The Big Short: Inside the Doomsday Machine

by Michael Lewis

  The moment Salomon Brothers demonstrated the potential gains to be had from turning an investment bank into a public corporation and leveraging its balance sheet with exotic risks, the psychological foundations of Wall Street shifted, from trust to blind faith. No investment bank owned by its employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs. I doubt any partnership would have sought to game the rating agencies, or leapt into bed with loan sharks, or even allowed mezzanine CDOs to be sold to its customers. The short-term expected gain would not have justified the long-term expected loss.

  No partnership, for that matter, would have hired me, or anyone remotely like me. Was there ever any correlation between an ability to get into, and out of, Princeton, and a talent for taking financial risk?

  At the top of Charlie Ledley's list of concerns, after Cornwall Capital had laid its bets against subprime loans, was that the powers that be might step in at any time to prevent individual American subprime mortgage borrowers from failing. The powers that be never did that, of course. Instead they stepped in to prevent the failure of the big Wall Street firms that had contrived to bankrupt themselves by making a lot of dumb bets on subprime borrowers.

  After Bear Stearns failed, the government encouraged J.P. Morgan to buy it by offering a knockdown price and guaranteeing Bear Stearns's shakiest assets. Bear Stearns bondholders were made whole and its stockholders lost most of their money. Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, and creditors left intact but with some uncertainty. Next came Lehman Brothers, which was simply allowed to go bankrupt--whereupon things became even more complicated. At first, the Treasury and the Federal Reserve claimed they allowed Lehman to fail to send the signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when all hell broke loose, and the market froze, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue Lehman. But then AIG failed a few days later, or tried to, before the Federal Reserve extended it a loan of $85 billion--soon increased to $180 billion--to cover the losses from its bets on subprime mortgage bonds. This time the Treasury charged a lot for the loans and took most of the equity. Washington Mutual followed, and was unceremoniously seized by the Treasury, wiping out both its creditors and its shareholders entirely. And then Wachovia failed, and the Treasury and FDIC encouraged Citigroup to buy it--again at a knockdown price and with a guarantee of the bad assets.

  The people in a position to resolve the financial crisis were, of course, the very same people who had failed to foresee it: Treasury Secretary Henry Paulson, future Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke, Goldman Sachs CEO Lloyd Blankfein, Morgan Stanley CEO John Mack, Citigroup CEO Vikram Pandit, and so on. A few Wall Street CEOs had been fired for their roles in the subprime mortgage catastrophe, but most remained in their jobs, and they, of all people, became important characters operating behind the closed doors, trying to figure out what to do next. With them were a handful of government officials--the same government officials who should have known a lot more about what Wall Street firms were doing, back when they were doing it. All shared a distinction: They had proven far less capable of grasping basic truths in the heart of the U.S. financial system than a one-eyed money manager with Asperger's syndrome.

  By late September 2008 the nation's highest financial official, U.S. Treasury Secretary Henry Paulson, persuaded the U.S. Congress that he needed $700 billion to buy subprime mortgage assets from banks. Thus was born TARP, which stood for Troubled Asset Relief Program. Once handed the money, Paulson abandoned his promised strategy and instead essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs, and a few others unnaturally selected for survival. For instance, the $13 billion AIG owed to Goldman Sachs, as a result of its bet on subprime mortgage loans, was paid off in full by the U.S. government: 100 cents on the dollar. These fantastic handouts--plus the implicit government guarantee that came with them--not only prevented Wall Street firms from failing but spared them from recognizing the losses in their subprime mortgage portfolios. Even so, just weeks after receiving its first $25 billion taxpayer investment, Citigroup returned to the Treasury to confess that--lo!--the markets still didn't trust Citigroup to survive. In response, on November 24, the Treasury granted another $20 billion from TARP and simply guaranteed $306 billion of Citigroup's assets. Treasury didn't ask for a piece of the action, or management changes, or for that matter anything at all except for a teaspoon of out-of-the-money warrants and preferred stock. The $306 billion guarantee--nearly 2 percent of U.S. gross domestic product, and roughly the combined budgets of the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development, and Transportation--was presented undisguised, as a gift. The Treasury didn't ever actually get around to explaining what the crisis was, just that the action was taken in response to Citigroup's "declining stock price."

  By then it was clear that $700 billion was a sum insufficient to grapple with the troubled assets acquired over the previous few years by Wall Street bond traders. That's when the U.S. Federal Reserve took the shocking and unprecedented step of buying bad subprime mortgage bonds directly from the banks. By early 2009 the risks and losses associated with more than a trillion dollars' worth of bad investments were transferred from big Wall Street firms to the U.S. taxpayer. Henry Paulson and Timothy Geithner both claimed that the chaos and panic caused by the failure of Lehman Brothers proved to them that the system could not tolerate the chaotic failure of another big financial firm. They further claimed, albeit not until months after the fact, that they had lacked the legal authority to wind down giant financial firms in an orderly manner--that is, to put a bankrupt bank out of business. Yet even a year later they would have done very little to acquire that power. This was curious, as they obviously weren't shy about asking for power.

  The events on Wall Street in 2008 were soon reframed, not just by Wall Street leaders but also by both the U.S. Treasury and the Federal Reserve, as a "crisis in confidence." A simple, old-fashioned financial panic, triggered by the failure of Lehman Brothers. By August 2009 the president of Goldman Sachs, Gary Cohn, even claimed, publicly, that Goldman Sachs had never actually needed government help, as Goldman had been strong enough to withstand any temporary panic. But there's a difference between an old-fashioned financial panic and what had happened on Wall Street in 2008. In an old-fashioned panic, perception creates its own reality: Someone shouts "Fire!" in a crowded theater and the audience crushes each other to death in its rush for the exits. On Wall Street in 2008 the reality finally overwhelmed perceptions: A crowded theater burned down with a lot of people still in their seats. Every major firm on Wall Street was either bankrupt or fatally intertwined with a bankrupt system. The problem wasn't that Lehman Brothers had been allowed to fail. The problem was that Lehman Brothers had been allowed to succeed.

  This new regime--free money for capitalists, free markets for everyone else--plus the more or less instant rewriting of financial history vexed all sorts of people, but few were as enthusiastically vexed as Steve Eisman. The world's most powerful and most highly paid financiers had been entirely discredited; without government intervention every single one of them would have lost his job; and yet those same financiers were using the government to enrich themselves. "I can understand why Goldman Sachs would want to be included in the conversation about what to do about Wall Street," he said. "What I can't understand is why anyone would listen to them." In Eisman's view, the unwillingness of the U.S. government to allow the bankers to fail was less a solution than a symptom of a still deeply dysfunctional financial system. The problem wasn't that the banks were, in and of themselves, critical to the success of the U.S. economy. The problem, he felt certain, was that some ga
rgantuan, unknown dollar amount of credit default swaps had been bought and sold on every one of them. "There's no limit to the risk in the market," he said. "A bank with a market capitalization of one billion dollars might have one trillion dollars' worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!" The failure of, say, Citigroup might be economically tolerable. It would trigger losses to Citigroup's shareholders, bondholders, and employees--but the sums involved were known to all. Citigroup's failure, however, would also trigger the payoff of a massive bet of unknown dimensions: from people who had sold credit default swaps on Citigroup to those who had bought them.

  This was yet another consequence of turning Wall Street partnerships into public corporations: It turned them into objects of speculation. It was no longer the social and economic relevance of a bank that rendered it too big to fail, but the number of side bets that had been made upon it.

  At some point I could not help but ask John Gutfreund about his biggest and most fateful act: Combing through the rubble of the avalanche, the decision to turn the Wall Street partnership into a public corporation looked a lot like the first pebble kicked off the top of the hill. "Yes," he said. "They--the heads of the other Wall Street firms--all said what an awful thing it was to go public and how could you do such a thing. But when the temptation rose, they all gave in to it." He agreed, though: The main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. "When things go wrong it's their problem," he said--and obviously not theirs alone. When the Wall Street investment bank screwed up badly enough, its risks became the problem of the United States government. "It's laissez-faire until you get in deep shit," he said, with a half chuckle. He was out of the game. It was now all someone else's fault.

  He watched me curiously as I scribbled down his words. "What's this for?" he asked.

  I told him that I thought it might be worth revisiting the world I'd described in Liar's Poker, now that it was finally dying. Maybe bring out a twentieth anniversary edition.

  "That's nauseating," he said.

  Hard as it was for him to enjoy my company, it was harder for me not to enjoy his: He was still tough, straight, and blunt as a butcher. He'd helped to create a monster but he still had in him a lot of the old Wall Street, where people said things like "a man's word is his bond." On that Wall Street people didn't walk out of their firms and cause trouble for their former bosses by writing a book about them. "No," he said, "I think we can agree about this: Your fucking book destroyed my career and it made yours." With that, the former king of a former Wall Street lifted the plate that held his appetizer and asked, sweetly, "Would you like a deviled egg?"

  Until that moment I hadn't paid much attention to what he'd been eating. Now I saw he'd ordered the best thing in the house, this gorgeous, frothy confection of an earlier age. Who ever dreamed up the deviled egg? Who knew that a simple egg could be made so complicated, and yet so appealing? I reached over and took one. Something for nothing. It never loses its charm.

  Acknowledgments

  My editor at the now deceased Portfolio, Kyle Pope, encouraged me at the start, as I set off to retrace my steps back to Wall Street. Brandon Adams generously offered his help digging out strange facts and figures and proved to be so smart about the subject that I half-wondered if perhaps he, instead of I, should be writing the book. Among other treasures he unearthed was A. K. Barnett-Hart, a Harvard undergraduate who had just written a thesis about the market for subprime mortgage-backed CDOs that remains more interesting than any single piece of Wall Street research on the subject. Marc Rosenthal served as my jungle guide in the netherworld of subprime lending, and the inner workings of the rating agencies' models, and could not have been more generous with his time or his insight. Al Zuckerman, at Writers House, represented this book ably, as he has my others. Several people read all or part of this manuscript and offered useful advice: John Seo, Doug Stumpf, my father, Tom Lewis, and my wife, Tabitha Soren. Janet Byrne performed an almost startlingly thorough, energetic, and intelligent job copyediting the manuscript, and also proved to be an ideal reader. Starling Lawrence at W. W. Norton, who has edited all but one of my books, and who edited Liar's Poker, was his usual wise and wonderful self.

  I've found it impossible to write a decent nonfiction narrative without unusually deep cooperation from my subjects. Steve Eisman, Michael Burry, Charlie Ledley, Jamie Mai, Vincent Daniel, Danny Moses, Porter Collins, and Ben Hockett allowed me to enter their lives. At some unquantifiable risk to themselves, they shared with me their thoughts and feelings. For that I'm eternally grateful.

  * United Jewish Appeal.

  * ISDA had been created back in 1986, by my bosses at Salomon Brothers, to deal with the immediate problem of an innovation called an interest rate swap. What seemed like a simple trade to the people doing it--I pay you a fixed rate of interest in exchange for your paying me a floating rate--wound up needing a blizzard of rules to govern it. Beneath the rules was the simple fear that the party on the other side of a Wall Street firm's interest rate swap might go bust and fail to pay off its bets. The interest rate swap, like the credit default swap, exposed Wall Street firms to other people's credit, and other people to the credit of Wall Street firms, in new ways.

  * The two major rating agencies employ slightly different terminology to convey the same idea. What Standard & Poor's denotes as AAA, for instance, Moody's denotes as Aaa, but both terms describe a bond judged to have the least risk of default. For simplicity's sake, the text will use only the S&P terms, and AAA will be called triple-A, and so forth.

  In 2008, when the ratings of a giant pile of subprime-related bonds proved meaningless, their intended meanings were hotly disputed. Wall Street investors had long interpreted them to mean the odds of default. For instance, a bond rated triple-A historically had less than a 1-in-10,000 chance of defaulting in its first year of existence. A bond rated double-A--the next highest rating--stood less than a 1-in-1,000 chance of default, and a bond rated triple-B, less than a 1-in-500 chance of default. In 2008, the rating agencies would claim that they never intended for their ratings to be taken as such precise measurements. Ratings were merely the agencies' best guess at a rank ordering of risk.

  * These losses turned not only on how many borrowers defaulted, but also on the cost of each default. After all, the lender held the collateral of the house. As a rule of thumb, in the event of default, the lender collected roughly 50 cents on the dollar. And so roughly 16 percent of the borrowers in a mortgage pool needed to default for the pool to experience losses of 8 percent.

  * The story of how and why they did this has been painstakingly told by Financial Times journalist Gillian Tett, in her book Fool's Gold.

  * London Interbank Offered Rate--the interest rate at which banks will lend money to each other. Once thought more or less riskless, it is now, more or less, not.

  * Dear Reader: If you have followed the story this far, you deserve not only a gold star but an answer to a complicated question: If Mike Burry was the only one buying credit default swaps on subprime mortgage bonds, and he bought a billion dollars' worth of them, who took the other $19 billion or so on the short side of the trade with AIG? The answer is, first, Mike Burry soon was joined by others, including Goldman Sachs itself--and so Goldman was in the position of selling bonds to its customers created by its own traders, so they might bet against them. Secondly, there was a crude, messy, slow, but acceptable substitute for Mike Burry's credit default swaps: the actual cash bonds. According to a former Goldman derivatives trader, Goldman would buy the triple-A tranche of some CDO, pair it off with the credit default swaps AIG sold Goldman that insured the tranche (at a cost well below the yield on the tranche), declare the entire package risk-free, and hold it off its balance sheet. Of course, the whole thing wasn't risk-free: If AIG went bust, the insurance was worthless, and Goldman could lose everything. Today Goldman Sachs is, to put it mildly, u
nhelpful when asked to explain exactly what it did, and this lack of transparency extends to its own shareholders. "If a team of forensic accountants went over Goldman's books, they'd be shocked at just how good Goldman is at hiding things," says one former AIG FP employee, who helped to unravel the mess, and who was intimate with his Goldman counterparts.

  * Zelman alienated her Wall Street employer with her pessimism, and finally quit and set up her own consulting firm. "It wasn't that hard in hindsight to see it," she says. "It was very hard to know when it would stop." Zelman spoke occasionally with Eisman, and always left these conversations feeling better about her views, and worse about the world. "You needed the occasional assurance that you weren't nuts," she says.

  * Confusingly, subprime mortgage bonds are classified not as mortgage bonds but, along with bonds backed by credit card loans, auto loans, and other, wackier collateral, as "asset-backed securities."