The Big Short: Inside the Doomsday Machine

by Michael Lewis

  By April 2006 he'd finished buying insurance on subprime mortgage bonds. In a portfolio of $555 million, he had laid $1.9 billion of these peculiar bets--bets that should be paying off but were not. In May he adopted a new tactic: asking Wall Street traders if they would be willing to sell him even more credit default swaps at the price they claimed they were worth, knowing that they were not. "Never once has any counterparty been willing to sell me my list at my marks," he wrote in an e-mail. "Eighty to ninety per cent of the names on my list are not even available at any price." A properly functioning market would assimilate new information into the prices of securities; this multi-trillion-dollar market in subprime mortgage risk never budged. "One of the oldest adages in investing is that if you're reading about it in the paper, it's too late," he said. "Not this time." Steve Druskin was becoming more involved in the market--and couldn't believe how controlled it was. "What's amazing is that they make a market in this fantasy stuff," said Druskin. "It's not a real asset." It was as if Wall Street had decided to allow everyone to gamble on the punctuality of commercial airlines. The likelihood of United Flight 001 arriving on time obviously shifted--with the weather, mechanical issues, pilot quality, and so on. But shifting probabilities could be ignored, until the plane did or did not arrive. It didn't matter when big mortgage lenders like Ownit and ResCap failed, or some pool of subprime loans experienced higher than expected losses. All that mattered was what Goldman Sachs and Morgan Stanley decided should matter.

  The world's single biggest capital market wasn't a market; it was something else--but what? "I am actually protesting to my counterparties that there must be fraud in the marketplace for credit default swaps to be at all-time lows," Burry wrote in an e-mail to an investor he trusted. "What if CDSs are a fraud? I am asking myself that question all the time, and never have I felt like I should be thinking that way more than now. No way we should be down 5% this year just in mortgage CDSs." To his Goldman Sachs saleswoman, he wrote, "I think I am short housing but am I not, because CDSs are criminal?" When, a few months later, Goldman Sachs announced it was setting aside $542,000 per employee for the 2006 bonus pool, he wrote again: "As a former gas station attendant, parking lot attendant, medical resident and current Goldman Sachs screwee, I am offended."

  In the middle of 2006, he began to hear of other money managers who wanted to make the same bet he did. A few actually called and asked for his help. "I had all these people telling me I needed to get out of this trade," he said. "And I was looking at these other people and thinking how lucky they were to be able to get into this trade." If the market had been at all rational it would have blown up long before. "Some of the biggest funds on the planet have picked my brain and copied my strategy," he wrote in an e-mail. "So it won't just be Scion that makes money if this happens. Still, it won't be everyone."

  He was now undeniably miserable. "It feels like my insides are digesting themselves," he wrote to his wife in mid-September. The source of his unhappiness was, as usual, other people. The other people who bothered him the most were his own investors. When he opened his fund, in 2000, he released only his quarterly returns, and told his investors that he planned to tell them next to nothing about what he was up to. Now they were demanding monthly and even fortnightly reports, and pestered him constantly about the wisdom of his pessimism. "I almost think the better the idea, and the more iconoclastic the investor, the more likely you will get screamed at by investors," he said. He didn't worry about how screwed-up the market for some security became because he knew that eventually it would be disciplined by logic: Businesses either thrived or failed. Loans either were paid off or were defaulted upon. But these people whose money he ran were incapable of keeping their emotional distance from the market. They were now responding to the same surface stimuli as the entire screwed-up subprime mortgage market, and trying to force him to conform to its madness. "I do my best to have patience," he wrote to one investor. "But I can only be as patient as my investors." To another griping investor he wrote, "The definition of an intelligent manager in the hedge fund world is someone who has the right idea, and sees his investors abandon him just before the idea pays off." When he was making them huge sums of money, he had barely heard from them; the moment he started actually to lose a little, they peppered him with their doubts and suspicions:

  So I take it the monster dragging us out to sea is the CDS. You have created the plight of the old man and the sea.

  When do you see the end of the bleeding? (August down again 5%.) Are you running a riskier strategy now?

  You make me physically ill.... How dare you?

  Can you explain to me how we keep losing money on this position? If our potential losses are fixed it would seem to me based on how much we have lost that they should be a tiny part of the portfolio now.

  This last question kept popping up: How could a stock picker be losing so much on this one quixotic bond market bet? And he kept trying to answer it: He was committed to paying annual premiums amounting to about 8 percent of the portfolio, every year, for as long as the underlying loans existed--likely around five years but possibly as long as thirty. Eight percent times five years came to 40 percent. If the value of the credit default swaps fell by half, Scion registered a mark-to-market loss of 20 percent.

  More alarmingly, his credit default swap contracts contained a provision that allowed the big Wall Street firms to cancel their bets with Scion if Scion's assets fell below a certain level. There was suddenly a real risk that that might happen. Most of his investors had agreed to a two-year "lockup" and could not pull their money out at will. But of the $555 million he had under management, $302 million was eligible to be withdrawn either at the end of 2006 or in the middle of 2007, and investors were lining up to ask for their money back. In October 2006, with U.S. house prices experiencing their greatest decline in thirty-five years, and just weeks before the ABX index of triple-B mortgage bonds experienced its first "credit event" (that is, loss), Michael Burry faced the likelihood of a run on his fund--a fund that was now devoted to betting against the subprime mortgage market. "We were clinically depressed," said one of the several analysts Burry employed but never figured out what to do with, as he insisted on doing all the analysis himself. "You'd go to work and you'd say, 'I don't want to be here.' The trade was moving against you and investors wanted out."

  One night, as Burry was complaining to his wife about the complete absence of long-term perspective in the financial markets, a thought struck him: His agreement with his investors gave him the right to keep their money if he had invested it "in securities for which there is no public market or that are not freely tradable." It was left to the manager to decide if there was a public market for a security. If Michael Burry thought there wasn't--for instance, if he thought a market was temporarily not functioning or somehow fraudulent--he was permitted to "side-pocket" an investment. That is, he could tell his investors that they couldn't have their money back until the bet he'd made with it had run its natural course.

  And so he did what seemed to him the only proper and logical thing to do: He side-pocketed his credit default swaps. The long list of investors eager to get their money back from him--a list that included his founding backer, Gotham Capital--received the news from him in a terse letter: He was locking up between 50 and 55 percent of their money. Burry followed this letter with his quarterly report, which he hoped might make everyone feel a bit better. But he had no talent for caring what others thought of him: It was almost as if he didn't know how to do it. What he wrote sounded less like an apology than an assault. "Never before have I been so optimistic about the portfolio for a reason that has nothing to do with stocks," it began, and then it went on to explain how he had established a position in the markets that should be the envy of any money manager. How he had placed a bet not on "housing Armageddon" (even though he suspected that was coming) but on "the worst 5% or so of loans made in 2005." How his investors should feel lucky. He wrote as if he was sitting on
top of the world, when he was expected to feel as if the world was sitting on top of him. One of his biggest New York investors shot him an e-mail: "I'd be careful in the future using derogatory phrases such as 'we're short the mortgage portfolio everyone would want if they knew what they were doing' and 'sooner or later one of the big boys should really read a prospectus.'" One of his original two e-mail friends--both had stuck by him--wrote, "Nobody else except the North Korean dictator Kim Jong-Il would write a letter like that when they are down 17%."

  Immediately, his partners at Gotham Capital threatened to sue him. They soon were joined by others, who began to organize themselves into a legal fighting force. What distinguished Gotham was that their leaders flew out from New York to San Jose and tried to bully Burry into giving them back the $100 million they had invested with him. In January 2006 Gotham's creator, Joel Greenblatt, had gone on television to promote a book and, when asked to name his favorite "value investors," had extolled the virtues of a rare talent named Mike Burry. Ten months later he traveled three thousand miles with his partner, John Petry, to tell Mike Burry he was a liar and to pressure him into abandoning the bet Burry viewed as the single shrewdest of his career. "If there was one moment I might have caved, that was it," said Burry. "Joel was like a godfather to me--a partner in my firm, the guy that 'discovered' me and backed me before anyone outside my family did. I respected him and looked up to him." Now, as Greenblatt told him no judge in any court of law would side with his decision to side-pocket what was clearly a tradable security, whatever feelings Mike Burry had for him vanished. When Greenblatt asked to see a list of the subprime mortgage bonds Burry had bet against, Burry refused. From Greenblatt's point of view, he had given this guy $100 million and the guy was not only refusing to give it back but to even talk to him.

  And Greenblatt had a point. It was wildly unconventional to side-pocket an investment for which there was obviously a market. There was clearly some low price at which Michael Burry might bail out of his bet against the subprime mortgage bond market. 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.

  He was acutely aware that a great many of the people who had given him their money now despised him. The awareness caused him to (a) withdraw into his office and shout "Fuck" at the top of his lungs even more than usual; (b) develop a new contempt for his own investors; and (c) keep trying to explain his actions to them, even though they quite clearly were no longer listening. "I would prefer that you talk less and listen more," his lawyer, Steve Druskin, wrote to him, in late October 2006. "They are strategizing litigation."

  "It was kind of interesting," said Kip Oberting, who had arranged for White Mountains to become Burry's other original investor, before leaving for other ventures. "Because he had explained exactly what he was doing. And he had made people a bunch of money. You would have thought people would stick with him." They weren't merely not sticking with him but fleeing as fast as he would allow them. They hated him. "I just don't understand why people just don't see that I don't mean any harm," he said. Late on the night of December 29, Michael Burry sat alone in his office and typed a quick e-mail to his wife: "So incredibly depressing; I'm trying to come home, but I'm just so mad and depressed right now."

  And so in January 2007, just before Steve Eisman and Charlie Ledley headed gleefully to Las Vegas, Michael Burry sat down to explain to his investors how, in a year when the S&P had risen by more than 10 percent, he had lost 18.4 percent. A person who had had money with him from the beginning would have enjoyed gains of 186 percent over those six years, compared to 10.13 percent for the S&P 500 Index, but Burry's long-term success was no longer relevant. He was now being judged monthly. "The year just completed was one in which I underperformed nearly all my peers and friends by, variably, thirty or forty percentage points," he wrote. "A money manager does not go from being a near nobody to being nearly universally applauded to being nearly universally vilified without some effect." The effect, he went on to demonstrate, was to make him ever more certain that the entire financial world was wrong and he was right. "I have always believed that a single talented analyst, working very hard, can cover an amazing amount of investment landscape, and this belief remains unchallenged in my mind."

  Then he returned, as he always did, to the not so small matter of his credit default swaps: All the important facts pointed to their eventual success. In just the last two months, three big mortgage originators had failed...The Center for Responsible Lending was now predicting that, in 2007, 2.2 million borrowers would lose their homes, and one in five subprime mortgages issued in 2005 and 2006 would fail...

  Michael Burry was as good as teed up to become a Wall Street villain. His quarterly letters to his investors, which Burry considered private, were now routinely leaked to the press. A nasty piece appeared in a trade journal, suggesting that he had behaved unethically in side-pocketing his bet, and Burry felt certain it had been planted by one of his own investors. "Mike wasn't paranoid," said a New York investor who observed the behavior of other New York investors in Scion Capital. "People really were out to get him. When he becomes a bad guy he becomes this greedy sociopath who is going to steal all the money. And he can always go back to being a neurologist. It was the first thing everyone jumped to with Mike: He was a doctor." Burry began to hear strange rumors about himself. He'd left his wife and gone into hiding. He had fled to South America. "It's an interesting life I'm leading lately," Burry wrote to one of the e-mail friends.

  With all that has gone on recently, I've had the opportunity to talk with many of our investors, which is the first time I've done so in the history of the funds. I've been shocked by what I've heard. It appears that investors only have passingly paid attention to my letters, and many have been clinging to various rumors and hearsay in place of analysis or original thought. I've variably launched a private equity fund, tried to buy a Venezuelan gold company, launched a separate hedge fund called Milton's Opus, got divorced, got blown up, never disclosed the derivatives trade, borrowed $8 billion, spent much of the last two years in Asia, accused everyone but me on Wall Street of being idiots, siphoned off the capital of the funds into my personal account, and more or less turned Scion into the next Amaranth.* None of this is made up.

  He'd always been different from what one might expect a hedge fund manager to be. He wore the same shorts and t-shirts to work for days on end. He refused to wear shoes with laces. He refused to wear watches or even his wedding ring. To calm himself at work he often blared heavy metal music. "I think these personal foibles of mine were tolerated among many as long as things were going well," he said. "But when things weren't going well, they became signs of incompetence or instability on my part--even among employees and business partners."

  After the conference in Las Vegas the market had dropped, then recovered right through until the end of May. To Charlie Ledley at Cornwall Capital, the U.S. financial system appeared systematically corrupted by a cabal of Wall Street banks, rating agencies, and government regulators. To Steve Eisman at FrontPoint Partners, the market seemed mainly stupid or delusional: A financial culture that had experienced so many tiny panics followed by robust booms saw any sell-off as merely another buying opportunity. To Michael Burry, the subprime mortgage market looked increasingly like a fraud perpetrated by a handful of subprime bond trading desks. "Given the massive cheating on the part of our counterparties, the idea of taking the CDS[s] out of the side pocket is no longer worth considering," he wrote at the end of March 2007.

  The first half of 2007 was a very strange period in financial history. The facts on the ground in the housing market diverged further and further from the prices on the bonds and the insuranc
e on the bonds. Faced with unpleasant facts, the big Wall Street firms appeared to be choosing simply to ignore them. There were subtle changes in the market, however, and they turned up in Burry's e-mail in-box. On March 19 his salesman at Citigroup sent him, for the first time, serious analysis on a pool of mortgages. The mortgages were not subprime but Alt-A.* Still, the guy was trying to explain how much of the pool consisted of interest-only loans, what percentage was owner-occupied, and so on--the way a person might do who actually was thinking about the creditworthiness of the borrowers. "When I was analyzing these back in 2005," Burry wrote in an e-mail, sounding like Stanley watching tourists march through the jungle on a path he had himself hacked, "there was nothing even remotely close to this sort of analysis coming out of brokerage houses. I glommed onto 'silent seconds'* as an indicator of a stretched buyer and made it a high-value criterion in my selection process, but at the time no one trading derivatives had any idea what I was talking about and no one thought they mattered." In the long quiet between February and June 2007, they had begun to matter. The market was on edge. In the first quarter of 2007 Scion Capital was up nearly 18 percent.

  Then something changed--though at first it was hard to see what it was. On June 14, the pair of subprime mortgage bond hedge funds effectively owned by Bear Stearns went belly-up. In the ensuing two weeks, the publicly traded index of triple-B-rated subprime mortgage bonds fell by nearly 20 percent. Just then Goldman Sachs appeared to Burry to be experiencing a nervous breakdown. His biggest positions were with Goldman, and Goldman was newly unable, or unwilling, to determine the value of those positions, and so could not say how much collateral should be shifted back and forth. On Friday, June 15, Burry's Goldman Sachs saleswoman, Veronica Grinstein, vanished. He called and e-mailed her, but she didn't respond until late the following Monday--to tell him that she was "out for the day."