The Big Short: Inside the Doomsday Machine

by Michael Lewis

  By the time they called UBS, the big Swiss bank, they knew enough not to answer when the guy on the other end of the line asked them how much money they had. "We learned to spin that one," said Jamie. As a result, UBS took a bit longer than the others to turn them down. "They were, like, 'How much do you short?'" recalled Charlie. "And we said not very much. So they ask, 'How often do you trade?' We say, not very often. And there was this long silence. Then, 'Let me talk to my boss.' And we never heard back from them."

  They had no better luck with Morgan Stanley or Merrill Lynch and the rest. "They would say, 'Show us your marketing materials,'" said Charlie, "and we would say, 'Uh, we don't have those.' They'd say, 'Okay, then show us your offering documents.' We didn't have any offering documents because it wasn't other people's money. So they'd say, 'Okay, then just show us your money.' We'd say, 'Um, we don't exactly have enough of that, either.' They'd say, 'Okay, then just show us your resumes.'" If Charlie and Jamie had any connection to the world of money management--former employment, say--it might have lent some credibility to their application, but they didn't. "It always ended with them sort of asking, 'So what do you have?'"

  Chutzpah. Plus $30 million with which they were willing and able to do anything they wanted to do. Plus a former derivatives trader with an apocalyptic streak who knew how these big Wall Street firms worked. "Jamie and Charlie had been asking for an ISDA for two years, but they really just didn't know how to ask," said Ben. "They didn't even know the term 'ISDA.'"

  Charlie never completely understood how Ben did it, but he somehow persuaded Deutsche Bank, which required an investor to control $2 billion to be treated as an institution, to accept Cornwall Capital on their "institutional platform." Ben claimed that it was really only a matter of knowing the right people to call, and the language in which to address their concerns. Before they knew it, a team from Deutsche Bank agreed to pay a call on Cornwall Capital to determine if they were worthy of the distinction: Deutsche Bank institutional customer. "Ben gives good bank," said Charlie.

  Deutsche Bank had a program it called KYC (Know Your Customer), which, while it didn't involve anything so radical as actually knowing their customers, did require them to meet their customers, in person, at least once. Hearing that they were to be on the receiving end of KYC, it occurred to Charlie and Jamie, for the first time, that working out of Julian Schnabel's studio in the wrong part of Greenwich Village might raise more questions than it answered. "We had an appearance problem," said Jamie delicately. From upstairs wafted the smell of fresh paint; from downstairs, the site of the lone toilet, came the sounds of a sweatshop. "Before they came," said Charlie, "I remember thinking, If anyone has to go to the bathroom, we're in trouble." Cornwall Capital's own little space inside the larger space was charmingly unfinancial--a dark room in the back with red brick walls that opened onto a small, junglelike garden in which it was easier to imagine a seduction scene than the purchase of a credit default swap. "There was an awkward moment or two, due to the fact that our offices had a tailor working downstairs, and they could hear her," said Jamie. But no one from Deutsche Bank had to go to the bathroom, and Cornwall Capital Management got its ISDA.

  This agreement, in its fine print, turned out to be long on Cornwall Capital's duties to Deutsche Bank and short on Deutsche Bank's duties to Cornwall Capital. If Cornwall Capital made a bet with Deutsche Bank and it wound up "in the money," Deutsche Bank was not required to post collateral. Cornwall would just have to hope that Deutsche Bank could make good on its debts. If, on the other hand, the trade went against Cornwall Capital, they were required to post the amount they were down, daily. At the time, Charlie and Jamie and Ben didn't worry much about this provision, or similar provisions in the ISDA they landed with Bear Stearns. They were happy just to be allowed to buy credit default swaps from Greg Lippmann.

  Now what? They were young men in a hurry--they couldn't believe the trade existed and didn't know how much longer it would--but they spent several weeks arguing among themselves about it. Lippmann's sales pitch was as alien to them as it was intriguing. Cornwall Capital had never bought or sold a mortgage bond, but they could see that a credit default swap was really just a financial option: You paid a small premium, and, if enough subprime borrowers defaulted on their mortgages, you got rich. In this case, however, they were being offered a cheap ticket to a drama that looked virtually certain to happen. They created another presentation to give to themselves. "We're looking at the trade," said Charlie, "and we're thinking, like, this is too good to be true. Why the hell should I be able to buy CDSs on the triple-Bs [credit default swaps on the triple-B tranche of subprime mortgage bonds] at these levels? Who in their right mind is saying, 'Wow, I think I'll take two hundred basis points to take this risk?' It just seems like a ridiculously low price. It doesn't make sense." It was now early October 2006. A few months earlier, in June, national home prices, for the first time, had begun to fall. In five weeks, on November 29, the index of subprime mortgage bonds, called the ABX, would post its first interest-rate shortfall. The borrowers were failing to make interest payments sufficient to pay off the riskiest subprime bonds. 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.'" Which of course just raised another question: Who, or what, was a CDO?

  Typically when they entered a new market--because they'd found some potential accident waiting to happen that seemed worth betting on--they found an expert to serve as a jungle guide. This market was so removed from their experience that it took them longer than usual to find help. "I had a vague idea what an ABS [asset-backed security] was," said Charlie. "But I had no idea what a CDO was." Eventually they figured out that language served a different purpose inside the bond market than it did in the outside world. Bond market terminology was designed less to convey meaning than to bewilder outsiders. Overpriced bonds were not "expensive" overpriced bonds were "rich," which almost made them sound like something you should buy. The floors of subprime mortgage bonds were not called floors--or anything else that might lead the bond buyer to form any sort of concrete image in his mind--but tranches. The bottom tranche--the risky ground floor--was not called the ground floor but the mezzanine, or the mezz, which made it sound less like a dangerous investment and more like a highly prized seat in a domed stadium. A CDO composed of nothing but the riskiest, mezzanine layer of subprime mortgages was not called a subprime-backed CDO but a "structured finance CDO." "There was so much confusion about the different terms," said Charlie. "In the course of trying to figure it out, we realize that there's a reason why it doesn't quite make sense to us. It's because it doesn't quite make sense."

  The subprime mortgage market had a special talent for obscuring what needed to be clarified. A bond backed entirely by subprime mortgages, for example, wasn't called a subprime mortgage bond. It was called an ABS, or asset-backed security. When Charlie asked Deutsche Bank exactly what assets secured an asset-backed security, he was handed lists of abbreviations and more acronyms--RMBS, HELs, HELOCs, Alt-A--along with categories of credit he did not know existed ("midprime"). RMBS stood for residential mortgage-backed security. HEL stood for home equity loan. HELOC stood for home equity line of credit. Alt-A was just what they called crappy mortgage loans for which they hadn't even bothered to acquire the proper documents--to verify the borrower's income, say. "A" was the designation attached to the most creditworthy borrowers; Alt-A, which stood for "Alternative A-paper," meant an alternative to the most creditworthy, which of course sounds a lot more fishy once it is put that way. As a rule, any loan that had been turned into an acronym or abbreviation could more clearly be called a "subprime loan," but the bond market didn't want to be clear. "Midprime" was a kind of triumph of language over truth. Some crafty bond mar
ket person had gazed upon the subprime mortgage sprawl, as an ambitious real estate developer might gaze upon Oakland, and found an opportunity to rebrand some of the turf. On Oakland's fringe there was a neighborhood, masquerading as an entirely separate town, called Rockridge. Simply by refusing to be called Oakland, Rockridge enjoyed higher property values. Inside the subprime mortgage market there was now a similar neighborhood known as midprime. Midprime was subprime--and yet somehow, ineffably, not. "It took me a while to figure out that all of this stuff inside the bonds was pretty much exactly the same thing," said Charlie. "The Wall Street firms just got the ratings agencies to accept different names for it so they could make it seem like a diversified pool of assets."

  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."

  They made a hasty list of what they hoped was the worst crap and called up several brokers. It had been hard for them to wriggle free of the brokers who covered rich people and to get into the arms of brokers who covered big, stock market-investing institutions. It was hard all over again to escape the big-time stock market brokers and win acceptance from the people inside th
e subprime mortgage bond market. "A lot of people when we called them said, 'Hey, why don't you guys buy some stocks!'" said Charlie. Bear Stearns couldn't believe that these young guys with no money wanted to buy not just credit default swaps but a credit default swap so esoteric that no one else had bought it. "I remember laughing at them," said the Bear Stearns credit default swap salesman who took their first inquiry.

  At Deutsche Bank they were passed off to a twenty-three-year-old bond salesman who had never had a customer of his own. "The reason I got to know Ben and Charlie," says this young man, "was that no one else at Deutsche Bank would deal with them. They had, like, twenty-five million bucks, which for Deutsche Bank was not really significant. No one wanted to pick up their calls. People were making fun of their name--they'd say, like, 'Oh, it's Cornhole Capital calling again.'" Still, Deutsche Bank proved, once again, the most willing to deal with them. On October 16, 2006, they bought from Greg Lippmann's trading desk $7.5 million in credit default swaps on the double-A tranche of a CDO named, for no apparent reason, Pine Mountain. Four days later, Bear Stearns sold them $50 million more. "They knew Ace somehow," said the Bear Stearns credit default swap salesman. "So we wound up dealing with them."

  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.