Friday Book Post: the Big Short

So, finished reading The Big Short at the beach last week (I was way over-optimistic on my beach reading— only finished this and got a little under way on The Poisoner’s Handbook). As expected, really great book on the financial crisis– highly recommended.  It was pretty technical at times, but it kind of had to be to really tell the story.  Anyway, I could write a huge post on this, but just a few points that really struck me that I’m going to restrict myself to.

1) Bond rating agencies were really dumb.  I already knew that, of course, but I just did not realize how jaw-droppingly stupid the people rating the toxic assets were.  I did know that this whole mess would’ve never happened without the ratings agencies giving AAA ratings (as solid as US T-bills) to absolute crap, but I was shocked to find out how moronic (I’m running out of words on this point) they were.  Here’s what really killed me.  Apparently, a person with a credit (FICO) score of 615 and above is quite unlikely, historically-speaking, to default on a loan.   Thus, Moody’s and Standard & Poor’s required that the average, i.e., mean, FICO score for a CDO (a slice of a collection of mortgages be 615.  They did not look at the individual mortgages at all.  Thus the Wall Street wizzes very quickly gamed the system.  Load up CDO’s with a bunch of awful mortgages to people with FICO scores of 450 and just make sure you balance them off with an equal number of people with 780– thus, your mean of 615.  Problem is, a mortgage to someone with a FICO score is pretty much doomed to fail, and these were a huge portion of the CDO.  Yet, these financial instruments got AAA ratings– again, suggesting they are basically no-risk investments.  Nuts!!!!   Bill Gates walks into a bar, the average patron in the bar is now a millionaire.  Rocket science, this ain’t.

2) Investors are over-privileged and stupid.  One of the heroes of the book is an investor, Mike Burry, who saw this coming and made huge returns for himself and his investors.  This guy was pulling in amazing profits for his investors, but once he started lagging the market for just a little while they were all ready to bail.  Do they really think they should always be having great returns?  Apparently so.  A lot of investors missed out on a lot of money because they were not patient with Burry when it was quite clear he was seeing things other people were not.

3) Incentives matter.  Again, not exactly a new point, but critical to this big mess is that the giant Wall Street Firms incentivized short-term profit, rather than long-term gain, at almost every step.    In fact, many of the people who basically destroyed our economy walked away multi-multi millionaires.  I think financial reform may have tried to address this to a degree, but I suspect not nearly enough.  Far too much of Wall Street is incentivized for what is truly little more than short-term gambling with no larger social benefit.  That sucks.

4) Read it.

About Steve Greene
Professor of Political Science at NC State

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