The Big Short: a Review


The Big Short: Inside the Doomsday Machine, by Michael Lewis - W. W. Norton & Company 2010

I loved this book. The Big Short is seen by others as a history of the real estate meltdown and the financial crisis that culminated in near-panic in the fall of 2008. But it is more than that. It is also the history and psychology of collective delusional thinking.

In fact, it is similar to a book that was first published almost 150 years ago (in 1841). That classic, Extraordinary Popular Delusions and the Madness of Crowds, by Charles Mackay, detailed financial follies from over the centuries, including the South Sea Bubble and the infamous Tulip Bulb Mania. In 1624 some tulip bulbs were trading at a higher price than gold.

At first glance it would seem that the key question is how people so easily buy into a collective delusion. For example, it seems painfully clear after the fact that an average salary of perhaps $60,000 in California couldn't sustain home prices that were averaging over $500,000. It seems insane on the face of it. But the willingness of people to play along is not really difficult to understand. In fact, if everyone is getting wealthier with real estate year after year, as insane as the prices are, it is perhaps harder to imagine people refusing to jump on the bandwagon and join in the profits.

When we look at it this way, the conclusion seems to be that the process itself is insane, but the players are acting rationally--a strange conclusion indeed. Is it rational to take advantage of irrationality, and can we apply these terms to collective action apart from individual actions? And at what point do people stop realizing they are playing a dangerous game (and did they ever know), and start really deluding themselves with justifications for the general insanity around them?

Well, back to Michael Lewis' book. Subtitled "Inside the Doomsday Machine," that's exactly where we are taken. The big short looks at how the big banks and big investors created a system that was sure to explode in their faces, and came to believe in it as something safe and useful. Loans that were clearly risky were packaged together and suddenly rated much higher based on the delusion that a bunch of risky bets are safer than one--a strange application of the theory of investment diversification.

Apart from the bizarre sense everyone seemed to have that all real estate transactions made sense at any price and with any borrowers, there is another interesting aspect to the whole mess that Lewis covers. It is the fact that a handful of players not only saw the delusional nature of it all (myself and million of others saw that), but also found ways to bet against the market. They bet big, and they won big.

Perhaps my only complaint about the book is that Lewis did not report on the role that Government policy played in inflating the real estate bubble. He seemed to believe that it was all a matter of the key players distorting the market, with no acknowledgement of the easy-money policies of the Federal Reserve, the special tax treatment that real estate gets, the forced lowering of standards for loans that were legislated, and other policies that contributed to the boom and subsequent bust.

In any case, it presents a great historical lesson we can learn from. Like his first book, Liar's Poker, The Big Short is written in an easy-to-read style and with a storyline that makes it hard to put down.

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