The Big Short: Inside the Doomsday Machine

by Michael Lewis

  A smaller number of people--more than ten, fewer than twenty--made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market and, by extension, the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed. Among them: a Minneapolis hedge fund called Whitebox, a Boston hedge fund called The Baupost Group, a San Francisco hedge fund called Passport Capital, a New Jersey hedge fund called Elm Ridge, and a gaggle of New York hedge funds: Elliott Associates, Cedar Hill Capital Partners, QVT Financial, and Philip Falcone's Harbinger Capital Partners. What most of these investors had in common was that they had heard, directly or indirectly, Greg Lippmann's argument. In Dallas, Texas, a former Bear Stearns bond salesman named Kyle Bass set up a hedge fund called Hayman Capital in mid-2006 and soon thereafter bought credit default swaps on subprime mortgage bonds. Bass had heard the idea from Alan Fournier of Pennant Capital, in New Jersey--who in turn had heard it from Lippmann. A rich American real estate investor named Jeff Greene went off and bought several billion dollars' worth of credit default swaps on subprime mortgage bonds for himself after hearing about it from the New York hedge fund manager John Paulson. Paulson, too, had heard Greg Lippmann's pitch--and, as he built a massive position in credit default swaps, used Lippmann as his sounding board. A proprietary trader at Goldman Sachs in London, informed that this trader at Deutsche Bank in New York was making a powerful argument, flew across the Atlantic to meet with Lippmann and went home owning a billion dollars' worth of credit default swaps on subprime mortgage bonds. A Greek hedge fund investor named Theo Phanos heard Lippmann pitch his idea at a Deutsche Bank conference in Phoenix, Arizona, and immediately placed his own bet. If you mapped the spread of the idea, as you might a virus, most of the lines pointed back to Lippmann. He was Patient Zero. Only one carrier of the disease could claim, plausibly, to have infected him. But Mike Burry was holed up in his office in San Jose, California, and wasn't talking to anyone.

  This small world of investors who made big bets against subprime mortgage bonds itself contained an even smaller world: people for whom the trade became an obsession. A tiny handful of investors perceived what was happening not just to the financial system but to the larger society it was meant to serve, and made investments against that system that were so large, in relation to their capital, that they effectively gave up being conventional money managers and became something else. John Paulson had by far the most money to play with, and so was the most obvious example. Nine months after Mike Burry failed to raise a fund to do nothing but buy credit default swaps on subprime mortgage bonds, Paulson succeeded, by presenting it to investors not as a catastrophe almost certain to happen but as a cheap hedge against the remote possibility of catastrophe. Paulson was fifteen years older than Burry, and far better known on Wall Street, but he was still, in some ways, a Wall Street outsider. "I called Goldman Sachs to ask them about Paulson," said one rich man whom Paulson had solicited for funds in mid-2006. "They told me he was a third-rate hedge fund guy who didn't know what he was talking about." Paulson raised several billion dollars from investors who regarded his fund as an insurance policy on their portfolios of real estate-related stocks and bonds. What prepared him to see what was happening in the mortgage bond market, Paulson said, was a career of searching for overvalued bonds to bet against. "I loved the concept of shorting a bond because your downside was limited," he told me. "It's an asymmetrical bet." He was shocked how much easier and cheaper it was to buy a credit default swap than it was to sell short an actual cash bond--even though they represented exactly the same bet. "I did half a billion. They said, 'Would you like to do a billion?' And I said, 'Why am I pussyfooting around?' It took two or three days to place twenty-five billion." Paulson had never encountered a market in which an investor could sell short 25 billion dollars' worth of a stock or bond without causing its price to move, even crash. "And we could have done fifty billion, if we'd wanted to."

  Even as late as the summer of 2006, as home prices began to fall, it took a certain kind of person to see the ugly facts and react to them--to discern, in the profile of the beautiful young lady, the face of an old witch. Each of these people told you something about the state of the financial system, in the same way that people who survive a plane crash told you something about the accident, and also about the nature of people who survive accidents. All of them were, almost by definition, odd. But they were not all odd in the same way. John Paulson was oddly interested in betting against dodgy loans, and oddly persuasive in talking others into doing it with him. Mike Burry was odd in his desire to remain insulated from public opinion, and even direct human contact, and to focus instead on hard data and the incentives that guide future human financial behavior. Steve Eisman was odd in his conviction that the leveraging of middle-class America was a corrupt and corrupting event, and that the subprime mortgage market in particular was an engine of exploitation and, ultimately, destruction. Each filled a hole; each supplied a missing insight, an attitude to risk which, if more prevalent, might have prevented the catastrophe. But there was at least one gaping hole no big-time professional investor filled. It was filled, instead, by Charlie Ledley.

  Charlie Ledley--curiously uncertain Charlie Ledley--was odd in his belief that the best way to make money on Wall Street was to seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening. Charlie and his partners had done this often enough, and had had enough success, to know that the markets were predisposed to underestimating the likelihood of dramatic change. Even so, in September 2006, as he paged through the document sent to him by a friend, a presentation about shorting subprime mortgage bonds by some guy at Deutsche Bank named Greg Lippmann, Ledley's first thought was, This is just too good to be true. He'd never traded a mortgage bond, knew essentially nothing about real estate, was bewildered by the jargon of the bond market, and wasn't even sure Deutsche Bank or anyone else would allow him to buy credit default swaps on subprime mortgage bonds--since this was a market for institutional investors, and he and his two partners, Ben Hockett and Jamie Mai, weren't anyone's idea of an institution. "But I just looked at it and said, 'How can this even be possible?'" He then sent the idea to his partners along with the question, Why isn't someone smarter than us doing this?

  Every new business is inherently implausible, but Jamie Mai and Charlie Ledley's idea, in early 2003, for a money management firm bordered on the absurd: a pair of thirty-year-old men with a Schwab account containing $110,000 occupy a shed in the back of a friend's house in Berkeley, California, and dub themselves Cornwall Capital Management. Neither of them had any reason to believe he had any talent for investing. Both had worked briefly for the New York private equity firm Golub Associates as grunts chained to their desks, but neither had made actual investment decisions. Jamie Mai was tall and strikingly handsome and so, almost by definition, had the air of a man in charge--until he opened his mouth and betrayed his lack of confidence in everything from tomorrow's sunrise to the future of the human race. Jamie had a habit of stopping himself midsentence and stammering--"uh, uh, uh"--as if he was somehow unsettled by his own thought. Charlie Ledley was even worse: He had the pallor of a mortician and the manner of a man bent on putting off, for as long as possible, definite action. Asked a simple question, he'd stare mutely into space, nodding and blinking like an actor who has forgotten his lines, so that when he finally opened his mouth the sound that emerged caused you to jolt in your chair. It speaks!

  Both were viewed by contemporaries as sweet-natured, disorganized, inquisitive, bright but lacking obvious direction--the kind of guys who might turn up at their fifteenth high school reunions with surprising facial hair and a complicated life story. Charlie left Amherst College after his freshman year to volunteer for Bill Clinton's first presidential campaign, and, though he eventually returned, he remained far more interested in his own idealism than in making money. Jamie's first job out of Duke University
had been delivering sailboats to rich people up and down the East Coast. ("That's when it became clear to me that--uh, uh, uh--I was going to have to adopt some profession.") At the age of twenty-eight, he'd taken an eighteen-month "sabbatical," traveling around the world with his girlfriend. He'd come to Berkeley not looking for fertile soil in which to grow money but because the girlfriend wanted to move there. Charlie didn't even really want to be in Berkeley; he'd grown up in Manhattan and turned into a pumpkin when he got to the other side of a bridge or tunnel. He'd moved to Berkeley because the idea of running money together, and the $110,000, had been Jamie's. The garage in which Charlie now slept was Jamie's, too.

  Instead of money or plausibility, what they had was an idea about financial markets. Or, rather, a pair of related ideas. 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." They believed, further, that public financial markets lacked investors with an interest in the big picture. U.S. stock market guys made decisions within the U.S. stock market; Japanese bond market guys made decisions within the Japanese bond market; and so on. "There are actually people who do nothing but invest in European mid-cap health care debt," said Charlie. "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.

  In early 2003 Cornwall Capital had just opened for business, which meant Jamie and Charlie spent even more hours of their day than before sitting in the Berkeley garage--Charlie's bedroom--shooting the shit about the market. Cornwall Capital, they decided, would not merely search for market inefficiency but search for it globally, in every market: stocks, bonds, currencies, commodities. To these two not so simple ambitions they soon added a third, even less simple, one, when they stumbled upon their first big opportunity, a credit card company called Capital One Financial.

  Capital One was a rare example of a company that seemed to have found a smart way to lend money to Americans with weak credit scores. Its business was credit cards, not home loans, but it dealt with the same socioeconomic class of people whose home loan borrowing would end in catastrophe just a few years later. Through the 1990s and into the 2000s, the company claimed, and the market believed, that it possessed better tools than other companies for analyzing the creditworthiness of subprime credit card users and for pricing the risk of lending to them. It had weathered a bad stretch for its industry, in the late 1990s, during which several of its competitors collapsed. Then, in July 2002, its stock crashed--falling 60 percent in two days, after Capital One's management voluntarily disclosed that they were in a dispute about how much capital they needed to reserve against potential subprime losses with their two government regulators, the Office of Thrift Supervision and the Federal Reserve.

  Suddenly the market feared that Capital One wasn't actually smarter than everyone else in their industry about making loans but simply better at hiding their losses. The regulators had discovered fraud, the market suspected, and were about to punish Capital One. Circumstantial evidence organized itself into what seemed like a damning case. For instance, the SEC announced that it was investigating the company's CFO, who had just resigned, for selling his shares in the company two months before the company announced its dispute with regulators and its share price collapsed.

  Over the next six months, the company continued to make money at impressive rates. It claimed that it had done nothing wrong, that the regulators were being capricious, and announced no special losses on its $20 billion portfolio of subprime loans. Its stock price remained depressed. Charlie and Jamie studied the matter, which is to say they went to industry conferences, and called up all sorts of people they didn't know and bugged them for information: short sellers, former Capital One employees, management consultants who had advised the company, competitors, and even government regulators. "What became clear," said Charlie, "was that there was a limited amount of information out there and we had the same information as everyone else." They decided that Capital One probably did have better tools for making subprime loans. That left only one question: Was it run by crooks?

  It wasn't a question two thirty-something would-be professional investors in Berkeley, California, with $110,000 in a Schwab account should feel it was their business to answer. But they did. They went hunting for people who had gone to college with Capital One's CEO, Richard Fairbank, and collected character references. Jamie paged through the Capital One 10-K filing in search of someone inside the company he might plausibly ask to meet. "If we had asked to meet with the CEO, we wouldn't have gotten to see him," explained Charlie. Finally they came upon a lower-ranking guy named Peter Schnall, who happened to be the vice-president in charge of the subprime portfolio. "I got the impression they were like, 'Who calls and asks for Peter Schnall?'" said Charlie. "Because when we asked to talk to him they were like, 'Why not?'" They introduced themselves gravely as Cornwall Capital Management but refrained from mentioning what, exactly, Cornwall Capital Management was. "It's funny," says Jamie. "People don't feel comfortable asking how much money you have, and so you don't have to tell them."

  They asked Schnall if they might visit him, to ask a few questions before they made an investment. "All we really wanted to do," said Charlie, "was to see if he seemed like a crook." They found him totally persuasive. Interestingly, he was buying stock in his own company. They left thinking that Capital One's dispute with its regulators was trivial and that the company was basically honest. "We concluded that maybe they were crooks," said Jamie, "but probably not."

  What happened next led them, almost by accident, to the unusual approach to financial markets that would soon make them rich. In the six months following the news of its troubles with the Federal Reserve and the Office of Thrift Supervision, Capital One's stock traded in a narrow band around $30 a share. That stability obviously masked a deep uncertainty. Thirty dollars a share was clearly not the "right" price for Capital One. The company was either a fraud, in which case the stock was probably worth zero, or the company was as honest as it appeared to Charlie and Jamie, in which case the stock was worth around $60 a share. Jamie Mai had just read You Can Be a Stock Market Genius, the book by Joel Greenblatt, the same fellow who had staked Mike Burry to his hedge fund. Toward the end of his book Greenblatt described how he'd made a lot of money using a derivative security, called a LEAP (for Long-term Equity AnticiPation Security), which conveyed to its buyer the right to buy a stock at a fixed price for a certain amount of time. There were times, Greenblatt explained, when it made more sense to buy options on a stock than the stock itself. This, in Greenblatt's world of value investors, counted as heresy. Old-fashioned value investors shunned options because options presumed an ability to time price movements in undervalued stocks. Greenblatt's simple point: When the value of a stock so obviously turned on some upcoming event whose date was known (a merger date, for instance, or a court date), the value investor could in good conscience employ options to express his views. It gave Jamie an idea: Buy a long-term option to buy the stock of Capital One. "It was kind of like, Wow, we have a view: This common stock looks interesting. But, Holy shit, look at the prices of these options!"

  The right to buy Capital One's shares for $40 at any time in the next two and a half years cost a bit more than $3. That made no sense. Capital One's problems with regulators would be resolved, or not, in the next few months. When they were, the stock would either coll
apse to zero or jump to $60. Looking into it a bit, Jamie found that the model used by Wall Street to price LEAPs, the Black-Scholes option pricing model, made some strange assumptions. For instance, it assumed a normal, bell-shaped distribution for future stock prices. If Capital One was trading at $30 a share, the model assumed that, over the next two years, the stock was more likely to get to $35 a share than to $40, and more likely to get to $40 a share than to $45, and so on. This assumption made sense only to those who knew nothing about the company. In this case the model was totally missing the point: When Capital One stock moved, as it surely would, it was more likely to move by a lot than by a little.

  Cornwall Capital Management quickly bought 8,000 LEAPs. Their potential losses were limited to the $26,000 they paid for their option to buy the stock. Their potential gains were theoretically unlimited. Soon after Cornwall Capital laid their chips on the table, Capital One was vindicated by its regulators, its stock price shot up, and Cornwall Capital's $26,000 option position was worth $526,000. "We were pretty fired up," says Charlie.