Profiting from a Catastrophe

Profiting from a Catastrophe

By Sanjay Kumar Singh | Sep 9, 2010
http://valueresearchonline.com/story/h2_storyview.asp?str=15150

The Big Short narrates the story of a few investors who had noticed as early as 2004-05 that lending standards within the US mortgage market had plummeted so sharply that in a few years loans would start going bad at a catastrophic rate. These investors took advantage of an instrument called the credit default swap (CDS), which is an insurance contract, to bet against the mortgage market. When calamity finally struck in 2008, it shook Wall Street and plunged the global economy into a crisis. But a small minority made a fortune out of it.

This is the story of dysfunction within financial markets on a massive scale. At the outset, the average reader would have many questions about the crisis. Why would any bank or mortgage lender lend to the subprime section of the population, knowing well that when the teaser-rate period ended borrowers would surely default? How did the rating agencies give high ratings to products underpinned by crappy loans? Why were abstruse instruments like collateralised debt obligations (CDOs) allowed to be created whose only purpose, in hindsight, was to do credit laundering (convert poor-quality bonds into higher-quality ones)? The book answers all these queries well.

If you have read Liar's Poker, you would surely be a Michael Lewis fan already. The author is in his elements once again, combining a Jeffrey Archer-like ability to spin a racy yarn while at the same time being able to explain complex financial developments to laymen.

One message that comes across starkly is that it pays to be sceptical in the financial markets. A Deutsche Bank bond trader named Greg Lippmann is convinced that making a bet against the subprime market would make a lot of money for his clients. So even though his own firm makes millions selling subprime mortgage bonds, he sets out to sell the idea of shorting the subprime mortgage market using CDS. One of the hedge funds he calls upon is Steve Eisman's. Eisman and his colleagues have been studying the subprime market for years and are convinced that it would implode. What they are not sure of is Lippmann's motives. They pepper him with a lot of questions. Lippmann's answers correspond with their own views. Finally, one of them blurts out what the group has been feeling all along (I have paraphrased): "All that you have said makes perfect sense. We believe this is a good trade and it will make us money. But tell me: finally, how do you plan to f… us?" Given the scale of mis-selling that happens in our country, I wish more of us had an equally heightened sense of scepticism towards the snake oil salesmen in the financial services industry.

My key take-aways from the book

• In any situation where there are conflicting viewpoints, those with their ears closest to the ground will be proved right eventually.
• People at the centre of events rarely see what's going wrong. They have too much at stake to have any real perspective. It's usually outsiders or the people at the fringes who spot the problems first.
• Incentives matter. If a line of action benefits someone in the short run, he will pursue it, unmindful of the long-term consequences. By the time the day of reckoning arrives, he will have moved on and someone else will have to bear the brunt.
• What started off as a good thing will not always remain so; it could by degrees mutate into something draconian.
• Watchdogs can turn predators. Witness the part played by rating agencies in the subprime crisis.
• And finally, if you don't understand it, don't get into it. Complexity is just another tool in the arsenal of those who sell financial products to dupe us with.