The Big Short: Inside the Doomsday Machine

by Michael Lewis

Rivals accused Whitney of being overrated; bloggers accused her of being lucky. What she was, mainly, was right.

“The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “‘The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he published that line, the Lomas Financial Corporation returned to bankruptcy.

It was the opposite of a poker face.

“He’s sort of a prick in a way, but he’s smart and honest and fearless.”

“He’s not tactically rude,” his wife explains. “He’s sincerely rude.

The big fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all.

“Growing up in Queens, you very quickly figure out where the money is,” said Vinny. “It’s in Manhattan.”

Really, it was a federal issue. Household was peddling these deceptive mortgages all over the country. Yet the federal government failed to act. Instead, at the end of 2002, Household settled a class action suit out of court and agreed to pay a $484 million fine distributed to twelve states. The following year it sold itself, and its giant portfolio of subprime loans, for $15.5 billion to the British financial conglomerate the HSBC Group.

“The very first day, we said, ‘There’s going to come a time when we’re going to make a fortune shorting this stuff. It’s going to blow up. We just don’t know how or when.’”

When he noticed that pro basketball stars were far less likely to be called for traveling than lesser players, he didn’t just holler at the refs. He stopped watching basketball altogether; the injustice of it killed his interest in the sport.

Formalized as an approach to financial markets during the Great Depression by Benjamin Graham, “value investing” required a tireless search for companies so unfashionable or misunderstood that they could be bought for less than their liquidation value.

“If you read what I wrote first, and then meet me, the meeting goes fine,” he said. “People who meet me who haven’t read what I wrote—it almost never goes well.

He’d read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them. In doing so, he likely also became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made. He was the opposite of an old-fashioned banker, however. He was looking not for the best loans to make but the worst loans—so that he could bet against them. He analyzed

By the time Greg Lippmann turned up in the FrontPoint conference room, in February 2006, Steve Eisman knew enough about the bond market to be wary, and Vincent Daniel knew enough to have decided that no one in it could ever be trusted. An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons.

Since 2000, people whose homes had risen in value between 1 and 5 percent were nearly four times more likely to default on their home loans than people whose homes had risen in value more than 10 percent. Millions of Americans had no ability to repay their mortgages unless their houses rose dramatically in value, which enabled them to borrow even more. That was the pitch in a nutshell: Home prices didn’t even need to fall. They merely needed to stop rising at the unprecedented rates they had the previous few years for vast numbers of Americans to default on their home loans.

Lippmann didn’t know exactly how Goldman Sachs had persuaded AIG FP to provide the same service to the booming market in subprime mortgage loans that it provided to the market for corporate loans. All he knew was that, in rapid succession, Goldman created a bunch of multibillion-dollar deals that transferred to AIG the responsibility for all future losses from $20 billion in triple-B-rated subprime mortgage bonds. It was incredible: In exchange for a few million bucks a year, this insurance company was taking the very real risk that $20 billion would simply go poof.

the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond–backed CDO, or collateralized debt obligation.

The long answer was that there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done.

The subprime mortgage machine roared on. The loans that were being made to actual human beings only grew crappier, but, bizarrely, the price of insuring them—the price of buying credit default swaps—fell. By April 2006 Lippmann’s superiors at Deutsche Bank were asking him to defend his quixotic gamble.

money down, interest payments deferred upon request. The housing blogs of southern California teemed with stories of financial abuses made possible by these so-called thirty-year payment option ARMs, or adjustable-rate mortgages. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.

people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible ratings for the worst possible loans. They performed the task with Ivy League thoroughness and efficiency. They quickly figured out, for instance, that the people at Moody’s and S&P didn’t actually evaluate the individual home loans, or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools.

Apparently the agencies didn’t grasp the difference between a “thin-file” FICO score and a “thick-file” FICO score. A thin-file FICO score implied, as it sounds, a short credit history. The file was thin because the borrower hadn’t done much borrowing. Immigrants who had never failed to repay a debt, because they had never been given a loan, often had surprisingly high thin-file FICO scores. Thus a Jamaican baby nurse or Mexican strawberry picker with an income of $14,000 looking to borrow three-quarters of a million dollars, when filtered through the models at Moody’s and S&P, became suddenly more useful, from a credit-rigging point of view.

tiny handful of investors perceived what was happening not just to the financial system but to the larger society it was meant to serve, and made investments against that system that were so large, in relation to their capital, that they effectively gave up being conventional money managers and became something else.

Bond market terminology was designed less to convey meaning than to bewilder outsiders. Overpriced bonds were not “expensive” overpriced bonds were “rich,” which almost made them sound like something you should buy. The floors of subprime mortgage bonds were not called floors—or anything else that might lead the bond buyer to form any sort of concrete image in his mind—but tranches. The bottom tranche—the risky ground floor—was not called the ground floor but the mezzanine, or the mezz, which made it sound less like a dangerous investment

was also a stunning opportunity: The market appeared to believe its own lie. It charged a lot less for insurance on a putatively safe double-A-rated slice of a CDO than it did for insurance on the openly risky triple-B-rated bonds. Why pay 2 percent a year to bet directly against triple-B-rated bonds when they could pay 0.5 percent a year to make effectively the same bet against the double-A-rated slice of the CDO? If

percent. Of course, if you are going to gamble on a CDO, it helps to know what, exactly, is inside a CDO, and they still didn’t. The sheer difficulty they had obtaining the information suggested that most investors were simply skipping this stage of their due diligence. Each CDO contained pieces of a hundred different mortgage bonds—which in turn held thousands of different loans. It was impossible, or nearly so, to find out which pieces, or which loans.

They watched Eisman double-dip his edamame in the communal soy sauce—dip, suck, redip, resuck—and waited for the room to explode. There was nothing to do but sit back and enjoy the show. Eisman had a curious way of listening; he didn’t so much listen to what you were saying as subcontract to some remote region of his brain the task of deciding whether whatever you were saying was worth listening to, while his mind went off to play on its own. As

Ashis mental subcontractor detected a level of interest in what you had just said, it radioed a signal to the mother ship, which then wheeled around with the most intense focus. “Say that again,” he’d say. And you would! Because now Eisman was so obviously listening to you, and, as he listened so selectively, you felt flattered.

The whole point of the CDO was to launder a lot of subprime mortgage market risk that the firms had been unable to place straightforwardly. The last thing you wanted was a CDO manager who asked lots of tough questions.

Now he got it: The credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets in order to synthesize more of them. “They

Charlie Ledley and Ben Hockett returned from Las Vegas on January 30, 2007, convinced that the entire financial system had lost its mind. “I said to my mother, ‘I think we might be facing something like the end of democratic capitalism,’” said Charlie. “She just said, ‘Oh, Charlie,’ and seriously suggested I go on lithium.”

Digging deeper, he called S&P and asked what happened to default rates if real estate prices fell. The man at S&P couldn’t say: Their model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” says Eisman.*

I keep coming back to this passage because it is truly mind-boggling--not from the organization, but from the modelers.

Eisman concluded that “S&P was worried that if they demanded the data from Wall Street, Wall Street would just go to Moody’s for their ratings.”* As an investor, Eisman was allowed to listen in on the quarterly conference calls held by Moody’s, but not invited to pose questions.

“We just shorted Merrill Lynch,” said Eisman. “Why?” asked Hintz. “We have a simple thesis,” said Eisman. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the Internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic: the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was crack the whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.

He’d been the first investor to diagnose the disorder in the American financial system in early 2003: the extension of credit by instrument. Complicated financial stuff was being dreamed up for the sole purpose of lending money to people who could never repay it. “I really do believe the final act in play is a crisis in our financial institutions, which are doing such dumb, dumb things,” he wrote, in April 2003, to a friend who had wondered why Scion Capital’s quarterly letters to its investors had turned so dark.

Pressed, one of the schools told Burry that his son suffered from inadequate gross and fine motor skills. “He had apparently scored very low on tests involving art and scissor use,” said Burry. “Big deal, I thought. I still draw like a four-year-old, and I hate art.” To silence his wife, however, he agreed to have their son tested. “It would just prove he’s a smart kid, an ‘absentminded genius.’” Instead, the tests administered by a child psychologist proved that their child had Asperger’s syndrome. A classic case, she said, and recommended that the child be pulled from the mainstream and sent to a special school.

On the other hand, it explained an awful lot about what he did for a living, and how he did it: his obsessive acquisition of hard facts, his insistence on logic, his ability to plow quickly through reams of tedious financial statements.

remained the same as if no loan in the pool was ever repaid. They had bought flood insurance that, if a drop of water so much as grazed any part of the house, paid them the value of the entire house. Thus designed, Morgan Stanley’s new bespoke credit default swap was virtually certain one day to pay off. For it to pay off in full required losses in the pool of only 4 percent, which pools of subprime mortgage loans experienced in good times. The only problem, from the point of view of Howie Hubler’s traders, was finding a Morgan Stanley customer stupid enough to take the other side of the bet—that is, to get the customer to sell Morgan Stanley what amounted to home insurance on a house designated for demolition. “They

In the murky and curious period from early February to June 2007, the subprime mortgage market resembled a giant helium balloon, bound to earth by a dozen or so big Wall Street firms. Each firm held its rope; one by one, they realized that no matter how strongly they pulled, the balloon would eventually lift them off their feet. In June, one by one, they silently released their grip. By edict of CEO Jamie Dimon, J.P. Morgan had abandoned the market by the late fall of 2006. Deutsche Bank, because of Lippmann, had always held on tenuously. Goldman Sachs was next, and did not merely let go, but turned and made a big bet against the subprime market—further accelerating the balloon’s fatal ascent.* When its subprime hedge funds crashed in June, Bear Stearns was forcibly severed from its line—and the balloon drifted farther from the ground.

“There was a lot of angst about it. It was sort of viewed as, These folks don’t know what they’re talking about. If losses go to ten percent there will be, like, a million homeless people.” (Losses in the pools Hubler’s group had bet on would eventually reach 40 percent.) As a senior Morgan Stanley executive outside Hubler’s group put it, “They didn’t want to show you the results. They kept saying, That state of the world can’t happen.”

And, all the way down, the debt collectors at Deutsche Bank sensed the bond traders at Morgan Stanley misunderstood their own trade. They weren’t lying; they genuinely failed to understand the nature of the subprime CDO. The correlation among triple-B-rated subprime bonds was not 30 percent; it was 100 percent. When one collapsed, they all collapsed, because they were all driven by the same broader economic forces.

Tuesday the U.S. Federal Reserve announced that it had lent $85 billion to the insurance company AIG, to pay off the losses on the subprime credit default swaps AIG had sold to Wall Street banks—the biggest of which was the $13.9 billion AIG owed to Goldman Sachs. When you added in the $8.4 billion in cash AIG had already forked over to Goldman in collateral, you saw that Goldman had transferred more than $20 billion in subprime mortgage bond risk into the insurance company, which was in one way or another being covered by the U.S. taxpayer. That fact alone was enough to make everyone wonder at once how much more of this stuff was out there, and who owned it.

Just as you revert to being about nine years old when you go home to visit your parents, you revert to total subordination when you are in the presence of your former CEO.