The Big Short: Inside the Doomsday Machine by Michael Lewis (2010) (read in 2017)

“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 gave up waiting. There was no scandal or reversal, I assumed, sufficiently great to sink the system.”

“Her message was clear: If you want to know what these Wall Street firms are really worth, take a cold, hard look at these crappy assets they’re holding with borrowed money, and imagine what they’d fetch in a fire sale.”

“This woman wasn’t saying that Wall Street bankers were corrupt. She was saying that they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.”

“By then there was a long and growing list of pundits who claimed they predicted the catastrophe, but a far shorter list of people who actually did.”

“Historically, a Wall Street firm worried over the creditworthiness of its customers; its customers often took it on faith that the casino would be able to pay off its winners. Mike Burry lacked faith. “I’m not making a bet against a bond,” he said. “I’m making a bet against a system.” He didn’t want to buy flood insurance from Goldman Sachs only to find, when the flood came, Goldman Sachs washed away and unable to pay him off. As the value of the insurance contract changed—say, as floodwaters approached but before they actually destroyed the building—he wanted Goldman Sachs and Deutsche Bank to post collateral, to reflect the increase in value of what he owned.”

“The U.S. mortgage bond market was huge, bigger than the market for U.S. Treasury notes and bonds. The entire economy was premised on its stability, and its stability in turn depended on house prices continuing to rise. “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.”

“At some point in between 1986 and 2006 a memo had gone out on Wall Street, saying that if you wanted to keep on getting rich shuffling bits of paper around to no obvious social purpose, you had better camouflage your true nature. Greg Lippmann was incapable of disguising himself or his motives. “I don’t have any particular allegiance to Deutsche Bank,” he’d say. “I just work there.” This was not an unusual attitude. What was unusual was that Lippmann said”

“Lippmann himself described it more bluntly to a Deutsche Bank colleague who had seen the presentation and dubbed him “Chicken Little.” “Fuck you,” Lippmann had said. “I’m short your house.””

“It didn’t matter whether Düsseldorf was buying actual cash subprime mortgage bonds or selling credit default swaps on those same mortgage bonds, as they amounted to one and the same thing: the long side of the bet.”

“Eisman really only had a couple of questions. The first: Tell me again how the hell a credit default swap works? The second: Why are you asking me to bet against bonds your own firm is creating, and arranging for the rating agencies to mis-rate? “In my entire life I never saw a sell-side guy come in and say, ‘Short my market,’” said Eisman.”

“There was more than one way to think about Mike Burry’s purchase of a billion dollars in credit default swaps. The first was as a simple, even innocent, insurance contract. Burry made his semiannual premium payments and, in return, received protection against the default of a billion dollars’ worth of bonds. He’d either be paid zero, if the triple-B-rated bonds he’d insured proved good, or a billion dollars, if those triple-B-rated bonds went bad. But of course Mike Burry didn’t own any triple-B-rated subprime mortgage bonds, or anything like them. He had no property to “insure” it was as if he had bought fire insurance on some slum with a history of burning down. To him, as to Steve Eisman, a credit default swap wasn’t insurance at all but an outright speculative bet against the market—and this was the second way to think about”

“The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs. And then—because it could not extend home loans fast enough to create a sufficient number of lower-rated bonds—it used credit default swaps to replicate the very worst of the existing bonds, many times over.”

“Goldman would buy the triple-A tranche of some CDO, pair it off with the credit default swaps AIG sold Goldman that insured the tranche (at a cost well below the yield on the tranche), declare the entire package risk-free, and hold it off its balance sheet. Of course, the whole thing wasn’t risk-free: If AIG went bust, the insurance was worthless, and Goldman could lose everything. Today Goldman Sachs is, to put it mildly, unhelpful when asked to explain exactly what it did,”

“The original home mortgage loans on whose fate both sides were betting played no other role. In a funny way, they existed only so that their fate might be gambled upon.”

“If credit default swaps were insurance, why weren’t they regulated as insurance? Why, for example, wasn’t AIG required to reserve capital against them? Why, for that matter, were Moody’s and Standard & Poor’s willing to bless 80 percent of a pool of dicey mortgage loans with the same triple-A rating they bestowed on the debts of the U.S. Treasury? Why didn’t someone, anyone, inside Goldman Sachs stand up and say, “This is obscene. The rating agencies, the ultimate pricers of all these subprime mortgage loans, clearly do not understand the risk, and their idiocy is creating a recipe for catastrophe”?”

“Confronted with the new fact—that his company was effectively long $50 billion in triple-B subprime mortgage bonds, masquerading as triple-A-rated diversified pools of consumer loans—Cassano at first sought to rationalize it. He clearly thought that any money he received for selling default insurance on highly rated bonds was free money. For the bonds to default, he now said, U.S. house prices had to fall, and Joe Cassano didn’t believe house prices could ever fall everywhere in the country at once. After all, Moody’s and S&P had both rated this stuff triple-A!”

“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.””

“Which of these poor Americans were likely to jump which way with their finances? How much did their home prices need to fall for their loans to blow up? Which mortgage originators were the most corrupt? Which Wall Street firms were creating the most dishonest mortgage bonds? What kind of people, in which parts of the country, exhibited the highest degree of financial irresponsibility?”

“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.”

“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.”

“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.”

“Barbell-shaped loan pools, with lots of very low and very high FICO scores in them, were a bargain compared to pools clustered around the 615 average—at least until the rest of Wall Street caught on to the hole in the brains of the rating agencies and bid up their prices.”

“As the bonds were all priced off the Moody’s rating, the most overpriced bonds were the bonds that had been most ineptly rated. And the bonds that had been most ineptly rated were the bonds that Wall Street firms had tricked the rating agencies into rating most ineptly. “I cannot fucking believe this is allowed,” said Eisman. “I must have said that one thousand times.””

“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. “I did half a billion. They said, ‘Would you like to do a billion?’ And I said, ‘Why am I pussyfooting around?’ It took two or three days to place twenty-five billion.” Paulson had never encountered a market in which an investor could sell short 25 billion dollars’ worth of a stock or bond without causing its price to move, even crash. “And we could have done fifty billion, if we’d wanted to.””

“The underlying mortgage loans were already going sour, and yet the prices of the bonds backed by the loans hadn’t budged. “That was the part that was so weird,” said Charlie. “They’d already started going bad. We just kept asking, ‘Who the hell is taking the other side of this trade?’ And the answer that kept coming back to us was, ‘It’s the CDOs.’””

“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 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.”

“Some of Lippmann’s former converts suspected that the subprime mortgage bond market was rigged by Wall Street to insure that credit default swaps would never pay off; others began to wonder if the investors on the other side of their bet might know something that they didn’t; and some simply wearied of paying insurance premiums to bet against bonds that never seemed to move.”

“Eisman had a curious way of listening; he didn’t so much listen to what you were saying as subcontract to some remote region of his brain the task of deciding whether whatever you were saying was worth listening to, while his mind went off to play on its own. As a result, he never actually heard what you said to him the first time you said it. If his mental subcontractor detected a level of interest in what you had just said, it radioed a signal to the mother ship, which then wheeled around with the most intense focus. “Say that again,” he’d say. And you would! Because now Eisman was so obviously listening to you, and, as he listened so selectively, you felt flattered”

“Later, whenever Eisman set out to explain to others the origins of the financial crisis, he’d start with his dinner with Wing Chau. Only now did he fully appreciate the central importance of the so-called mezzanine CDO—the CDO composed mainly of triple-B-rated subprime mortgage bonds—and its synthetic counterpart: the CDO composed entirely of credit default swaps on triple-B-rated subprime mortgage bonds. “You have to understand this,” he’d say. “This was the engine of doom.” He’d draw a picture of several towers of debt. The first tower was the original subprime loans that had been piled together. At the top of this tower was the triple-A tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche—the bonds Eisman had bet against. The Wall Street firms had taken these triple-B tranches—the worst of the worst—to build yet another tower of bonds: a CDO. A collateralized debt obligation. The reason they’d done this is that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce 80 percent of the bonds in it triple-A. These bonds could then be sold to investors—pension funds, insurance companies—which were allowed to invest only in highly rated securities.”

“Now that AIG had exited the market, the main buyers were CDO managers like Wing Chau. All by himself, Chau generated vast demand for the riskiest slices of subprime mortgage bonds, for which there had previously been essentially no demand. This demand led inexorably to the supply of new home loans, as material for the bonds.”

“That’s when Steve Eisman finally understood the madness of the machine. He and Vinny and Danny had been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the triple-B tranche of subprime mortgage–backed bonds without fully understanding why those firms were so eager to accept them. Now he was face-to-face with the actual human being on the other side of his credit default swaps. Now he got it: The credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product.”

“Wall Street needed his bets in order to synthesize more of them. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” said Eisman. “They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the subprime loans. That’s when I realized they needed us to keep the machine running. I was like, This is allowed?””

“There was only one answer: The triple-A ratings gave everyone an excuse to ignore the risks they were running.”

“He walked around the Las Vegas casino incredulous at the spectacle before him: seven thousand people, all of whom seemed delighted with the world as they found it. A society with deep, troubling economic problems had rigged itself to disguise those problems, and the chief beneficiaries of the deceit were its financial middlemen.”

““The ratings agency people were all like government employees.” Collectively they had more power than anyone in the bond markets, but individually they were nobodies. “They’re underpaid,” said Eisman. “The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for. There should be no greater thing you can do as an analyst than to be the Moody’s analyst. It should be, ‘I can’t go higher as an analyst.’ Instead it’s the bottom! No one gives a fuck if Goldman likes General Electric paper. If Moody’s downgrades GE paper, it is a big deal. So why does the guy at Moody’s want to work at Goldman Sachs? The guy who is the bank analyst at Goldman Sachs should want to go to Moody’s. It should be that elite.””

“In Vegas the question lingering at the back of their minds ceased to be, Do these bond market people know something we do not? It was replaced by, Do they deserve merely to be fired, or should they be put in jail? Are they delusional, or do they know what they’re doing? Danny thought that the vast majority of the people in the industry were blinded by their interests and failed to see the risks they had created. Vinny, always darker, said, “There were more morons than crooks, but the crooks were higher up.” The rating agencies were about as low as you could go and still be in the industry, and the people who worked for them really did not seem to know just how badly they had been gamed by big Wall Street firms. Their”

“To Charlie and Ben and Jamie it seemed perfectly clear that Wall Street was propping up the price of these CDOs so that they might either dump losses on unsuspecting customers or make a last few billion dollars from a corrupt market. In either case, they were squeezing and selling the juice from oranges that were undeniably rotten.”

“Complicated financial stuff was being dreamed up for the sole purpose of lending money to people who could never repay it.”

“To some meaningful number of his investors, it looked as if Burry simply did not want to accept the judgment of the marketplace: He’d made a bad bet and was failing to accept his loss. But to Burry, the judgment of the marketplace was fraudulent, and Joel Greenblatt didn’t know what he was talking about. “It became clear to me that they still didn’t understand the [credit default swap] positions,” he said.”

“That the panic inside Wall Street firms had begun before June 25 suggested to Michael Burry mainly that the Wall Street firms might be working with inside information about the remittance data. “The dealers often owned [mortgage] servicers,” he wrote, “and might have been able to get an inside track on the deterioration in the numbers.””

“I was in a state of perpetual disbelief. I would have thought that someone would have recognized what was coming before June 2007. If it really took that June remit data to cause a sudden realization, well, it makes me wonder what a ‘Wall Street analyst’ really does all day.””

“Morgan Stanley was making a bet not on the entire pool of subprime home loans but on the few loans in the pool least likely to be repaid. The size of the bet, however, remained the same as if no loan in the pool was ever repaid. They had bought flood insurance that, if a drop of water so much as grazed any part of the house, paid them the value of the entire house.”

“Between September 2006 and January 2007, the highest-status bond trader inside Morgan Stanley had, for all practical purposes, purchased $16 billion in triple-A-rated CDOs, composed entirely of triple-B-rated subprime mortgage bonds, which became valueless when the underlying pools of subprime loans experienced losses of roughly 8 percent. In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market but not smart enough to realize how cynical he needed to be.”

“VaR measured only the degree to which a given stock or bond had jumped around in the past, with the recent movements receiving a greater emphasis than movements in the more distant past. Having never fluctuated much in value, triple-A-rated subprime-backed CDOs registered on Morgan Stanley’s internal reports as virtually riskless.”

“Triple-A-rated subprime CDOs, of which there were now hundreds of billions of dollars’ worth buried inside various Wall Street firms, and which were assumed to be riskless, were now, according to Greg Lippmann, only worth 70 cents on the dollar.”

“At which point Greg Lippmann just said, Dude, fuck your model. I’ll make you a market. They are seventy–seventy-seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my fucking one point two billion dollars. Morgan Stanley didn’t want to buy any more subprime mortgage bonds. Howie Hubler didn’t want to buy any more subprime-backed bonds: He’d released his grip on the rope that tethered him to the rising balloon. Yet he didn’t want to take a loss, and insisted that, despite his unwillingness to buy more at 77, his triple-A CDOs were still worth 95 cents on the dollar.”

“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:”

“How do you explain to an innocent citizen of the free world the importance of a credit default swap on a double-A tranche of a subprime-backed collateralized debt obligation?”

“To his founding investor, Gotham Capital, he shot off an unsolicited e-mail that said only, “You’re welcome.” He’d already decided to kick them out of the fund, and insist that they sell their stake in his business. When they asked him to suggest a price, he replied, “How about you keep the tens of millions you nearly prevented me from earning for you last year and we call it even?””

“There was now hardly an important figure on Wall Street whom Eisman had not insulted, or tried to. At a public event in Hong Kong, after the chairman of HSBC had claimed that his bank’s subprime losses were “contained,” Eisman had raised his hand and said, “You don’t actually believe that, do you? Because your whole book is fucked.””

“At the end of 2007, Bear Stearns had nevertheless invited Eisman to a warm and fuzzy meet and greet with their new CEO, Alan Schwartz. Christmas with Bear, they called it. Schwartz told his audience how “crazy” the subprime bond market was, as no one in it seemed to be able to agree on the price of any given bond. “And whose fault is that?” Eisman had blurted out. “This is how you guys wanted it. So you could rip off your customers.””

““The upper classes of this country raped this country. You fucked people. You built a castle to rip people off. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience. Nobody ever said, ‘This is wrong.’ And no one ever gave a shit about what I had to say.” Actually, Eisman didn’t speak those final sentences that morning; he merely thought them.”

“On Tuesday the U.S. Federal Reserve announced that it had lent $85 billion to the insurance company AIG, to pay off the losses on the subprime credit default swaps AIG had sold to Wall Street banks—the biggest of which was the $13.9 billion AIG owed to Goldman Sachs. When you added in the $8.4 billion in cash AIG had already forked over to Goldman in collateral, you saw that Goldman had transferred more than $20 billion in subprime mortgage bond risk into the insurance company, which was in one way or another being covered by the U.S. taxpayer. That fact alone was enough to make everyone wonder at once how much more of this stuff was out there, and who owned it.”

“Merrill Lynch, which had begun by saying they had $7 billion in losses, now admitted the number was over $50 billion. Citigroup appeared to have about $60 billion. Morgan Stanley had its own $9-plus billion hit, and who knew what behind it. “We’d been wrong in our interpretation of what was going on,” said Charlie. “We had always assumed that they sold the triple-A CDOs to, like, the Korean Farmers Corporation. The way they were all blowing up implied they hadn’t. They’d kept it themselves.” The big Wall Street firms, seemingly so shrewd and self-interested, had somehow become the dumb money. The people who ran them did not understand their own businesses, and their regulators obviously knew even less.”

“The changes were camouflage. They helped to distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture. The surface rippled, but down below, in the depths, the bonus pool remained undisturbed.”

“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.”

“All that was clear was that the profits to be had from smart people making complicated bets overwhelmed anything that could be had from servicing customers, or allocating capital to productive enterprise.”

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

“U.S. Treasury Secretary Henry Paulson, persuaded the U.S. Congress that he needed $700 billion to buy subprime mortgage assets from banks. Thus was born TARP, which stood for Troubled Asset Relief Program. Once handed the money, Paulson abandoned his promised strategy and instead essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs, and a few others unnaturally selected for survival. For instance, the $13 billion AIG owed to Goldman Sachs, as a result of its bet on subprime mortgage loans, was paid off in full by the U.S. government: 100 cents on the dollar. These fantastic handouts—plus the implicit government guarantee that came with them—not only prevented Wall Street firms from failing but spared them from recognizing the losses in their subprime mortgage portfolios.”

“succeed. This new regime—free money for capitalists, free markets for everyone else—plus the more or less instant rewriting of financial history vexed all sorts of people, but few were as enthusiastically vexed as Steve Eisman. The world’s most powerful and most highly paid financiers had been entirely discredited; without government intervention every single one of them would have lost his job; and yet those same financiers were using the government to enrich themselves.”

““I can understand why Goldman Sachs would want to be included in the conversation about what to do about Wall Street,” he said. “What I can’t understand is why anyone would listen to them.” In Eisman’s view, the unwillingness of the U.S. government to allow the bankers to fail was less a solution than a symptom of a still deeply dysfunctional financial system.”

“The ability of Wall Street traders to see themselves in their success and their management in their failure would later be echoed, when their firms, which disdained the need for government regulation in good times, insisted on being rescued by government in bad times. Success was individual achievement; failure was a social problem.”