As a basic explanation sub-prime mortgage bonds were collections of housing loans that were gathered together into a bond that could be traded. This system enabled housing loan originators, such as small banks and mortgage lenders, to make loans and then pass the liability on to someone else. The theory was that a collection of housing loans was of less risk than an individual loan because of the diversification involved. This is the same theory that is applied to buying a corporate bond that is composed of the loans of a number of company loans rather than an individual loan from an individual company. It is common sense that if you loan 100 companies a million dollars each you are at less risk than if you loan a single company 100 million dollars. However the sub-prime mortgage bonds went wrong on three fronts. Firstly, passing the risk to someone else while making money on the lending provided an incentive for people to make more and more loans that were more and more risky. In the book Michael Lewis tells of a strawberry picker with an annual income of US $14,000 who was lent the complete amount to buy a house for US $724,000. He also tells a story of a stripper who ended up owning five houses because as housing prices rose the equity in the previous house was used to by the next house. Secondly, the history of the housing market was one of not having fallen for 60 years, which encouraged everyone in the system to keep taking bigger and bigger risks because as long as house prices stayed up there was little chance of default. Thirdly, it was assumed because the bonds held a diversified package of loans only a few might default. This last assumption ignored the fact that in a housing bubble collapse losses would be across the board.
The premise of the book is that while quite a few people were forecasting a market/mortgage collapse there were not that many who put their money on the line, so the story is from the perspective of a few of those that did. The fact that the individuals chosen in the book were strange from the perspective of societal and market standards, including having Asperger's syndrome, adds to the drama of the story. These people needed to be different because they were taking large bets that the sub- prime mortgage market would collapse while everyone around them was making huge amounts of money from betting on its success. Essentially what they did was to buy the insurance contracts on these bonds that were being supplied by companies like AIG. These contracts required them to keep paying a fee every year to maintain the insurance, and they could only make money if the bonds collapsed. Adding to the drama were the concerns that even if they won their bets they might not get paid because the collapse might cause the parties on the other side of the bets to become insolvent. It takes a special kind of person to keep paying large sums of money every year for several years on the chance that the rest of the world is wrong.
I found the book very hard to put down and that is remarkable for a story about some fairly complex and intricate deals. Michael Lewis has a real talent for turning a story like this into a rollicking yarn while still retaining most of the important information.
There has been some criticism in other book reviews that the author has lionised the individuals in the book as heroes and they were far from it. In fact they admit themselves in the book that the bets they made extended and worsened the crisis. I do not believe that this criticism is warranted for the most part as the author does raise these issues and provides quotes from the characters involved that talk about these issues. I did find the last chapter and a half a bit disappointing because it appeared to me to be a bit self-serving and too sympathetic to the characters in the story who knew exactly what they were doing. This to me was the only drawback in the book. There has also been criticism that the author has reduced the complexity too much in order to tell the story. I don't agree with that criticism because the subject matter is extremely complex and I believe that Michael Lewis has reached a reasonable compromise. It is far more important that a larger number of people read the story than a smaller number of people read a far more complex book.
I would strongly recommend this book to anyone interested in the financial markets or their own superannuation fund investments because it is a real eye opener as well as being an enjoyable read.