Vinny was otherwise on his own. "I'm twenty-six years old," he says, "and I haven't really understood what mortgage-backed securities really are." Eisman didn't know anything about them either--he was a stock market guy, and Oppenheimer didn't even have a bond department. Vinny had to teach himself. When he was done, he had an explanation for the unpleasant odor wafting from the subprime mortgage industry that Eisman had detected. 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. When Eisman had bugged them for these, they'd pretended that the fact was irrelevant, as they had sold all the loans off to people who packaged them into mortgage bonds: The risk was no longer theirs. This was untrue. 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. The accounting rules allowed them to assume the loans would be repaid, and not prematurely. This assumption became the engine of their doom.
What first caught Vinny's eye were the high prepayments coming in from a sector called "manufactured housing." ("It sounds better than 'mobile homes.'") Mobile homes were different from the wheel-less kind: Their value dropped, like cars', the moment they left the store. The mobile home buyer, unlike the ordinary home buyer, couldn't expect to refinance in two years and take money out. Why were they prepaying so fast? Vinny asked himself. "It made no sense to me. Then I saw that the reason the prepayments were so high is that they were involuntary." "Involuntary prepayment" sounds better than "default." Mobile home buyers were defaulting on their loans, their mobile homes were being repossessed, and the people who had lent them money were receiving fractions of the original loans. "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.
To sift every pool of subprime mortgage loans took him six months, but when he was done he came out of the room and gave Eisman the news. All these subprime lending companies were growing so rapidly, and using such goofy accounting, that they could mask the fact that they had no real earnings, just illusory, accounting-driven, ones. 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. "I wasn't actually a hundred percent sure I was right," said Vinny, "but I go to Steve and say, 'This really doesn't look good.' That was all he needed to know. I think what he needed was evidence to downgrade the stock."
The report Eisman wrote trashed all of the subprime originators; one by one, he exposed the deceptions of a dozen companies. "Here is the difference," he said, "between the view of the world they are presenting to you and the actual numbers." The subprime companies did not appreciate his effort. "He created a shitstorm," said Vinny. "All these subprime companies were calling and hollering at him: You're wrong. Your data's wrong. And he just hollered back at them, 'It's YOUR fucking data!'" One of the reasons Eisman's report disturbed so many is that he'd failed to give the companies he'd insulted fair warning. He'd violated the Wall Street code. "Steve knew this was going to create a shitstorm," said Vinny. "And he wanted to create the shitstorm. And he didn't want to be talked out of it. And if he told them, he'd have had all these people trying to talk him out of it."
"We were never able to evaluate the loans before because we never had the data," said Eisman later. "My name was wedded to this industry. My entire reputation had been built on covering these stocks. If I was wrong, that would be the end of the career of Steve Eisman."
Eisman published his report in September 1997, in the middle of what appeared to be one of the greatest economic booms in U.S. history. Less than a year later, Russia defaulted and a hedge fund called Long-Term Capital Management went bankrupt. In the subsequent flight to safety, the early subprime lenders were denied capital and promptly went bankrupt en masse. Their failure was interpreted as an indictment of their accounting practices, which allowed them to record profits before they were realized. No one but Vinny, so far as Vinny could tell, ever really understood the crappiness of the loans they had made. "It made me feel good that there was such inefficiency to this market," he said. "Because if the market catches on to everything, I probably have the wrong job. You can't add anything by looking at this arcane stuff, so why bother? But I was the only guy I knew who was covering companies that were all going to go bust during the greatest economic boom we'll ever see in my lifetime. I saw how the sausage was made in the economy and it was really freaky."
That was the moment it first became clear that Eisman wasn't just a little cynical. He held a picture of the financial world in his head that was radically different from, and less flattering than, the financial world's self-portrait. A few years later, he quit his job and went to work for a giant hedge fund called Chilton Investment. He'd lost interest in telling other people where to put their money. He thought he might be able to remain interested if he managed money himself and bet on his own judgments. Having hired Eisman, Chilton Investment had second thoughts. "The whole thing about Steve," said a Chilton colleague, "was, 'Yeah, he's a really smart guy. But can he pick stocks?'" Chilton decided that he couldn't and relegated him to his old role of analyzing companies for the guy who actually made the investment decisions. Eisman hated it, but he did it, and in doing it he learned something that prepared him uniquely for the crisis that was about to occur. He learned what was really going on inside the market for consumer loans.
The year was now 2002. There were no public subprime lending companies left in America. There was, however, an ancient consumer lending giant called Household Finance Corporation. Created in the 1870s, it had long been a leader in the field. Eisman understood the company well, he thought, until he realized that he didn't. In early 2002 he got his hands on Household's new sales document offering home equity loans. The company's CEO, Bill Aldinger, had grown Household even as his competitors went bankrupt. Americans, digesting the Internet bust, seemed in no position to take on new debts, and yet Household was making loans at a faster pace than ever. A big source of its growth had been the second mortgage. The document offered a fifteen-year, fixed-rate loan, but it was bizarrely disguised as a thirty-year loan. It took the stream of payments the homeowner would make to Household over fifteen years, spread it hypothetically over thirty years, and asked: If you were making the same dollar payments over thirty years that you are in fact making over fifteen, what would your "effective rate" of interest be? It was a weird, dishonest sales pitch. The borrower was told he had an "effective interest rate of 7 percent" when he was in fact paying something like 12.5 percent. "It was blatant fraud," said Eisman. "They were tricking their customers."
It didn't take long for Eisman to find complaints from borrowers who had figured out what had just happened to them. He scoured small newspapers around the country. In the town of Bellingham, Washington--the last city of any size before you reach Canada--he found a reporter named John Stark, who wrote for the Bellingham News. Before Eisman called him out of the blue, Stark had written a small piece about four locals who thought they had been deceived by Household and found a plaintiff's attorney willing to sue the company and void the mortgage contracts. "I was skeptical at first," says Stark. "I thought, Here's another person who has borrowed too much money and hired a lawyer. I wasn't too sympathetic." When the piece was published, it drew a crowd: Hundreds of people in and around Bellingham had picked up the newspaper to discover that their 7 percent mortgage was in fact a 12.5 percent mortgage. "People were coming out of the woodwork," says Stark. "They were an
gry. A lot of them didn't realize what had happened to them."
Whatever Eisman was meant to be doing got pushed to one side. His job became a single-minded crusade against the Household Finance Corporation. He alerted newspaper reporters, he called up magazine writers, he became friendly with the Association of Community Organizations for Reform Now (ACORN), which must be the first time a guy from a Wall Street hedge fund exhibited such interest in an organization devoted to guarding the interests of the poor. He repeatedly pestered the office of the attorney general of the state of Washington. He was incredulous to learn that the attorney general had investigated Household and then been prevented, by a state judge, from releasing the results of his investigation. Eisman obtained a copy; its contents confirmed his worst suspicions. "I would say to the guy in the attorney general's office, 'Why aren't you arresting people?' He'd say, 'They're a powerful company. If they're gone, who would make subprime loans in the state of Washington?' I said, 'Believe me, there will be a train full of people coming to lend money.'"
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.
Eisman was genuinely shocked. "It never entered my mind that this could possibly happen," he said. "This wasn't just another company--this was the biggest company by far making subprime loans. And it was engaged in just blatant fraud. They should have taken the CEO out and hung him up by his fucking testicles. Instead they sold the company and the CEO made a hundred million dollars. And I thought, Whoa! That one didn't end the way it should have." His pessimism toward high finance was becoming tinged with political ideas. "That's when I started to see the social implications," he said. "If you are going to start a regulatory regime from scratch, you'd design it to protect middle-and lower-middle-income people, because the opportunity for them to get ripped off was so high. Instead what we had was a regime where those were the people who were protected the least."
Eisman left work at noon every Wednesday so that he might be present at Midtown Comics when the new shipment of stories arrived. He knew more than any grown man should about the lives of various superheroes. He knew the Green Lantern oath by heart, for instance, and understood Batman's inner life better than the Caped Crusader himself. Before the death of his son, Eisman had read the adult versions of the comics he'd read as a child--Spider-Man was his favorite. Now he read only the darkest adult comics, and favored those that took familiar fairy tales and rearranged them without changing any of the facts, so that the story became less familiar, and something other than a fairy tale. "Telling a story that is consistent with everything that happened before," as he put it. "And yet the story is totally different. And it leads you to look at the earlier episodes differently." He preferred relations between Snow White and the dwarves to be a bit more fraught. Now a fairy tale was being reinvented before his eyes in the financial markets. "I started to look more closely at what a subprime mortgage loan was all about," he said. "A subprime auto loan is in some ways honest because it's at a fixed rate. They may be charging you high fees and ripping your heart out, but at least you know it. The subprime mortgage loan was a cheat. You're basically drawing someone in by telling them, 'You're going to pay off all your other loans--your credit card debt, your auto loans--by taking this one loan. And look at the low rate!' But that low rate isn't the real rate. It's a teaser rate."
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."
Eisman asked, "Are any regulators interested in this?"
"No," said Sandler.
"That's when I decided the system was really, 'Fuck the poor.'"
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. He attributed his first baby steps back to the middle of the political spectrum to the end of the cold war. "I wasn't as right-wing because there wasn't as much to be right-wing about." 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."
Denied the chance to manage money by his hedge fund employer, he quit and tried to start his own hedge fund. An outfit called FrontPoint Partners, soon to be wholly owned by Morgan Stanley, housed a collection of hedge funds. In early 2004, Morgan Stanley agreed to let Eisman set up a fund that focused exclusively on financial companies: Wall Street banks, home builders, mortgage originators, companies with big financial services divisions--General Electric (GE), for instance--and anyone else who touched American finance. Morgan Stanley took a cut of the fees off the top and provided him with office space, furniture, and support staff. The only thing they didn't supply him with was money. Eisman was expected to drum that up on his own. He flew all over the world and eventually met with hundreds of big-time investors. "Basically we tried to raise money, and didn't really do it," he says. "Everyone said, 'It's a pleasure to meet you. Let's see how you do.'"
By the spring of 2004 he was in a state. He hadn't raised money; he didn't know that he would; he didn't even know if he could. He certainly didn't believe that the world was fair, or that things always worked out for the best, or that he enjoyed some special protection from life's accidents. He was waking up at four in the morning, drenched in sweat. He was also in therapy. He was still Eisman, however, and so it wasn't conventional therapy. "Work group," it was called. A handful of professionals gathered with a trained psychotherapist to share their problems in a safe environment. Eisman would burst in late to these meetings, talk through whatever was bothering him, and then rush off before the others had a chance to tell him about their problems. After he'd done this a couple of times, the therapist said something to him about it, but he didn't appear to have heard her. So she took to calling Eisman's wife, whom she knew, to ask her to have a word with her husband. That didn't work either. "I always knew when he'd been to group," said Valerie, "because she'd call and say, 'He did it again!'"
Valerie was clearly weary of the rat race. She told Eisman that if this latest Wall Street venture didn't work out, they would leave New York for Rhode Island and open a bed-and-breakfast. Valerie had scouted places and spoke often about spending more time with the twins she'd given birth to, and even raising chickens. It was almost as hard for Eisman to imagine himself raising chickens as it was for people who knew him, but he'd agreed. "The idea of it was so unbelievably unappealing to him," says his wife, "that he started to work harder." Eisman traveled all over Europe and the United States searching for people willing to invest with him and found exactly one: an insurance company, which staked him to $50 million. It wasn't enough to create a sustainable equity fund, but it was a start.
Instead of money, Eisman attracted people, whose views of the world were as shaded as his own. Vinny, who had just coauthored a gloomy report called "A Home without Equity Is
Just a Rental with Debt," came right away. Porter Collins, a two-time Olympic oars-man who had worked with Eisman at Chilton Investment and never really understood why the guy with the bright ideas wasn't given more authority, came along too. Danny Moses, who became Eisman's head trader, came third. Danny had worked as a salesman at Oppenheimer and Co. and had pungent memories of Eisman doing and saying all sorts of things that sell-side analysts seldom did. In the middle of one trading day, for instance, Eisman had walked to the podium at the center of the Oppenheimer trading floor, called for everyone's attention, announced that "the following eight stocks are going to zero," and then listed eight companies that indeed went bankrupt. Raised in Georgia, the son of a finance professor, Danny was less openly fatalistic than Vinny or Steve, but he nevertheless shared a general sense that bad things can and do happen, especially on Wall Street. When a Wall Street firm helped him to get into a trade that seemed perfect in every way, he asked the salesman, "I appreciate this, but I just want to know one thing: How are you going to fuck me?"
Heh-heh-heh, c'mon, we'd never do that, the trader started to say, but Danny, though perfectly polite, was insistent.
We both know that unadulterated good things like this trade don't just happen between little hedge funds and big Wall Street firms. I'll do it, but only after you explain to me how you are going to fuck me. And the salesman explained how he was going to fuck him. And Danny did the trade.
The Big Short: Inside the Doomsday Machine Page 3