Book review: The Great Short - by Michael Lewis

The great Short - by Michael Lewis

I bought this book from a book store at Heathrow airport sometime around August 2010 mainly because I needed to buy another book to avail a promotional offer of buy 2 and get a third at half price. I had already selected the two books that I was really keen to get my hands on, and started to browse the collection for the third one. And it's then that I came across this book. I’d read the reviews for “Poker’s Liar” – another of Michael’s best sellers and read some great comments for this book as well. And since I was intrigued by the financial crises, asking not just the obvious question of how it happened, but also how come no one saw it coming; and how did we dig ourselves so deep that the only way to be safe was to dig deeper, rather than dig ourselves out!  And I finally managed to get around to reading this book last month.

This is a really great book – mainly due to three reasons:

The author handles a fairly complicated and vast subject of financial crises in a simple and coherent way that makes the storyline easy to follow.
The author does not assume that the readers have great knowledge about financial products. He takes the time to explain what these different products mean.
Finally, it is not a book just about the facts related to what was going on in the market at the time but the author takes the liberty to explain the linkages, and adds his commentary to outline the implications of various actions.

My take on the book is similar to something the author mentions briefly towards the end of the book (but I assure you that I had formed my view way before I reached the final pages!). In my mind, I draw parallels between the financial industry and gambling industry (albeit in a regulated environment) – with two exceptions. The first exception is that the gambling industry is based on regulation that is governed primarily by the industry players. Take two examples: in the event that there is a trend of large bets placed on a given outcome, the industry regulator raises alarms – which means that either the betting for that outcome is suspended or/ and there is an investigation to assure that the outcome is not rigged. Secondly, the industry is based on transparency – you can clearly see the odds and returns offered by each player (and these don’t tend to vary too much) mainly because the it’s the same industry that is answerable and has to pay for all outcomes – i.e. it takes the winnings, as well as pays out – and therefore, has to balance the books.

Why do I think financial trading is like gambling? In some aspects – Options, future obligations to buy or sell, Bonds etc, are all a bet on a specific future outcome (value of the underlying instrument in this case). And the investors are playing the odds. In many cases, that may pay off, while in others it may not. So when I read the book, the question I wanted to answer was where did it all go wrong? Why did the financial industry lose it and ended up in a huge disaster, affecting the global economy so severely? And here’s my take:

The first problem was the lack of transparency. The inability of rating agencies and most in the business to understand the products that they were trading in, and the inability to accurately assess the risks related to these products (a fundamental basis of financial trading) clearly evidenced the lack of transparency and understanding.
The second issue was the lack of accountability – the bets were made by the industry, but the industry for some strange reasons was not responsible for both ends of the trade – it involved the insurance industry (AIG), it included the investment banks, private investors, money managers, and ultimately common man (thanks, ultimately, to the government intervention). And hence, it is because of this that the people who were on either side of the bets that the subprime market would collapse, remarkably ended up with money and rich – how is that possible? Because the third element – the public – got involved and ended up paying for both the bets! As an aside, it is in the news recently that AIG and other insurers are looking to sue the financial firms for not disclosing the risks associated with these financial products when these were traded.
And the third issue was that the regulation wasn't coherent – the market and its impact stretched across the globe – across multiple industries and players including consumers, while the regulation was based on a smaller and restricted level – never able to gain an overarching view that was required. The interconnectedness of the market and the trades was far removed from the mirror image that you’d expect the regulators of such a market to have.

So, where does that leave us now? We’ve had the crash and as a result millions have lost their homes and jobs. However,the finance industry has rebounded to its performance levels that are similar to those prior to the crash. And there is a small matter of billions of debt that the government is straddled with. Based on my understanding of the crisis, I reckon we need to find solution to the following issues:

Firstly, we need to fix the rating industry. Many claim that the genesis of the problem was that the rating agencies did not attribute the correct ratings to financial instruments that were being traded (CDO’s and Synthetic CDO’s) because they could not assess their risk or value. And hence, the investment banks led them to rate the instruments triple A when in reality these were made up of mortgages that would have certainly attracted triple B rating. I still haven’t come to understand on what logic can you consider something as rated triple A when you know that it’s made up of mortgages that individually would be triple B or B? The questions that we should be looking to answer is that if the rating agencies are unable to assess risks on complicated products designed by the bright investment bankers, then should these instruments be permitted to be traded at all? And why don't we come up with a team made up of the nrightest representatives from different agencies involved in the trade - so that the "buy" and "sell" side have a 360 degree view and a responsibility to determine the ratings?

 

Secondly, we should be looking to review the regulatory structure that blankets the industry, and align in a way that it closely reflects the interconnectness of the financial trading across world markets. I think, the EU regulatory structure, proposed by leaders such as Gordon Brown, is a great start. It needs to be joined up further across continents.

 

That's my take on this book.