The Big Short by Michael Lewis: Summary & Notes

Rating: 9/10

Available at: Amazon

Related: Liar’s Poker, Going Infinite, Flash Boys


An awesome book. The Big Short tells the story of the 2008 financial crisis in such an entertaining form that only Michael Lewis could have written it.

His first book, Liar’s Poker, unwittingly sets the stage for this crisis, and so I would recommend reading the pair together, in order.

The story of the financial crisis is one of misaligned incentives, misunderstood risk, and the issues with our current financial system that allow such things to happen. Everyone who invests at all should read this book, in hopes of better understanding the players and risk that exist in investing.


  • History doesn’t repeat itself but it rhymes: the bond trading craze in the 1980s set the stage for the mortgage backed securities crisis, and the motivators in both cases were similar.
  • It can be very lucrative to take advantage of a trend or market in the short term. The trick is knowing when to get out.
  • Whenever there are powerful financial incentives for one outcome over another, be very careful. Ratings agencies were good examples of those who fell prey to this kind of pressure before the crisis.
  • Ask “Can you explain that to me in simpler terms?” a lot of times, and you’re guaranteed to learn something, including whether the person you’re talking to knows what they’re talking about.
  • Beware floating-rate loans and make sure you do the math on what that loan might cost if interest rates change dramatically.
  • Good situations to look for are those with a fixed downside, and a much higher, non-fixed upside. The credit default swaps that Michael Burry bought to bet against subprime mortgage bonds were these type of bets.
  • Incentives drive behaviour. If you want to influence behavior, change the incentives. And if you want to show others you’re serious about your behavior, align your incentives. Burry didn’t make any money off his investors’ money until he made money for them first.
  • People—especially people investing—don’t like risk, and don’t like to think about bad things happening. That means that you can gain an edge if you can better assess the risk, and are willing to think deeply about bad things happening.
  • Credit card delinquencies and mortgage-related fraud are two predictors of bubbles, and indications that people are no longer able to meet their obligations.
  • Once you become the defender of an idea, it becomes much harder to change your mind about it. Beware debates where you have to become the defender.
  • Selling is a skill central to every industry. In investing, you need to sell your ideas to investors, in a way that is compelling but doesn’t give them all the tools to do it themselves.
  • Complexity and opacity are the hallmarks of an informational advantage, and therefore what investors love. Beware them if you are on the other side though, as there is likely risk you are not seeing, or you are being taken advantage of in some other way (like price).
  • Banks and traders are often not the ones assuming the ultimate risk; they are merely brokers. In the sub-prime crisis, Goldman was selling the credit default swaps, but the triple-A rated insurance company AIG (American Insurance Group) was actually on the other side of the bet.
  • Historically, the ratio of median home price to income in the US has been around 3:1. Though this varies widely across the country, in late 2004 it was 4:1 nationally, 10:1 in LA, and 8.5:1 in Miami.
  • Another way to view home prices: the value-to-gross rental ratio. The rule of thumb is that you buy at ten and sell at twenty.
  • One pair that made a ton of money during the crisis were Jamie Mai and Charlie Ledley, who started their own money management firm at age 30, with $110K in the bank.
  • When the value of a stock obviously turns on some upcoming event whose date was known, options are a good way to have higher upside with limited downside than simply buying the stock.
  • Black-Scholes option pricing models don’t make much sense for pricing options because they use a bell curve to predict the chance of the stock moving to a certain price.
  • If something looks too good to be true, it probably is. And if it isn’t, it might be a huge opportunity.
  • Past performance is no guarantee of future performance. The turkey problem is prevalent particularly in financial markets where the incentives are to keep things going the way they are.
  • Credit quality gets better in March and April because that’s when people get their tax refunds.
  • The incentives of a public corporation are far different than that of a partnership, where more people have skin in the game. Salomon Brothers was the first example, and the bailing out of banks means that people know they can aim to make a profit by any means necessary, without considering the risk, and will be bailed out by the government if they fail.

Detailed Notes

PROLOGUE: Poltergeist

What I never imagined is that the future reader might look back on any of this, or on my own peculiar experience, and say, "How quaint." How innocent. Not for a moment did I suspect that the financial 1980s would last for two full decades longer, or that the difference in degree between Wall Street and ordinary economic life would swell to a difference in kind. That a single bond trader might be paid $47 million a year and feel cheated. That the mortgage bond market invented on the Salomon Brothers trading floor, which seemed like such a good idea at the time, would lead to the most purely financial economic disaster in history. That exactly twenty years after Howie Rubin became a scandalous household name for losing $250 million, another mortgage bond trader named Howie, inside Morgan Stanley, would lose $9 billion on a single mortgage trade, and remain essentially unknown, without anyone beyond a small circle inside Morgan Stanley ever hearing about what he'd done, or why.

When I sat down to write my first book, I had no great agenda, apart from telling what I took to be a remarkable tale. If you'd gotten a few drinks in me and then asked what effect the book would have on the world, I might have said something like, "I hope that college students trying to decide what to do with their lives might read it and decide that it's silly to phony it up, and abandon their passions or even their faint interests, to become financiers." I hoped that some bright kid at Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Goldman Sachs, and set out to sea.

In the two decades after I left, I waited for the end of Wall Street as I had known it. The outrageous bonuses, the endless parade of rogue traders, the scandal that sank Drexel Burnham, the scandal that destroyed John Gutfreund and finished off Salomon Brothers, the crisis following the collapse of my old boss John Meriwether's Long-Term Capital Management, the Internet bubble: Over and over again, the financial system was, in some narrow way, discredited. Yet the big Wall Street banks at the center of it just kept on growing, along with the sums of money that they doled out to twenty-six-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents' world when you can buy it and sell off the pieces?

At some point I couldn't contain myself: I called Meredith Whitney. This was back in March 2008, just before the failure of Bear Stearns, when the outcome still hung in the balance. I thought, If she's right, this really could be the moment when the financial world gets put back into the box from which it escaped in the early 1980s. I was curious to see if she made sense, but also to know where this young woman who was crashing the stock market with her every utterance had come from.

She'd arrived on Wall Street in 1994, out of the Brown University Department of English. "I got to New York and I didn't even know research existed," she says. She'd wound up landing a job at Oppenheimer and Co. and then had the most incredible piece of luck: to be trained by a man who helped her to establish not merely a career but a worldview. His name, she said, was Steve Eisman. "After I made the Citi call," she said, "one of the best things that happened was when Steve called and told me how proud he was of me." Having never heard of Steve Eisman, I didn't think anything of this.

But then I read the news that a little-known New York hedge fund manager named John Paulson had made $20 billion or so for his investors and nearly $4 billion for himself. This was more money than anyone had ever made so quickly on Wall Street. Moreover, he had done it by betting against the very subprime mortgage bonds now sinking Citigroup and every other big Wall Street investment bank

CHAPTER ONE: A Secret Origin Story

Eisman's parents, old-fashioned value investors at heart, had always told him that the best way to learn about Wall Street was to work as an equity analyst. He started in equity analysis, working for the people who shaped public opinion about public companies.

Eisman quickly established himself as one of the few analysts at Oppenheimer whose opinions might stir the markets. "It was like going back to school for me," he said. "I would learn about an industry and I would go and write a paper about it."

The mortgage bond was different in important ways from old-fashioned corporate and government bonds. A mortgage bond wasn't a single giant loan for an explicit fixed term. A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages. These cash flows were always problematic, as the borrowers had the right to pay off any time they pleased. This was the single biggest reason that bond investors initially had been reluctant to invest in home mortgage loans: Mortgage borrowers typically repaid their loans only when interest rates fell, and they could refinance more cheaply, leaving the owner of a mortgage bond holding a pile of cash, to invest at lower interest rates. The investor in home loans didn't know how long his investment would last, only that he would get his money back when he least wanted it. To limit this uncertainty, the people I'd worked with at Salomon Brothers, who created the mortgage bond market, had come up with a clever solution. They took giant pools of home loans and carved up the payments made by homeowners into pieces, called tranches. The buyer of the first tranche was like the owner of the ground floor in a flood: He got hit with the first wave of mortgage prepayments. In exchange, he received a higher interest rate. The buyer of the second tranche--the second story of the skyscraper--took the next wave of prepayments and in exchange received the second highest interest rate, and so on. The investor in the top floor of the building received the lowest rate of interest but had the greatest assurance that his investment wouldn't end before he wanted it to.

The big fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all. The pool of loans underlying the mortgage bond conformed to the standards, in their size and the credit quality of the borrowers, set by one of several government agencies: Freddie Mac, Fannie Mae, and Ginnie Mae. The loans carried, in effect, government guarantees; if the homeowners defaulted, the government paid off their debts. When Steve Eisman stumbled into this new, rapidly growing industry of specialty finance, the mortgage bond was about to be put to a new use: making loans that did not qualify for government guarantees. The purpose was to extend credit to less and less creditworthy homeowners, not so that they might buy a house but so that they could cash out whatever equity they had in the house they already owned. The mortgage bonds created from subprime home loans extended the logic invented to address the problem of early repayment to cope with the problem of no repayment at all. The investor in the first floor, or tranche, would be exposed not to prepayments but to actual losses. He took the first losses until his investment was entirely wiped out, whereupon the losses hit the guy on the second floor. And so on.

By the time Household's CEO, Bill Aldinger, collected his $100 million, Eisman was on his way to becoming the financial market's first socialist. "When you're a conservative Republican, you never think people are making money by ripping other people off," he said. His mind was now fully open to the possibility. "I now realized there was an entire industry, called consumer finance, that basically existed to rip people off."

Denied the chance to manage money by his hedge fund employer, he quit and tried to start his own hedge fund. An outfit called FrontPoint Partners, soon to be wholly owned by Morgan Stanley, housed a collection of hedge funds. In early 2004, Morgan Stanley agreed to let Eisman set up a fund that focused exclusively on financial companies: Wall Street banks, home builders, mortgage originators, companies with big financial services divisions--General Electric (GE), for instance--and anyone else who touched American finance. Morgan Stanley took a cut of the fees off the top and provided him with office space, furniture, and support staff. The only thing they didn't supply him with was money. Eisman was expected to drum that up on his own. He flew all over the world and eventually met with hundreds of big-time investors. "Basically we tried to raise money, and didn't really do it," he says. "Everyone said, 'It's a pleasure to meet you. Let's see how you do.'"

All of them enjoyed, immensely, the idea of running money with Steve Eisman. Working for Eisman, you never felt you were working for Eisman. He'd teach you but he wouldn't supervise you. Eisman also put a fine point on the absurdity they saw everywhere around them. "Steve's fun to take to any Wall Street meeting," said Vinny. "Because he'll say 'explain that to me' thirty different times. Or 'could you explain that more, in English?' Because once you do that, there's a few things you learn. For a start, you figure out if they even know what they're talking about. And a lot of times they don't!"

By early 2005 Eisman's little group shared a sense that a great many people working on Wall Street couldn't possibly understand what they were doing. The subprime mortgage machine was up and running again, as if it had never broken down in the first place. If the first act of subprime lending had been freaky, this second act was terrifying. Thirty billion dollars was a big year for subprime lending in the mid-1990s. In 2000 there had been $130 billion in subprime mortgage lending, and 55 billion dollars' worth of those loans had been repackaged as mortgage bonds. In 2005 there would be $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds. Half a trillion dollars in subprime mortgage-backed bonds in a single year. Subprime lending was booming even as interest rates were rising--which made no sense at all. Even more shocking was that the terms of the loans were changing, in ways that increased the likelihood they would go bad. Back in 1996, 65 percent of subprime loans had been fixed-rate, meaning that typical subprime borrowers might be getting screwed, but at least they knew for sure how much they owed each month until they paid off the loan. By 2005, 75 percent of subprime loans were some form of floating-rate, usually fixed for the first two years.

The original cast of subprime financiers had been sunk by the small fraction of the loans they made that they had kept on their books. The market might have learned a simple lesson: Don't make loans to people who can't repay them. Instead it learned a complicated one: You can keep on making these loans, just don't keep them on your books. Make the loans, then sell them off to the fixed income departments of big Wall Street investment banks, which will in turn package them into bonds and sell them to investors. Long Beach Savings was the first existing bank to adopt what was called the "originate and sell" model. This proved such a hit--Wall Street would buy your loans, even if you would not!--that a new company, called B&C mortgage, was founded to do nothing but originate and sell. Lehman Brothers thought that was such a great idea that they bought B&C mortgage. By early 2005 all the big Wall Street investment banks were deep into the subprime game. Bear Stearns, Merrill Lynch, Goldman Sachs, and Morgan Stanley all had what they termed "shelves" for their subprime wares, with strange names like HEAT and SAIL and GSAMP, that made it a bit more difficult for the general audience to see that these subprime bonds were being underwritten by Wall Street's biggest names.

By "this stuff," Eisman meant the stocks of companies involved in subprime lending. Stock prices could do all sorts of crazy things: He didn't want to short them until the loans started going bad. To that end, Vinny kept a close eye on the behavior of the American subprime mortgage borrower. On the twenty-fifth of each month, the remittance reports arrived on his computer screen, and he scanned them for any upticks in delinquencies. "According to the things we were tracking," says Vinny, "the credit quality was still good. At least until the second half of 2005."

In the fog of the first eighteen months of running his own business, Eisman had an epiphany, an identifiable moment when he realized he'd been missing something obvious. Here he was, trying to figure out which stocks to pick, but the fate of the stocks depended increasingly on the bonds. As the subprime mortgage market grew, every financial company was, one way or another, exposed to it. "The fixed income world dwarfs the equity world," he said. "The equity world is like a fucking zit compared to the bond market." Just about every major Wall Street investment bank was effectively run by its bond departments. In most cases--Dick Fuld at Lehman Brothers, John Mack at Morgan Stanley, Jimmy Cayne at Bear Stearns--the CEO was a former bond guy. Ever since the 1980s, when the leading bond firm, Salomon Brothers, had made so much money that it looked as if it was in a different industry than the other firms, the bond market had been where the big money was made. "It was the golden rule," said Eisman. "The people who have the gold make the rules."

CHAPTER TWO: In the Land of the Blind

“Writing a check separates a commitment from a conversation.”--Warren Buffett

He now had a tactical investment problem. The various floors, or tranches, of subprime mortgage bonds all had one thing in common: The bonds were impossible to sell short. To sell a stock or bond short, you needed to borrow it, and these tranches of mortgage bonds were tiny and impossible to find. You could buy them or not buy them, but you couldn't bet explicitly against them; the market for subprime mortgages simply had no place for people in it who took a dim view of them. You might know with certainty that the entire subprime mortgage bond market was doomed, but you could do nothing about it. You couldn't short houses. You could short the stocks of home building companies--Pulte Homes, say, or Toll Brothers--but that was expensive, indirect, and dangerous. Stock prices could rise for a lot longer than Burry could stay solvent.

A couple of years earlier, he'd discovered credit default swaps. A credit default swap was confusing mainly because it wasn't really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing. It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million. It was also an asymmetric bet, like laying down money on a number in roulette. The most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money. "Credit default swaps remedied the problem of open-ended risk for me," said Burry. "If I bought a credit default swap, my downside was defined and certain, and the upside was many multiples of it."

The only problem was that there was no such thing as a credit default swap on a subprime mortgage bond, not that he could see. He'd need to prod the big Wall Street firms to create them. But which firms? If he was right and the housing market crashed, these firms in the middle of the market were sure to lose a lot of money. There was no point buying insurance from a bank that went out of business the minute the insurance became valuable. He didn't even bother calling Bear Stearns and Lehman Brothers, as they were more exposed to the mortgage bond market than the other firms. Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his mind, the most likely to survive a crash. He called them all. Five of them had no idea what he was talking about; two came back and said that, while the market didn't exist, it might one day. Inside of three years, credit default swaps on subprime mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of dollars' worth of losses inside big Wall Street firms. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.

Burry did not think investing could be reduced to a formula or learned from any one role model. The more he studied Buffett, the less he thought Buffett could be copied; indeed, the lesson of Buffett was: To succeed in a spectacular fashion you had to be spectacularly unusual. "If you are going to be a great investor, you have to fit the style to who you are," Burry said. "At one point I recognized that Warren Buffett, though he had every advantage in learning from Ben Graham, did not copy Ben Graham, but rather set out on his own path, and ran money his way, by his own rules.... I also immediately internalized the idea that no school could teach someone how to be a great investor. If it were true, it'd be the most popular school in the world, with an impossibly high tuition. So it must not be true." Investing was something you had to learn how to do on your own, in your own peculiar way. Burry had no real money to invest, but he nevertheless dragged his obsession along with him through high school, college, and medical school. He'd reached Stanford Hospital without ever taking a class in finance or accounting, let alone working for any Wall Street firm. He had maybe $40,000 in cash, against $145,000 in student loans. He had spent the previous four years working medical student hours. Nevertheless, he had found time to make himself a financial expert of sorts.

Before I went to college the military had this "we do more before 9am than most people do all day" and I used to think “and I do more than the military.” As you know there are some select people that just find a drive in certain activities that supersedes EVERYTHING else.

Once he figured out he had nothing more to learn from the crowd on his thread, he quit it to create what later would be called a blog but at the time was just a weird form of communication. He was working sixteen-hour shifts at the hospital, confining his blogging mainly to the hours between midnight and three in the morning. On his blog he posted his stock market trades and his arguments for making the trades. People found him. As a money manager at a big Philadelphia value fund said, "The first thing I wondered was, When is he doing this? The guy was a medical intern. I only saw the nonmedical part of his day, and it was simply awesome. He's showing people his trades. And people are following it in real time. He's doing value investing--in the middle of the dot-com bubble. He's buying value stocks, which is what we're doing. But we're losing money. We're losing clients. All of a sudden he goes on this tear. He's up fifty percent. It's uncanny. He's uncanny. And we're not the only ones watching it."

Mike Burry couldn't see exactly who was following his financial moves, but he could tell which domains they came from. In the beginning his readers came from EarthLink and AOL. Just random individuals. Pretty soon, however, they weren't. People were coming to his site from mutual funds like Fidelity and big Wall Street investment banks like Morgan Stanley. One day he lit into Vanguard's index funds and almost instantly received a cease and desist order from Vanguard's attorneys. Burry suspected that serious investors might even be acting on his blog posts, but he had no clear idea who they might be. "The market found him," says the Philadelphia mutual fund manager. "He was recognizing patterns no one else was seeing."

His $40,000 in assets against $145,000 in student loans posed the question of exactly what portfolio he would run. His father had died after another misdiagnosis: A doctor had failed to spot the cancer on an X-ray, and the family had received a small settlement. The father disapproved of the stock market, but the payout from his death funded his son into it. His mother was able to kick in $20,000 from her settlement, his three brothers kicked in $10,000 each of theirs. With that, Dr. Michael Burry opened Scion Capital.

He arrived at the big New York money management firm as formally attired as he had ever been in his entire life to find its partners in t-shirts and sweatpants. The exchange went something like this. "We'd like to give you a million dollars.""Excuse me?""We want to buy a quarter of your new hedge fund. For a million dollars.""You do?""Yes. We're offering a million dollars.""After tax!" Somehow Burry had it in his mind that one day he wanted to be worth a million dollars, after tax. At any rate, he'd just blurted that last bit out before he fully understood what they were after. And they gave it to him! At that moment, on the basis of what he'd written on his blog, he went from being an indebted medical student with a net worth of minus $105,000 to a millionaire with a few outstanding loans. Burry didn't know it, but it was the first time Joel Greenblatt had done such a thing. "He was just obviously this brilliant guy, and there aren't that many of them," says Greenblatt. Shortly after that odd encounter, he had a call from the insurance holding company White Mountains. White Mountains was run by Jack Byrne, a member of Warren Buffett's inner circle, and they had spoken to Gotham Capital. "We didn't know you were selling part of your firm," they said--and Burry explained that he didn't realize it either until a few days earlier, when someone offered a million dollars, after tax, for it. It turned out that White Mountains, too, had been watching Michael Burry closely. "What intrigued us more than anything was that he was a neurology resident," says Kip Oberting, then at White Mountains. "When the hell was he doing this?" From White Mountains he extracted $600,000 for a smaller piece of his fund, plus a promise to send him $10 million to invest. "And yes," said Oberting, "he was the only person we found on the Internet and cold-called and gave him money."

This method of attracting funds suited Mike Burry. More to the point, it worked. He'd started Scion Capital with a bit more than a million dollars--the money from his mother and brothers and his own million, after tax. In his first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55 percent. The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion was up again: 16 percent. The next year, 2003, the stock market finally turned around and rose 28.69 percent, but Mike Burry beat it again--his investments rose by 50 percent. By the end of 2004, Mike Burry was managing $600 million and turning money away. "If he'd run his fund to maximize the amount he had under management, he'd have been running many, many billions of dollars," says a New York hedge fund manager who watched Burry's performance with growing incredulity. "He designed Scion so it was bad for business but good for investing."

Warren Buffett had an acerbic partner, Charlie Munger, who evidently cared a lot less than Buffett did about whether people liked him. Back in 1995, Munger had given a talk at Harvard Business School called "The Psychology of Human Misjudgment." If you wanted to predict how people would behave, Munger said, you only had to look at their incentives. FedEx couldn't get its night shift to finish on time; they tried everything to speed it up but nothing worked--until they stopped paying night shift workers by the hour and started to pay them by the shift. Xerox created a new, better machine only to have it sell less well than the inferior older ones--until they figured out the salesmen got a bigger commission for selling the older one. "Well, you can say, 'Everybody knows that,'" said Munger. "I think I've been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I've underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther."

Even in life or death situations, doctors, nurses, and patients all responded to bad incentives. In hospitals in which the reimbursement rates for appendectomies ran higher, for instance, the surgeons removed more appendixes. The evolution of eye surgery was another great example. In the 1990s, the ophthalmologists were building careers on performing cataract procedures. They'd take half an hour or less, and yet Medicare would reimburse them $1,700 a pop. In the late 1990s, Medicare slashed reimbursement levels to around $450 per procedure, and the incomes of the surgically minded ophthalmologists fell. Across America, ophthalmologists rediscovered an obscure and risky procedure called radial keratotomy, and there was a boom in surgery to correct small impairments of vision. The inadequately studied procedure was marketed as a cure for the suffering of contact lens wearers. "In reality," says Burry, "the incentive was to maintain their high, often one-to two-million-dollar incomes, and the justification followed. The industry rushed to come up with something less dangerous than radial keratotomy, and Lasik was eventually born."

Thus when Mike Burry went into business he made sure that he had the proper incentives. He disapproved of the typical hedge fund manager's deal. Taking 2 percent of assets off the top, as most did, meant the hedge fund manager got paid simply for amassing vast amounts of other people's money. Scion Capital charged investors only its actual expenses--which typically ran well below 1 percent of the assets. To make the first nickel for himself, he had to make investors' money grow. "Think about the genesis of Scion," says one of his early investors. "The guy has no money and he chooses to forgo a fee that any other hedge fund takes for granted. It was unheard of."

For roughly $100 a year he became a subscriber to 10-K Wizard. Scion Capital's decision-making apparatus consisted of one guy in a room, with the door closed and the shades drawn, poring over publicly available information and data on 10-K Wizard. He went looking for court rulings, deal completions, or government regulatory changes--anything that might change the value of a company.

Often as not, he turned up what he called "ick" investments. In October 2001, he explained the concept in his letter to investors: "Ick investing means taking a special analytical interest in stocks that inspire a first reaction of 'ick.'"The alarmingly named Avant! Corporation was a good example. He'd found it searching for the word "accepted" in news stories. He knew that, standing on the edge of the playing field, he needed to find unorthodox ways to tilt it to his advantage, and that usually meant finding unusual situations the world might not be fully aware of. "I wasn't searching for a news report of a scam or fraud per se," he said. "That would have been too backward-looking, and I was looking to get in front of something. I was looking for something happening in the courts that might lead to an investment thesis. An argument being accepted, a plea being accepted, a settlement being accepted by the court." A court had accepted a plea from a software company called the Avant! Corporation. Avant! had been accused of stealing from a competitor the software code that was the whole foundation of Avant!'s business. The company had $100 million in cash in the bank, was still generating $100 million a year of free cash flow--and had a market value of only $250 million! Michael Burry started digging; by the time he was done, he knew more about the Avant! Corporation than any man on earth. He was able to see that even if the executives went to jail (as they did) and the fines were paid (as they were), Avant! would be worth a lot more than the market then assumed. Most of its engineers were Chinese nationals on work visas, and thus trapped--there was no risk that anyone would quit before the lights were out. To make money on Avant!'s stock, however, he'd probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.

Burry bought his first shares of Avant! in June 2001 at $12 a share. Avant!'s management then appeared on the cover of an issue of Business Week under the headline "Does Crime Pay?" The stock plunged; Burry bought more. Avant!'s management went to jail. The stock fell some more. Mike Burry kept on buying it--all the way down to $2 a share. He became Avant!'s single largest shareholder; he pressed management for changes. "With [the former CEO's] criminal aura no longer a part of operating management," he wrote to the new bosses, "Avant! has a chance to demonstrate its concern for shareholders." In August, in another e-mail, he wrote, "Avant! still makes me feel I'm sleeping with the village slut. No matter how well my needs are met, I doubt I'll ever brag about it. The 'creep' factor is off the charts. I half think that if I pushed Avant! too hard I'd end up being terrorized by the Chinese mafia." Four months later, Avant! got taken over for $22 a share. "That was a classic Mike Burry trade," says one of his investors. "It goes up by ten times but first it goes down by half."

This isn't the sort of ride most investors enjoy, but it was, Burry thought, the essence of value investing. His job was to disagree loudly with popular sentiment. He couldn't do this if he was at the mercy of very short-term market moves, and so he didn't give his investors the ability to remove their money on short notice, as most hedge funds did. If you gave Scion your money to invest, you were stuck for at least a year. Burry also designed his fund to attract people who wanted to be long the stock market--who wanted to bet on stocks going up rather than stocks going down. "I am not a short at heart," he said. "I don't dig into companies looking to short them, generally. I want the upside to be much more than the downside, fundamentally." He also didn't like the idea of taking the risk of selling a stock short, as the risk was, theoretically, unlimited. It could only fall to zero, but it could rise to infinity.

On May 19, 2005--a month before the terms were finalized--Mike Burry did his first subprime mortgage deals. He bought $60 million in credit default swaps from Deutsche Bank--$10 million each on six different bonds. "The reference securities," these were called. You didn't buy insurance on the entire subprime mortgage bond market but on a particular bond, and Burry had devoted himself to finding exactly the right ones to bet against. He'd read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them. In doing so, he likely also became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made. He was the opposite of an old-fashioned banker, however. He was looking not for the best loans to make but the worst loans--so that he could bet against them.

He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans. It surprised him that Deutsche Bank didn't seem to care which bonds he picked to bet against. From their point of view, so far as he could tell, all subprime mortgage bonds were the same. The price of insurance was driven not by any independent analysis but by the ratings placed on the bond by the rating agencies, Moody's and Standard & Poor's.* If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier A-rated tranches, he might pay 50 basis points (0.50 percent); and, on the even less safe triple-B-rated tranches, 200 basis points--that is, 2 percent. (A basis point is one-hundredth of one percentage point.) The triple-B-rated tranches--the ones that would be worth zero if the underlying mortgage pool experienced a loss of just 7 percent--were what he was after. He felt this to be a very conservative bet, which he was able, through analysis, to turn into even more of a sure thing. Anyone who even glanced at the prospectuses could see that there were many critical differences between one triple-B bond and the next--the percentage of interest-only loans contained in their underlying pool of mortgages, for example. He set out to cherry-pick the absolute worst ones, and was a bit worried that the investment banks would catch on to just how much he knew about specific mortgage bonds, and adjust their prices.

By the end of July he owned credit default swaps on $750 million in subprime mortgage bonds and was privately bragging about it. "I believe no other hedge fund on the planet has this sort of investment, nowhere near to this degree, relative to the size of the portfolio," he wrote to one of his investors, who had caught wind that his hedge fund manager had some newfangled strategy. Now he couldn't help but wonder who exactly was on the other side of his trades--what madman would be selling him so much insurance on bonds he had handpicked to explode? The credit default swap was a zero-sum game. If Mike Burry made $100 million when the subprime mortgage bonds he had handpicked defaulted, someone else must have lost $100 million. Goldman Sachs made it clear that the ultimate seller wasn't Goldman Sachs. Goldman Sachs was simply standing between insurance buyer and insurance seller and taking a cut.

In the second quarter of 2005, credit card delinquencies hit an all-time high--even though house prices had boomed. That is, even with this asset to borrow against, Americans were struggling more than ever to meet their obligations.

"It is ludicrous to believe that asset bubbles can only be recognized in hindsight," he wrote. "There are specific identifiers that are entirely recognizable during the bubble's inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud.... The FBI reports mortgage-related fraud is up fivefold since 2000." Bad behavior was no longer on the fringes of an otherwise sound economy; it was its central feature. "The salient point about the modern vintage of housing-related fraud is its integral place within our nation's institutions," he added.

This wasn’t all that different from what he’d been saying in his quarterly letters to his investors for the past two years. Back in July 2003, he'd written them a long essay on the causes and consequences of what he took to be a likely housing crash: "Alan Greenspan assures us that home prices are not prone to bubbles--or major deflations--on any national scale," he'd said. "This is ridiculous, of course.... In 1933, during the fourth year of the Great Depression, the United States found itself in the midst of a housing crisis that put housing starts at 10% of the level of 1925. Roughly half of all mortgage debt was in default. During the 1930s, housing prices collapsed nationwide by roughly 80%." He harped on the same theme again in January 2004, then again in January 2005: "Want to borrow $1,000,000 for just $25 a month? Quicken Loans has now introduced an interest only adjustable rate mortgage that gives borrowers six months with both zero payments and a 0.03% interest rate, no doubt in support of that wholesome slice of Americana--the home buyer with the short term cash flow problem."

It has been my experience that apocalyptic forecasts on the U.S. financial markets are rarely realized within limited horizons," one investor wrote to Burry. "There have been legitimate apocalyptic cases to be made on U.S. financial markets during most of my career. They usually have not been realized." Burry replied that while it was true that he foresaw Armageddon, he wasn't betting on it. That was the beauty of credit default swaps: They enabled him to make a fortune if just a tiny fraction of these dubious pools of mortgages went bad.

Inadvertently, he'd opened up a debate with his own investors, which he counted among his least favorite activities. "I hated discussing ideas with investors," he said, "because I then become a Defender of the Idea, and that influences your thought process." Once you became an idea's defender you had a harder time changing your mind about it. He had no choice: Among the people who gave him money there was pretty obviously a built-in skepticism of so-called macro thinking

When he'd started Scion, he'd told potential investors that, because he was in the business of making unfashionable bets, they should evaluate him over the long term--say, five years. Now he was being evaluated moment to moment. "Early on, people invested in me because of my letters," he said. "And then somehow after they invested, they stopped reading them." His fantastic success attracted lots of new investors, but they were less interested in the spirit of his enterprise than in how much money he could make them quickly. Every quarter, he told them how much he'd made or lost from his stock picks. Now he had to explain that they had to subtract from that number these...subprime mortgage bond insurance premiums. One of his New York investors called and said ominously, "You know a lot of people are talking about withdrawing funds from you."

Oddly, as Mike Burry's investors grew restive, his Wall Street counterparties took a new and envious interest in what he was up to. In late October 2005, a subprime trader at Goldman Sachs called to ask him why he was buying credit default swaps on such very specific tranches of subprime mortgage bonds. The trader let it slip that a number of hedge funds had been calling Goldman to ask "how to do the short housing trade that Scion is doing." Among those asking about it were people Burry had solicited for Milton's Opus--people who had initially expressed great interest. "These people by and large did not know anything about how to do the trade and expected Goldman to help them replicate it," Burry wrote in an e-mail to his CFO. "My suspicion is Goldman helped them, though they deny it." If nothing else, he now understood why he couldn't raise money for Milton's Opus. "If I describe it enough it sounds compelling, and people think they can do it for themselves," he wrote to an e-mail confidant. "If I don't describe it enough, it sounds scary and binary and I can't raise the capital." He had no talent for selling.

CHAPTER THREE: “How Can a Guy Who Can't Speak English Lie?"

The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they'd be reported to some authority. Bond traders could exploit inside information without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation--one reason why so many derivatives had been derived, one way or another, from bonds.

The bigger, more liquid end of the bond market--the market for U.S. Treasury bonds, for example--traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn't know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.

Since 2000, people whose homes had risen in value between 1 and 5 percent were nearly four times more likely to default on their home loans than people whose homes had risen in value more than 10 percent. Millions of Americans had no ability to repay their mortgages unless their houses rose dramatically in value, which enabled them to borrow even more. That was the pitch in a nutshell: Home prices didn't even need to fall. They merely needed to stop rising at the unprecedented rates they had the previous few years for vast numbers of Americans to default on their home loans.

The alacrity with which subprime borrowers paid off their loans was yet another strange aspect of this booming market. It had to do with the structure of the loans, which were fixed for two or three years at an artificially low teaser rate before shooting up to the "go-to" floating rate. "They were making loans to lower-income people at a teaser rate when they knew they couldn't afford to pay the go-to rate," said Eisman. "They were doing it so that when the borrowers get to the end of the teaser rate period, they'd have to refinance, so the lenders can make more money off them." Thirty-year loans were thus designed to be repaid in a few years. At worst, if you bought credit default swaps on $100 million in subprime mortgage bonds you might wind up shelling out premium for six years--call it $12 million. At best: Losses on the loans rose from the current 4 percent to 8 percent, and you made $100 million. The bookies were offering you odds of somewhere between 6:1 and 10:1 when the odds of it working out felt more like 2:1. Anyone in the business of making smart bets couldn't not do it.

The subprime mortgage market was generating half a trillion dollars' worth of new loans a year, but the circle of people redistributing the risk that the entire market would collapse was tiny. When the Goldman Sachs saleswoman called Mike Burry and told him that her firm would be happy to sell him credit default swaps in $100 million chunks, Burry guessed, rightly, that Goldman wasn't ultimately on the other side of his bets. Goldman would never be so stupid as to make huge naked bets that millions of insolvent Americans would repay their home loans. He didn't know who, or why, or how much, but he knew that some giant corporate entity with a triple-A rating was out there selling credit default swaps on subprime mortgage bonds. Only a triple-A-rated corporation could assume such risk, no money down, and no questions asked. Burry was right about this, too, but it would be three years before he knew it. The party on the other side of his bet against subprime mortgage bonds was the triple-A-rated insurance company AIG--American International Group, Inc. Or, rather, a unit of AIG called AIG FP.

AIG Financial Products was created in 1987 by refugees from Michael Milken's bond department at Drexel Burnham, led by a trader named Howard Sosin, who claimed to have a better model to trade and value interest rate swaps. Nineteen eighties financial innovation had all sorts of consequences, but one of them was a boom in the number of deals between big financial firms that required them to take each other's credit risks. Interest rate swaps--in which one party swaps a floating rate of interest for another party's fixed rate of interest--was one such innovation.

Once upon a time, Chrysler issued a bond through Morgan Stanley, and the only people who wound up with credit risk were the investors who bought the Chrysler bond. Chrysler might sell its bonds and simultaneously enter into a ten-year interest rate swap transaction with Morgan Stanley--and just like that, Chrysler and Morgan Stanley were exposed to each other. If Chrysler went bankrupt, its bondholders obviously lost; depending on the nature of the swap, and the movement of interest rates, Morgan Stanley might lose, too. If Morgan Stanley went bust, Chrysler, along with anyone else who had done interest rate swaps with Morgan Stanley, stood to suffer. Financial risk had been created out of thin air, and it begged to be either honestly accounted for or disguised.

Enter Sosin, with his supposedly new and improved interest rate swap model--even though Drexel Burnham was not at the time a market leader in interest rate swaps. There was a natural role for a blue-chip corporation with the highest credit rating to stand in the middle of swaps and long-term options and the other risk-spawning innovations. The traits required of this corporation were that it not be a bank--and thus subject to bank regulation, and the need to reserve capital against risky assets--and that it be willing and able to bury exotic risks on its balance sheet. It needed to be able to insure $100 billion in subprime mortgage loans, for instance, without having to disclose to anyone what it had done. There was no real reason that company had to be AIG; it could have been any triple-A-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. AIG just got there first.

In a financial system that was rapidly generating complicated risks, AIG FP became a huge swallower of those risks. In the early days it must have seemed as if it was being paid to insure events extremely unlikely to occur, as it was. Its success bred imitators: Zurich Re FP, Swiss Re FP, Credit Suisse FP, Gen Re FP. ("Re" stands for Reinsurance.) All of these places were central to what happened in the last two decades; without them, the new risks being created would have had no place to hide and would have remained in full view of bank regulators. All of these places, when the crisis came, would be washed away by the general nausea felt in the presence of complicated financial risks, but there was a moment when their existence seemed cartographically necessary to the financial world. AIG FP was the model for them all.

But then, in the early 2000s, the financial markets performed this fantastic bait and switch, in two stages. Stage One was to apply a formula that had been dreamed up to cope with corporate credit risk to consumer credit risk. The banks that used AIG FP to insure piles of loans to IBM and GE now came to it to insure much messier piles, which included credit card debt, student loans, auto loans, prime mortgages, aircraft leases, and just about anything else that generated a cash flow. As there were many different sorts of loans, to different sorts of people, the logic that had applied to corporate loans seemed to apply to them, too: They were sufficiently diverse that they were unlikely all to go bad at once.

Stage Two, beginning at the end of 2004, was to replace the student loans and the auto loans and the rest with bigger piles consisting of nothing but U.S. subprime mortgage loans. "The problem," as one AIG FP trader put it, "is that something else came along that we thought was the same thing as what we'd been doing." The "consumer loan" piles that Wall Street firms, led by Goldman Sachs, asked AIG FP to insure went from being 2 percent subprime mortgages to being 95 percent subprime mortgages. In a matter of months, AIG FP, in effect, bought $50 billion in triple-B-rated subprime mortgage bonds by insuring them against default. And yet no one said anything about it--not AIG CEO Martin Sullivan, not the head of AIG FP, Joe Cassano, not the guy in AIG FP's Connecticut office in charge of selling his firm's credit default swap services to the big Wall Street firms, Al Frost. The deals, by all accounts, were simply rubber-stamped inside AIG FP, and then again by AIG brass. Everyone concerned apparently assumed they were being paid insurance premiums to take basically the same sort of risk they had been taking for nearly a decade. They weren't. They were now, in effect, the world's biggest owners of subprime mortgage bonds.

Greg Lippmann watched his counterparts at Goldman Sachs find and exploit someone else's willingness to sell huge amounts of cheap insurance on subprime mortgage bonds and pretty much instantly guessed the seller's identity. Word spread quickly in the small world of subprime mortgage bond creators and traders: AIG FP was now selling credit default swaps on triple-A-rated subprime bonds for a mere 0.12 percent a year. Twelve basis points! Lippmann didn't know exactly how Goldman Sachs had persuaded AIG FP to provide the same service to the booming market in subprime mortgage loans that it provided to the market for corporate loans. All he knew was that, in rapid succession, Goldman created a bunch of multibillion-dollar deals that transferred to AIG the responsibility for all future losses from $20 billion in triple-B-rated subprime mortgage bonds. It was incredible: In exchange for a few million bucks a year, this insurance company was taking the very real risk that $20 billion would simply go poof. The deals with Goldman had gone down in a matter of months and required the efforts of just a few geeks on a Goldman bond trading desk and a Goldman salesman named Andrew Davilman, who, for his services, soon would be promoted to managing director. The Goldman traders had booked profits of somewhere between $1.5 billion and $3 billion--even by bond market standards, a breathtaking sum.

In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans. Its logic was exactly that of the original mortgage bonds. In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a CDO you gathered one hundred different mortgage bonds--usually, the riskiest, lower floors of the original tower--and used them to erect an entirely new tower of bonds. The innocent observer might reasonably ask, What's the point of using floors from one tower of debt simply to create another tower of debt? The short answer is, They are too near to the ground. More prone to flooding--the first to take losses--they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building.

The long answer was that there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. Their--soon to be everyone's--nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different triple-B-rated bonds), they persuaded the rating agencies that these weren't, as they might appear, all exactly the same things. They were another diversified portfolio of assets! This was absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally exposed. But never mind: The rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, pronounced 80 percent of the new tower of debt triple-A.

The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold.

Back in the 1980s, the original stated purpose of the mortgage-backed bond had been to redistribute the risk associated with home mortgage lending. Home mortgage loans could find their way to the bond market investors willing to pay the most for them. The interest rate paid by the homeowner would thus fall. The goal of the innovation, in short, was to make the financial markets more efficient. Now, somehow, the same innovative spirit was being put to the opposite purpose: to hide the risk by complicating it.

No wonder Goldman Sachs was suddenly so eager to sell Mike Burry credit default swaps in giant, $100 million chunks, or that the Goldman Sachs bond trader had been surprisingly indifferent to which subprime bonds Mike Burry bet against. The insurance Mike Burry bought was inserted into a synthetic CDO and passed along to AIG. The roughly $20 billion in credit default swaps sold by AIG to Goldman Sachs meant roughly $400 million in riskless profits for Goldman Sachs. Each year. The deals lasted as long as the underlying bonds, which had an expected life of about six years, which, when you did the math, implied a profit for the Goldman trader of $2.4 billion.

Lippmann had at least one good reason for not putting up a huge fight: There was a fantastically profitable market waiting to be created. Financial markets are a collection of arguments. The less transparent the market and the more complicated the securities, the more money the trading desks at big Wall Street firms can make from the argument. The constant argument over the value of the shares of some major publicly traded company has very little value, as both buyer and seller can see the fair price of the stock on the ticker, and the broker's commission has been driven down by competition. The argument over the value of credit default swaps on subprime mortgage bonds--a complex security whose value was derived from that of another complex security--could be a gold mine. The only other dealer making serious markets in credit default swaps was Goldman Sachs, so there was, in the beginning, little price competition. Supply, thanks to AIG, was virtually unlimited. The problem was demand: investors who wanted to do Mike Burry's trade. Incredibly, at this critical juncture in financial history, after which so much changed so quickly, the only constraint in the subprime mortgage market was a shortage of people willing to bet against it.

CHAPTER FOUR: How to Harvest a Migrant Worker

The other piece of news concerned home prices. Eisman spoke often to a housing market analyst at Credit Suisse named Ivy Zelman. The simple measure of sanity in housing prices, Zelman argued, was the ratio of median home price to income. Historically, in the United States, it ran around 3:1; by late 2004, it had risen nationally, to 4:1. "All these people were saying it was nearly as high in some other countries," says Zelman. "But the problem wasn't just that it was four to one. In Los Angeles it was ten to one and in Miami, eight-point-five to one. And then you coupled that with the buyers. They weren't real buyers. They were speculators."* The number of For Sale signs began rising in mid-2005 and never stopped. In the summer of 2006, the Case-Shiller index of house prices peaked, and house prices across the country began to fall. For the entire year they would fall, nationally, by 2 percent.

Either piece of news--rising ratings standards or falling house prices--should have disrupted the subprime bond market and caused the price of insuring the bonds to rise. Instead, the price of insuring the bonds fell. Insurance on the crappiest triple-B tranche of a subprime mortgage bond now cost less than 2 percent a year. "We finally just did a trade with Lippmann," says Eisman. "Then we tried to figure out what we'd done."

They called Wall Street trading desks and asked for menus of subprime mortgage bonds, so they might find the most rotten ones and buy the smartest insurance. The juiciest shorts--the bonds ultimately backed by the mortgages most likely to default--had several characteristics. First, the underlying loans were heavily concentrated in what Wall Street people were now calling the sand states: California, Florida, Nevada, and Arizona. House prices in the sand states had risen fastest during the boom and so would likely crash fastest in a bust--and when they did, those low California default rates would soar. Second, the loans would have been made by the more dubious mortgage lenders. Long Beach Savings, wholly owned by Washington Mutual, was a prime example of financial incontinence. Long Beach Savings had been the first to embrace the originate and sell model and now was moving money out the door to new home buyers as fast as it could, few questions asked. Third, the pools would have a higher than average number of low-doc or no-doc loans--that is, loans more likely to be fraudulent. Long Beach Savings, it appeared to Eisman and his partners, specialized in asking homeowners with bad credit and no proof of income to accept floating-rate mortgages. No money down, interest payments deferred upon request. The housing blogs of southern California teemed with stories of financial abuses made possible by these so-called thirty-year payment option ARMs, or adjustable-rate mortgages. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.

The big Wall Street firms--Bear Stearns, Lehman Brothers, Goldman Sachs, Citigroup, and others--had the same goal as any manufacturing business: to pay as little as possible for raw material (home loans) and charge as much as possible for their end product (mortgage bonds). The price of the end product was driven by the ratings assigned to it by the models used by Moody's and S&P. The inner workings of these models were, officially, a secret: Moody's and S&P claimed they were impossible to game. But everyone on Wall Street knew that the people who ran the models were ripe for exploitation. "Guys who can't get a job on Wall Street get a job at Moody's," as one Goldman Sachs trader-turned-hedge fund manager put it. Inside the rating agency there was another hierarchy, even less flattering to the subprime mortgage bond raters. "At the ratings agencies the corporate credit people are the least bad," says a quant who engineered mortgage bonds for Morgan Stanley. "Next are the prime mortgage people. Then you have the asset-backed people, who are basically like brain-dead."* Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible ratings for the worst possible loans. They performed the task with Ivy League thoroughness and efficiency. They quickly figured out, for instance, that the people at Moody's and S&P didn't actually evaluate the individual home loans, or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools.

Their handling of FICO scores was one example. FICO scores--so called because they were invented, in the 1950s, by a company called the Fair Isaac Corporation--purported to measure the creditworthiness of individual borrowers. The highest possible FICO score was 850; the lowest was 300; the U.S. median was 723. FICO scores were simplistic. They didn't account for a borrower's income, for instance. They could also be rigged. A would-be borrower could raise his FICO score by taking out a credit card loan and immediately paying it back. But never mind: The problem with FICO scores was overshadowed by the way they were misused by the rating agencies. Moody's and S&P asked the loan packagers not for a list of the FICO scores of all the borrowers but for the average FICO score of the pool. To meet the rating agencies' standards--to maximize the percentage of triple-A-rated bonds created from any given pool of loans--the average FICO score of the borrowers in the pool needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680. A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place. But the hole in the rating agencies' models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615.

Where to find the borrowers with high FICO scores? Here the Wall Street bond trading desks exploited another blind spot in the rating agencies' models. Apparently the agencies didn't grasp the difference between a "thin-file" FICO score and a "thick-file" FICO score. A thin-file FICO score implied, as it sounds, a short credit history. The file was thin because the borrower hadn't done much borrowing. Immigrants who had never failed to repay a debt, because they had never been given a loan, often had surprisingly high thin-file FICO scores. Thus a Jamaican baby nurse or Mexican strawberry picker with an income of $14,000 looking to borrow three-quarters of a million dollars, when filtered through the models at Moody's and S&P, became suddenly more useful, from a credit-rigging point of view. They might actually improve the perceived quality of the pool of loans and increase the percentage that could be declared triple-A. The Mexican harvested strawberries; Wall Street harvested his FICO score.The models used by the rating agencies were riddled with these sorts of opportunities. The trick was finding them before others did--finding, for example, that both Moody's and S&P favored floating-rate mortgages with low teaser rates over fixed-rate ones. Or that they didn't care if a loan had been made in a booming real estate market or a quiet one. Or that they were seemingly oblivious to the fraud implicit in no-doc loans. Or that they were blind to the presence of "silent seconds"--second mortgages that left the homeowner with no equity in his home and thus no financial incentive not to hand the keys to the bank and walk away from it. Every time some smart Wall Street mortgage bond packager discovered another example of the rating agencies' idiocy or neglect, he had himself an edge in the marketplace: Crappier pools of loans were cheaper to buy than less crappy pools.

CHAPTER FIVE: Accidental Capitalists

By the end of 2006, according to the PerTrac Hedge Fund Database Study, there were 13,675 hedge funds reporting results, and thousands of other types of institutional investors allowed to invest in credit default swaps. Lippmann's pitch, in one form or another, reached many of them. Yet only one hundred or so dabbled in the new market for credit default swaps on subprime mortgage bonds. Most bought this insurance on subprime mortgages not as an outright bet against them but as a hedge against their implicit bet on them--their portfolios of U.S. real estate-related stocks or bonds. A smaller group used credit default swaps to make what often turned out to be spectacularly disastrous gambles on the relative value of subprime mortgage bonds--buying one subprime mortgage bond while simultaneously selling another. They would bet, for instance, that bonds with large numbers of loans made in California would underperform bonds with very little of California in them. Or that the upper triple-A-rated floor of some subprime mortgage bond would outperform the lower, triple-B-rated, floor. Or that bonds issued by Lehman Brothers or Goldman Sachs (both notorious for packaging America's worst home loans) would underperform bonds packaged by J.P. Morgan or Wells Fargo (which actually seemed to care a bit about which loans it packaged into bonds). 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.

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.

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.

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.

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.

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."

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 collapse 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. "We couldn't believe people would sell us these long-term options so cheaply," said Jamie. "We went looking for more long-dated options."

It instantly became a fantastically profitable strategy: Start with what appeared to be a cheap option to buy or sell some Korean stock, or pork belly, or third-world currency--really anything with a price that seemed poised for some dramatic change--and then work backward to the thing the option allowed you to buy or sell. The options suited the two men's personalities: They never had to be sure of anything. Both were predisposed to feel that people, and by extension markets, were too certain about inherently uncertain things. Both sensed that people, and by extension markets, had difficulty attaching the appropriate probabilities to highly improbable events. Both had trouble generating conviction of their own but no trouble at all reacting to what they viewed as the false conviction of others. Each time they came upon a tantalizing long shot, one of them set to work on making the case for it, in an elaborate presentation, complete with PowerPoint slides. They didn't actually have anyone to whom they might give a presentation. They created them only to hear how plausible they sounded when pitched to each other. They entered markets only because they thought something dramatic might be about to happen in them, on which they could make a small bet with long odds that might pay off in a big way. They didn't know the first thing about Korean stocks or third world currencies, but they didn't really need to. If they found what appeared to be a cheap bet on the price movements of any security, they could then hire an expert to help them sort out the details. "That has been a pattern of ours," said Jamie Mai. "To rely on the work of smart people who know more than we do."

They followed their success with Capital One with a similar success, in a distressed European cable television company called United Pan-European Cable. This time, since they had more money, they bought $500,000 in call options, struck at a price far from the market. When UPC rallied, they turned a quick $5 million profit. "We're now getting really, really excited," says Jamie. Next they bet on a company that delivered oxygen tanks directly to sick people in their homes. That $200,000 bet quickly turned into $3 million. "We're now three for three," said Charlie. "We think it's hilarious. For the first time I could see myself doing this for a really long time."

“We spent a lot of time building Black-Scholes models ourselves, and seeing what happened when you changed various assumptions in them," said Jamie. What struck them powerfully was how cheaply the models allowed a person to speculate on situations that were likely to end in one of two dramatic ways. If, in the next year, a stock was going to be worth nothing or $100 a share, it was silly for anyone to sell a year-long option to buy the stock at $50 a share for $3. Yet the market often did something just like that. The model used by Wall Street to price trillions of dollars' worth of derivatives thought of the financial world as an orderly, continuous process. But the world was not continuous; it changed discontinuously, and often by accident.

Event-driven investing: That was the name they either coined or stole for what they were doing. That made it sound a lot less fun than it was. One day Charlie found himself intrigued by the market for ethanol futures. He didn't know much about ethanol, but he could see that it enjoyed a U.S. government subsidy of 50 cents a gallon, and so was supposed to trade at a 50-cent-a-gallon premium to gasoline, and always had. In early 2005, when he became interested, it traded, briefly, at a 50-cent discount to gas. He didn't know why and never found out; instead, Charlie bought two rail cars' worth of ethanol futures, and made headlines in Ethanol Today, a magazine of whose existence he was previously unaware. To the intense irritation of Cornwall's broker, they wound up having to accept rail cars filled with ethanol in some stockyard in Chicago--to make a sum of money that struck the broker as absurdly small. "The administrative complexity of what we were doing was out of proportion to our assets," said Charlie. "People who were our size didn't trade across asset classes."

One day on the phone with Ben, Charlie said, You hate taking even remote risks, but you live in a house on top of a mountain that's on a fault line, in a housing market that's at an all-time high. "He just said, 'I gotta go,' and hung up," recalled Charlie. "We had trouble getting hold of him for, like, two months.""I got off the phone," said Ben, "and I realized, I have to sell my house. Right now." His house was worth a million dollars and maybe more yet would rent for no more than $2,500 a month. "It was trading more than thirty times gross rental," said Ben. "The rule of thumb is that you buy at ten and sell at twenty." In October 2005 he moved his family into a rental unit, away from the fault.

The losses, by design, were no big deal; the losses were part of the plan. They had more losers than winners, but their losses, the cost of the options, had been trivial compared to their gains. There was a possible explanation for their success, which Charlie and Jamie had only intuited but which Ben, who had priced options for a big Wall Street firm, came ready to explain: Financial options were systematically mispriced. The market often underestimated the likelihood of extreme moves in prices. The options market also tended to presuppose that the distant future would look more like the present than it usually did. Finally, the price of an option was a function of the volatility of the underlying stock or currency or commodity, and the options market tended to rely on the recent past to determine how volatile a stock or currency or commodity might be. When IBM stock was trading at $34 a share and had been hopping around madly for the past year, an option to buy it for $35 a share anytime soon was seldom underpriced. When gold had been trading around $650 an ounce for the past two years, an option to buy it for $2,000 an ounce anytime during the next ten years might well be badly underpriced. The longer-term the option, the sillier the results generated by the Black-Scholes option pricing model, and the greater the opportunity for people who didn't use it.

The longest options available to individual investors on public exchanges were LEAPs, which were two-and-a-half-year options on common stocks. You know, Ben said to Charlie and Jamie, if you established yourself as a serious institutional investor, you could phone up Lehman Brothers or Morgan Stanley and buy eight-year options on whatever you wanted. Would you like that?

Charlie, Jamie, and Ben entered the subprime mortgage market assuming they wanted to do what Mike Burry and Steve Eisman had already done, and find the very worst subprime bonds to lay bets against. They quickly got up to speed on FICO scores and loan-to-value ratios and silent seconds and the special madness of California and Florida, and the shockingly optimistic structure of the bonds themselves: The triple-B-minus tranche, the bottom floor of the building, required just 7 percent losses in the underlying pool to be worth zero. But then they wound up doing something quite different from--and, ultimately, more profitable than--what everyone else who bet against the subprime mortgage market was doing: They bet against the upper floors--the double-A tranches--of the CDOs. After the fact, they'd realize they'd had two advantages. The first was that they had stumbled into the market very late, just before its collapse, and after a handful of other money managers. "One of the reasons we could move so fast," said Charlie, "is that we were seeing a lot of compelling analysis that we didn't have to create from scratch." The other advantage was their quixotic approach to financial markets: They were consciously looking for long shots. They were combing the markets for bets whose true odds were 10:1, priced as if the odds were 100:1. "We were looking for nonrecourse leverage," said Charlie. "Leverage means to magnify the effect. You have a crowbar, you take a little bit of pressure, you turn it into a lot of pressure. We were looking to get ourselves into a position where small changes in states of the world created huge changes in values."

Enter the CDO. They may not have known what a CDO was, but their minds were prepared for it, because a small change in the state of the world created a huge change in the value of a CDO. A CDO, in their view, was essentially just a pile of triple-B-rated mortgage bonds. Wall Street firms had conspired with the rating agencies to represent the pile as a diversified collection of assets, but anyone with eyes could see that if one triple-B subprime mortgage went bad, most would go bad, as they were all vulnerable to the same economic forces. Subprime mortgage loans in Florida would default for the same reasons, and at the same time, as subprime mortgage loans in California. And yet fully 80 percent of the CDO composed of nothing but triple-B bonds was rated higher than triple-B: triple-A, double-A, or A. To wipe out any triple-B bond--the ground floor of the building--all that was needed was a 7 percent loss in the underlying pool of home loans. That same 7 percent loss would thus wipe out, entirely, any CDO made up of triple-B bonds, no matter what rating was assigned it. "It took us weeks to really grasp it because it was so weird," said Charlie. "But the more we looked at what a CDO really was, the more we were like, Holy shit, that's just fucking crazy. That's fraud. Maybe you can't prove it in a court of law. But it's fraud."

It was also a stunning opportunity: The market appeared to believe its own lie. It charged a lot less for insurance on a putatively safe double-A-rated slice of a CDO than it did for insurance on the openly risky triple-B-rated bonds. Why pay 2 percent a year to bet directly against triple-B-rated bonds when they could pay 0.5 percent a year to make effectively the same bet against the double-A-rated slice of the CDO? If they paid four times less to make what was effectively the same bet against triple-B-rated subprime mortgage bonds, they could afford to make four times more of it.

They called around big Wall Street firms to see if anyone could dissuade them from buying credit default swaps on the double-A tranche of CDOs. "It really looked just too good to be true," said Jamie. "And when something looks too good to be true, we try to find out why." A fellow at Deutsche Bank named Rich Rizzo, who worked for Greg Lippmann, gave it a shot. The ISDA agreement that standardized CDSs on CDOs (a different agreement than the ISDA agreement that had standardized CDSs on mortgage bonds) had only been created a few months before, in June 2006, Rizzo explained. No one had as yet bought credit default swaps on the double-A piece of a CDO, which meant there wasn't likely to be a liquid market for them. Without a liquid market, they were not assured of being able to sell them when they wanted to, or to obtain a fair price." The other thing he said," recalled Charlie, "was that [things] will never get so bad that CDOs will go bad." Cornwall Capital disagreed. They didn't know for sure that subprime loans would default in sufficient numbers to cause the CDOs to collapse. All they knew was that Deutsche Bank didn't know, either, and neither did anybody else. There might be some "right" price for insuring the first losses on pools of bonds backed by pools of dubious loans, but it wasn't one-half of 1 percent.

Of course, if you are going to gamble on a CDO, it helps to know what, exactly, is inside a CDO, and they still didn't. The sheer difficulty they had obtaining the information suggested that most investors were simply skipping this stage of their due diligence. Each CDO contained pieces of a hundred different mortgage bonds--which in turn held thousands of different loans. It was impossible, or nearly so, to find out which pieces, or which loans. Even the rating agencies, who they at first assumed would be the most informed source, hadn't a clue. "I called S&P and asked if they could tell me what was in a CDO," said Charlie. "And they said, 'Oh yeah, we're working on that.'" Moody's and S&P were piling up these triple-B bonds, assuming they were diversified, and bestowing ratings on them--without ever knowing what was behind the bonds! There had been hundreds of CDO deals--400 billion dollars' worth of the things had been created in just the past three years--and yet none, as far as they could tell, had been properly vetted. Charlie located a reliable source for the contents of a CDO, a data company called Intex, but Intex wouldn't return his phone calls, and he gathered they didn't have much interest in talking to small investors. At length he found a Web site, run by Lehman Brothers, called LehmanLive.* LehmanLive didn't tell you exactly what was in a CDO, either, but it did offer a crude picture of its salient characteristics: what year the bonds behind it had been created, for instance, and how many of those bonds were backed chiefly by subprime loans. Projecting data onto the red brick wall of Julian Schnabel's studio, Charlie and Jamie went searching for two specific traits: CDOs that contained the highest percentage of bonds backed entirely by recent subprime mortgage loans, and CDOs that contained the highest percentage of other CDOs. Here was another bizarre fact about CDOs: Often they simply repackaged tranches of other CDOs, presumably those tranches their Wall Street creators had found difficult to sell. Even more amazing was their circularity: CDO "A" would contain a piece of CDO "B" CDO "B" would contain a piece of CDO "C" and CDO "C" would contain a piece of CDO "A"! Looking for bad bonds inside a CDO was like fishing for crap in a Port-O-Let: The question wasn't whether you'd catch some but how quickly you'd be satisfied you'd caught enough. Their very names were disingenuous, and told you nothing about their contents, their creators, or their managers: Carina, Gemstone, Octans III, Glacier Funding. "They all had these random names," said Jamie. "A lot of them for some reason we never figured out were named for mountains in the Adirondacks."

Charlie and Jamie continued to call everyone they could think of who was even remotely connected to this new market, in hopes of finding someone who could explain what appeared to them to be its sheer madness. A month later they finally found, and hired, their market expert--a fellow named David Burt. It was a measure of how much money people were making in the bond market that the magazine Institutional Investor was about to create a hot list of people who worked in it, called The 20 Rising Stars of Fixed Income. It was a measure of how much money people were making in the subprime mortgage market that David Burt made the list. Burt had worked for the $1 trillion bond fund BlackRock, owned, in part, by Merrill Lynch, evaluating subprime mortgage credit. His job was to identify for BlackRock the bonds that were going to go bad before they went bad. Now he had quit in hopes of raising his own fund to invest in subprime mortgage bonds, and, to make ends meet, he was willing to rent his expertise for $50,000 a month to these oddballs at Cornwall Capital. Burt had the most sensational information, and models to analyze that information--he could tell you, for example, what would happen to mortgage loans, zip code by zip code, in various house price scenarios. He could then take that information and tell you what was likely to happen to specific mortgage bonds. The best way to use this information, he thought, was to buy what appeared to be the sounder mortgage bonds and simultaneously sell the unsound ones.

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?"

CHAPTER SIX: Spider-Man at The Venetian

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.

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.

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.

CHAPTER SEVEN: The Great Treasure Hunt

Credit quality always gets better in March and April," said Eisman. "And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. And they sort of did. But they let the credit spreads tighten. We just thought that was moronic. What are you, fucking stupid?" Amazingly, the stock market continued to soar, and the television over the FrontPoint trading desks emitted a ceaselessly bullish signal.

CHAPTER NINE: A Death of Interest

It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader. The best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions.

At length the moment had come: The last buyer of subprime mortgage risk had stopped buying. On August 1, 2007, shareholders brought their first lawsuit against Bear Stearns in connection with the collapse of its subprime-backed hedge funds. Among its less visible effects was to alarm greatly the three young men at Cornwall Capital who sat on what was for them an enormous pile of credit default swaps purchased mostly from Bear Stearns. Ever since Las Vegas, Charlie Ledley had been unable to shake his sense of the enormity of the events they were living through. Ben Hockett, the only one of the three who had worked inside a big Wall Street firm, also tended to travel very quickly in his mind to some catastrophic endgame. And Jamie Mai just thought a lot of people on Wall Street were scumbags. All three were worried that Bear Stearns might fail and be unable to make good on its gambling debts. "There can come a moment when you can't trade with a Wall Street firm anymore," said Ben, "and it can come like that."

That first week in August, they kicked around and tried to get a feel for the prices of double-A-rated CDOs, which just a few months earlier had been trading at prices that suggested they were essentially riskless. "The underlying bonds were collapsing and all the people we'd dealt with were saying we'll give you two points," said Charlie. Right up through late July, Bear Stearns and Morgan Stanley were saying, in effect, that double-A CDOs were worth 98 cents on the dollar. The argument between Howie Hubler and Greg Lippmann was replaying itself throughout the market.

Cornwall Capital owned credit default swaps on twenty crappy CDOs, but each was crappy in its own special way, and so it was hard to get a read on exactly where they stood. One thing was clear: Their long-shot bet was no longer a long shot. Their Wall Street dealers had always told them that they'd never be able to get out of these obscure credit default swaps on double-A tranches of CDOs, but the market was panicking, and seemed eager to buy insurance on anything related to subprime mortgage bonds. The calculation had changed: For the first time, Cornwall stood to lose quite a bit of money if something happened that caused the market to rebound--if, say, the U.S. government stepped in and guaranteed all the subprime mortgages. And of course if Bear Stearns went down, they'd lose it all. Oddly alert to the possibility of catastrophe, they now felt oddly exposed to one. They rushed to cover themselves--to find some buyer of these strange and newly relevant insurance policies they had accumulated.

The job fell to Ben Hockett. Charlie Ledley had tried a few times to act as their trader and failed miserably. "There are all these little rules," said Charlie. "You have to know exactly what to say, and if you don't, everyone gets pissed off at you. I'd think I'd be saying, like, 'Sell!' and it turned out I was saying, like, 'Buy!' I sort of stumbled into the realization that I should not be doing trades." Ben had traded for a living and was the only one of the three who knew what to say and how to say it. Ben, however, was in the south of England, on vacation with his wife’s family.

“And so it was that Ben Hockett found himself sitting in a pub called The Powder Monkey, in the city of Exmouth, in the county of Devon, England, seeking a buyer of $205 million in credit default swaps on the double-A tranches of mezzanine subprime CDOs. The Powder Monkey had the town's lone reliable wireless Internet connection, and none of the enthusiastic British drinkers seemed to mind, or even notice, the American in the corner table bashing on his Bloomberg machine and talking into his cell phone from two in the afternoon until eleven at night. Up to that point, only three Wall Street firms had proved willing to deal with Cornwall Capital and give them the ISDA agreements necessary for dealing in credit default swaps: Bear Stearns, Deutsche Bank, and Morgan Stanley. "Ben had always told us that it's possible to do a trade without an ISDA, but it was really not typical," said Charlie. This was not a typical moment. On Friday, August 3, Ben called every major Wall Street firm and said, You don't know me and I know you won't give us an ISDA agreement, but I've got insurance on subprime mortgage-backed CDOs I’m willing to sell. Would you be willing to deal with me without an ISDA agreement? “The stock answer was no," said Ben. "And I'd say, 'Call your head of credit trading and call your head of risk management and see if they feel differently.'" That Friday only one bank seemed eager to deal with him: UBS. And they were very eager. The last man clinging to the helium balloon had just let go of his rope.

On Monday, August 6, Ben returned to The Powder Monkey and began to trade. For insurance policies costing half of 1 percent, UBS was now offering him 30 points up front--that is, Cornwall's $205 million in credit default swaps, which cost about a million bucks to buy, were suddenly worth a bit more than $60 million (30 percent of $205 million). UBS was no longer alone in their interest, however; the people at Citigroup and Merrill Lynch and Lehman Brothers, so dismissive on Friday, were eager on Monday. All of them were sweating and moaning to price the risks of these CDOs their firms had created. "It was easier for me because they had to look at every single deal," said Ben. "And I just wanted money." Cornwall had twenty separate positions to sell. Ben's Internet connection came and went, as did his cell phone reception. Only the ardor of the Wall Street firms, desperate to buy fire insurance on their burning home, remained undimmed. "It's the first time we're seeing any prices that reflect anything close to like what they're really worth," said Charlie. “We had positions that were being valued by Bear Stearns at six hundred grand that went to six million the next day.”

By eleven o’clock Thursday night Ben was finished. It was August 9, the same day that the French bank BNP announced that investors in their money market funds would be prevented from withdrawing their savings because of problems with U.S. subprime mortgages. Ben, Charlie, and Jamie were not clear on why three-quarters of their bets had been bought by a Swiss bank. The letters U B S had scarcely been mentioned inside Cornwall Capital until the bank had started begging them to sell them what was now very high-priced subprime insurance. "I had no particular reason to think UBS was even in the subprime business," said Charlie. "In retrospect, I can't believe we didn't turn around and get short UBS." In taking Cornwall's credit default swaps off its hands, neither UBS nor any of their other Wall Street buyers expressed the faintest reservations that they were now assuming the risk that Bear Stearns might fail: That thought, inside big Wall Street firms, was still unthinkable. Cornwall Capital, started four and a half years earlier with $110,000, had just netted, from a million-dollar bet, more than $80 million. "There was a relief that we had not been the chumps at the table," said Jamie. They had not been the chumps at the table. The long shot had paid 80:1. And no one at The Powder Monkey ever asked Ben what he was up to.

When banking stops, credit stops, and when credit stops, trade stops, and when trade stops--well, the city of Chicago had only eight days of chlorine on hand for its water supply. Hospitals ran out of medicine. The entire modern world was premised on the ability to buy now and pay later.

Twenty-two days later, on August 31, 2007, Michael Burry lifted the side pocket and began to unload his own credit default swaps in earnest. His investors could have their money back. There was now more than twice as much of it as they had given him. Just a few months earlier, Burry was being offered 200 basis points--or 2 percent of the principal--for his credit default swaps, which peaked at $1.9 billion. Now he was being offered 75, 80, and 85 points by Wall Street firms desperate to cushion their fall. At the end of the quarter, he'd report that the fund was up more than 100 percent. By the end of the year, in a portfolio of less than $550 million, he would have realized profits of more than $720 million.

CHAPTER TEN: Two Men in a Boat

The people rising out of the hole in the ground on the northeast corner of Madison Avenue and Forty-seventh Street at 6:40 in the morning revealed a great deal about themselves, if you knew what to look for. Anyone in that place at that time probably worked on Wall Street, for instance. The people emerging from the holes surrounding Penn Station, where Vincent Daniel’s train arrived at exactly the same time, weren’t so easy to predict. “Vinny’s morning train is only fifty-five percent financial, because that’s where the construction workers come in,” said Danny Moses. “Mine’s ninety-five.” To the untrained eye, the Wall Street people who rode from the Connecticut suburbs to Grand Central were an undifferentiated mass, but within that mass Danny noted many small and important distinctions.

If they were on their BlackBerrys, they were probably hedge fund guys, checking their profits and losses in the Asian markets. If they slept on the train they were probably sell-side people--brokers, who had no skin in the game. Anyone carrying a briefcase or a bag was probably not employed on the sell side, as the only reason you'd carry a bag was to haul around brokerage research, and the brokers didn't read their own reports--at least not in their spare time. Anyone carrying a copy of the New York Times was probably a lawyer or a back-office person or someone who worked in the financial markets without actually being in the markets.

Their clothes told you a lot, too. The guys who ran money dressed as if they were going to a Yankees game. Their financial performance was supposed to be all that mattered about them, and so it caused suspicion if they dressed too well. If you saw a buy-side guy in a suit, it usually meant that he was in trouble, or scheduled to meet with someone who had given him money, or both. Beyond that, it was hard to tell much about a buy-side person from what he was wearing. The sell side, on the other hand, might as well have been wearing their business cards: The guy in the blazer and khakis was a broker at a second-tier firm; the guy in the three-thousand-dollar suit and the hair just so was an investment banker at J.P. Morgan or someplace like that.

Danny could guess where people worked by where they sat on the train. The Goldman Sachs, Deutsche Bank, and Merrill Lynch people, who were headed downtown, edged to the front--though when Danny thought about it, few Goldman people actually rode the train anymore. They all had private cars. Hedge fund guys such as himself worked uptown and so exited Grand Central to the north, where taxis appeared haphazardly and out of nowhere to meet them, like farm trout rising to corn kernels.

EPILOGUE: Everything Is Correlated

What are the odds that people will make smart decisions about money if they don't need to make smart decisions--if they can get rich making dumb decisions? The incentives on Wall Street were all wrong; they're still all wrong.

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?

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.

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.

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.


Book: Fool's Gold by Gillian Tett

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