets whose true odds were 10:1, priced as if the odds were 100:1.

“We were looking for nonrecourse leverage,” said Charlie. “Leverage means to magnify the effect. You have a crowbar, you take a little bit of pressure, you turn it into a lot of pressure. We were looking to get ourselves into a position where small changes in states of the world created huge changes in values.”

The challenge, as always, was to play the role of market generalist without also playing the role of fool at the poker table.

“Credit quality always gets better in March and April,” said Eisman. “And the reason it always gets better in March and April is that people get their tax refunds.

Bonds backed by floating-rate mortgages received higher ratings than bonds backed by fixed-rate ones—

Grant’s Interest Rate Observer.

The big Wall Street firms, seemingly so shrewd and self-interested, had somehow become the dumb money. The people who ran them did not understand their own businesses, and their regulators obviously knew even less.

The moment Salomon Brothers demonstrated the potential gains to be had from turning an investment bank into a public corporation and leveraging its balance sheet with exotic risks, the psychological foundations of Wall Street shifted, from trust to blind faith.

In an old-fashioned panic, perception creates its own reality: Someone shouts “Fire!” in a crowded theater and the audience crushes each other to death in its rush for the exits. On Wall Street in 2008 the reality finally overwhelmed perceptions: A crowded theater burned down with a lot of people still in their seats.