Not many finance books read like a thriller. Yet The Big Short, Michael Lewis’ account of the US sub-prime mortgage implosion – the trigger for the credit crunch – contains enough conspiracy, paranoia, and intrigue to keep you up at night, wondering why the perpetrators aren’t in jail.

Penetrating the black heart of Wall Street, Lewis portrays an unholy cabal of mortgage lenders, big banks, rating agencies and money managers that almost destroyed the world’s financial system.

They played a trillion dollar game of pass-the-parcel with sticks of dynamite marked Collateralised Debt Obligations (CDOs). Each player took their cut of the profits and bet that they could offload the incendiaries onto someone else before it all blew up.

Looming disaster

The story of The Big Short unfolds as a tale of outsiders (a misfit group of hedge fund managers) who come to realise the game is rigged to explode.

They fight the system the hedge fund manger way – not by taking out the bad guys, but by shorting them. It’s a giant bet that stands to make them rich but which they come to see as a bet against the entire financial system and ultimately society itself.

Just like Titanic, the story isn’t spoiled by knowing the ending, because The Big Short is really about how it all began. Uncovering the origins of the disaster that ended in the massive destruction of wealth, huge job losses, and colossal debts that we’re burdened with now.

How they got away with it

This book takes you into the black box and reveals the inner workings of CDOs and credit default swaps in language a mere mortal can understand.

Yet Lewis’ finest achievement is to humanise the event. He transforms it from an unstoppable chain reaction of market forces into a more comprehensible study of human immorality and greed.

And that’s when you become angry at Wall Street. When you realise how obscene, avoidable and unjust the credit crunch and its consequences were.

The perpetrators of the crisis became very rich. They banked fat profits while ignoring the tottering pile of risk that was building. And when it all came crashing down, the billions in losses had to be absorbed by using the livelihoods of ordinary people as crash bags.

But there’s no point getting mad, our only duty is to get even. And that means learning the lessons The Big Short has to teach us about the people at the heart of the financial system.

Lesson one: Trust no-one

According to Michael Lewis, the Wall Street banks tricked the rating agencies into approving assets that should have been slapped with a health warning. The rating agencies played dumb because they were scared of losing business from the banks. In other words, conflicts of interest are rife.

Few financial players will prioritise the interests of the small investor. As The Governor of the Bank of England Mervyn King has remarked, many in financial services believe:

If it’s possible to make money out of gullible or unsuspecting customers, that’s perfectly acceptable.

It’s buyer beware out there. Stay sceptical about everything and everyone.

Lesson Two: Know thy enemy

The smart advice is to avoid stock picking if you’re a private investor. While you might do weights once in a while, you’re walking into a bar-fight with the financial SAS. Your opponents’ access to data and computing power is the equivalent of pitting a chain-gun and airstrikes against your flick-knife. Let’s just say, you’re hoping for a lucky shot.

But it’s all easy to ignore that advice. We never look our investing opponents in the eyes. How hard can they be? Lewis puts together a compelling photo-fit of the ruthless, immoral, workholic hombres you’re up against.

Investing is a zero sum game. We lose, they win. So tread warily. Better still, don’t play the game – invest in index trackers.

Lesson Three: No one cares about you, except you

The list of the culpable in The Big Short is shocking. Wall Street’s greed may not be so surprising but the lack of due diligence by pension funds certainly is.

Many didn’t properly vet the sub-prime assets they bought into. They also hired asset managers who scooped up piles of toxic CDOs because they were paid according to the scale of Assets Under Management, not by quality of results.

In a world where everybody is out for number one, the only way to protect yourself is to do it yourself.

Lesson Four: Understand what you’re buying

People were making a killing from sub-prime before the crisis hit. Bond traders, banks, insurance companies, hedge funds and pension funds all piled in for a piece of the action.

Most had no idea what they were really buying and how dangerous it was. That’s why so many lost billions when the market turned against them.

If you don’t understand an investment then run a mile. If it seems willfully confusing then that’s almost certainly because it contains some unpleasant side-effect that the seller would prefer you not to know about.

It’s easy for small investors to ignore the warning signals. Many don’t bother to unravel complexity or just think they’re being slow on the uptake. We assume protection that doesn’t exist. An investment is probably okay, or else why would it be allowed?

The industrial-scale concealment and blundering witnessed in The Big Short puts paid to that kind of innocent thinking.

Lesson Five: It’s hard to swim against the tide

The handful of hedge-fund managers who bet against the sub-prime market set themselves up for life. But they had to endure years of doubt and ridicule from the mainstream before their bet paid off. They looked like prize chumps when everyone else was riding the sub-prime rocket ship to the stars.

It’s hard not to get swept along when everyone else is charging in the same direction. Ultimately, the heroes of The Big Short show that winning is about setting your own course and then having the mental courage to believe in yourself.

Take it steady,

The Accumulator

Some great money reads from around the web.

I have written before on Monevator about my in-built thrifty disposition, and how it probably veers towards tightness.

For this reason I was thrilled to see The Accumulator explaining how he saves money this week. It’s vitally useful information that I just can’t share from experience.

My problem is spending it!

I have a soft spot for occasional black cabs after midnight and good food. Otherwise, the only thing I find easy to buy are equities.

Perhaps I’m like Warren Buffett in that regard – he used to refuse his wife a new sofa on the grounds that it would cost $1 million, after taking compound interest into account. (Alas I don’t share his prodigious mental abilities, and I can’t quite match his track record. At least not yet…)

This week I was reminded why equities are worth splashing out on through a short Forbes article. In it we learn that if you’d:

…skipped the purchase of a $5,700 Apple PowerBook G3 250 in 1997 and put the money into Apple stock, and your shares would now be worth $330,563.

Even relatively new customers can find reasons for regret. If you’d skipped the purchase of an Apple Xserve G5 in 2005 for $3,999 and bought Apple stock instead, your investment would now be worth $33,877.

The data is based on Kyle Conroy’s clever table of Apple products versus stock gains. It’s been around for a while, but now that Apple is the second most valuable company in the world, the numbers are becoming crazy. As someone who only ever buys Apple-made computers, I can relate.

Obviously few investments will do as well as Apple. Index investors don’t even try to catch the best ones, but instead sensibly settle for market returns. Either way, over time buying equities will make you richer, not poorer.

[continue reading…]

I have previously discussed the high risk/return nature of subscription shares. (Please do read my first article on subscription shares to get you up to speed).

These niche investments give you the opportunity to earn a geared return on the underlying investment trust, and so can increase the money you make by investing.

But there’s a catch – you risk losing your entire investment if the trust’s share price doesn’t rise sufficiently high before the day its subscription shares expire.

Note: Gearing in investing means getting more exposure to an underlying asset for the money you put up. When you buy a house, you gear up your initial downpayment with a mortgage. If you put in say a 10% deposit, then a subsequent 10% rise in the house price will multiply your deposit by 100%, while a 10% drop will wipe it out. That’s the risk/reward of gearing!

Usually when you want to gear up you have to borrow to invest, which is rarely a good idea.

However subscription shares enable you to gear up and multiply your gains without taking on debt. The big risk is that instead of multiplying your gains, you multiply your losses – although your maximum loss is limited to the amount you invest in the subscription shares. ¹

Warning: Subscription shares are very risky. Don’t even consider them unless you’re a seasoned investor with plenty of experience. I take zero responsibility for any money, fingers, houses or spouses you lose!

Understanding the price of a subscription share

Imagine two kind of shares that give you exposure to the (fictional!) Monevator investment trust:

• Monevator Investment Trust shares (MIT), which have a price of £1.50.

• Monevator Investment Trust Subscription Shares (MSS), each one of which grants you the right to buy one MIT share for £1 on a certain exercise date.

What price will the MSS subscription shares trade at?

The easy answer is that MSS should cost you very close to 50p. That’s because instead of buying MIT in the open market for £1.50, you could buy MSS for just under 50p, and convert them into MIT shares for £1, and so make a tiny profit (because £1 plus nearly 50p is less than the £1.50 that MIT shares would cost you).

The price of MSS will therefore rise or fall as the market arbitrages away any potential anomaly vs. the price of MIT.

In reality, however, MSS’ price will not be exactly 50p unless it’s just a few days – or even hours – before the exercise date. Here’s why.

You know those science fiction films where halfway through a crazy (yet strangely handsome) science geek writes an impossibly complex equation on a blackboard that might just save the world?

That’s the sort of equation that would be required to work out the exactly ‘correct’ price of a subscription share. ²

Until the moment it can be exercised, the price of MSS in our example will tend towards the price implied by the trust’s share price and the subscription share’s exercise price but it will also be affected by:

• How much time there is to go until the exercise date
• Supply and demand
• The spread on the shares
• How volatile the underlying investment trust share price is
• And more!

Let’s leave all that for part three, though, since the ‘easy’ price (rounded up to 50p) is close enough to understand the basics of the geared return you’ll get.

How subscription shares multiply your gains

Sticking with our simplified example then, let’s now see how buying the subscription shares gears up the returns you make on the investment trust.

First, let’s suppose that as above:

• MIT is priced at £1.50.

• MSS (the subscription shares) can be exercised for £1.

• MSS is therefore currently trading at 50p.

Now imagine that one of the Monevator Investment Trust’s core holdings invents a cure for cancer / baldness / middle-class ennui, which sends its value soaring.

Let’s say that as result, MIT’s share price doubles from £1.50 to £3.

That’s a 100% return. Nice! But if you were holding the subscription shares you’d have done even better:

• MIT is now priced at £3.

• MSS can still be exercised for £1.

• The price of MSS will therefore now rise to £2. ³

So if you’d previously bought MSS shares for 50p, that would be a 300% return – or three times better than if you’d merely bought the MIT shares.

What about losing money?

On the other hand, let’s pretend the cure for cancer kills people, or the baldness cure turns people’s heads purple (and middle-class ennui is obviously unsolvable).

Let’s imagine as a result MIT shares crash from £1.50 to 50p, for a loss of 66%.

Bad – but it will be much worse if you bought the MSS sub shares:

• MIT is now priced at 50p.

• MSS can still be exercised for £1, which is more than you need to pay to buy MIT in the open market.

• MSS are therefore currently worthless.

Ouch – you’ve lost 100% of your investment in the subscription shares.

In a complicated relationship

Now, as I stressed above this example is overly simplified.

In reality MSS wouldn’t go to zero, because until the exercise date had passed there would be some chance of the trust recovering its value.

Equally, MSS wouldn’t post an exactly 300% gain, because MIT’s share price could still fall at any point until the date when the subscription shares can be exercised.

But the rule of thumb, ignoring those complications, is that:

The gearing = (Trust share price / subscription share price)

So in the example above, the MSS shares were three times geared (£1.50/50p), which sure enough we saw with the 300% gain.

In practice, subscription shares can be especially volatile while the underlying trust’s price is below the exercise price. But once it rises above the exercise price, you can roughly assume the subscription shares should move in step penny for penny with the underlying trust.

The gearing on offer, then, depends on how cheaply you can buy the subscription shares versus the trust’s current share price. And that depends on many factors that we’ll consider in part three. (Subscribe to ensure you get it!)

1. In contrast, if you borrow to invest and your investment goes to zero, you can still be left with a big debt to pay off.[↩]
2. Assuming you believe such precision is possible, which I do not.[↩]
3. £3-£1.[↩]