Thoughts on The Big Short by Michael Lewis

Just devoured the Michael Lewis book: flipping marvellous it was, too.

Baruch has 3 major takeaways.

Takeaway One: I wrote not so long ago that “investing should be a solitary activity” — in a (-nother overlong) post which was nicely taken up and expanded upon by Tadas at Abnormal Returns. What I meant was that you shouldn’t be dependent on Baruch and others for your investing results. The Big Short is a reminder of something else: that the independence of mind working alone creates is a huge asset. All the guys in the book were “out of the flow”; Mike Burry because of his Asperger’s, Cornwall Capital because it was just too small for anyone to want to service it, and Steve Eisman, well, because he was on a mission to punish evil-doers. And being out of the flow allowed them to see the unclothed nature of the Emperor. Baruch has lived through bubbles; he knows the attractions of being well-connected, getting “first call” on the hottest new trend or IPO. But its mostly bullshit; an invitation to join the current groupthink.

Takeaway Two: out of the three investors in the book, Baruch identifies most with the Cornwall Capital guys. He largely shares their epistemology, as described by Lewis. They and Baruch are Talebian investors, people who know the opportunity is that they live in Extremistan, but many things are priced like it’s Mediocristan instead. Betting on mispriced, assymetric outcomes is what Baruch tries to do too, and tech investing is great place to find opportunities like that.  It’s odd though that Taleb isn’t mentioned by Lewis in the sections relating to Cornwall, as he is sort of the intellectual father (OK, maybe uncle) of investment strategies such as Cornwall’s — but never mind.

Shorting subprime debt via buying credit default swaps, which weirdly amounted to, as Lewis makes clear, something akin to writing subprime CDOs, was the classic Talebian strategy: a small outlay for an outsized payoff in the case of an outcome wrongly judged by the crowd to be highly improbable. Situations like that can be excessively profitable for the smart punter on the right side of the trade, yet the other side is correspondingly highly dangerous. In the case of subprime, the other side was the financial system. If we ever do somehow “fix” everything, remove the leverage, create redundancy and robustness in the system, it struck Baruch, might we not also partially remove from the system the ability to make big bucks? I hope not. After all, that’s how I put food on my children, as George Bush used to say.

Takeaway 3. I’m not sure how to feel about Lewis’ conclusion about overall financial system. He thinks that when the big old Wall Street partnerships went public it removed all restraint and socialized all the risks; the managers of partnerships with unlimited liability, Lewis thinks, tend to be more careful with the money, which after all belongs to them, than when the capital belongs to faceless shareholders. This is a good insight, and should not be controversial.

However, could the old partnership structure sustain the massive expansion of financial services in the past 30 years? Many would say that is exactly the point, that our current financial system is far too dynamic, too big. But really, can we be sure there aren’t positive aspects to this as well? The past 30 years also happen to be the period where, despite the odd systemic crisis, more people around the world have been brought out of hopeless poverty into the global economy than ever before, and while we have created some undeserving super rich, I suspect that when you consider the relative change in real incomes in BRIC markets, wealth inequality on a global basis might have actually fallen. It may only be a coincidence that the two phenomena occured at the same time. Then again, it may not. If an economy gets bigger and more complex, might it not need an increase in the size and complexity of its circulatory system?

Anyway, let’s see. Roll on the next crisis if it means another book as good as this one.


12 thoughts on “Thoughts on The Big Short by Michael Lewis”

  1. I will have to buy and read the book now that Baruch approves.

    On three, I think you’re both right. I think we’re missing a scalable check to the managers of the largest financial institutions. Maybe concentrating more voting rights in the hands of a recognized class of institutional “fiduciary” shareholders might work. The threat of a takeover cannot be serious for managers at Citi, GS, &c. What would keep them honest?

    1. Yes, Michael, you will have to buy the book.

      I don’t know what structure will keep bankers honest, except maybe fear. I like TED’s idea of super evil regulators recruited from the ranks of the seediest, nastiest bankers to be found, and paid big enough bucks to be mostly uncorruptible. Your “fiduciary” shareholders would also have to be involved in management, in the day-day stuff where the real decisions are made, and in a way, the current managers with tons of deferred comp tied up in shares are like that already, and that didn’t work either. And doesn’t it sound like a board of shareholders anyway?

      No I think only fear. Unlimited liability, being on the hook for assymetric outcomes, provided the fear in the olden days of partnership. Maybe some form of physical punishment, by contract, is needed. Loss of a limb for every billion in trading losses, an eye for half a bill, and maybe a mild chinese burn if you book too expensive a flight or something.

  2. You sound so reasonable that I want to give up. But maybe there is some threshold effect at work. Would a shareholder class with special fiduciary duties end up captured the same way even independent directors have been? Maybe. But there are only a dozen or so board members. Two or three dozen might be too difficult to capture.

    I don’t see that these hypothetical shareholders would need to be involved in management decisions either. I don’t even think it would be necessary (or wise) for them to be able to observe board meetings.

    The problem I see is that voting power is too diffuse to put a check on management the way it used to. It’s only a guess, but there does seem to be some threshold we passed around the same time that the unlimited liability partnerships fell by the wayside.

    Anyway it’s worth experimenting at the margins. Who wants to be governed by fear?

    1. Close involvement in not just management decisions but also in day-day bread and butter activities would be vital. The traders and bankers were creating products and doing trades that their line managers simply didn’t understand properly. Lewis makes this clear. The bosses of the line managers were further removed and thus still more clueless about what was hitting them when it all went wrong. Fiduciary shareholders, even dozens of them, kept at arms length, will be in a still worse position than this in terms of being able to understand and control dangerous behaviours, and thus not entirely useful in preventing the next crisis.

      When the line manager is a partner, and his personal net worth is on the hook, he will make damn sure that either he understands what his traders are doing, or restricts them to doing things he can understand.

      It is said that when it comes to money, greed and fear are the big motivators. When you’re dealing with others’ money and not your own, there simply isn’t enough fear to restrain risky behaviour, is I guess Lewis’ point. We — you and me, Michael — would not be governed by fear. We would simply be ensuring that the people to whom we give the opportunity to make millions in banking get a bracing dose of it.

  3. I see your point — there’s an information problem, and adding more checks at a higher level won’t necessarily solve it. And certainly giving a class of shareholders stronger rights against management won’t help if those same shareholders don’t have enough information to make informed decisions. Accounting reform is greatly needed. Off-balance sheet accounting, in particular, looks to me like low-hanging fruit for a young SEC attorney with aspirations.

    More fear (for them) might not be a bad thing. But that these kinds of people are already the kind that are fearless in a way that most of the rest of us would call reckless. The question is what kind of structural change to incentives permits fear without wrecking efficiency?

    A check on the board and management through a more powerful class of shareholders is indeed far removed from the trading floor. But these checks ripple out far more than most people appreciate. Consider how much waste there is toward the end of the quarter at many companies, as everybody scrambles to push the ball ahead before the buzzer. Why should a trader care? Ultimately shareholders do have an influence on formal rules and informal culture inside institutions. But they had more when their interests weren’t too diffuse to be a potent check on management. Or that’s how it seems to me anyway. The exceptions are interesting, and seem to prove the rule. Look at the owner-operated companies like Oracle, Koch, or half the startups in Silicon Valley.

    1. Steve, you’ll have to stop reading me as well then. I had no inkling that anything that bad was coming down the pipe in mortgage lending either, until Jim Cramer’s CNBC freakout. Sure, there were a few specialists like la Tavakoli who got it right, and they have the right to point fingers if they want. Even if it’s not totally classy.

      But if you demand infallibility from your writers you’ll end up with a pretty short reading list. Also people who are right all the time tend not to be very good writers.

      1. Ah, now I understand. I am infallibly correct, and I am an excellent writer. Now I understand why I have no readers, other than the few buy side punters like Baruch I bribe with the occasional insider trading tip.

        I learn something new every day.

  4. Yes, bring back the partnerships. And if you doubt that wisdom, I have two words for you.

    William Blair

    They are thriving, and if I worked there I would be laughing at everyone else while i eat their lunch.

    1. Sadly, Stock, although I am sympathetic to your perspective, I believe the evidence is against you. Private partnerships simply cannot scale up large enough to compete at the highest level with the global behemoths. Remember that before it stripped off its knickers and went public Goldman Sachs went begging to the Hawaiians for capital to trade against the then-puny Morgan Stanley et al.

      Now, the round lot investment size for a top tier bank is beyond the capacity of any manageably sized group of private individuals, no matter how wealthy. Hence, you need other people’s money.

      As far as William Blair and a few others go, do not be confused. The hearty “lunch” they are eating from their betters’ tables is merely the table scraps the big guys can’t be bothered to reach down and pick up off the floor.

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