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December 6 - December 16, 2020
He concluded that there was effectively no way for an accountant assigned to audit a giant Wall Street firm to figure out whether it was making money or losing money.
“You can be positive and wrong on the sell side,” says Vinny. “But if you’re negative and wrong you get fired.”
These companies disclosed their ever-growing earnings, but not much else. One of the many items they failed to disclose was the delinquency rate of the home loans they were making.
All retained some small fraction of the loans they originated, and the companies were allowed to book as profit the expected future value of those loans.
They had the essential feature of a Ponzi scheme: To maintain the fiction that they were profitable enterprises, they needed more and more capital to create more and more subprime loans.
In his youth, Eisman had been a strident Republican. He joined right-wing organizations, voted for Reagan twice, and even loved Robert Bork. It wasn’t until he got to Wall Street, oddly, that his politics drifted left.
Back in 1996, 65 percent of subprime loans had been fixed-rate, meaning that typical subprime borrowers might be getting screwed, but at least they knew for sure how much they owed each month until they paid off the loan. By 2005, 75 percent of subprime loans were some form of floating-rate, usually fixed for the first two years.
You can keep on making these loans, just don’t keep them on your books. Make the loans, then sell them off to the fixed income departments of big Wall Street investment banks, which will in turn package them into bonds and sell them to investors.
“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.’”
Stock prices could do all sorts of crazy things: He didn’t want to short them until the loans started going bad.
Eisman had an epiphany, an identifiable moment when he realized he’d been missing something obvious. Here he was, trying to figure out which stocks to pick, but the fate of the stocks depended increasingly on the bonds. As the subprime mortgage market grew, every financial company was, one way or another, exposed to it. “The fixed income world dwarfs the equity world,” he said. “The equity world is like a fucking zit compared to the bond market.”
Every mortgage bond came with its own mind-numbingly tedious 130-page prospectus. If you read the fine print, you saw that each was its own little corporation. Burry spent the end of 2004 and early 2005 scanning hundreds and actually reading dozens of them, certain he was the only one apart from the lawyers who drafted them to do so—even though you could get them all for $100 a year from 10K Wizard.com.
The bonds were impossible to sell short. To sell a stock or bond short, you needed to borrow it, and these tranches of mortgage bonds were tiny and impossible to find. You could buy them or not buy them, but you couldn’t bet explicitly against them; the market for subprime mortgages simply had no place for people in it who took a dim view of them.
Stock prices could rise for a lot longer than Burry could stay solvent.
A credit default swap was confusing mainly because it wasn’t really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term.
On March 19, 2005, alone in his office with the door closed and the shades drawn, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit default swaps on subprime mortgage bonds.
two came back and said that, while the market didn’t exist, it might one day. Inside of three years, credit default swaps on subprime mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of dollars’ worth of losses inside big Wall Street firms.
“It took all my energy to look someone in the eye,” he said. “If I am looking at you, that’s the one time I know I won’t be listening to you.”
He knew instantly he’d been misdiagnosed: How could you be bipolar if you were never depressed? Or, rather, if you were only depressed while doing your rounds and pretending to be interested in practicing, as opposed to studying, medicine? He’d become a doctor not because he enjoyed medicine but because he didn’t find medical school terribly difficult. The actual practice of medicine, on the other hand, either bored or disgusted him.
“One scene with people carrying legs over their shoulders to the sink to wash out the feces just turned my stomach, and I was done.” Of his feeling about the patients: “I wanted to help people—but not really.”
“value investing” required a tireless search for companies so unfashionable or misunderstood that they could be bought for less than their liquidation value.
He had maybe $40,000 in cash, against $145,000 in student loans. He had spent the previous four years working medical student hours. Nevertheless, he had found time to make himself a financial expert of sorts. “Time
By this time the craze for Internet stocks was completely out of control and had infected the Stanford University medical community. “The residents in particular, and some of the faculty, were captivated by the dot-com bubble,” said Burry.
People who worry about seeming sufficiently committed to medicine probably aren’t sufficiently committed to medicine.
“I found it fascinating and seemingly true,” he said, “that if I could run a portfolio well, then I could achieve success in life, and that it wouldn’t matter what kind of person I was perceived to be, even though I felt I was a good person deep down.”
But the hole in the rating agencies’ models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615.
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. They might actually improve the perceived quality of the pool of loans and increase the percentage that could be declared triple-A.
They were consciously looking for long shots. They were combing the markets for bets whose true odds were 10:1, priced as if the odds were 100:1.
“I want to short his paper. Sight unseen.”
The only interested parties missing from the conference were the ultimate borrowers, the American home buyers, but even they, in a way, were on hand, serving drinks, spinning wheels, and rolling dice. “Vegas was booming,” said Danny. “The homeowners were at the fucking tables.” A friend of Danny’s returned from a night on the town to report he’d met a stripper with five separate home equity loans.
There should be no greater thing you can do as an analyst than to be the Moody’s analyst. It should be, ‘I can’t go higher as an analyst.’ Instead it’s the bottom! No one gives a fuck if Goldman likes General Electric paper. If Moody’s downgrades GE paper, it is a big deal. So why does the guy at Moody’s want to work at Goldman Sachs?
In Vegas the question lingering at the back of their minds ceased to be, Do these bond market people know something we do not? It was replaced by, Do they deserve merely to be fired, or should they be put in jail?
From February 25 to May 25 (the remittance data always came on the twenty-fifth of the month), the combined delinquencies, foreclosures, and bankruptcies inside OOMLT 2005-3 rose from 15.6 percent to 16.9 percent. On June 25 the total number of loans in default spiked to 18.68 percent. In July it spiked again, to 21.4 percent. In August it leapt to 25.44 percent, and by the end of the year it stood at 37.7 percent—more than a third of the pool of borrowers had defaulted on their loans. The losses were sufficient to wipe out not only the bonds Michael Burry had bet against but also a lot of the
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You could either like asset-backed bonds or you could love asset-backed bonds, but there was no point in hating them, because there was no tool for betting against them.
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.
They showed up again in a calculation known as value at risk (VaR). The tool most commonly used by Wall Street management to figure out what their traders had just done, VaR measured only the degree to which a given stock or bond had jumped around in the past, with the recent movements receiving a greater emphasis than movements in the more distant past.
The pretense that these loans were not all essentially the same, doomed to default en masse the moment house prices stopped rising, had justified the decisions by Moody’s and S&P to bestow triple-A ratings on roughly 80 percent of every CDO.
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.
Could Morgan Stanley please wire $1.2 billion to Deutsche Bank by the end of the day? Or, as Lippmann actually put it—according to someone who heard the exchange—Dude, you owe us one point two billion.
The defaults mounted, the bonds universally crashed, and the CDOs composed of the bonds followed. Several times on the way down, Deutsche Bank offered Morgan Stanley the chance to exit its trade.
In the end, it made little sense for a CDO to fall from 100 to 95 to 77 to 70 and down to 7. The subprime bonds beneath them were either all bad or all good. The CDOs were worth either zero or 100.
He’d been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006, to prevent him from quitting. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street.
He further explained that the traders at UBS who executed the trade were motivated mainly by their own models—which, at the moment of the trade, suggested they had turned a profit of $30 million.
Cornwall Capital, started four and a half years earlier with $110,000, had just netted, from a million-dollar bet, more than $80 million. “There was a relief that we had not been the chumps at the table,” said Jamie. They had not been the chumps at the table. The long shot had paid 80:1.
“Being short in 2007 and making money from it was fun, because we were short bad guys,” said Steve Eisman. “In 2008 it was the entire financial system that was at risk. We were still short. But you don’t want the system to crash. It’s sort of like the flood’s about to happen and you’re Noah. You’re on the ark. Yeah, you’re okay. But you are not happy looking out at the flood. That’s not a happy moment for Noah.”
Bear Stearns was deep in the subprime market. It had $40 in bets on its subprime mortgage bonds for every dollar of capital it held against those bets. The question wasn’t how Bear Stearns could possibly fail but how it could possibly survive.
“It was as if they took one swimmer in the Olympics and made him swim in a separate pool,” Burry said. “His time won the gold. But he got no medal. I honestly think that’s what killed it for me. I was looking for some recognition. There was none. I trained for the Olympics, and then they told me to go and swim in the retard pool.”
The mezzanine CDO was invented by Michael Milken’s junk bond department at Drexel Burnham in 1987. The first mortgage-backed CDO was created at Credit Suisse in 2000 by a trader who had spent his formative years, in the 1980s and early 1990s, in the Salomon Brothers mortgage department.
The soundest investment has the defining trait of a bet (you losing all of your money in hopes of making a bit more), and the wildest speculation has the salient characteristic of an investment (you might get your money back with interest). Maybe the best definition of “investing” is “gambling with the odds in your favor.”
The moment Salomon Brothers demonstrated the potential gains to be had from turning an investment bank into a public corporation and leveraging its balance sheet with exotic risks, the psychological foundations of Wall Street shifted, from trust to blind faith.
