The Big Short: Inside the Doomsday Machine

by Michael Lewis

  "We just shorted Merrill Lynch," said Eisman.

  "Why?" asked Hintz.

  "We have a simple thesis," said Eisman. "There is going to be a calamity, and whenever there is a calamity, Merrill is there." When it came time to bankrupt Orange County with bad advice, Merrill was there. When the Internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman's logic: the logic of Wall Street's pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was crack the whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.

  On July 17, 2007, two days before Ben Bernanke, the Fed chairman, told the U.S. Senate that he saw no more than $100 billion in losses in the subprime mortgage market, FrontPoint did something unusual: It hosted its own conference call. They'd had calls with their tiny population of investors, but this time they just opened it up. Steve Eisman had become a poorly kept secret. "Steve was one of about two investors who completely understood what was going on," said one prominent Wall Street analyst. Five hundred people called in to hear what Eisman had to say, and another five hundred logged in afterward to listen to the recording. He explained the strange alchemy of the mezzanine CDO--and said that he expected losses up to $300 billion from this sliver of the market alone. To evaluate the situation, he told his audience, "Just throw your model in the garbage can. The models are all backward-looking. The models don't have any idea of what this world has become.... For the first time in their lives people in the asset-backed securitization world are actually having to think." He explained that the rating agencies were morally bankrupt and living in fear of becoming actually bankrupt. "The ratings agencies are scared to death," he said. "They're scared to death about doing nothing because they'll look like fools if they do nothing." He expected that fully half of all U.S. home mortgage loans--many trillions of dollars' worth--would suffer losses. "We are in the midst of one of the greatest social experiments this country has ever seen," said Eisman. "It's just not going to be a fun experiment.... You think this is ugly. You haven't seen anything yet." When he was done, the next speaker, an Englishman who ran a separate fund at FrontPoint, was slow to respond. "Sorry," the Englishman said wryly, "I just needed to calm down from hearing Steve say the world is ending." And everyone laughed.

  Later that very day, investors in the collapsed Bear Stearns hedge funds were informed that their $1.6 billion in triple-A-rated subprime-backed CDOs had not merely lost some value, they were worthless. Eisman was now convinced a lot of the biggest firms on Wall Street did not understand their own risks, and were in peril. At the bottom of his conviction lay his memory of his dinner with Wing Chau--when he grasped the central role of the mezzanine CDO and made a massive bet against those very same CDOs. This of course raised the question: What exactly is inside a CDO? "I didn't know what the fuck was in the things," said Eisman. "You couldn't do the analysis. You couldn't say, 'Give me all the ones with all California in them.' No one knew what was in them." They learned enough to know, as Danny put it, that "it was just all the pieces of shit we'd already shorted wrapped up together, into a portfolio." Beyond that they were flying blind. "Steve's nature is to put it on and figure it out later," said Vinny.

  Then came news. Eisman had long subscribed to a newsletter famous in Wall Street circles and obscure outside them, Grant's Interest Rate Observer. Its editor, Jim Grant, had been prophesying doom ever since the great debt cycle began, in the mid-1980s. In late 2006 Grant decided to investigate these strange Wall Street creations known as CDOs. Or, rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an MBA, to see if he could understand them. Gertner went off with the documents explaining CDOs to potential investors and sweated and groaned and heaved and suffered. "Then he came back," says Grant, "and said, 'I can't figure this thing out.' And I said, 'I think we have our story.'"

  Gertner dug and dug and finally concluded that no matter how much digging he did he'd never be able to get to the bottom of what exactly was inside a CDO--which, to Jim Grant, meant that no investor possibly could either. In turn this suggested what Grant already knew, that far too many people were taking far too many financial statements on faith. In early 2007 Grant wrote a series of pieces suggesting that the rating agencies had abandoned their posts--that they were almost surely rating these CDOs without themselves knowing exactly what was inside them. "The readers of Grant's have seen for themselves how a stack of non-investment grade mortgage slices can be rearranged to form a collateral debt obligation," one piece began. "And they have stared in amazement at the improvements that this mysterious process can effect in the credit ratings of the slices..." For his troubles, Grant, along with his trusted assistant, was called into S&P for a dressing-down. "We were actually summoned to the rating agency and told, 'You guys just don't get it,'" says Gertner. "Jim used the term 'alchemy' and they didn't like that term."

  Just a few miles north of Grant's Wall Street offices, an equity hedge fund manager with a darkening view of the world was wondering why he hadn't heard others voice suspicion about the bond market and its abstruse creations. In Jim Grant's essay, Steve Eisman found independent confirmation of his theory of the financial world. "When I read it," said Eisman, "I thought, Oh my God, this is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm."

  CHAPTER EIGHT

  The Long Quiet

  The day Steve Eisman became the first man ever to take almost sexual pleasure in an essay in Grant's Interest Rate Observer, Dr. Michael Burry received from his CFO a copy of the same story, along with a jokey note: "Mike--you haven't taken a side job writing for Grant's, have you?"

  "I haven't," Burry replied, seeing no obvious good news in the discovery that there was someone out there who thought as he did. "I'm a bit surprised we haven't been contacted by Grant's..." He was still in the financial world but apart from it, as if on the other side of a pane of glass he couldn't bring himself to tap upon. He'd been the first investor to diagnose the disorder in the American financial system in early 2003: the extension of credit by instrument. Complicated financial stuff was being dreamed up for the sole purpose of lending money to people who could never repay it. "I really do believe the final act in play is a crisis in our financial institutions, which are doing such dumb, dumb things," he wrote, in April 2003, to a friend who had wondered why Scion Capital's quarterly letters to its investors had turned so dark. "I have a job to do. Make money for my clients. Period. But boy it gets morbid when you start making investments that work out extra great if a tragedy occurs." Then, in the spring of 2005, he had identified, before any other investor, precisely which tragedy was most likely to occur, when he made a large, explicit bet against subprime mortgage bonds.

  Now, in February 2007, subprime loans were defaulting in record numbers, financial institutions were less steady every day, and no one but him seemed to recall what he'd said and done. He had told his investors that they might need to be patient--that the bet might not pay off until the mortgages issued in 2005 reached the end of their teaser rate period. They had not been patient. Many of his investors mistrusted him, and he in turn felt betrayed by them. At the beginning he had imagined the end, but none of the parts in between. "I guess I wanted to just go to sleep and wake up in 2007," he said. To keep his bets against subprime mortgage bonds, he'd been forced to fire half his small staff, and dump billions of dollars' worth of bets he had made against the companies most closely associated with the subprime mortgage market. He was now more isolated than he'd ever been. The only thing that had changed was his explanation for it.

  Not long before, his wife had dragged him to the office of a Stanford psychologist. A preschool teacher had noted certain worrying beha
viors in their four-year-old son, Nicholas, and suggested he needed testing. Nicholas didn't sleep when the other kids slept. He drifted off when the teacher talked at any length. His mind seemed "very active." Michael Burry had to resist his urge to take offense. He was, after all, a doctor, and he suspected that the teacher was trying to tell them that he had failed to diagnose attention deficit disorder in his own son. "I had worked in an ADHD clinic during my residency, and had strong feelings that this was overdiagnosed," he said. "That it was a 'savior' diagnosis for too many kids whose parents wanted a medical reason to drug their children, or to explain their kids' bad behavior." He suspected his son was a bit different from the other kids, but different in a good way. "He asked a ton of questions," said Burry. "I had encouraged that, because I always had a ton of questions as a kid, and I was frustrated when I was told to be quiet." Now he watched his son more carefully, and noted that the little boy, while smart, had problems with other people. "When he did try to interact, even though he didn't do anything mean to the other kids, he'd somehow tick them off." He came home and told his wife, "Don't worry about it! He's fine!"

  His wife stared at him and asked, "How would you know?"

  To which Dr. Michael Burry replied, "Because he's just like me! That's how I was."

  Their son's application to several kindergartens met with quick rejections, unaccompanied by explanations. Pressed, one of the schools told Burry that his son suffered from inadequate gross and fine motor skills. "He had apparently scored very low on tests involving art and scissor use," said Burry. "Big deal, I thought. I still draw like a four-year-old, and I hate art." To silence his wife, however, he agreed to have their son tested. "It would just prove he's a smart kid, an 'absentminded genius.'"

  Instead, the tests administered by a child psychologist proved that their child had Asperger's syndrome. A classic case, she said, and recommended that the child be pulled from the mainstream and sent to a special school. And Dr. Michael Burry was dumbstruck: He recalled Asperger's from med school, but vaguely. His wife now handed him the stack of books she had accumulated on autism and related disorders. On top were The Complete Guide to Asperger's Syndrome, by a clinical psychologist named Tony Attwood, and Attwood's Asperger's Syndrome: A Guide for Parents and Professionals.

  "Marked impairment in the use of multiple non-verbal behaviors such as eye-to-eye gaze..."

  Check.

  "Failure to develop peer relationships..."

  Check.

  "A lack of spontaneous seeking to share enjoyment, interests, or achievements with other people..."

  Check.

  "Difficulty reading the social/emotional messages in someone's eyes..."

  Check.

  "A faulty emotion regulation or control mechanism for expressing anger..."

  Check.

  "...One of the reasons why computers are so appealing is not only that you do not have to talk or socialize with them, but that they are logical, consistent and not prone to moods. Thus they are an ideal interest for the person with Asperger's Syndrome..."

  Check.

  "Many people have a hobby.... The difference between the normal range and the eccentricity observed in Asperger's Syndrome is that these pursuits are often solitary, idiosyncratic and dominate the person's time and conversation."

  Check...Check...Check.

  After a few pages, Michael Burry realized that he was no longer reading about his son but about himself. "How many people can pick up a book and find an instruction manual for their life?" he said. "I hated reading a book telling me who I was. I thought I was different, but this was saying I was the same as other people. My wife and I were a typical Asperger's couple, and we had an Asperger's son." His glass eye no longer explained anything; the wonder is that it ever had. How did a glass eye explain, in a competitive swimmer, a pathological fear of deep water--the terror of not knowing what lurked beneath him? How did it explain a childhood passion for washing money? He'd take dollar bills and wash them, dry them off with a towel, press them between the pages of books, and then stack books on top of those books--all so he might have money that looked "new." "All of a sudden I've become this caricature," said Burry. "I've always been able to study up on something and ace something really fast. I thought it was all something special about me. Now it's like, 'Oh, a lot of Asperger's people can do that.' Now I was explained by a disorder."

  He resisted the news. He had a gift for finding and analyzing information on the subjects that interested him intensely. He always had been intensely interested in himself. Now, at the age of thirty-five, he'd been handed this new piece of information about himself--and his first reaction to it was to wish he hadn't been given it. "My first thought was that a lot of people must have this and don't know it," he said. "And I wondered, Is this really a good thing for me to know at this point? Why is it good for me to know this about myself?"

  He went and found his own psychologist to help him sort out the effect of his syndrome on his wife and children. His work life, however, remained uninformed by the new information. He didn't alter the way he made investment decisions, for instance, or the way he communicated with his investors. He didn't let his investors know of his disorder. "I didn't feel it was a material fact that had to be disclosed," he said. "It wasn't a change. I wasn't diagnosed with something new. It's something I'd always had." On the other hand, it explained an awful lot about what he did for a living, and how he did it: his obsessive acquisition of hard facts, his insistence on logic, his ability to plow quickly through reams of tedious financial statements. People with Asperger's couldn't control what they were interested in. It was a stroke of luck that his special interest was financial markets and not, say, collecting lawn mower catalogues. When he thought of it that way, he realized that complex modern financial markets were as good as designed to reward a person with Asperger's who took an interest in them. "Only someone who has Asperger's would read a subprime mortgage bond prospectus," he said.

  By early 2007 Michael Burry found himself in a characteristically bizarre situation. He'd bought insurance on a lot of truly crappy subprime mortgage bonds, created from loans made in 2005, but they were his credit default swaps. They weren't traded often by others; a lot of people took the view that the loans made in 2005 were somehow sounder than the loans made in 2006; in bond market parlance, they were "off the run." That was their biggest claim: The pools of loans he had bet against were "relatively clean." To counter the assertion, he commissioned a private study, and found that the pools of loans he had shorted were nearly twice as likely to be in bankruptcy and a third more likely to have been foreclosed upon than the general run of 2005 subprime deals. The loans made in 2006 were indeed worse than those made in 2005, but the loans made in 2005 remained atrocious, and closer to the dates when their interest rates would reset. He had picked exactly the right homeowners to bet against.

  All through 2006, and the first few months of 2007, Burry sent his list of credit default swaps to Goldman and Bank of America and Morgan Stanley with the idea they would show it to possible buyers, so he might get some idea of the market price. That, after all, was the dealers' stated function: middlemen. Market-makers. That is not the function they served, however. "It seemed the dealers were just sitting on my lists and bidding extremely opportunistically themselves," said Burry. The data from the mortgage servicers was worse every month--the loans underlying the bonds were going bad at faster rates--and yet the price of insuring those loans, they said, was falling. "Logic had failed me," he said. "I couldn't explain the outcomes I was seeing." At the end of each day there was meant to be a tiny reckoning: If the subprime market had fallen, they would wire money to him; if it had strengthened, he would wire money to them. The fate of Scion Capital turned on these bets, but that fate was not, in the short run, determined by an open and free market. It was determined by Goldman Sachs and Bank of America and Morgan Stanley, who decided each day whether Mike Burry's credit default swaps had made or lost money.
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br />   It was true, however, that his portfolio of credit default swaps was uncommon. They were selected by an uncommon character, with an uncommon view of the financial markets, operating alone and apart. This fact alone enabled Wall Street firms to dictate to him the market price. With no one else buying and selling exactly what Michael Burry was buying and selling, there was no hard evidence what these things were worth--so they were worth whatever Goldman Sachs and Morgan Stanley said they were worth. Burry detected a pattern in how they managed their market: All good news about the housing market, or the economy, was treated as an excuse to demand collateral from Scion Capital; all bad news was pooh-poohed as in some way irrelevant to the specific bets he had made. The firms always claimed that they had no position themselves--that they were running matched books--but their behavior told him otherwise. "Whatever the banks' net position was would determine the mark," he said. "I don't think they were looking to the market for their marks. I think they were looking to their needs." That is, the reason they refused to acknowledge that his bet was paying off was that they were on the other side of it. "When you talk to dealers," he wrote in March 2006 to his in-house lawyer, Steve Druskin, "you are getting the view from their book. Whatever they've got on their book will be their view. Goldman happens to be warehousing a lot of this risk. They'll talk as if nothing has been seen in the mortgage pools. No need to incite panic...and this has worked. As long as they can entice more [money] into the market, the problem is resolved. That's been the history of the last 3-4 years."