New York University Schack Institute of Real Estate

Master of Science in Real Estate

Fall 2010
Applied Project in Real Estate Finance
Professors Oler and Korologos

Name: Joshua Kogan

Date: December 13, 2010
Assignment: Lessons Learned from Michael Lewis’ The Big Short

Chapter 1

1. Vincent Daniel, while working for Eisman in 1997 concludes that subprime
lending companies were growing so rapidly, and using such goofy accounting, that
they could mask the fact that they had no real earnings, just illusory, accounting-
driven ones. They had the essential features of a Ponzi scheme. A year later Eisman
issues a report to this effect. Less than a year later, LTCM crisis occurred – the early
subprime lenders were denied capital and promptly went bankrupt en masse.

2 By 2005 the subprime mortgage machine was up and running again as if it never
broke-down in the first place, and in even more unsustainable ways (e.g. with
floating-rate mortgages, to the tune of $625bn.

3. The lesson learned from the LTCM crisis was that those making subprime loans
had to keep them off their books.

Chapter 2

4 . Michael Burry looks for ways to bet against subprime mortgage lending, and
solicited the interest of major banks in credit default swaps on subprime mortgage
bonds. He was able to cherry-pick some of the banks worst bonds to bet against, as
the banks didn’t realize that the underlying value of these bonds could be worthless.

Chapter 3

5. AIG was found to be on the other side of Burry and Lippman’s bets against the
bonds. AIG felt that they figured out a way to insure subprime mortgage loans
without having to disclose to anyone what they had done.

6. Goldman Sachs devised a CDO to disguise the risk of subprime mortgage loans,
thus allowing them to be re-rated as triple-A.

7. In a matter of months AIG FP bought more than $50bn in triple-B-rated subprime

mortgage bonds by insuring them against default through CDO securitization.
8. The assumption was made that one pile of subprime mortgage loans wasn’t
exposed to the same forces as another – that a subprime mortgage bond with loans
heavily concentrated in Florida wasn’t very much like a subprime mortgage bond
more concentrated in California. The financial engineers crate the illusion of
security.

9. Instead of feeling qualms, the other major banks felt “shame” that Goldman Sachs
had been the first to find this particular “pay dirt” , so they too began the same
process.

Chapter 4

10. Gene Park figured out that the credit default swaps AIG was buying were 95%
prime, but the dictatorial CEO of AIG, Joe Cassano, resisted the news.

11. FICO scores were being manipulated by lenders for home mortgages; Eisman
and Daniel found this out and said nothing.

Chapter 5

12. Greg Lippman led 10-20 people to bet against the entire subprime mortgage
market and, by extension, the global financial system. These people (including John
Paulson, Cornwall Capital, etc.) were looked at as odd by other investors. Big
positions against CDO were accruing.

Chapter 6

13. CDO managers like Wing Chau were securitizing their CDOs to create more
triple-A CDOs (CDO-squared). In a 1997 conference in Las Vegas, Eisman learned
that there were 7000 people in attendance making money off of subprime
mortgages. The industry was growing rapidly.

Chapter 7

14. Bear Stearns collapsed after mortgage defaults that backed the bonds, and a
subsequent “run on the bank”.

15. Eisman hosts a conference call predicting larger losses – creating frenzy – and
shorts Merrill Lynch.
Chapter 9

16. Howie Hubler creates the essentially fraudulent credit default swap; they were
designed to be bets almost certain to pay billions of dollars. The essence of the
scheme being that the pretense that the subprime mortgage loans were not all
essentially the same, and thus not all likely to default at the same time.

17. Hubler loses more money than any trader in the history of Wall Street (about
$9bn) and did not violate any laws.

18. Hubler trusted the ratings of the ratings agencies and gambled that slightly
better mortgages would remain sound.

19. In 2007 Goldman Sachs makes a large bet against subprime market, further
accelerating its collapse.

20. John Mack (CEO of Morgan Stanley) demonstrates on a conference call that he
didn’t know the market well enough to describe what happened to his company.

21. 1 Trillion dollars in losses had been created by American financiers, out of
whole cloth, and embedded in the American financial system.

22. Wall Street failed to realize the correlation of the entire market to the subprime
market.

General

23. Rating agencies were accepting explanations for rating complicated CDOs from
Wall Street banks.

24. Nearly everyone involved was ignorant of the process. For quite some time, the
heroes could not figure out why there was an insatiable demand for the other sided
of their trade – why they continued to lose on daily mark-to-market in face of a
deteriorating housing market. They didn’t even know what a CDO was, nonetheless
there were CDO managers.

25. The CDO market came to dwarf the actual market for loans – subprime or
otherwise.

26. The reining model at the time of how the market worked precluded the
possibility of such a calamitous event. Nor did it understand the effect from a
confluence of events too specific and improbable for anyone to predict, like a black
swan.
27. Millions of people with shaky or nonexistent credit histories were seduced into
accepting adjustable-rate mortgages with very low teaser rates at initiation.

28. Due diligence on a market, sub-market, and/or property level was simply not
completed by the purchasers of triple-A rated subprime mortgage bonds, or their
associated CDOs.

29. Wall Street and the SEC did not listen to warnings from Eisman, Lippman and
others when alerted about the potential catastrophe on the horizon.

30. As a sales strategy, consumer loans were mixed with corporate loans and
bundled together to reduce risk. Although this provides diversity, it is makes things
more complex and heavily skews the projected returns from the realized returns.

31. U.S. regulators did not act to arrest the largest housing bubble in U.S. history,
and the outcome was a worldwide financial crisis.

32. Regulators have consistently failed to recognize or to prevent bubbles, but The
Big Short shows that—for those who recognize that a bubble is developing—credit
default swaps can provide powerful incentives to speculate against bubbles.

33. Even though clients may lose money, the employees of various financial firms
are still being paid heavy bonuses.

34. Creative financial engineering was utilized to inflate bank balance sheets to
show that their company was performing healthy and making huge profits.

35. The complexity and the pace at which these bonds were created made it
impossible for accountants to value the loans.

36. The prospectus for each bond was very large and essentially nobody besides the
lawyers who wrote them and a handful of investors actually took time to read
through it to understand what they are investing in.

37. During the boom, many traders went from dealing stocks to being active in the
bond market. The associated skills are not easily transferred with regards to making
investment decisions.

38. Many of these bets were dependent on historical information and the idea that
home prices will never go down in the US.

39. When hedge funds started to realize that home owner would at some point,
default on their loans, they started buying insurance policies that protected their
bets and this created a huge reinsurance market.

40. The rating agencies were being paid by the banks that were making the loans.