The Big Short: Inside the Doomsday Machine

by Michael Lewis

All of them enjoyed, immensely, the idea of running money with Steve Eisman. Working for Eisman, you never felt you were working for Eisman. He'd teach you but he wouldn't supervise you. Eisman also put a fine point on the absurdity they saw everywhere around them. "Steve's fun to take to any Wall Street meeting," said Vinny. "Because he'll say 'explain that to me' thirty different times. Or 'could you explain that more, in English?' Because once you do that, there's a few things you learn. For a start, you figure out if they even know what they're talking about. And a lot of times they don't!"

  By early 2005 Eisman's little group shared a sense that a great many people working on Wall Street couldn't possibly understand what they were doing. The subprime mortgage machine was up and running again, as if it had never broken down in the first place. If the first act of subprime lending had been freaky, this second act was terrifying. Thirty billion dollars was a big year for subprime lending in the mid-1990s. In 2000 there had been $130 billion in subprime mortgage lending, and 55 billion dollars' worth of those loans had been repackaged as mortgage bonds. In 2005 there would be $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds. Half a trillion dollars in subprime mortgage-backed bonds in a single year. Subprime lending was booming even as interest rates were rising--which made no sense at all. Even more shocking was that the terms of the loans were changing, in ways that increased the likelihood they would go bad. 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.

  The original cast of subprime financiers had been sunk by the small fraction of the loans they made that they had kept on their books. 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. Long Beach Savings was the first existing bank to adopt what was called the "originate and sell" model. This proved such a hit--Wall Street would buy your loans, even if you would not!--that a new company, called B&C mortgage, was founded to do nothing but originate and sell. Lehman Brothers thought that was such a great idea that they bought B&C mortgage. By early 2005 all the big Wall Street investment banks were deep into the subprime game. Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley all had what they termed "shelves" for their subprime wares, with strange names like HEAT and SAIL and GSAMP, that made it a bit more difficult for the general audience to see that these subprime bonds were being underwritten by Wall Street's biggest names.

  Eisman and his team had a from-the-ground-up understanding of both the U.S. housing market and Wall Street. They knew most of the subprime lenders--the guys on the ground making the loans. Many were the very same characters who had created the late 1990s debacle. Eisman was predisposed to suspect the worst of whatever Goldman Sachs might be doing with the debts of lower-middle-class Americans. "You have to understand," he says. "I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn't give a shit what it sold." What he couldn't understand was who was buying the bonds from this second wave of subprime mortgage lending. "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.'"

  By "this stuff," Eisman meant the stocks of companies involved in subprime lending. Stock prices could do all sorts of crazy things: He didn't want to short them until the loans started going bad. To that end, Vinny kept a close eye on the behavior of the American subprime mortgage borrower. On the twenty-fifth of each month, the remittance reports arrived on his computer screen, and he scanned them for any upticks in delinquencies. "According to the things we were tracking," says Vinny, "the credit quality was still good. At least until the second half of 2005."

  In the fog of the first eighteen months of running his own business, 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." Just about every major Wall Street investment bank was effectively run by its bond departments. In most cases--Dick Fuld at Lehman Brothers, John Mack at Morgan Stanley, Jimmy Cayne at Bear Stearns--the CEO was a former bond guy. Ever since the 1980s, when the leading bond firm, Salomon Brothers, had made so much money that it looked as if it was in a different industry than the other firms, the bond market had been where the big money was made. "It was the golden rule," said Eisman. "The people who have the gold make the rules."

  Most people didn't understand how what amounted to a two-decade boom in the bond market had overwhelmed everything else. Eisman certainly hadn't. Now he did. He needed to learn everything he could about the fixed income world. He had plans for the bond market. What he didn't know was that the bond market also had plans for him. It was about to create an Eisman-shaped hole.

  CHAPTER TWO

  In the Land of the Blind

  Writing a check separates a commitment from a conversation.

  --Warren Buffett

  In early 2004 another stock market investor, Michael Burry, immersed himself for the first time in the bond market. He learned all he could about how money got borrowed and lent in America. He didn't talk to anyone about what became his new obsession; he just sat alone in his office, in San Jose, California, and read books and articles and financial filings. He wanted to know, especially, how subprime mortgage bonds worked. A giant number of individual loans got piled up into a tower. The top floors got their money back first and so got the highest ratings from Moody's and S&P and the lowest interest rate. The low floors got their money back last, suffered the first losses, and got the lowest ratings from Moody's and S&P. Because they were taking on more risk, the investors in the bottom floors received a higher rate of interest than investors in the top floors. Investors who bought mortgage bonds had to decide in which floor of the tower they wanted to invest, but Michael Burry wasn't thinking about buying mortgage bonds. He was wondering how he might short subprime mortgage bonds.

  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. As he explained in an e-mail:

  So you take something like NovaStar, which was an originate and sell subprime mortgage lender, an archetype at the time. The names [of the bonds] would be NHEL 2004-1, NHEL 2004-2, NHEL 2004-3, NHEL 2005-1, etc. NHEL 2004-1 would for instance contain loans from the first few months of 2004 and the last few months of 2003, and 2004-2 would have loans from the middle part, and 2004-3 would get the latter part of 2004. You could pull these prospectuses, and just quickly check the pulse of what was happening in the subprime mortgage portion of the originate-and-sell industry. And you'd see that 2/28 interest only ARM mortgages were only 5.85% of the pool in early 2004, but by late 2004 they were 17.48% of the pool, and by late summer 2005 25.34% of the pool. Yet average FICO [consumer credit] scores for the pool, percent of no-doc ["Liar"] loan to value measures and other indicators were pretty static.... The point is that these measures could stay roughly static, but the overall pool of mortgages b
eing issued, packaged and sold off was worsening in quality, because for the same average FICO scores or the same average loan to value, you were getting a higher percentage of interest only mortgages.

  As early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry's view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. You, the home buyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principal balance. It wasn't hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn't understand was why a person who lent money would want to extend such a loan. "What you want to watch are the lenders, not the borrowers," he said. "The borrowers will always be willing to take a great deal for themselves. It's up to the lenders to show restraint, and when they lose it, watch out." By 2003 he knew that the borrowers had already lost it. By early 2005 he saw that lenders had, too.

  A lot of hedge fund managers spent time chitchatting with their investors and treated their quarterly letters to them as a formality. Burry disliked talking to people face-to-face and thought of these letters as the single most important thing he did to let his investors know what he was up to. In his quarterly letters he coined a phrase to describe what he thought was happening: "the extension of credit by instrument." That is, a lot of people couldn't actually afford to pay their mortgages the old-fashioned way, and so the lenders were dreaming up new instruments to justify handing them new money. "It was a clear sign that lenders had lost it, constantly degrading their own standards to grow loan volumes," Burry said. He could see why they were doing this: They didn't keep the loans but sold them to Goldman Sachs and Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds and sold them off. The end buyers of subprime mortgage, he assumed, were just "dumb money." He'd study up on them, too, but later.

  He now had a tactical investment problem. The various floors, or tranches, of subprime mortgage bonds all had one thing in common: 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. You might know with certainty that the entire subprime mortgage bond market was doomed, but you could do nothing about it. You couldn't short houses. You could short the stocks of home building companies--Pulte Homes, say, or Toll Brothers--but that was expensive, indirect, and dangerous. Stock prices could rise for a lot longer than Burry could stay solvent.

  A couple of years earlier, he'd discovered credit default swaps. 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. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing. It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million. It was also an asymmetric bet, like laying down money on a number in roulette. The most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money. "Credit default swaps remedied the problem of open-ended risk for me," said Burry. "If I bought a credit default swap, my downside was defined and certain, and the upside was many multiples of it."

  He was already in the market for corporate credit default swaps. In 2004 he began to buy insurance on companies he thought might suffer in a real estate downturn: mortgage lenders, mortgage insurers, and so on. This wasn't entirely satisfying. A real estate market meltdown might cause these companies to lose money; there was no guarantee that they would actually go bankrupt. He wanted a more direct tool for betting against subprime mortgage lending. 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.

  The idea hit him as he read a book about the evolution of the U.S. bond market and the creation, in the mid-1990s, at J.P. Morgan, of the first corporate credit default swaps. He came to a passage explaining why banks felt they needed credit default swaps at all. It wasn't immediately obvious--after all, the best way to avoid the risk of General Electric's defaulting on its debt was not to lend to General Electric in the first place. In the beginning, credit default swaps had been a tool for hedging: Some bank had loaned more than they wanted to General Electric because GE had asked for it, and they feared alienating a long-standing client; another bank changed its mind about the wisdom of lending to GE at all. Very quickly, however, the new derivatives became tools for speculation: A lot of people wanted to make bets on the likelihood of GE's defaulting. It struck Burry: Wall Street is bound to do the same thing with subprime mortgage bonds, too. Given what was happening in the real estate market--and given what subprime mortgage lenders were doing--a lot of smart people eventually were going to want to make side bets on subprime mortgage bonds. And the only way to do it would be to buy a credit default swap.

  The credit default swap would solve the single biggest problem with Mike Burry's big idea: timing. The subprime mortgage loans being made in early 2005 were, he felt, almost certain to go bad. But as their interest rates were set artificially low, and didn't reset for two years, it would be two years before that happened. Subprime mortgages almost always bore floating interest rates, but most of them came with a fixed, two-year "teaser" rate. A mortgage created in early 2005 might have a two-year "fixed" rate of 6 percent that, in 2007, would jump to 11 percent and provoke a wave of defaults. The faint ticking sound of these loans would grow louder with time, until eventually a lot of people would suspect, as he suspected, that they were bombs. Once that happened, no one would be willing to sell insurance on subprime mortgage bonds. He needed to lay his chips on the table now and wait for the casino to wake up and change the odds of the game. A credit default swap on a thirty-year subprime mortgage bond was a bet designed to last for thirty years, in theory. He figured that it would take only three to pay it off.

  The only problem was that there was no such thing as a credit default swap on a subprime mortgage bond, not that he could see. He'd need to prod the big Wall Street firms to create them. But which firms? If he was right and the housing market crashed, these firms in the middle of the market were sure to lose a lot of money. There was no point buying insurance from a bank that went out of business the minute the insurance became valuable. He didn't even bother calling Bear Stearns and Lehman Brothers, as they were more exposed to the mortgage bond market than the other firms. Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his mind, the most likely to survive a crash. He called them all. Five of them had no idea what he was talking about; 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. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.

  He sensed that he was different from other people before he understood why. When he was two years old he'd developed a rare form of cancer, and the operation to remove the tumor had cost him his left eye. A boy with one eye sees the world differently than everyone else, but it didn't take long for Mike Burry to see his l
iteral distinction in more figurative terms. Grown-ups were forever insisting that he should look other people in the eye, especially when he was talking to them. "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." His left eye didn't line up with whomever he was trying to talk to; when he was in social situations trying to make chitchat, the person to whom he was speaking would steadily drift left. "I don't really know how to stop it," he said, "so people just keep moving left until they're standing way to my left, and I'm trying not to turn my head anymore. I end up facing right and looking left with my good eye, through my nose."

  His glass eye, he assumed, was the reason that face-to-face interaction with other people almost always ended badly for him. He found it maddeningly difficult to read people's nonverbal signals; and their verbal signals he often took more literally than they meant them. When trying his best he was often at his worst. "My compliments tended not to come out right," he said. "I learned early that if you compliment somebody it'll come out wrong. For your size, you look good. That's a really nice dress: It looks homemade. The glass eye became his private explanation for why he hadn't really fit in with groups. The eye oozed and wept and required constant attention. It wasn't the sort of thing other kids ever allowed him to be unselfconscious about. They called him cross-eyed, even thought he wasn't. Every year they begged him to pop his eye out of its socket--but when he complied, it became infected and disgusting and a cause of further ostracism.

  In his glass eye he found the explanation for other traits peculiar to himself. His obsession with fairness, for example. When he noticed that pro basketball stars were far less likely to be called for traveling than lesser players, he didn't just holler at the refs. He stopped watching basketball altogether; the injustice of it killed his interest in the sport. Even though he was ferociously competitive, well built, physically brave, and a good athlete, he didn't care for team sports. The eye helped to explain this, as most team sports were ball sports, and a boy with poor depth perception and limited peripheral vision couldn't very well play ball sports. He tried hard at the less ball-centric positions in football, but his eye popped out if he hit someone too hard.