TANONA: A question on the risk again, [which] I know everybody has been dancing around.... Help us understand how this could happen that you could take this large of a loss. I mean, I would imagine that you guys have position limits and risk limits as such. I just--it [bewilders] me to think that you guys could have one desk that could lose $8 billion [sic].
JOHN MACK: That's a wrong question.
TANONA: Excuse me?
JOHN MACK: Hello. Hi. And...
TANONA: I missed you...
JOHN MACK: Bill, look, let's be clear. One, this trade was recognized and entered into our accounts. Two, it was entered into our risk management system. It's very simple. When these got, it's simple, it's very painful, so I'm not being glib. When these guys stress loss the scenario on putting on this position, they did not envision...that we could have this degree of default, right. It is fair to say that our risk management division did not stress those losses as well.* It's just simple as that. Those are big fat tail risks that caught us hard, right. That's what happened.
TANONA: Okay. Fair enough. I guess the other thing I would question. I am surprised that your trading VaR stayed stable in the quarter given this level of loss, and given that I would suspect that these were trading assets. So can you help me understand why your VaR didn't increase in the quarter dramatically?+
MACK: Bill, I think VaR is a very good representation of liquid trading risk. But in terms of the (inaudible) of that, I am very happy to get back to you on that when we have been out of this, because I can't answer that at the moment.
The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks. After all, he was himself a former bond trader, and had been brought in to embolden Morgan Stanley's risk-taking culture. Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion.
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.
His wife's extended English family of course wondered where he had been, and he tried to explain. He thought what was happening was critically important. The banking system was insolvent, he assumed, and that implied some grave upheaval. 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. "I'd come home at midnight and try to talk to my brother-in-law about our children's future," said Ben. "I asked everyone in the house to make sure their accounts at HSBC were insured. I told them to keep some cash on hand, as we might face some disruptions. But it was hard to explain." 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? He tried, but his English in-laws just looked at him strangely. They understood that someone else had just lost a great deal of money and Ben had just made a great deal of money, but never got much past that. "I can't really talk to them about it," he says. "They're English."
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. Still he heard not a peep from his investors. "Even when it was clear it was a big year and I was proven right, there was no triumph in it," he said. "Making money was nothing like I thought it would be." 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?"
When he'd started out, he'd decided not to charge his investors the usual 2 percent or so management fee for his services. In the one year in which he had not turned his investors' money into more money, the absence of a fee had meant having to fire employees. He now wrote his investors a letter letting them know he'd changed his policy--which enabled his investors to be angry with him all over again, even as he was making them rich. "I just wonder where you come up with the ways you find to piss people off," one of his e-mail friends wrote to him. "You have a gift."
One of the things he'd learned about Asperger's, since he'd discovered that he had it, was the role that his interests served. They were a safe place to which he could retreat from a hostile world. That was why people with Asperger's experienced them so intensely. That was also, oddly, why they couldn't control them. "The therapist I see helped me figure it out," he wrote in an e-mail, "and it makes a lot of sense when I look back at my own life:
Let me see if I can get it right--it always sounds better when the therapist says it. Well, if you start with a person who has tremendous difficulty integrating himself into the social workings of society, and often feels misunderstood, slighted, and lonely as a result, you will see where an intense interest can be something that builds up the ego in the classical sense. Asperger's kids can apply tremendous focus and ramp up knowledge of a subject in which they have an interest very quickly, often well beyond the level of any peers. That ego-reinforcement is very soothing, providing something that Asperger's kids just do not experience often, if at all. As long as the interest provides that reinforcement, there is little danger of a change. But when the interest encounters a rocky patch, or the person experiences failure in the interest, the negativity can be felt very intensely, especially when it comes from other people. The interest in such a case can simply start to mimic all that the Asperger's person was trying to escape--the apparent persecution, the misunderstanding, the exclusion by others. And the person with Asperger's would have to find another interest to build up and maintain the ego.
Most of 2006 and early 2007 Dr. Michael Burry had experienced as a private nightmare. In an e-mail, he wrote, "The partners closest to me tend to ultimately hate me.... This business kills a part of life that is pretty essential. The thing is, I haven't identified what it kills. But it is something vital that is dead inside of me. I can feel it." As his interest in financial markets seeped out of him, he bought his first guitar. It was strange: He couldn't play the guitar and had no talent for it. He didn't even want to play the guitar. He just needed to learn all about the sorts of wood used to make guitars, and to buy guitars and tubes and amps. He just needed to...know everything there was to know about guitars.
He'd picked an intelligent moment for the death of his interest. It was the moment at which the end was written: the moment at which there was nothing left to prevent. Six months from that moment, the International Monetary Fund would put losses on U.S.-originated subprime-related assets at a trillion dollars. One trillion dollars in losses had been created by American financiers, out of whole cloth, and embedded in the American financial system. Each Wall Street firm held some share of those losses, and could do nothing to avoid them. No Wall Street firm would be able to extricate itself, as there were no longer any buyers. It was as if bombs of differing sizes had been placed in virtually every major Western financial institution. The fuses had been lit and could not be extinguished. All that remained was to observe the speed of the spark, and the size of the explosions.
CHAPTER TEN
Two Men in a Boat
Virtually no one--be they homeowners, financial institutions, rating agencies, regulators, or investors--anticipated what is occurring.
--Deven Sharma, president of S&P Testimony before U.S. House of Representatives October 22, 2008
Pope Benedict XVI was the first to predict the crisis in the global financial system...Italian Finance Minister Giulio Tremonti said. "The prediction that an undisciplined economy would collapse by its own rules can be found" in an article written by Cardinal Joseph Ratzinger [in 1985], Tremonti said yesterday at Milan's Cattolica University.
--Bloomberg News, November 20, 2008
Greg Lippmann had imagined the subprime mortgage market as a great financial tug-of-war: On one side pulled the Wall Street machine making the loans, packaging the bonds, and repackaging the worst of the bonds into CDOs and then, when they ran out of loans, creating fake ones out of thin air; on the other side, his noble army of short sellers betting against the loans. The optimists versus the pessimists. The fantasists versus the realists. The sellers of credit default swaps versus the buyers. The wrong versus the right. The metaphor was apt, up to a point: this point. Now the metaphor was two men in a boat, tied together by a rope, fighting to the death. One man kills the other, hurls his inert body over the side--only to discover himself being yanked over the side. "Being short in 2007 an
d making money from it was fun, because we were short bad guys," said Steve Eisman. "In 2008 it was the entire financial system that was at risk. We were still short. But you don't want the system to crash. It's sort of like the flood's about to happen and you're Noah. You're on the ark. Yeah, you're okay. But you are not happy looking out at the flood. That's not a happy moment for Noah."
By the end of 2007 FrontPoint's bets against subprime mortgages had paid off so spectacularly that they had doubled the size of their fund, from a bit over $700 million to $1.5 billion. The moment it was clear they had made a fantastic pile of money, both Danny and Vinny wanted to cash in their bets. Neither one of had ever come around to completely trusting Greg Lippmann, and their mistrust extended even to this fantastic gift he had given them. "I'd never buy a car from Lippmann," said Danny. "But I bought five hundred million dollars' worth of credit default swaps from him." Vinny had an almost karmic concern about making so much money so quickly. "It was the trade of a lifetime," he said. "If we gave up the trade of a lifetime for greed, I'd have killed myself."
All of them, including Eisman, thought Eisman was temperamentally less than perfectly suited to making short-term trading judgments. He was emotional, and he acted on his emotions. His bets against subprime mortgage bonds were to him more than just bets; he intended them almost as insults. Whenever Wall Street people tried to argue--as they often did--that the subprime lending problem was caused by the mendacity and financial irresponsibility of ordinary Americans, he'd say, "What--the entire American population woke up one morning and said, 'Yeah, I'm going to lie on my loan application'? Yeah, people lied. They lied because they were told to lie." The outrage that fueled his gamble was aimed not at the entire financial system but at the people at the top of it, who knew better, or should have: the people inside the big Wall Street firms. "It was more than an argument," Eisman said. "It was a moral crusade. The world was upside down." The subprime loans at the bottom of their gamble were worthless, he argued, and if the loans were worthless, the insurance they owned on those loans should go nowhere but up. And so they held on to their credit default swaps, and waited for more loans to default. "Vinny and I would have done fifty million dollars and made twenty-five million dollars," said Danny. "Steve did five hundred and fifty million and made four hundred million."
The Big Short: Inside the Doomsday Machine Page 23
