The Big Short

The Big Short by Michael Lewis

This is a difficult book to understand for those with little background in the financial markets. Lewis seeks to get inside the trade - he wants to understand exactly how people made money. But much of Wall St - particularly the debt market - is arcane. You don't need to understand the arcane details to get the big picture, but you do if you want to understand how and why individual players on Wall St acted as they did.

Some people have said they need a glossary while reading this book.

A few points of background/basics that may be useful:

Zero-sum trade

If you sell me a car for $5000, we both benefit: you clearly wanted the $5000 more than the car, and I want the car more than $5000. We both make gains from trade. Many markets are like this.

Financial security markets are different. If you buy a share of Apple for $400, and I sell it for $400, one of us will gain and one will lose. This is ever clearer in wagers: if I bet you $5 that Nadal will win the US Open, and you accept the bet because you think Federer will win, one of us will gain from the trade and one will lose. The sum of our gains is zero; it is a zero-sum trade.

Insurance markets may seem like zero-sum trades. If you pay $2000 a year to ensure your house for fire, and it never burns down, your insurer gets $2000 a year and you lose $2000 a year. If your house does burn down, you get a big payout and your insurer loses money on the deal. But insurance does not work like that because of diversification. Your insurer has many clients, and the risk that all their houses will burn down is negligible.

But what if all the houses did burn down? Your insurer would be bankrupt and unable to pay its claims.

Debt Markets

When you take out a mortgage you sign a contract many pages long. That contract commits you to pay a certain amount for the life of the mortgage. But that document now has value. A lender can sell that contract to someone else. They then have the money to make another loan, instead of waiting thirty years to get all of their money back.

To make money from a trade, you need both a buyer and a seller. In the book, Lewis documents how banks such as Goldman Sachs found buyers for clients who wanted to sell.

Shorting the housing market is an example. If I think your house price will fall, what can I do about it? I can wait until it falls, and then maybe buy it at a low price and hope it appreciates again. But I may wait a long time, and my payback is uncertain. What if I write on a piece of paper that I will pay $X if the house price rises, but you must pay me $X if the house price falls? Someone may be willing to buy that piece of paper. Now we have a market for these pieces of paper that is derived from the price of the house.

Transparency

As Lewis points out, the most money to be made is when markets are hard to understand and information is not perfect.

Values on Wall St

Wall St believes that if someone is willing to buy something, and someone else is willing to sell it, they should be allowed to make the trade. That is the definition of a free market. Trades are the way Wall St makes money. Obviously, anything that inhibits trading inhibits their ability to make money, and they would be against it.

Leverage

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