The Big Short: Inside the Doomsday Machine

by Michael Lewis

  "Would you say that five percent is a probability or a possibility?" asked Eisman.

  A probability, said the CEO, and went back to giving his speech.

  Eisman had his hand up in the air again, waving it around. Oh no, thought Moses, and sank deeper in his chair. "The one thing Steve always says is that you must assume they are lying to you," said Daniel. "They will always lie to you." Danny and Vinny both knew what Eisman thought of these subprime lenders, but didn't see the need for him to express it here, in this manner. For Steve wasn't raising his hand to ask a question. Steve had his thumb and index finger in a big circle. Steve was using his fingers to speak on his behalf. "Zero!" they said.

  "Yes?" asked the obviously irritated CEO. "Is that another question?"

  "No," said Eisman. "It's a zero. There is zero probability that your default rate will be five percent." The losses on subprime loans would be far, far greater. Before the guy could reply, Eisman's cell phone rang. Rather than shut it down, Eisman reached in his pocket and answered it. "Excuse me," he said, standing up. "But I need to take this call." And with that, he walked out of the speech. The caller was his wife.

  "It wasn't important at all," she says with a sigh. "I was a prop."

  After that something must have come over Eisman, for he stopped looking for a fight and started looking for higher understanding. He walked around the Las Vegas casino incredulous at the spectacle before him: seven thousand people, all of whom seemed delighted with the world as they found it. A society with deep, troubling economic problems had rigged itself to disguise those problems, and the chief beneficiaries of the deceit were its financial middlemen. How could this be? Eisman actually wondered, albeit very briefly, if he was missing something. "He kept saying, 'What the hell is going on here? Who the fuck are all these people?'" said Danny Moses. The short answer to that second question was: the optimists. The subprime mortgage market in its current incarnation never had done anything but rise. The people in it who were regarded as successes were those who had always said "buy." Now they should really all be saying "sell," but they didn't know how to do it. "You always knew that fixed income guys thought they knew more than you did," said Eisman, "and generally that was true. I wasn't a fixed income guy, but here I'd taken this position that was a bet against their whole industry, and I wanted to know if they know something I don't. Could it really be this obvious? Could it really be this simple?" He entered private meetings with the lenders and the bankers and the rating agencies probing for an intelligence he had yet to detect. "He was in learning mode," said Vinny. "When he's fascinated about a subject, his curiosity becomes far more important than being confrontational. He'll claim it was years of therapy that enabled him to behave, but the truth is it was the first time he was connecting all the dots."

  Much of Steve Eisman wanted to believe the worst, and that gave him a huge tactical advantage in the U.S. financial markets circa 2007. There was still some part of him, however, that was as credulous as the little kid who lent his new bike to a total stranger. He was still capable of being shocked. His experience with Household Finance had disabused him of any hope that the government would intercede to prevent rich corporations from doing bad things to poor people. Inside the free market, however, there might be some authority capable of checking its excess. The rating agencies, in theory, were just such an authority. As the securities became more complex, the rating agencies became more necessary. Everyone could evaluate a U.S. Treasury bond; hardly anyone could understand a subprime mortgage-backed CDO. There was a natural role for an independent arbiter to pass judgment on these opaque piles of risky loans. "In Vegas it became clear to me that this entire huge industry was just trusting in the ratings," Eisman said. "Everyone believed in the ratings, so they didn't have to think about it."

  Eisman had worked on Wall Street for nearly two decades, but, like most stock market people, he'd never before sat down with anyone from Moody's or Standard & Poor's. Unless they covered insurance companies, which lost their ability to sell their product the moment their ability to meet their obligations was thrown into doubt, stock market people didn't pay much attention to the rating agencies. Now Eisman had his first exchanges with them, and what struck him immediately--and struck Danny and Vinny, too--was the caliber of their employees. "You know how when you walk into a post office you realize there is such a difference between a government employee and other people," said Vinny. "The ratings agency people were all like government employees." Collectively they had more power than anyone in the bond markets, but individually they were nobodies. "They're underpaid," said Eisman. "The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for. There should be no greater thing you can do as an analyst than to be the Moody's analyst. It should be, 'I can't go higher as an analyst.' Instead it's the bottom! No one gives a fuck if Goldman likes General Electric paper. If Moody's downgrades GE paper, it is a big deal. So why does the guy at Moody's want to work at Goldman Sachs? The guy who is the bank analyst at Goldman Sachs should want to go to Moody's. It should be that elite."

  The entire industry had been floated on the backs of the rating agencies, but the people who worked at the rating agencies barely belonged in the industry. If they roamed the halls they might be mistaken, just, for some low-level commercial bankers at Wells Fargo, or flunkies at mortgage lenders, such as Option One: nine-to-fivers. They wore suits in Vegas, which told you half of what you needed to know about them--the other half you got from the price of those suits. Just about everyone else dressed business casual; the few guys who were actually important people wore three-thousand-dollar Italian suits. (One of the mysteries of the Wall Street male was that he was ignorant of the finer points of couture but could still tell in an instant how much another Wall Street male's suit had cost.) The rating agencies guys wore blue suits from J.C. Penney, with ties that matched too well, and shirts that were starched just a bit too stiffly. They weren't players and they didn't know the people who were, either. They got paid to rate the bonds of Lehman and Bear Stearns and Goldman Sachs, but they couldn't tell you the names of, or any of the other important facts about, the guys at Lehman and Bear Stearns and Goldman Sachs who were making a fortune exploiting loopholes in the rating agencies' models. They appeared to know enough to justify their jobs, and nothing more. They seemed timid, fearful, and risk-averse. As Danny put it, "You wouldn't see them at the craps table."

  It was in Vegas that Eisman realized that "all the stuff I was worried about, the ratings agencies didn't care. I remember sitting there thinking, Jeez, this is really pathetic. You know when you're with someone who is intellectually powerful: You just know it. When you sit down with Richard Posner [the legal scholar], you know it's Richard Posner. When you sit down with the ratings agencies you know it's the ratings agencies." To judge from their behavior, all the rating agencies worried about was maximizing the number of deals they rated for Wall Street investment banks, and the fees they collected from them. Moody's, once a private company, had gone public in 2000. Since then its revenues had boomed, from $800 million in 2001 to $2.03 billion in 2006. Some huge percentage of the increase--more than half, certainly, but exactly how much more than half they declined to tell Eisman--flowed from the arcane end of the home finance sector, known as structured finance. The surest way to attract structured finance business was to accept the assumptions of the structured finance industry. "We asked everyone the same two questions," said Vinny. "What is your assumption about home prices, and what is your assumption about loan losses." Both rating agencies said they expected home prices to rise and loan losses to be around 5 percent--which, if true, meant that even the lowest-rated, triple-B, subprime mortgage bonds crafted from them were money-good. "It was like everyone had agreed in advance that five percent was the number," said Eisman. "They all said five percent. It was a party and there was a party line."* What shocked Eisman was that none of the people he met in Las Vegas seemed to have wrestled with an
ything. They were doing what they were doing without thinking very much about it.

  It was in Las Vegas that Eisman and his associates' attitude toward the U.S. bond market hardened into something like its final shape. As Vinny put it, "That was the moment when we said, 'Holy shit, this isn't just credit. This is a fictitious Ponzi scheme.'" In Vegas the question lingering at the back of their minds ceased to be, Do these bond market people know something we do not? It was replaced by, Do they deserve merely to be fired, or should they be put in jail? Are they delusional, or do they know what they're doing? Danny thought that the vast majority of the people in the industry were blinded by their interests and failed to see the risks they had created. Vinny, always darker, said, "There were more morons than crooks, but the crooks were higher up." The rating agencies were about as low as you could go and still be in the industry, and the people who worked for them really did not seem to know just how badly they had been gamed by big Wall Street firms. Their meeting in Las Vegas with the third and smallest rating agency, Fitch Ratings, stuck in Vinny's mind. "I know you're sort of irrelevant," he'd said to them, as politely as he could. "There are these two big guys everyone pays attention to, and then there is you. If you want to make a statement--and get people to notice you--why don't you go your own way and be the honest one?" He expected the good people of Fitch Ratings service to see the point, and maybe even chuckle nervously. Instead they seemed almost offended. "They went all pure on me," said Vinny. "It was like they didn't understand what I was saying."

  They had left for Las Vegas with a short position in subprime mortgage bonds of a bit less than $300 million. Upon their return they raised it to $550 million, with new bets against the CDOs created by Wing Chau. With only $500 million under management, the position now overwhelmed their portfolio. They didn't stop there, however. Their first day back in the office, they shorted the stock of Moody's Corporation, at $73.25 a share, then went searching for other companies and other people, like Wing Chau, on the other side of their trade.

  CHAPTER SEVEN

  The Great Treasure Hunt

  Charlie Ledley and Ben Hockett returned from Las Vegas on January 30, 2007, convinced that the entire financial system had lost its mind. "I said to my mother, 'I think we might be facing something like the end of democratic capitalism,'" said Charlie. "She just said, 'Oh, Charlie,' and seriously suggested I go on lithium." They had created an investment approach that harnessed their talent for distancing themselves from other people's convictions; to find such great conviction in themselves was new and uncomfortable. Jamie penned a memo to his two partners, in which he asked them if they were making a bet on the collapse of a society--and therefore a bet that the government would never allow to succeed. "If a broad range of CDO spreads starts to widen," he wrote,* "it means that a material global financial clusterfuck is likely occurring.... The U.S. Fed is in a position to fix the problem by intervening.... I guess the question is, How wide would the meltdown need to be in order to be 'too big to fail'?"

  The conference in Las Vegas had been created, among other things, to boost faith in the market. The day after the subprime mortgage market insiders left Las Vegas and returned to their trading desks, the market cracked. On January 31, 2007, the ABX, a publicly traded index of triple-B-rated subprime mortgage bonds--exactly the sort of bonds used to create subprime CDOs--fell more than a point, from 93.03 to 91.98. For the past several months, it had drifted down in such tiny increments, from 100 to 93, that a full point move came as shocking--and heightened Charlie's anxiety that they'd discovered this sensational trade a moment too late to wager as much on it as they should. The woman from Morgan Stanley was, at first, true to her word: She pushed through their ISDA agreement, which would normally have taken months of negotiations, in ten days. She sent Charlie a list of double-A tranches of CDOs on which Morgan Stanley was willing to sell them credit default swaps.* Charlie stayed up nights figuring out which ones to bet against, and then called her up to find that Morgan Stanley had experienced a change of heart. She had told Charlie that he could buy insurance for around 100 basis points (1 percent of the insured amount a year), but when he called up the next morning to do the trade, the price had more than doubled. Charlie bitched and moaned about the unfairness of it and she and her bosses caved, a bit. On February 16, 2007, Cornwall paid Morgan Stanley 150 basis points to buy $10 million in credit default swaps on a CDO cryptically called Gulfstream, whatever that was.

  Five days later, on February 21, the market began to trade an index of CDOs called the TABX. For the first time, Charlie Ledley, and everyone else in the market, was able to see on a screen the price of one of these CDOs. The price confirmed Cornwall's thesis in a way that no amount of conversation with market insiders ever could have. After the first day of trading, the tranche that took losses when the underlying bonds experienced losses of more than 15 percent of the pool--the double-A-rated tranche that Cornwall had bet against--closed at 49.25: It had lost more than half its value. There was now this huge disconnect: With one hand the Wall Street firms were selling low interest rate-bearing double-A-rated CDOs at par, or 100; with the other they were trading this index composed of those very same bonds for 49 cents on the dollar. In a flurry of e-mails, their salespeople at Morgan Stanley and Deutsche Bank tried to explain to Charlie that he should not deduce anything about the value of his bets against subprime CDOs from the prices on these new, publicly traded subprime CDOs. That it was all very complicated.

  The next morning Charlie called back Morgan Stanley in hopes of buying more insurance. "She was like, 'I'm really, really sorry but we're not doing any more of this. The firm's changed its mind.'" Overnight, Morgan Stanley had gone from being wildly eager to sell insurance on the subprime mortgage market to not wanting to do it at all. "Then she puts us on the phone with her boss--because we were like, 'What the fuck is going on?'--and he's like, 'Look, I'm really sorry, but something has happened in another arm of the bank that's caused some kind of risk management decision at the very highest levels of Morgan Stanley.' And we never traded with them again." Charlie had no idea what exactly had awakened inside Morgan Stanley, and didn't think too much about it--he and Ben were too busy trying to talk the guy from Wachovia whom Charlie had pounced on in Las Vegas into dealing with Cornwall Capital. "They didn't have one hedge fund client, and they were sort of excited to see us," said Ben. "They were trying to be big-time." Wachovia, amazingly, remained willing to sell cheap insurance on subprime mortgage bonds; the risk its credit officers were unwilling to take was the risk of dealing directly with Cornwall Capital. It took a while, but Charlie arranged for his Uzi-shooting companions from Bear Stearns to sit in the middle between the two parties, for a fee. The details of a $45 million trade more or less agreed upon in February 2007 took several months to hammer out, and the trade didn't go through until early May. "Wachovia was a gift from God," said Ben. "It was like we were in a plane at thirty thousand feet, which had stalled, and Wachovia still had a few parachutes for sale. No one else was still selling parachutes, but no one really wanted to believe they were needed, either.... After that, the market completely shut down."

  In a portfolio of less than $30 million, Cornwall Capital now owned $205 million in credit default swaps on subprime mortgage bonds, and were disturbed mainly that they didn't own more. "We were doing everything we possibly could to buy more," said Charlie. "We'd put in our bids at the offering prices. They'd call back and say, 'Oops, you almost got it!' It was very sort of Charlie Brown and Lucy. We'd go up to kick the football and they'd pull it back. We'd raise our bid and the minute we did their offer would jump up."

  It made no sense: The subprime CDO market was ticking along as it had before, and yet the big Wall Street firms suddenly had no use for the investors who had been supplying the machine with raw material--the investors who wanted to buy credit default swaps. "Ostensibly other people were going long, but we were not allowed to go short," said Charlie.

  He couldn't know for s
ure what was happening inside the big firms, but he could guess: Some of the traders on the inside had woken up to the impending disaster and were scrambling to get out of the market before it collapsed. "With the Bear guys I had this suspicion that, if there were any credit default swaps on CDOs to buy, they were buying it for themselves," said Charlie. At the end of February a Bear Stearns analyst named Gyan Sinha published a long treatise arguing that the recent declines in subprime mortgage bonds had nothing to do with the quality of the bonds and everything to do with "market sentiment." Charlie read it thinking that the person who wrote it had no idea what was actually happening in the market. According to the Bear Stearns analyst, double-A CDOs were trading at 75 basis points above the risk-free rate--that is, Charlie should have been able to buy credit default swaps for 0.75 percent in premiums a year. The Bear Stearns traders, by contrast, weren't willing to sell them to him for five times that price. "I called the guy up and said, 'What the fuck are you talking about?' He said, "Well, this is where the deals are printing.' I asked him, 'Are desks actually buying and selling at that price?' And he says, 'Gotta go,' and hung up."

  Their trade now seemed to them ridiculously obvious--it was as if they had bought cheap fire insurance on a house engulfed in flames. If the subprime mortgage market had the slightest interest in being efficient, it would have shut down right there and then. For more than eighteen months, from mid-2005 until early 2007, there had been this growing disconnect between the price of subprime mortgage bonds and the value of the loans underpinning them. In late January 2007 the bonds--or rather, the ABX index made up of the bonds--began to fall in price. The bonds fell at first steadily but then rapidly--by early June, the index of triple-B-rated subprime bonds was closing in the high 60s--which is to say the bonds had lost more than 30 percent of their original value. It stood to reason that the CDOs, which were created out of these triple-B-rated subprime bonds, should collapse, too. If the oranges were rotten, the orange juice was also rotten.