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Posted on 28, July 2012 July 28 2012 2012年7月28日 by alexander-berger

The Big Short

The Big Short: Inside the Doomsday Machine     

The Big Short: Inside the Doomsday Machine by Michael Lewis
My rating: 5 of 5 stars

Michael Lewis does an amazing job of explaining the stock market crash of 2008 clearly and in an extremely interesting manner. Rather than simply demonizing the investment bankers for their mistakes, he shows the environmental variables that resulted in their actions. While the media or an average person on the street might blame the bankers poor moral judgement, or lack of empathy, Lewis takes a more sociological position and demonstrates the way in which compensation and recognition were structured within the mortgage investment banking industry in a ways that encouraged behavior not in the long term interest of the market or the firm. This book is a must read for anyone who is interested in investment banking, the stock market, efficient market theory, and the great story telling style of Michael Lewis. 

While understanding the causes of the ‘08 crash was the primary reason I read this book, I was most intrigued by the stories about the few special investors who predicted the crash and profited massively from it. In various ways, each of them came to the conclusion that there were far too many bad loans being made and that the risk inherent in these poor quality investments was not being accurately priced into the market. By utilizing an investment vehicle called credit default swaps these investors were able to essentially buy cheap insurance on mortgage backed bonds (regardless of if they actually owned the bonds), that in the event of a market collapse, would create massive profits. These select investors then had the tenacity to hang onto massive positions in these securities even as the market went against them, investment banks continued hyping their mortgage bonds, and the media carried right along feeding the housing frenzy. In one case, Michael Burry manager of Scion capital, had to take legal action to prevent his investors from abandoning the fund as they thought he had lost his mind. Even more impressive is the story of Charles Ledley and James Mai who started with 100k trading from their garage. They ended up founding Cornwall Capital and making hundreds of millions in a couple years.

Both of these investors have 1 thing in common: they DO NOT believe in efficient market hypothesis (Also Investopedia Definition). According to EMH financial markets are “informationally efficient” and as a result it is impossible to consistently beat the market on a risk-adjusted basis (IE without taking riskier positions), because everyone else has access to the same information you do and therefore this information has already been priced into the market.

Obviously in the case of Michael Burry, Steve Eisman, and Cornwall Capital, all available information had NOT been accurately priced into the market. They were able to find an underlying flaw in the assumptions made by big banks, other hedge funds, pension plans, and individual investors: the assumption that the price of houses would always go up. Were their predictions and profits just a one time fluke or is it possible to consistently predict and profit from these so called black swan events? I don’t know, but after reading The Big Short I am determined to find out.