The Big Short: Inside the Doomsday Machine

by Michael Lewis

He was instantly struck by the opacity of an investment bank’s books. None of his fellow accountants was able to explain why the traders were doing what they were doing. “I didn’t know what I was doing,” said Vinny. “But the scary thing was, my managers didn’t know anything either. I asked these basic questions—like, Why do they own this mortgage bond? Are they just betting on it, or is it part of some larger strategy? I thought I needed to know. It’s really difficult to audit a company if you can’t connect the dots.” 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. They were giant black boxes, whose hidden gears were in constant motion.

“Eventually I saw that all the subprime sectors were either being prepaid or going bad at an incredible rate,” said Vinny. “I was just seeing stunningly high delinquency rates in these pools.” 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.

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.

In a financial system that was rapidly generating complicated risks, AIG FP became a huge swallower of those risks. In the early days it must have seemed as if it was being paid to insure events extremely unlikely to occur, as it was. Its success bred imitators: Zurich Re FP, Swiss Re FP, Credit Suisse FP, Gen Re FP. (“Re” stands for Reinsurance.) All of these places were central to what happened in the last two decades; without them, the new risks being created would have had no place to hide and would have remained in full view of bank regulators.

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.

Financial markets are a collection of arguments.

The constant argument over the value of the shares of some major publicly traded company has very little value, as both buyer and seller can see the fair price of the stock on the ticker, and the broker’s commission has been driven down by competition.

Their stint in the private equity business—in which firms buy and sell entire companies over the counter—led them to believe that private stock markets might be more efficient than public ones. “In private transactions,” said Charlie, “you usually have an advisor on both sides that’s sophisticated. You don’t have people who just fundamentally don’t know what something’s worth. In public markets you have people focused on quarterly earnings rather than the business franchise. You have people doing things for all sorts of insane reasons.”

“I don’t think the problem is specific to finance. I think that parochialism is common to modern intellectual life. There is no attempt to integrate.”

The financial markets paid a lot of people extremely well for narrow expertise and a few people, poorly, for the big, global views you needed to have if you were to allocate capital across markets.

They never had to be sure of anything. 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.

The triple-A ratings gave everyone an excuse to ignore the risks they were running.

The rating agencies, in theory, were just such an authority. As the securities became more complex, the rating agencies became more necessary. Everyone could evaluate a U.S. Treasury bond; hardly anyone could understand a subprime mortgage–backed CDO. There was a natural role for an independent arbiter to pass judgment on these opaque piles of risky loans. “In Vegas it became clear to me that this entire huge industry was just trusting in the ratings,” Eisman said. “Everyone believed in the ratings, so they didn’t have to think about it.”

When he thought of it that way, he realized that complex modern financial markets were as good as designed to reward a person with Asperger’s who took an interest in them.

A properly functioning market would assimilate new information into the prices of securities;

He didn’t worry about how screwed-up the market for some security became because he knew that eventually it would be disciplined by logic: Businesses either thrived or failed. Loans either were paid off or were defaulted upon. But these people whose money he ran were incapable of keeping their emotional distance from the market. They were now responding to the same surface stimuli as the entire screwed-up subprime mortgage market, and trying to force him to conform to its madness.

They actually spent time wondering how people who had been so sensationally right (i.e., they themselves) could preserve the capacity for diffidence and doubt and uncertainty that had enabled them to be right. The more sure you were of yourself and your judgment, the harder it was to find opportunities premised on the notion that you were, in the end, probably wrong.

Anti–Wall Street feelings then ran high enough for Rudolph Giuliani to float a political career upon them, but the result felt more like a witch hunt than an honest reappraisal of the financial order.

The changes were camouflage. They helped to distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture. The surface rippled, but down below, in the depths, the bonus pool remained undisturbed.

What are the odds that people will make smart decisions about money if they don’t need to make smart decisions—

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. No investment bank owned by its employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs. I doubt any partnership would have sought to game the rating agencies, or leapt into bed with loan sharks, or even allowed mezzanine CDOs to be sold to its customers. The short-term expected gain would not have justified the long-term expected loss.

But there’s a difference between an old-fashioned financial panic and what had happened on Wall Street in 2008. 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. Every major firm on Wall Street was either bankrupt or fatally intertwined with a bankrupt system. The problem wasn’t that Lehman Brothers had been allowed to fail. The problem was that Lehman Brothers had been allowed to succeed.

The ability of Wall Street traders to see themselves in their success and their management in their failure would later be echoed, when their firms, which disdained the need for government regulation in good times, insisted on being rescued by government in bad times. Success was individual achievement; failure was a social problem.