The Big Short: Inside the Doomsday Machine

by Michael Lewis

  The insider's artful complexity didn't much interest Cornwall Capital. Spending a lot of time trying to pick the best subprime mortgage bonds was silly, if you suspected that the entire market was about to blow up. They handed Burt the list of CDOs they had bet against and asked him what he thought. "We always looked for someone to explain to us why we didn't know what we were doing," said Jamie. "He couldn't." What Burt could tell them was that they were probably the first people ever to buy a credit default swap on the double-A tranche of a CDO. Not reassuring. They assumed there was a lot about the CDO market they didn't understand; they had selected the CDOs they had bet against inside of a day, and assumed they could do a craftier job of it. "We were already throwing darts," said Jamie. "We said, 'Let's throw darts a little better.'"

  The analysis Burt gave them a few weeks later surprised them as much as it did him: They'd picked beautifully. "He said, like, 'Wow, you guys did great. There are a lot of really crappy bonds in these CDOs,'" said Charlie. They didn't realize yet that the bonds inside their CDOs were actually credit default swaps on the bonds, and so their CDOs weren't ordinary CDOs but synthetic CDOs, or that the bonds on which the swaps were based had been handpicked by Mike Burry and Steve Eisman and others betting against the market. In many ways, they were still innocents.

  The challenge, as always, was to play the role of market generalist without also playing the role of fool at the poker table. By January 2007, in their tiny $30 million fund, they owned $110 million in credit default swaps on the double-A tranche of asset-backed CDOs. The people who had sold them the swaps still didn't know what to make of them. "They were putting on bets that were multiples of the capital they had," said the young Deutsche Bank broker. "And they were doing it in CDSs on CDOs, which probably, like, three or four guys in the whole bank could speak intelligently about." Charlie and Jamie and Ben sort of understood what they had done, but sort of didn't. "We're kind of obsessed about this trade," said Charlie. "And we've exhausted our network of people to talk to about it. And we still can't totally figure out who is on the other side. We kept trying to find people who could explain to us why we were wrong. We just kept wondering if we were crazy. There was this overwhelming feeling of, Are we going out of our minds?"

  It's just weeks before the market will turn, and the crisis will commence, but they don't know that. They suspect that this empty theater into which they've stumbled is preparing to stage the most fantastic financial drama they'll ever see, but they don't know that, either. All they know is that there is a lot they don't know. On the phone one day, their Bear Stearns credit default swap salesman mentioned that the big annual subprime conference would be held five days hence, in Las Vegas. Every big cheese in the subprime mortgage market would be there, with a name tag, and wandering around The Venetian hotel. Bear Stearns was planning a special outing for its customers, at a Vegas firing range, where they could learn to shoot everything from a Glock to an Uzi. "My parents were New York City liberals," said Charlie. "I wasn't even allowed to have, like, a toy gun." Off he flew, with Ben, to Las Vegas, to shoot with Bear Stearns, and to see if they could find anyone to explain to them why they were wrong to bet against the subprime mortgage market.

  CHAPTER SIX

  Spider-Man at The Venetian

  Golfing with Eisman wasn't like golfing with other Wall Street people. The round usually began with a collective discomfort on the first tee, after Eisman turned up wearing something that violated the Wall Street golfer's notion of propriety. On January 28, 2007, he arrived at the swanky Bali Hai Golf Club in Las Vegas dressed in gym shorts, t-shirt, and sneakers. Strangers noticed; Vinny and Danny squirmed. "C'mon, Steve," Danny pleaded with a man who, technically, was his boss, "there's an etiquette here. You at least have to wear a collared shirt." Eisman took the cart to the clubhouse and bought a hoodie. The hoodie covered up his t-shirt and made him look a lot like a guy who had just bought a hoodie to cover up his t-shirt. In hoodie, gym shorts, and sneakers, Eisman approached his first shot. Like every other swing of the Eisman club, this was less a conclusive event than a suggestion. Displeased with where the ball had landed, he pulled another from his bag and dropped it in a new and better place. Vinny would hit his drive in the fairway; Danny would hit his in the rough; Steve would hit his in the bunker, march into the sand, and grab the ball and toss it out, near Vinny's. It was hard to accuse him of cheating, as he didn't make the faintest attempt to disguise what he was doing. He didn't even appear to notice anything unusual in the pattern of his game. The ninth time Eisman retrieved a ball from some sand trap, or pretended his shot had not splashed into the water, he acted with the same unapologetic aplomb he had demonstrated the first time. "Because his memory is so selective, he has no scars from prior experience," said Vinny. He played the game like a child, or like someone who was bent on lampooning a sacred ritual, which amounted to the same thing. "The weird thing is," said Danny, "he's actually not bad."

  After a round of golf, they headed out to a dinner at the Wynn hotel hosted by Deutsche Bank. This was the first time Eisman had ever been to a conference for bond market people and, not knowing what else to do, he had put himself in Greg Lippmann's hands. Lippmann had rented a private room in some restaurant and invited Eisman and his partners to what they assumed was something other than a free meal. "Even when he had an honest agenda, there was always something underneath the honest agenda," said Vinny. Any dinner that was Lippmann's idea must have some hidden purpose--but what?

  As it turned out, Lippmann had a new problem: U.S. house prices were falling, subprime loan defaults were rising, yet subprime mortgage bonds somehow held firm, as did the price of insuring them. He was now effectively short $10 billion in subprime mortgage bonds, and it was costing him $100 million a year in premiums, with no end in sight. "He was obviously getting his nuts blown off," said Danny. Thus far Lippmann's giant bet had been subsidized by investors, like Steve Eisman, who paid him a toll when they bought and sold credit default swaps, but investors like Steve Eisman were losing heart. Some of Lippmann's former converts suspected that the subprime mortgage bond market was rigged by Wall Street to insure that credit default swaps would never pay off; others began to wonder if the investors on the other side of their bet might know something that they didn't; and some simply wearied of paying insurance premiums to bet against bonds that never seemed to move. Lippmann had staged this great game of tug-of-war, assembled a team to pull on his end of the rope, and now his teammates were in full flight. He worried that Eisman might quit, too.

  The teppanyaki room inside the Okada restaurant consisted of four islands, each with a large, cast-iron hibachi and dedicated chef. Around each island Lippmann seated a single hedge fund manager whom he had persuaded to short subprime bonds, along with investors who were long those same bonds. The hedge fund people, he hoped, would see just how stupid the investors on the other side of those bets were, and cease to worry that the investors knew something they did not. This was shrewd of him: Danny and Vinny never stopped worrying if they were the fools at Lippmann's table. "We understood the subprime lending market and knew the loans were going bad," said Vinny. "What we didn't have any comfort in was the bond market machine. The whole reason we went to Vegas was we still felt we needed to learn how we were going to get screwed, if we were going to get screwed."

  Eisman took his assigned seat between Greg Lippmann and a fellow who introduced himself as Wing Chau and said that he ran an investment firm called Harding Advisory. When Eisman asked exactly what Harding Advisory advised, Wing Chau explained that he was a CDO manager. "I had no idea there was such a thing as a CDO manager," said Eisman. "I didn't know there was anything to manage." Later Eisman would fail to recall what Wing Chau looked like, what he wore, where he'd come from, or what he ate and drank--everything but the financial idea he represented. But from his seat across the hibachi, Danny Moses watched and wondered about the man Lippmann had so carefully seated next to Eisman. He was short, with a Wall Street belly--
not the bleacher bum's boiler but the discreet, necessary pouch of a squirrel just before winter. He'd graduated from the University of Rhode Island, earned a business degree at Babson College, and spent most of his career working sleepy jobs at sleepy life insurance companies--but all that was in the past. He was newly, obviously rich. "He had this smirk, like, I know better," said Danny. Danny didn't know Wing Chau, but when he heard that he was the end buyer of subprime CDOs, he knew exactly who he was: the sucker. "The truth is that I didn't really want to talk to him," said Danny, "because I didn't want to scare him."

  When they saw that Lippmann had seated Eisman right next to the sucker, both Danny and Vinny had the same thought: Oh no. This isn't going to end well. Eisman couldn't contain himself. He'd figure out the guy was a fool, and let him know it, and then where would they be? They needed fools; only fools would take the other side of their trades. And they wanted to do more trades. "We didn't want people to know what we were doing," said Vinny. "We were spies, on a fact-finding mission." They watched Eisman double-dip his edamame in the communal soy sauce--dip, suck, redip, resuck--and waited for the room to explode. There was nothing to do but sit back and enjoy the show. Eisman had a curious way of listening; he didn't so much listen to what you were saying as subcontract to some remote region of his brain the task of deciding whether whatever you were saying was worth listening to, while his mind went off to play on its own. As a result, he never actually heard what you said to him the first time you said it. If his mental subcontractor detected a level of interest in what you had just said, it radioed a signal to the mother ship, which then wheeled around with the most intense focus. "Say that again," he'd say. And you would! Because now Eisman was so obviously listening to you, and, as he listened so selectively, you felt flattered. "I keep looking over at them," said Danny. "And I see Steve saying over and over, Say that again. Say that again."

  Later, whenever Eisman set out to explain to others the origins of the financial crisis, he'd start with his dinner with Wing Chau. Only now did he fully appreciate the central importance of the so-called mezzanine CDO--the CDO composed mainly of triple-B-rated subprime mortgage bonds--and its synthetic counterpart: the CDO composed entirely of credit default swaps on triple-B-rated subprime mortgage bonds. "You have to understand this," he'd say. "This was the engine of doom." He'd draw a picture of several towers of debt. The first tower was the original subprime loans that had been piled together. At the top of this tower was the triple-A tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche--the bonds Eisman had bet against. The Wall Street firms had taken these triple-B tranches--the worst of the worst--to build yet another tower of bonds: a CDO. A collateralized debt obligation. The reason they'd done this is that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce 80 percent of the bonds in it triple-A. These bonds could then be sold to investors--pension funds, insurance companies--which were allowed to invest only in highly rated securities. It came as news to Eisman that this ship of doom was piloted by Wing Chau and people like him. The guy controlled roughly $15 billion, invested in nothing but CDOs backed by the triple-B tranche of a mortgage bond or, as Eisman put it, "the equivalent of three levels of dog shit lower than the original bonds." A year ago, the main buyer of the triple-A-rated tranche of subprime CDOs--which is to say the vast majority of CDOs--had been AIG. Now that AIG had exited the market, the main buyers were CDO managers like Wing Chau. All by himself, Chau generated vast demand for the riskiest slices of subprime mortgage bonds, for which there had previously been essentially no demand. This demand led inexorably to the supply of new home loans, as material for the bonds. The soy sauce in which Eisman double-dipped his edamame was shared by a man who had made it possible for tens of thousands of actual human beings to be handed money they could never afford to repay.

  As it happened, FrontPoint Partners had spent a lot of time digging around in those loans, and knew that the default rates were already sufficient to wipe out Wing Chau's entire portfolio. "God," Eisman said to him. "You must be having a hard time."

  "No," Wing Chau said. "I've sold everything out."

  Say that again.

  It made no sense. The CDO manager's job was to select the Wall Street firm to supply him with subprime bonds that served as the collateral for CDO investors, and then to vet the bonds themselves. The CDO manager was further charged with monitoring the hundred or so individual subprime bonds inside each CDO, and replacing the bad ones, before they went bad, with better ones. That, however, was mere theory; in practice, the sorts of investors who handed their money to Wing Chau, and thus bought the triple-A-rated tranche of CDOs--German banks, Taiwanese insurance companies, Japanese farmers' unions, European pension funds, and, in general, entities more or less required to invest in triple-A-rated bonds--did so precisely because they were meant to be foolproof, impervious to losses, and unnecessary to monitor or even think about very much. The CDO manager, in practice, didn't do much of anything, which is why all sorts of unlikely people suddenly hoped to become one. "Two guys and a Bloomberg terminal in New Jersey" was Wall Street shorthand for the typical CDO manager. The less mentally alert the two guys, and the fewer the questions they asked about the triple-B-rated subprime bonds they were absorbing into their CDOs, the more likely they were to be patronized by the big Wall Street firms. The whole point of the CDO was to launder a lot of subprime mortgage market risk that the firms had been unable to place straightforwardly. The last thing you wanted was a CDO manager who asked lots of tough questions.

  The bond market had created what amounted to a double agent--a character who seemed to represent the interests of investors when he better represented the interests of Wall Street bond trading desks. To assure the big investors who had handed their billions to him that he had their deep interests at heart, the CDO manager kept ownership of what was called the "equity," or "first loss" piece, of the CDO--the piece that vanished first when the subprime loans that ultimately supplied the CDO with cash defaulted. But the CDO manager was also paid a fee of 0.01 percent off the top, before any of his investors saw a dime, and another, similar fee, off the bottom, as his investor received their money back. That doesn't sound like much, but, when you're running tens of billions of dollars with little effort and no overhead, it adds up. Just a few years earlier, Wing Chau was making $140,000 a year managing a portfolio for the New York Life Insurance Company. In one year as a CDO manager, he'd taken home $26 million, the haul from half a dozen lifetimes of working at New York Life.

  Now, almost giddily, Chau explained to Eisman that he simply passed all the risk that the underlying home loans would default on to the big investors who had hired him to vet the bonds. His job was to be the CDO "expert," but he actually didn't spend a lot of time worrying about what was in CDOs. His goal, he explained, was to maximize the dollars in his care. He was now doing this so well that, from January 2007 until the market crashed in September, Harding Advisory would be the world's biggest subprime CDO manager. Among its other achievements, Harding had established itself as the go-to buyer for Merrill Lynch's awesome CDO machine, notorious not only for its rate of production (Merrill created twice as many of the things as the next biggest Wall Street firm) but also for its industrial waste (its CDOs were later proven to be easily the worst). "He 'managed' the CDOs," said Eisman, "but managed what? I was just appalled that the structured finance market could be so insane as to allow someone to manage a CDO portfolio without having any exposure to the CDOs. People would pay up to have someone 'manage' their CDOs--as if this moron was helping you. I thought, You prick, you don't give a fuck about the investors in this thing." Chau's real job was to serve as a new kind of front man for the Wall Street firms he "hired" investors felt better buying a Merrill Lynch CDO if it didn't appear to be run by Merrill Lynch.

  There was a reason Greg Lippmann had picked Wing Chau to sit beside Steve Eisman. If Wing Chau detected Eisman's disapproval, he
didn't show it; instead, he spoke to Eisman in a tone of condescension. I know better. "Then he says something that blew my mind," said Eisman. "He says, 'I love guys like you who short my market. Without you I don't have anything to buy.'"

  Say that again.

  "He says to me, 'The more excited that you get that you're right, the more trades you'll do, and the more trades you do, the more product for me.'"

  That's when Steve Eisman finally understood the madness of the machine. He and Vinny and Danny had been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the triple-B tranche of subprime mortgage-backed bonds without fully understanding why those firms were so eager to accept them. Now he was face-to-face with the actual human being on the other side of his credit default swaps. Now he got it: The credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. Wall Street needed his bets in order to synthesize more of them. "They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford," said Eisman. "They were creating them out of whole cloth. One hundred times over! That's why the losses in the financial system are so much greater than just the subprime loans. That's when I realized they needed us to keep the machine running. I was like, This is allowed?"