The Big Short Essay Questions

Why did Michael Lewis choose to write about the 2007-2008 financial crisis?

Lewis was inspired, in part, by his personal experience on Wall Street in the 1980s. He had worked for Salomon Brothers in New York and in London, and became disillusioned with Wall Street as a whole because of his negative experiences with the company. He experienced the financial irresponsibility and crisis of the 1980s, and believed that, after this, Wall Street would get its act together. In fact, he wrote a book called Liar's Poker about his experiences on Wall Street in the 1980s, which he believed would warn people against repeating the mistakes he had observed. But when he realized that an even worse financial crisis had been set up for 2007-2008 by the irresponsibility he originally observed in the 1980s, he chose to write about this in The Big Short. He wanted to trace how this second crisis had come about, and why only a few people were able to predict it.

Who is Meredith Whitney and why is she important to the story?

Whitney is an analyst who correctly predicted that Citigroup had badly mismanaged its affairs, and caused a crash in the stock market. People began to listen to her warnings about how risky and unbalanced Wall Street had been in 2007, when she began to speak up. Lewis felt personally invested in Whitney’s takedown of Wall Street because he knew that he could have raised similar alarm bells; he had worked with many of the same people that she warned against. In March 2008, he reached out to her in order to find out more about how she had been able to make these predictions. It turned out that she had a background in literature, and ended up working at Oppenheimer and Co. thanks to a kind mentor named Steve Eisman who helped her to rise through the ranks. Whitney those provided Lewis with his connection to Eisman, who becomes an important character in the story.

What are mortgage bonds, and how are they involved in the lead-up to the financial crisis of 2007-2008?

Mortgage bonds are different from normal corporate and government bonds; they are not one giant loan for an explicit fixed term, as these other two types tend to be. Instead, a mortgage bond is based on cash that comes from a pool of thousands of individual home mortgages. Investors don’t know how long their investment in home loans would last, but do know that they will get their money back only when interest rates fall and mortgage borrowers can refinance more cheaply. This is the worst time for investors to get their investment back, since they end up with cash that they can invest only at lower interest rates. Salomon Brothers originally came up with the mortgage bond market, and they also came up with a solution to this problem: they took big pools of home loans and divided the payments made by homeowners into different pieces called “tranches.” The buyer of the first tranche would get hit with the first wave of mortgage prepayments, but would also get a higher interest rate in exchange. The owner of the second tranche took the next wave and the next highest interest rate, and so on. The investor in the last tranche had a low interest rate but also a very high assurance that his investment wouldn’t end before he was ready. Standards for these mortgage bonds would be set by government agencies like Freddie Mac and Fannie Mae, which guaranteed that if homeowners defaulted—or, in other words, failed to pay back their loans at all—the government would pay off their debts. Eventually, mortgage bonds did fail, spectacularly—leading to the 2007-2008 crisis.

How is the subprime lending industry like a Ponzi scheme?

A Ponzi Scheme is an investment scam where the returns for older investors are gotten through revenue paid by new investors, rather than from actual profits. The subprime lending industry can be compared to a Ponzi scheme because the people running the industry borrowed more and more capital to create more and more subprime loans that were not actually going to be profitable for their lenders. In effect, there was no actual profit being generated; rather, those who ran the subprime lending industry simply got more and more investors to contribute to the industry, to give the impression that they were being profitable.

What was the role of insurance companies such as the American International Group Financial Products in the subprime mortgage market?

AIG FP was created to stand in the middle of swaps and long-term options, and other risk-spawning innovations that began in the late 1980s. It was well-suited for this role because it had a high credit rating, was not a bank (and thus not subject to bank regulations or the need to reserve capital against risky assets) and was able to bury exotic risks on its balance sheet. Basically, it became a reservoir for the risks being generated by the financial system. In the beginning, it was paid to insure events that were very unlikely to occur. But, over time, it began to cover riskier events; its existence allowed these new risks to be created in the first place by giving them a place to hide. For its first fifteen years, it was amazingly profitable with no sign of running huge risks. In the early 2000s, however, the financial markets changed: the banks that used AIG FP to insure piles of loans started to insure much messier piles that included credit card debt, student loans, auto loans, prime mortgages, etc. They believed these loans were sufficiently diverse that they couldn’t possibly all go bad at once. This prediction turned out to be tragically false.

How did banks benefit from the sale of credit default swaps?

Credit default swaps were beneficial to banks because they enabled them to create another bond identical in every way except one: it did not involve any actual home loans or home buyers, and only the gains and losses from the side bets on this bond were real. This was because the banks could package the triple-B bonds bought by people like Burry into a synthetic CDO, which was then rated by an agency that re-rated them as triple-A. Both those buying and those selling credit default swaps benefitted from them. This new market for synthetic CDOs meant there was no limit on the size of risk associated with subprime mortgage lending. In other words, to make a billion-dollar bet you did not need to accumulate a billion dollars’ worth of actual mortgage loans; you just had to find someone else in the market willing to take on the other side of the bet.

What did Eisman and Daniel unearth in their investigation of mortgage loans?

Eisman and Daniel realized that the bonds backed by mortgages most likely to default tended to be located in “sand states." This referred to states like California, Florida, Nevada and Arizona, where housing prices had risen fastest during the boom and so would likely crash fastest in a bust. They also found that loans in these states were made by the more dubious mortgage lenders. These states also had a higher-than-average number of loans that were likely to be fraudulent. Eisman and Daniel recognized patterns in the states, such as lending huge sums to poor immigrants, that signaled just how bad the quality of these loans really was.

What "blind spot" did Eisman discover in the rating agencies' models, regarding lending to immigrants?

Eisman discovered that the rating agencies didn’t understand the difference between a “thin file” and a “thick file” score for the creditworthiness of individual borrowers (known as a FICO score). A thin file meant a short credit history, which should have indicated that, even if the credit history was good, this could simply be because the borrower in question had never borrowed money before and thus had had no chance to bring their credit score down. For example, this was the case with many poor immigrants. Thus, rating agencies lumped such immigrants in with people who had borrowed and successfully lots of money in the past, giving them effectively the same ratings despite their actually very different profiles. In actuality, poor immigrants only had a thin file because they had not borrowed much in the past, and they actually had very little ability to repay a huge loan. But to the rating agencies, their ability to repay loans seemed to be the same as that of people with a thick file, who had borrowed lots and returned lots in the past.

How did Charlie Ledley and Jamie Mai approach the subprime lending industry differently from Eisman and Burry?

Ledley and Mai realized it might make most sense to bet against the upper floors, or double-A-tranches, of the CDOs. No one had done this yet, since even investors like Eisman and Burry had picked the triple-B-minus tranche, knowing it was most likely to fail spectacularly. The Ledley, Mai and Hockett strategy ended up being more profitable. This was thanks in part to the advantage they gained from joining the process so late, but also thanks to their strategy of looking mainly for long shots. In this case, the long shot was to bet against the upper floors, which would take longer to collapse. But they did eventually collapse as well, in a spectacular fashion that left Ledley and Mai with very significant profits.

How did the people who had predicted the disaster, and bet against the industry, respond when they were proven right?

People like Eisman, Burry, Ledley, and Mai recognized just how big of a disaster was possible if the housing market collapsed: when banking stops, credit stops, and when credit stops, trade stops, and when trade stops...important goods like medications, core food staples, water supplies, etc. are endangered. People like Ben Hockett and Charlie Ledley had been able to predict this disaster and bet against it precisely because they were hyper-aware of the risks. But now, their hyper-awareness of risk only made them more deeply anxious about what would end up happening, whereas other people may have been simply happy that they had personally made so much money. Michael Burry, as well, was disillusioned by his success. As he said, “Making money was nothing like I thought it would be." And Eisman responded by recognizing that he had been proven right, and no longer had to struggle to be heard. In response, he became a more accommodating and pleasant person overall.