The Big Short: Inside the Doomsday Machine

by Michael Lewis

“Who else studies Talmud so that they can find the mistakes?”

The interest rate on the loans wasn’t high enough to justify the risk of lending to this particular slice of the American population. It was as if the ordinary rules of finance had been suspended in response to a social problem. A thought crossed his mind: How do you make poor people feel wealthy when wages are stagnant? You give them cheap loans.

Obsessing over Household, he attended a lunch organized by a big Wall Street firm. The guest speaker was Herb Sandler, the CEO of a giant savings and loan called Golden West Financial Corporation. “Someone asked him if he believed in the free checking model,” recalls Eisman. “And he said, ‘Turn off your tape recorders.’ Everyone turned off their tape recorders. And he explained that they avoided free checking because it was really a tax on poor people—in the form of fines for overdrawing their checking accounts. And that banks that used it were really just banking on being able to rip off poor people even more than they could if they charged them for their checks.”

By the time Household’s CEO, Bill Aldinger, collected his $100 million, Eisman was on his way to becoming the financial market’s first socialist. “When you’re a conservative Republican, you never think people are making money by ripping other people off,” he said. His mind was now fully open to the possibility. “I now realized there was an entire industry, called consumer finance, that basically existed to rip people off.”

“A Home without Equity Is Just a Rental with Debt,”

The market might have learned a simple lesson: Don’t make loans to people who can’t repay them. Instead it learned a complicated one: 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.

In his Match.com profile, he described himself frankly as “a medical student with only one eye, an awkward social manner, and $145,000 in student loans.” His obsession with personal honesty was a cousin to his obsession with fairness.

Who borrowed money to buy a house and defaulted inside of twelve months? He went on for a bit, then showed Eisman this little chart that he’d created, and which he claimed was the reason he had become interested in the trade. It illustrated an astonishing fact: 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.

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.

In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a CDO you gathered one hundred different mortgage bonds—usually, the riskiest, lower floors of the original tower—and used them to erect an entirely new tower of bonds. The innocent observer might reasonably ask, What’s the point of using floors from one tower of debt simply to create another tower of debt? The short answer is, They are too near to the ground. More prone to flooding—the first to take losses—they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building. 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. Their—soon to be everyone’s—nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different triple-B-rated bonds), they persuaded the rating agencies that these weren’t, as they might appear, all exactly the same things. They were another diversified portfolio of assets! This was absurd. The 100 buildings occupied the same floodplain; in ...

Probably the heart of this book - and the financial crisis. This is so absurd that I thought maybe in the movie they exaggerated, but here it is in black and white. Insanity.

The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold.

To make a billion-dollar bet, you no longer needed to accumulate a billion dollars’ worth of actual mortgage loans. All you had to do was find someone else in the market willing to take the other side of the bet.

“He scared the shit out of us,” said another. “He comes in and describes this brilliant trade. It makes total sense. To us the risk was, we do it, it works, then what? How do we get out? He controls the market; he may be the only one we can sell to. And he says, ‘You have no way out of this swimming pool but through me, and when you ask for the towel I’m going to rip your eyeballs out.’ He actually said that, that he was going to rip our eyeballs out. The guy was totally transparent.”

The simple measure of sanity in housing prices, Zelman argued, was the ratio of median home price to income. Historically, in the United States, it ran around 3:1; by late 2004, it had risen nationally, to 4:1. “All these people were saying it was nearly as high in some other countries,” says Zelman. “But the problem wasn’t just that it was four to one. In Los Angeles it was ten to one and in Miami, eight-point-five to one. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.”*

What kind of people, in which parts of the country, exhibited the highest degree of financial irresponsibility? The default rate in Georgia was five times higher than that in Florida, even though the two states had the same unemployment rate. Why? Indiana had a 25 percent default rate; California, only 5 percent, even though Californians were, on the face of it, far less fiscally responsible. Why? Vinny and Danny flew down to Miami, where they wandered around empty neighborhoods built with subprime loans, and saw with their own eyes how bad things were. “They’d call me and say, ‘Oh my God, this is a calamity here,’” recalls Eisman.

“Guys who can’t get a job on Wall Street get a job at Moody’s,”

To meet the rating agencies’ standards—to maximize the percentage of triple-A-rated bonds created from any given pool of loans—the average FICO score of the borrowers in the pool needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680. A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place. 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.

Both were predisposed to feel that people, and by extension markets, were too certain about inherently uncertain things. Both sensed that people, and by extension markets, had difficulty attaching the appropriate probabilities to highly improbable events.

Financial options were systematically mispriced. The market often underestimated the likelihood of extreme moves in prices. The options market also tended to presuppose that the distant future would look more like the present than it usually did. Finally, the price of an option was a function of the volatility of the underlying stock or currency or commodity, and the options market tended to rely on the recent past to determine how volatile a stock or currency or commodity might be.

A CDO composed of nothing but the riskiest, mezzanine layer of subprime mortgages was not called a subprime-backed CDO but a “structured finance CDO.” “There was so much confusion about the different terms,” said Charlie. “In the course of trying to figure it out, we realize that there’s a reason why it doesn’t quite make sense to us. It’s because it doesn’t quite make sense.”

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.

The reason they’d done this is that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce 80 percent of the bonds in it triple-A. These bonds could then be sold to investors—pension funds, insurance companies—which were allowed to invest only in highly rated securities. It came as news to Eisman that this ship of doom was piloted by Wing Chau and people like him. The guy controlled roughly $15 billion, invested in nothing but CDOs backed by the triple-B tranche of a mortgage bond or, as Eisman put it, “the equivalent of three levels of dog shit lower than the original bonds.”

The CDO manager was further charged with monitoring the hundred or so individual subprime bonds inside each CDO, and replacing the bad ones, before they went bad, with better ones. That, however, was mere theory; in practice, the sorts of investors who handed their money to Wing Chau, and thus bought the triple-A-rated tranche of CDOs—German banks, Taiwanese insurance companies, Japanese farmers’ unions, European pension funds, and, in general, entities more or less required to invest in triple-A-rated bonds—did so precisely because they were meant to be foolproof, impervious to losses, and unnecessary to monitor or even think about very much.

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 weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” said Eisman. “They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the subprime loans. That’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

To the right were the targets: a photograph of Osama bin Laden, a painting of Osama bin Laden as a zombie, various hooded al Qaeda terrorists, a young black kid attacking a pretty white woman, an Asian hoodlum waving a pistol.

Above the roulette tables, screens listed the results of the most recent twenty spins of the wheel. Gamblers would see that it had come up black the past eight spins, marvel at the improbability, and feel in their bones that the tiny silver ball was now more likely to land on red. That was the reason the casino bothered to list the wheel’s most recent spins: to help gamblers to delude themselves.

“You know how when you walk into a post office you realize there is such a difference between a government employee and other people,” said Vinny. “The ratings agency people were all like government employees.” Collectively they had more power than anyone in the bond markets, but individually they were nobodies. “They’re underpaid,” said Eisman. “The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for. 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? The guy who is the bank analyst at Goldman Sachs should want to go to Moody’s. It should be that elite.”

“That was the moment when we said, ‘Holy shit, this isn’t just credit. This is a fictitious Ponzi scheme.’”

Vinny, always darker, said, “There were more morons than crooks, but the crooks were higher up.”

“The impact on the broader economy and the financial markets of the problems in the subprime markets seems likely to be contained,” U.S. Federal Reserve chairman Ben Bernanke was quoted as saying in the newspapers on March 7. “Credit quality always gets better in March and April,” said Eisman. “And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. And they sort of did. But they let the credit spreads tighten. We just thought that was moronic. What are you, fucking stupid?”

Bonds backed by floating-rate mortgages received higher ratings than bonds backed by fixed-rate ones—which was why the percentage of subprime mortgages with floating rates had risen, in the past five years, from 40 to 80. A lot of these loans were now going bad, but subprime bonds weren’t moving—because Moody’s and S&P, disturbingly, still hadn’t changed their official opinions of them.

The arbiter of the value of the bonds lacked access to relevant information about the bonds. “When we asked her why,” said Vinny, “she said, ‘The issuers won’t give it to us.’ That’s when I lost it. ‘You need to demand to get it!’ She looked at us like, We can’t do that. We were like, ‘Who is in charge here? You’re the grown-up. You’re the cop! Tell them to fucking give it to you!!!’” 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.”

More alarmingly, his credit default swap contracts contained a provision that allowed the big Wall Street firms to cancel their bets with Scion if Scion’s assets fell below a certain level.

On June 20, Grinstein finally returned to tell him that Goldman Sachs had experienced “systems failure.” That was funny, Burry replied, because Morgan Stanley had said more or less the same thing. And his salesman at Bank of America claimed they’d had a “power outage.”

For more than twenty years, the bond market’s complexity had helped the Wall Street bond trader to deceive the Wall Street customer. It was now leading the bond trader to deceive himself.

Saturn's children

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.

Six months from that moment, the International Monetary Fund would put losses on U.S.-originated subprime-related assets at a trillion dollars. One trillion dollars in losses had been created by American financiers, out of whole cloth, and embedded in the American financial system. Each Wall Street firm held some share of those losses, and could do nothing to avoid them. No Wall Street firm would be able to extricate itself, as there were no longer any buyers. It was as if bombs of differing sizes had been placed in virtually every major Western financial institution. The fuses had been lit and could not be extinguished. All that remained was to observe the speed of the spark, and the size of the explosions.

“The upper classes of this country raped this country. You fucked people. You built a castle to rip people off. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience. Nobody ever said, ‘This is wrong.’ And no one ever gave a shit about what I had to say.” Actually, Eisman didn’t speak those final sentences that morning; he merely thought them. And he didn’t actually know what was happening in the stock market; the one time he couldn’t check his BlackBerry was when he was speaking. But as he spoke a Wall Street investment bank was failing, for a reason other than fraud. And the obvious question was, Why?

“There was no market. It was really only then that I realized there was a bigger issue than just our portfolio. Fundamentals didn’t matter. Stocks were going to move up or down on pure emotion and speculation of what the government would do.”

“We saw the bodies being carried out. But we were never inside.” A Bloomberg News headline that caught Jamie’s eye, and stuck in his mind: “Senate Majority Leader on Crisis: No One Knows What to Do.”

All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the United States government. They all got rich, too.

Next came Lehman Brothers, which was simply allowed to go bankrupt—whereupon things became even more complicated. At first, the Treasury and the Federal Reserve claimed they allowed Lehman to fail to send the signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when all hell broke loose, and the market froze, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue Lehman.

By late September 2008 the nation’s highest financial official, U.S. Treasury Secretary Henry Paulson, persuaded the U.S. Congress that he needed $700 billion to buy subprime mortgage assets from banks. Thus was born TARP, which stood for Troubled Asset Relief Program. Once handed the money, Paulson abandoned his promised strategy and instead essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs, and a few others unnaturally selected for survival.

In response, on November 24, the Treasury granted another $20 billion from TARP and simply guaranteed $306 billion of Citigroup’s assets. Treasury didn’t ask for a piece of the action, or management changes, or for that matter anything at all except for a teaspoon of out-of-the-money warrants and preferred stock. The $306 billion guarantee—nearly 2 percent of U.S. gross domestic product, and roughly the combined budgets of the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development, and Transportation—was presented undisguised, as a gift.

In an old-fashioned panic, perception creates its own reality: Someone shouts “Fire!” in a crowded theater and the audience crushes each other to death in its rush for the exits. On Wall Street in 2008 the reality finally overwhelmed perceptions: A crowded theater burned down with a lot of people still in their seats.

free money for capitalists, free markets for everyone else

The main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders.

Hard as it was for him to enjoy my company, it was harder for me not to enjoy his: He was still tough, straight, and blunt as a butcher. He’d helped to create a monster but he still had in him a lot of the old Wall Street, where people said things like “a man’s word is his bond.”

You can kind of see the seed of what later gets him in trouble with SBF here...