The Big Short: Inside the Doomsday Machine

by Michael Lewis

  The Great Treasure Hunt had yielded a long list of companies exposed to subprime loans. By March 14, 2008, they had sold short the stocks of virtually every financial firm in any way connected to the doomsday machine. "We were positioned for Armageddon," said Eisman, "but always at the back of our minds was, What if Armageddon doesn't happen?"

  On March 14, the question became moot. From the time Bear Stearns's subprime hedge funds had collapsed, in June 2007, the market was asking questions about the rest of Bear Stearns. Over the past decade, like every other Wall Street firm, Bear Stearns had increased the size of the bets it made with every dollar of its capital. In just the past five years, Bear Stearns's leverage had gone from 20:1 to 40:1. Merrill Lynch's had gone from 16:1 in 2001 to 32:1 in 2007. Morgan Stanley and Citigroup were now at 33:1, Goldman Sachs looked conservative at 25:1, but then Goldman had a gift for disguising how leveraged it actually was. To bankrupt any of these firms, all that was required was a very slight decline in the value of their assets. The trillion-dollar question was, What were those assets? Until March 14, the stock market had given the big Wall Street firms the benefit of the doubt. No one knew what was going on inside Bear Stearns or Merrill Lynch or Citigroup, but these places had always been the smart money, ergo their bets must be the smart bets. On March 14, the market changed its opinion.

  That morning, Eisman had been invited on short notice by Deutsche Bank's prominent bank analyst Mike Mayo to address a roomful of big investors. In an auditorium at Deutsche Bank's Wall Street headquarters, Eisman was scheduled to precede the retired chairman of the Federal Reserve, Alan Greenspan, and be paired with a famous investor named Bill Miller--who also happened to own more than $200 million of Bear Stearns stock. Eisman obviously thought it insane that anyone would sink huge sums of money into any Wall Street firm. Greenspan he viewed as almost beneath his contempt, which was saying something. "I think Alan Greenspan will go down as the worst chairman of the Federal Reserve in history," he'd say, when given the slightest chance. "That he kept interest rates too low for too long is the least of it. I'm convinced that he knew what was happening in subprime, and he ignored it, because the consumer getting screwed was not his problem. I sort of feel sorry for him because he's a guy who is really smart who was basically wrong about everything."

  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." Eisman had invited the bullish-on-subprime Bear Stearns analyst Gyan Sinha to his office and grilled him so mercilessly that a Bear Stearns salesman had called afterward and complained.

  "Gyan is upset," he said.

  "Tell him not to be," said Eisman. "We enjoyed it!"

  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."

  To which the new CEO replied, "I don't want to cast blame."

  Which Wall Street big shots Eisman had insulted was a matter of which Wall Street big shots' presence Eisman was allowed into. On March 14, 2008, he was invited into the presence of one of the biggest and most famous bullish investors in Wall Street banks, plus that of the illustrious former chairman of the Federal Reserve. It was a busy day in the markets--there were rumors that Bear Stearns might be having troubles--but, given a choice between watching the markets and watching Eisman, Danny Moses and Vincent Daniel and Porter Collins didn't think twice. "Let's be honest," said Vinny. "We went for the entertainment. It's like Ali-Frasier. Why would you not want to be there?" They drove to the fight with Ali, but took seats in the back row, and prepared to hide.

  Eisman sat at a long table with the legendary Bill Miller. Miller spoke for maybe three minutes, and explained the wisdom of his investment in Bear Stearns. "And now for our bear," said Mike Mayo. "Steve Eisman."

  "I got to stand up for this," said Eisman.

  Miller had given his little talk sitting down. The event was meant to be more of a panel discussion than a speech, but Eisman made for the podium. Noting the presence of his mother in the third row, but ignoring his partners in the back, along with the crowd of twenty his partners had alerted (free tickets to Ali-Frasier!), Eisman launched a ruthlessly reasonable dissection of the U.S. financial system. "Why This Time Is Different" was the title of his speech--even though it still wasn't clear he was meant to be giving anything so formal as a speech. "We are going through the greatest deleveraging in the history of financial services and it's going to go on and on and on," he said. "There is no solution other than time. Time to take the pain..."

  As Eisman had risen, Danny had sunk in his chair, instinctively. "There is always the possibility of embarrassment," Danny said. "But it's like watching a car crash. You can't not watch." All around him men hunched over their BlackBerrys. They wanted to hear what Eisman had to say, clearly, but the stock market was distracting them from the show. At 9:13, as Eisman was finding his place at the front of the room, Bear Stearns had announced that it had gotten a loan from J.P. Morgan. Nine minutes later, as Bill Miller explained why it was such a good idea to own stock in Bear Stearns, Alan Schwartz had issued a press release. "Bear Stearns has been the subject of a multitude of rumors concerning our liquidity," it began. Liquidity. When an executive said his bank had plenty of liquidity it always meant that it didn't.

  At 9:41, or roughly the time Eisman made his bid for the podium, Danny sold some Bear Stearns shares that Eisman, oddly enough, had bought the night before, at $53 a share. They'd made a few bucks, but it was still mystifying that Eisman had bought them, over everyone else's objections. Every now and then, Eisman made some short-term trade of trivial size that totally contradicted everything they believed. Danny and Vinny both thought the problem in this case was Eisman's affinity for Bear Stearns. The most hated firm on Wall Street, famous mainly for its total indifference to the good opinion of its competitors, Eisman identified with the place! "He'd always say Bear Stearns could never be acquired by anyone because the culture of the firm could never be assimilated into anything else," said Vinny. "I think he saw some of himself in them." Eisman's wife, Valerie, had her own theory. "It's this weird antidote he has to his 'the world is going to blow up' theory," she said. "Every now and then he would show up at home with this totally bizarre long."

  Whatever the psychological origins of Eisman's sudden urge, the previous afternoon, to buy a few shares in Bear Stearns, Danny was just glad to be done with the matter. Eisman was now explaining why the world was going to blow up, but his partners were only half-listening...because the financial world was blowing up. "The minute Steve starts to speak," said Vinny, "the stock starts to fall." As Eisman explained why no one in his right mind would own the very shares he had bought sixteen hours earlier, Danny dashed off text messages to his partners.

  9:49. Oh my--Bear at 47

  "If [the U.S. financial system] sounds like a circular Ponzi scheme it's because it is."

  9:55. Bear is 43 last OMG

  "The banks in the United States are only beginning to come to grips with their massive loan problems. For instance, I wouldn't own a single bank in the State of Florida because I think they might all be gone."

  10:02. Bear 29 last!!!!

  "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."

  Actuall
y, Eisman didn't speak those final sentences that morning; he merely thought them. And he didn't actually know what was happening in the stock market; the one time he couldn't check his BlackBerry was when he was speaking. But as he spoke a Wall Street investment bank was failing, for a reason other than fraud. And the obvious question was, Why?

  The collapse of Bear Stearns would later be classified as a run on the bank, and in a sense that was correct--other banks were refusing to do business with it, hedge funds were pulling their accounts. It raised a question, however, that would be raised again six months later: Why did the market suddenly distrust a giant Wall Street firm whose permanence it not so very long before took for granted? The demise of Bear Stearns had been so unthinkable in March of 2007 that Cornwall Capital had bought insurance against its collapse for less than three-tenths of 1 percent. They'd put down $300,000 to make $105 million.

  "Leverage" was Eisman's answer, on this day. To generate profits, Bear Stearns, like every other Wall Street firm, was perching more and more speculative bets on top of each dollar of its capital. But the problem was obviously more complicated than that. The problem was also the nature of those speculative bets.

  The subprime mortgage market had experienced at least two distinct phases. The first, in which AIG had taken most of the risk of a market collapse, lasted until the end of 2005. When AIG abruptly changed its mind, traders inside AIG FP assumed their decision might completely shut down the subprime mortgage market.* That's not what happened, of course. Wall Street was already making too much money using CDOs to turn crappy triple-B-rated subprime bonds into putatively riskless triple-A ones to simply stop doing it. The people who ran the CDO machine at the various firms had acquired too much authority. From the end of 2005 until the middle of 2007, Wall Street firms created somewhere between $200 and $400 billion in subprime-backed CDOs: No one was exactly sure how many there were. Call it $300 billion, of which roughly $240 billion would have been triple-A-rated and thus treated, for accounting purposes, as riskless, and therefore unnecessary to disclose. Much, if not all, of it was held off balance sheets.

  By March 2008 the stock market had finally grasped what every mortgage bond salesman had long known: Someone had lost at least $240 billion. But who? Morgan Stanley still owned $13 billion or so in CDOs, courtesy of Howie Hubler. The idiots in Germany owned some, Wing Chau and CDO managers like him owned some more, though whose money they were using to buy the bonds was a bit murky. Ambac Financial Group and MBIA Inc., which had long made their living insuring municipal bonds, had taken over where AIG had left off, and owned maybe 10 billion dollars' worth each. The truth is it was impossible to know how big the losses were, or who had them. All that anyone knew was that any Wall Street firm deep in the subprime market was probably on the hook for a lot more of them than they had confessed. Bear Stearns was deep in the subprime market. It had $40 in bets on its subprime mortgage bonds for every dollar of capital it held against those bets. The question wasn't how Bear Stearns could possibly fail but how it could possibly survive.

  Finishing his little speech and heading back to his chair, Steve Eisman passed Bill Miller and patted him on the back, almost sympathetically. In the brief question-and-answer session that followed, Miller pointed out how unlikely it was that Bear Stearns might fail, because thus far, big Wall Street investment banks had failed only after they were caught in criminal activities. Eisman blurted out, "It's only five past ten. Give it time." Apart from that, he'd been almost polite. In the back of the room, Vinny and Danny felt the curious combination of relief and disappointment that followed a tornado that narrowly missed the big city.

  It wasn't Eisman who upset the tone in the room, but some kid in the back. He looked to be in his early twenties, and he was, like everyone else, punching on his BlackBerry the whole time Miller and Eisman spoke. "Mr. Miller," he said. "From the time you started talking, Bear Stearns stock has fallen more than twenty points. Would you buy more now?"

  Miller looked stunned. "He clearly had no idea what had happened," said Vinny. "He just said, 'Yeah, sure, I'd buy more here.'"

  After that, the men in the room rushed for the exits, apparently to sell their shares in Bear Stearns. By the time Alan Greenspan arrived to speak, there was hardly anyone who cared to hear what he had to say. The audience was gone. By Monday, Bear Stearns was of course gone, too, sold to J.P. Morgan for $2 a share.*

  The people rising out of the hole in the ground on the northeast corner of Madison Avenue and Forty-seventh Street at 6:40 in the morning revealed a great deal about themselves, if you knew what to look for. Anyone in that place at that time probably worked on Wall Street, for instance. The people emerging from the holes surrounding Penn Station, where Vincent Daniel's train arrived at exactly the same time, weren't so easy to predict. "Vinny's morning train is only fifty-five percent financial, because that's where the construction workers come in," said Danny Moses. "Mine's ninety-five." To the untrained eye, the Wall Street people who rode from the Connecticut suburbs to Grand Central were an undifferentiated mass, but within that mass Danny noted many small and important distinctions. If they were on their BlackBerrys, they were probably hedge fund guys, checking their profits and losses in the Asian markets. If they slept on the train they were probably sell-side people--brokers, who had no skin in the game. Anyone carrying a briefcase or a bag was probably not employed on the sell side, as the only reason you'd carry a bag was to haul around brokerage research, and the brokers didn't read their own reports--at least not in their spare time. Anyone carrying a copy of the New York Times was probably a lawyer or a back-office person or someone who worked in the financial markets without actually being in the markets.

  Their clothes told you a lot, too. The guys who ran money dressed as if they were going to a Yankees game. Their financial performance was supposed to be all that mattered about them, and so it caused suspicion if they dressed too well. If you saw a buy-side guy in a suit, it usually meant that he was in trouble, or scheduled to meet with someone who had given him money, or both. Beyond that, it was hard to tell much about a buy-side person from what he was wearing. The sell side, on the other hand, might as well have been wearing their business cards: The guy in the blazer and khakis was a broker at a second-tier firm; the guy in the three-thousand-dollar suit and the hair just so was an investment banker at J.P. Morgan or someplace like that. Danny could guess where people worked by where they sat on the train. The Goldman Sachs, Deutsche Bank, and Merrill Lynch people, who were headed downtown, edged to the front--though when Danny thought about it, few Goldman people actually rode the train anymore. They all had private cars. Hedge fund guys such as himself worked uptown and so exited Grand Central to the north, where taxis appeared haphazardly and out of nowhere to meet them, like farm trout rising to corn kernels. The Lehman and Bear Stearns people used to head for the same exit as he did, but they were done. One reason why, on September 18, 2008, there weren't nearly as many people on the northeast corner of Forty-seventh Street and Madison Avenue at 6:40 in the morning as there had been on September 18, 2007.

  Danny noticed many little things about his fellow financial man--that was his job, in a way. To notice the little things. Eisman was the big-picture guy. Vinny was the analyst. Danny, the head trader, was their eyes and ears on the market. Their source for the sort of information that never gets broadcast or written down: rumors, the behavior of the sell-side brokers, the patterns on the screens. His job was to be alive to detail, quick with numbers--and to avoid getting fucked.

  To that end he kept five computer screens on his desk. One scrolled newswires, another showed moment-to-moment movements inside their portfolio, the other three scrolled Danny's conversations with maybe forty Wall Street brokers and fellow investors. His e-mail in-box for the month contained 33,000 messages. To an outsider, this torrent of picayune detail about the financial markets would have been disorienting. To him it all made sense, as long as he didn't really need to make sense of it. Danny was t
he small-picture guy.

  By Thursday, September 18, 2008, however, the big picture had grown so unstable that the small picture had become nearly incoherent to him. On Monday, Lehman Brothers had filed for bankruptcy, and Merrill Lynch, having announced $55.2 billion in losses on subprime bond-backed CDOs, had sold itself to Bank of America. The U.S. stock market had fallen by more than it had since the first day of trading after the attack on the World Trade Center. 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.