The Big Short: Inside the Doomsday Machine

by Michael Lewis

  Wing Chau didn't know he'd been handpicked by Greg Lippmann to persuade Steve Eisman that the people on the other end of his credit default swaps were either crooks or morons, but he played the role anyway. Between shots of sake he told Eisman that he would rather have $50 billion in crappy CDOs than none at all, as he was paid mainly on volume. He told Eisman that his main fear was that the U.S. economy would strengthen, and dissuade hedge funds from placing bigger bets against the subprime mortgage market. Eisman listened and tried to understand how an investor on opposite ends of his bets could be hoping for more or less the same thing he was--and how any insurance company or pension fund could hand its capital to Wing Chau. There was only one answer: The triple-A ratings gave everyone an excuse to ignore the risks they were running.

  Danny and Vinny watched them closely through the hibachi steam. As far as they could tell, Eisman and Wing Chau were getting along famously. But when the meal was over, they watched Eisman grab Greg Lippmann, point to Wing Chau, and say, "Whatever that guy is buying, I want to short it." Lippmann took it as a joke, but Eisman was completely serious: He wanted to place a bet specifically against Wing Chau. "Greg," Eisman said, "I want to short his paper. Sight unseen." Thus far Eisman had bought only credit default swaps on subprime mortgage bonds; from now on he'd buy specifically credit default swaps on Wing Chau's CDOs. "He finally met the enemy, face-to-face," said Vinny.

  In what amounted to a brief attempt to live someone else's life, Charlie Ledley selected from the wall a Beretta pistol, a sawed-off shotgun, and an Uzi. Not long before he'd walked out the door for Las Vegas, he'd dashed an e-mail off to his partner Ben Hockett, who planned to meet him there, and Jamie Mai, who didn't. "Do you guys think we're screwed since we haven't preregistered for anything?" he asked. It wasn't the first time Cornwall Capital had heard about some big event in the markets to which they hadn't been formally invited and more or less invited themselves, and it wouldn't be the last. "If you just kind of show up at these things," said Jamie, "they almost always let you in." The only people Charlie knew in Vegas were a few members of the subprime mortgage machine at Bear Stearns, and he'd never actually met them in person. Nevertheless, they had sent him an e-mail telling him, after he landed in Las Vegas, to meet them not at the conference but at this indoor shooting range, a few miles from the strip. "We goin' shootin on Sunday...," it began. Charlie was so taken aback, he called to ask them what it meant. "I was like, 'So you're going to go shoot...guns?'"

  That Sunday afternoon of January 28, at The Gun Store in Las Vegas, it wasn't hard to spot the Bear Stearns CDO salesmen. They came dressed in khakis and polo shirts and were surrounded by burly men in tight black t-shirts who appeared to be taking the day off from hunting illegal immigrants with the local militia. Behind the cash register, the most sensational array of pistols and shotguns and automatic weapons lined the wall. To the right were the targets: a photograph of Osama bin Laden, a painting of Osama bin Laden as a zombie, various hooded al Qaeda terrorists, a young black kid attacking a pretty white woman, an Asian hoodlum waving a pistol. "They put down the Bear Stearns credit card and started buying rounds of ammunition," said Charlie. "And so I started picking my guns." It was the Uzi that made the biggest impression on him. That, and the giant photograph of Saddam Hussein he selected from the wall of targets. The shotgun kicked and bruised your shoulder, but the Uzi, with far more killing power, was almost gentle; there was a thrilling disconnect between the pain you experienced and the damage you caused. "The Beretta was fun but the Uzi was totally awesome," said Charlie, who left The Gun Store with both a lingering feeling of having broken some law of nature, and an unanswered question: Why had he been invited? The Bear Stearns guys had been great, but no one had uttered a word about subprime mortgages or CDOs. "It was totally weird, because I'd never met the guys before and I'm the only Bear Stearns customer who's there," said Charlie. "They were paying for all this ammo and so I'm like, 'Guys, I can buy a few rounds for myself if you want,' but they insisted on treating me like the customer." Of course, the safest way to expense to one's Wall Street firm a day of playing Full Metal Jacket was to invite some customer along. And, of course, the most painless customer to invite was one whose business was so trivial that his opinion of the festivities didn't actually matter. That these thoughts never occurred to Charlie told you something about him: He was not nearly as cynical as he needed to be. But that would soon change.

  The next morning, Charlie and Ben wandered the halls of The Venetian. "Everyone who was trying to sell something was wearing a tie," said Ben. "Everyone who was there to buy wasn't. It was hard to find someone I wanted to talk to. We were just kind of interlopers, walking around." They knew just one person in the entire place--David Burt, the former BlackRock guy whom they were now paying $50,000 a month to evaluate the CDOs they were betting against--but they didn't think that mattered, as their plan was to go to the open sessions, the big speeches and panel discussions. "It was not entirely clear why we were there," said Ben. "We were trying to meet people. Charlie would sneak up on whoever was at the podium after speeches. We were trying to find people who could tell us why we were wrong." They were looking for some persuasive mirror image of themselves. Someone who could tell them why what the market deemed impossible was at least improbable.

  Charlie's challenge was to suck unsuspecting market insiders into arguments before they thought to ask him who he was or what he did. "The consistent reaction whenever we met someone was, like, 'Wait, where did you guys come from?' They were just baffled," said Charlie. "People were like, 'Why are you here?'"

  A guy from a rating agency on whom Charlie tested Cornwall's investment thesis looked at him strangely and asked, "Are you sure you guys know what you're doing?" The market insiders didn't agree with them, but they didn't offer persuasive counter-arguments. Their main argument, in defense of subprime CDOs, was that "the CDO buyer will never go away." Their main argument, in defense of the underlying loans, was that, in their short history, they had never defaulted in meaningful amounts. Above the roulette tables, screens listed the results of the most recent twenty spins of the wheel. Gamblers would see that it had come up black the past eight spins, marvel at the improbability, and feel in their bones that the tiny silver ball was now more likely to land on red. That was the reason the casino bothered to list the wheel's most recent spins: to help gamblers to delude themselves. To give people the false confidence they needed to lay their chips on a roulette table. The entire food chain of intermediaries in the subprime mortgage market was duping itself with the same trick, using the foreshortened, statistically meaningless past to predict the future.

  "Usually, when you do a trade, you can find some smart people on the other side of it," said Ben. "In this instance we couldn't."

  "Nobody we talked to had any credible reason to think this wasn't going to become a big problem," said Charlie. "No one was really thinking about it."

  One of the Bear Stearns CDO guys, after Charlie asked him what was likely to happen to these CDOs in seven years, said, "Seven years? I don't care about seven years. I just need it to last for another two."

  Three months earlier, when Cornwall bought their first $100 million in credit default swaps on the double-A-rated tranches of subprime CDOs, they believed they were making a cheap bet on an unlikely event--$500,000 a year in premium for the chance to make $100,000,000. The market, and the rating agencies, effectively had set the odds of default at 1 in 200. They thought the odds were better than that--say, 1 in 10. Still, it was, like most of their bets, a long shot. An intelligent long shot, perhaps, but a long shot nonetheless. The more they listened to the people who ran the subprime market, the more they felt the collapse of double-A-rated bonds wasn't a long shot at all, but likely. A thought crossed Ben's mind: These people believed that the collapse of the subprime mortgage market was unlikely precisely because it would be such a catastrophe. Nothing so terrible could ever actually happen.

  The first morning of the c
onference, they'd followed a crowd of thousands out of the casino and into the vast main ballroom to attend the opening ceremony. It was meant to be a panel discussion, but of course the men on the panel had little interest in talking to each other and more interest in delivering measured, prepared remarks. They'd watch a dozen of these events over the next three days and all were tedious. This one session was different, though, because its moderator appeared to be drunk, or at least unhinged. His name was John Devaney and he ran a hedge fund that invested in subprime mortgage bonds, United Capital Markets. For a decade now, Devaney had sponsored this conference--called ASF, or the American Securitization Forum, in part because it sounded more dignified than the Association for Subprime Lending. To the extent that the market for subprime mortgage bonds had moral leaders, John Devaney was one. He was also an enthusiastic displayer of his own wealth. He owned a Renoir, a Gulfstream, a helicopter, plus, of course, a yacht. This year he'd paid some huge sum to fly in Jay Leno to serve as the entertainment.

  Now, looking as if he had just rolled in from a night on the town without pausing to take a nap, John Devaney delivered what was clearly an extemporaneous rant about the state of the subprime market. "It was incredible," said Charlie. "Stream of consciousness. He went on about how the ratings agencies were whores. How the securities were worthless. How they all knew it. He gave words to stuff we were just suspecting. It was like he was talking out of school. When he was finished there was complete silence. No one specifically attempted a defense. They just talked around him. It was like everyone pretended he hadn't said it."* On the one hand, it was exhilarating to hear a market insider say what he thought to be true; on the other, if the market became self-aware, its madness couldn't last long. Charlie and Jamie and Ben assumed they had time to think things over before they went out and bought even more credit default swaps on the double-A tranche of subprime CDOs. "That speech spooked us," said Ben. "It seemed rather than six months to get our trade on we had one week."

  The trouble, as ever, was finding Wall Street firms willing to deal with them. Their one source of supply, Bear Stearns, suddenly seemed more interested in shooting than in trading with them. Every other firm treated them as a joke. Cornhole Capital. But here, in Las Vegas, luck found them. To their surprise, they found that the consultant they now employed to analyze CDOs for them, David Burt, enjoyed serious stature in the industry. "David Burt was like God in Vegas," said Charlie. "We started just following him around. 'Hey. That guy you're talking to. We're paying him--can we talk to you too?'" This rented God introduced Charlie to a woman from Morgan Stanley named Stacey Strauss. Her job was to find investors who wanted to buy credit default swaps as quickly as she could. Charlie never figured out why she was willing in the extreme to bend Morgan Stanley's usual standards to do business with Cornwall. Charlie also accosted a man who analyzed the subprime mortgage bond market for Wachovia Bank, who happened to have been on the panel moderated by the shocking John Devaney. During the opening panel discussion, he, like everyone else, had pretended he hadn't heard John Devaney. When Devaney was finished, the Wachovia guy had given his little speech about the fundamental soundness of the subprime mortgage bond market. As he came off the stage, Charlie ambushed him and asked him if maybe Wachovia didn't want to put its money where its mouth was and sell him some credit default swaps.

  The morning after his dinner with Wing Chau, Eisman woke up to his first glimpse of the bond market in the flesh, and a lot of sensationally phony baroque ceiling frescoes. The Venetian hotel--Palazzo Ducale on the outside, Divine Comedy on the inside--was overrun by thousands of white men in business casual now earning their living, one way or another, off subprime mortgages. Like all of Las Vegas, The Venetian was a jangle of seemingly random effects designed to heighten and exploit irrationality: the days that felt like nights and the nights that felt like days; the penny slots and the cash machines that spat out hundred-dollar bills; the grand hotel rooms that cost so little and made you feel so big. The point of all of it was to alter your perception of your chances and your money, and all of it depressed Eisman: He didn't even like to gamble. "I wouldn't know how to calculate odds if my life depended on it," he said. At the end of each day Vinny would head off to play low-stakes poker, Danny would join Lippmann and the other bond people at the craps tables, and Eisman would go to bed. That craps was the game of choice of the bond trader was interesting, though. Craps offered the player the illusion of control--after all, he rolled the dice--and a surface complexity that masked its deeper idiocy. "For some reason, when these people are playing it they actually believe they have the power to make the dice work," said Vinny.

  Thousands and thousands of serious financial professionals, most of whom, just a few years ago, had been doing something else with their lives, were now playing craps with the money they had made off subprime mortgage bonds. The subprime mortgage industry Eisman once knew better than anyone on the planet had been a negligible corner of the capital markets. In just a few years it had somehow become the most powerful engine of profits and employment on Wall Street--and it made no economic sense. "It was like watching an unthinking machine that could not stop itself," he said. He felt as if he had moved into a new house, opened the door to what he presumed was a small closet, and discovered an entirely new wing. "I'd been to equity conferences," said Eisman. "This was totally different. At an equity conference you're lucky if you get five hundred people. There were seven thousand people at this thing. Just the fact that no one from the equity world was there told you that no one had figured it out. We knew no one. We still assumed we were the only ones who were short."

  He had no interest in listening to other people's speeches. He had no interest in attending the panel discussion and hearing the potted remarks. He wanted private sessions with market insiders. Lippmann had introduced them to the people inside Deutsche Bank peddling CDOs to investors, and these helpful Deutsche Bank people had arranged for Eisman and his partners to meet the bond market's financial intermediaries: the mortgage lenders, the banks that packaged the mortgage loans into mortgage bonds, the bankers who repackaged the bonds into CDOs, and the rating agencies that blessed the process at each stage. The only interested parties missing from the conference were the ultimate borrowers, the American home buyers, but even they, in a way, were on hand, serving drinks, spinning wheels, and rolling dice. "Vegas was booming," said Danny. "The homeowners were at the fucking tables." A friend of Danny's returned from a night on the town to report he'd met a stripper with five separate home equity loans.*

  The Deutsche Bank CDO salesman--a fellow named Ryan Stark--had been assigned to keep an eye on Eisman and prevent him from causing trouble. "I started getting these e-mails from him, before the conference," said Danny. "He was nervous about us. It was like, 'I just want to clarify the purpose of the meetings,' and, 'Just to be clear why we're meeting...' He wanted to make sure we knew we remembered that we were there to buy the bonds." Deutsche Bank had even sent along the formal handouts intended for subprime buyers, as a kind of script for them to follow. "The purpose of the conference is to convince people it's still okay to create and to buy this shit," said Danny. "It was unheard of for an equity investor looking to short the bonds to come in and scope the place out for information. The only way we got these one-on-one meetings was by saying that we weren't short. Deutsche Bank escorted us, to make sure we didn't blow up their relationships. They put a salesman in the meeting just to monitor us."

  There was of course no point in trying to monitor Eisman. He saw himself as a crusader, a champion of the underdog, an enemy of sinister authority. He saw himself, roughly speaking, as Spider-Man. He was perfectly aware of how absurd it sounded when, for instance, his wife told people, "My husband thinks he and Spider-Man are living the same life." Eisman didn't go around telling strangers about the shocking number of parallels between himself and Peter Parker--when they had gone to college, what they had studied, when they'd married, and on and on--or that, by the time he
was in law school, he was picking up the latest Spider-Man comic half expecting to discover in it the next turn his life would take. But Eisman was quick to see narratives, he explained the world in stories, and this was one of the stories he used to explain himself.

  The first sign that Spider-Man had no interest in Deutsche Bank's dark dealings came at a speech that morning, given by the CEO of Option One, the mortgage originator owned by H&R Block. Option One had popped onto Eisman's radar screen seven months earlier, in June 2006, when the company announced a surprising loss in its portfolio of subprime mortgage loans. The loss was surprising because Option One was in the business of making loans and selling them off to Wall Street--they weren't meant to be taking risk. In these deals, however, there was a provision that allowed Wall Street to put the loans back to Option One if the borrowers failed to make their first payment. "Who takes out a home loan and doesn't make the first payment?" asked Danny Moses, putting the matter one way. "Who the fuck lends money to people who can't make the first payment?" asked Eisman, putting it another.

  When the CEO of Option One got to the part of his speech about Option One's subprime loan portfolio, he claimed that the company had put its problems behind it and was now expecting a (modest) loss rate on its loans of 5 percent. Eisman raised his hand. Moses and Daniel sank in their chairs. "It wasn't a Q&A," says Moses. "The guy was giving a speech. He sees Steve's hand and says, 'Yes?'"