The Big Short: Inside the Doomsday Machine

by Michael Lewis

  Eisman quickly established himself as one of the few analysts at Oppenheimer whose opinions might stir the markets. "It was like going back to school for me," he said. "I would learn about an industry and I would go and write a paper about it." Wall Street people came to view him as a genuine character. He dressed half-fastidiously, as if someone had gone to great trouble to buy him nice new clothes but not told him exactly how they should be worn. His short-cropped blond hair looked as if he had cut it himself. The focal point of his soft, expressive, not unkind face was his mouth, mainly because it was usually at least half open, even while he ate. It was as if he feared that he might not be able to express whatever thought had just flitted through his mind quickly enough before the next one came, and so kept the channel perpetually clear. His other features all arranged themselves, almost dutifully, around the incipient thought. It was the opposite of a poker face.

  In his dealings with the outside world, a pattern emerged. The growing number of people who worked for Steve Eisman loved him, or were at least amused by him, and appreciated his willingness and ability to part with both his money and his knowledge. "He's a born teacher," says one woman who worked for him. "And he's fiercely protective of women." He identified with the little guy and the underdog without ever exactly being one himself. Important men who might have expected from Eisman some sign of deference or respect, on the other hand, often came away from encounters with him shocked and outraged. "A lot of people don't get Steve," Meredith Whitney had told me, "but the people who get him love him." One of the people who didn't get Steve was the head of a large U.S. brokerage firm, who listened to Eisman explain in front of several dozen investors at lunch why he, the brokerage firm head, didn't understand his own business, then watched him leave in the middle of the lunch and never return. ("I had to go to the bathroom," says Eisman. "I don't know why I never went back.") After the lunch, the guy had announced he'd never again agree to enter any room with Steve Eisman in it. The president of a large Japanese real estate firm was another. He'd sent Eisman his company's financial statements and then followed, with an interpreter, to solicit Eisman's investment. "You don't even own stock in your company," said Eisman, after the typically elaborate Japanese businessman introductions. The interpreter conferred with the CEO.

  "In Japan it is not customary for management to own stock," he said at length.

  Eisman noted that the guy's financial statements didn't actually disclose any of the really important details about the guy's company; but, rather than simply say that, he lifted the statement in the air, as if disposing of a turd. "This...this is toilet paper," he said. "Translate that."

  "The Japanese guy takes off his glasses," recalled a witness to the strange encounter. "His lips are quavering. World War Three is about to break out. 'Toy-lay paper? Toy-lay paper?'"

  A hedge fund manager who counted Eisman as a friend set out to explain him to me but quit a minute into it--after he'd described Eisman exposing various bigwigs as either liars or idiots--and started to laugh. "He's sort of a prick in a way, but he's smart and honest and fearless."

  "Even on Wall Street people think he's rude and obnoxious and aggressive," says Eisman's wife, Valerie Feigen, who worked at J.P. Morgan before quitting to open the women's clothing store Edit New York, and to raise their children. "He has no interest in manners. Believe me, I've tried and I've tried and I've tried." After she'd brought him home for the first time, her mother had said, "Well, we can't use him but we can definitely auction him off at UJA."* Eisman had what amounted to a talent for offending people. "He's not tactically rude," his wife explains. "He's sincerely rude. He knows everyone thinks of him as a character but he doesn't think of himself that way. Steven lives inside his head."

  When asked about the pattern of upset he leaves in his wake, Eisman simply looks puzzled, even a bit wounded. "I forget myself sometimes," he says with a shrug.

  Here was the first of many theories about Eisman: He was simply so much more interested in whatever was rattling around his brain than he was in whoever happened to be standing in front of him that the one overwhelmed the other. This theory struck others who knew Eisman well as incomplete. His mother, Lillian, offered a second theory. "Steven actually has two personalities," she said carefully. One was that of the boy to whom she had given the brand-new bicycle he so desperately craved, only to have him pedal it into Central Park, lend it to a kid he'd never met, and watch it vanish into the distance. The other was that of the young man who set out to study the Talmud, not because he had the slightest interest in God but because he was curious about its internal contradictions. His mother had been appointed chairman of the Board of Jewish Education in New York City, and Eisman was combing the Talmud for inconsistencies. "Who else studies Talmud so that they can find the mistakes?" asks his mother. Later, after Eisman became seriously rich and had to think about how to give money away, he landed on an organization called Footsteps, devoted to helping Hasidic Jews flee their religion. He couldn't even give away his money without picking a fight.

  By pretty much every account, Eisman was a curious character. And he'd walked onto Wall Street at the very beginning of a curious phase. The creation of the mortgage bond market, a decade earlier, had extended Wall Street into a place it had never before been: the debts of ordinary Americans. At first the new bond market machine concerned itself with the more solvent half of the American population. Now, with the extension of the mortgage bond market into the affairs of less creditworthy Americans, it found its fuel in the debts of the less solvent half.

  The mortgage bond was different in important ways from old-fashioned corporate and government bonds. A mortgage bond wasn't a single giant loan for an explicit fixed term. A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages. These cash flows were always problematic, as the borrowers had the right to pay off any time they pleased. This was the single biggest reason that bond investors initially had been reluctant to invest in home mortgage loans: Mortgage borrowers typically repaid their loans only when interest rates fell, and they could refinance more cheaply, leaving the owner of a mortgage bond holding a pile of cash, to invest at lower interest rates. The investor in home loans didn't know how long his investment would last, only that he would get his money back when he least wanted it. To limit this uncertainty, the people I'd worked with at Salomon Brothers, who created the mortgage bond market, had come up with a clever solution. They took giant pools of home loans and carved up the payments made by homeowners into pieces, called tranches. The buyer of the first tranche was like the owner of the ground floor in a flood: He got hit with the first wave of mortgage prepayments. In exchange, he received a higher interest rate. The buyer of the second tranche--the second story of the skyscraper--took the next wave of prepayments and in exchange received the second highest interest rate, and so on. The investor in the top floor of the building received the lowest rate of interest but had the greatest assurance that his investment wouldn't end before he wanted it to.

  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. The pool of loans underlying the mortgage bond conformed to the standards, in their size and the credit quality of the borrowers, set by one of several government agencies: Freddie Mac, Fannie Mae, and Ginnie Mae. The loans carried, in effect, government guarantees; if the homeowners defaulted, the government paid off their debts. When Steve Eisman stumbled into this new, rapidly growing industry of specialty finance, the mortgage bond was about to be put to a new use: making loans that did not qualify for government guarantees. The purpose was to extend credit to less and less creditworthy homeowners, not so that they might buy a house but so that they could cash out whatever equity they had in the house they already owned.

  The mortgage bonds created from subprime home loans extended the logic invented to address the problem of early repayment to cope with the problem of no repayment at all. The inve
stor in the first floor, or tranche, would be exposed not to prepayments but to actual losses. He took the first losses until his investment was entirely wiped out, whereupon the losses hit the guy on the second floor. And so on.

  In the early 1990s, just a pair of Wall Street analysts devoted their careers to understanding the effects of extending credit into places where that sun didn't often shine. Steve Eisman was one; the other was Sy Jacobs. Jacobs had gone through the same Salomon Brothers training program that I had, and now worked for a small investment bank called Alex Brown. "I sat through the Salomon training program and got to hear what this great new securitization model Lewie Ranieri was creating was going to do," he recalls. (Ranieri was the closest thing the mortgage bond market had to a founding father.) The implications of turning home mortgages into bonds were mind-bogglingly vast. One man's liability had always been another man's asset, but now more and more of the liabilities could be turned into bits of paper that you could sell to anyone. In short order, the Salomon Brothers trading floor gave birth to small markets in bonds funded by all sorts of strange stuff: credit card receivables, aircraft leases, auto loans, health club dues. To invent a new market was only a matter of finding a new asset to hock. The most obvious untapped asset in America was still the home. People with first mortgages had vast amounts of equity locked up in their houses; why shouldn't this untapped equity, too, be securitized? "The thinking in subprime," says Jacobs, "was there was this social stigma to being a second mortgage borrower and there really shouldn't be. If your credit rating was a little worse, you paid a lot more--and a lot more than you really should. If we can mass market the bonds, we can drive down the cost to borrowers. They can replace high interest rate credit card debt with lower interest rate mortgage debt. And it will become a self-fulfilling prophecy."

  The growing interface between high finance and lower-middle-class America was assumed to be good for lower-middle-class America. This new efficiency in the capital markets would allow lower-middle-class Americans to pay lower and lower interest rates on their debts. In the early 1990s, the first subprime mortgage lenders--The Money Store, Greentree, Aames--sold shares to the public, so that they might grow faster. By the mid-1990s, dozens of small consumer lending companies were coming to market each year. The subprime lending industry was fragmented. Because the lenders sold many--though not all--of the loans they made to other investors, in the form of mortgage bonds, the industry was also fraught with moral hazard. "It was a fast-buck business," says Jacobs. "Any business where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people. That was the seamy underbelly of the good idea. Eisman and I both believed in the big idea and we both met some really sleazy characters. That was our job: to figure out which of the characters were the right ones to pull off the big idea."

  Subprime mortgage lending was still a trivial fraction of the U.S. credit markets--a few tens of billions in loans each year--but its existence made sense, even to Steve Eisman. "I thought it was partly a response to growing income inequality," he said. "The distribution of income in this country was skewed and becoming more skewed, and the result was that you have more subprime customers." Of course, Eisman was paid to see the sense in subprime lending: Oppenheimer quickly became one of the leading bankers to the new industry, in no small part because Eisman was one of its leading proponents. "I took a lot of subprime companies public," says Eisman. "And the story they liked to tell was that 'we're helping the consumer. Because we're taking him out of his high interest rate credit card debt and putting him into lower interest rate mortgage debt.' And I believed that story." Then something changed.

  Vincent Daniel had grown up in Queens, without any of the perks Steve Eisman took for granted. And yet if you met them you might guess that it was Vinny who had grown up in high style on Park Avenue and Eisman who had been raised in the small duplex on Eighty-second Avenue. Eisman was brazen and grandiose and focused on the big kill. Vinny was careful and wary and interested in details. He was young and fit, with thick, dark hair and handsome features, but his appearance was overshadowed by his concerned expression--mouth ever poised to frown, eyebrows ever ready to rise. He had little to lose but still seemed perpetually worried that something important was about to be taken from him. His father had been murdered when he was a small boy--though no one ever talked about that--and his mother had found a job as a bookkeeper at a commodities trading firm. She'd raised Vinny and his brother alone. Maybe it was Queens, maybe it was what had happened to his father, or maybe it was just the way Vincent Daniel was wired, but he viewed his fellow man with the most intense suspicion. It was with the awe of a champion speaking of an even greater champion that Steve Eisman said, "Vinny is dark."

  Eisman was an upper-middle-class kid who had been faintly surprised when he wound up at Penn instead of Yale. Vinny was a lower-middle-class kid whose mother was proud of him for getting into any college at all and prouder still when, in 1994, after Vinny graduated from SUNY-Binghamton, he'd gotten himself hired in Manhattan by Arthur Andersen, the accounting firm that would be destroyed a few years later, in the Enron scandal. "Growing up in Queens, you very quickly figure out where the money is," said Vinny. "It's in Manhattan." His first assignment in Manhattan, as a junior accountant, was to audit Salomon Brothers. 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. Several months into the audit, Vinny's manager grew tired of his questions. "He couldn't explain it to me. He said, 'Vinny, it's not your job. I hired you to do XYZ, do XYZ and shut your mouth.' I walked out of his office and said, 'I gotta get out of here.'"

  Vinny went looking for another job. An old school friend of his worked at a place called Oppenheimer and Co. and was making good money. He handed Vinny's resume in to human resources, and it made its way to Steve Eisman, who turned out to be looking for someone to help him parse the increasingly arcane accounting used by subprime mortgage originators. "I can't add," says Eisman. "I think in stories. I need help with numbers." Vinny heard that Eisman could be difficult and was surprised that, when they met, Eisman seemed interested only in whether they'd be able to get along. "He seemed to be just looking for a good egg," says Vinny. They'd met twice when Eisman phoned him out of the blue. Vinny assumed he was about to be offered a job, but soon after they started to talk, Eisman received an emergency call on the other line and put Vinny on hold. Vinny sat waiting for fifteen minutes in silence, but Eisman never came back on the line.

  Two months later, Eisman called him back. When could Vinny start?

  Eisman didn't particularly recall why he had put Vinny on hold and never picked up again, any more than he recalled why he had gone to the bathroom in the middle of lunch with a big-time CEO and never returned. Vinny soon found his own explanation: When he'd picked up the other line, Eisman had been informed that his first child, a newborn son named Max, had died. Valerie, sick with the flu, had been awakened by a night nurse, who informed her that she, the night nurse, had rolled on top of the baby in her sleep and smothered him. A decade later, the people closest to Eisman would describe this as an event that changed his relationship to the world around him. "Steven always thought he had an angel on his shoulder," said Valerie. "Nothing bad ever happened to Steven. He was protected and he was safe. After Max, the angel on his shoulder was done. Anything can happen to a
nyone at any time." From that moment, she noticed many changes in her husband, large and small, and Eisman did not disagree. "From the point of view of the history of the universe, Max's death was not a big deal," said Eisman. "It was just my big deal."

  At any rate, Vinny and Eisman never talked about what had happened. All Vinny knew was that the Eisman he went to work for was obviously not quite the same Eisman he'd met several months earlier. The Eisman Vinny had interviewed with was, by the standards of Wall Street analysts, honest. He was not completely uncooperative. Oppenheimer was among the leading bankers to the subprime mortgage industry. They never would have been given the banking business if Eisman, their noisiest analyst, had not been willing to say nice things about them. Much as he enjoyed bashing the less viable companies, he accepted that the subprime lending industry was a useful addition to the U.S. economy. His willingness to be rude about a few of these subprime originators was, in a way, useful. It lent credibility to his recommendations of the others.

  Eisman was now about to become noticeably more negatively disposed, in ways that, from the point of view of his employer, were financially counterproductive. "It was like he'd smelled something," said Vinny. "And he needed my help figuring out what it was he'd smelled." Eisman wanted to write a report that more or less damned the entire industry, but he needed to be more careful than usual. "You can be positive and wrong on the sell side," says Vinny. "But if you're negative and wrong you get fired." Ammunition to cause trouble had just arrived a few months earlier from Moody's: The rating agency now possessed, and offered for sale, all sorts of new information about subprime mortgage loans. While the Moody's database did not allow you to examine individual loans, it offered a general picture of the pools of loans underlying individual mortgage bonds: how many were floating-rate, how many of the houses borrowed against were owner-occupied. Most importantly: how many were delinquent. "Here's this database," Eisman said simply. "Go into that room. Don't come out until you've figured out what it means." Vinny had the feeling Eisman already knew what it meant.