The Big Short: Inside the Doomsday Machine

by Michael Lewis

  What had happened was that he had been right, the world had been wrong, and the world hated him for it. And so Michael Burry ended where he began--alone, and comforted by his solitude. He remained inside his office in Cupertino, California, big enough for a staff of twenty-five people, but the fund was shuttered and the office was empty. The last man out was Steve Druskin, and among Druskin's last acts was to figure out what to do about Michael Burry's credit default swaps on subprime mortgage bonds. "Mike kept a couple of them, just for fun," he said. "Just a couple. To see if we could get paid off in full." And he had, though it wasn't for fun but vindication: to prove to the world that the investment-grade bonds he had bet against were indeed entirely without value. The two bets he had saved were against subprime bonds created back in 2005 by Lehman Brothers. They'd gone to zero at roughly the same time as their creator. Burry had wagered $100,000 or so on each, and made $5 million.

  The problem, from the point of view of a lawyer closing an investment fund, was that these strange contracts did not expire until 2035. The brokers had long since paid them in full: 100 cents on the dollar. No Wall Street firm even bothered to send them quotes on the things anymore. "I don't get a statement from a broker saying we have an open position with them," says Druskin. "But we do. It's like no one wants to talk about this anymore. It's like, 'All right, you've got your ten million dollars. Don't keep haranguing me about it.'"

  On Wall Street, the lawyers play the same role as medics in war: They come in after the shooting is over to clean up the mess. Thirty-year contracts that had some remote technical risk of repayment--exactly what that risk was he was still trying to determine--was the last of Michael Burry's mess. "It's possible the brokers have thrown the contracts away," Druskin said. "No one three years ago expected this to happen on the brokerage side. So no one's been trained to deal with this. We've pretty much said, 'We're going out of business.' And they said, 'Okay.'"

  By the time Eisman got the call from Danny Moses saying that he might be having a heart attack, and that he and Vinny and Porter were sitting on the steps of St. Patrick's Cathedral, he was in the midst of a slow, almost menopausal, change. He'd been unprepared for his first hot flash, in the late fall of 2007. By then it was clear to many that he had been right and they had been wrong and that he had gotten rich to boot. He'd gone to a conference put on by Merrill Lynch, right after they'd fired their CEO, Stan O'Neal, and disclosed $20 billion or so of their $52 billion in subprime-related losses. There he had sidled up to Merrill's chief financial officer, Jeff Edwards, the same Jeff Edwards Eisman had taunted, some months earlier, about Merrill Lynch's risk models. "You remember what I said about those risk models of yours?" Eisman now said. "I guess I was right, huh?" Instantly, and amazingly, he regretted having said it. "I felt bad about it," said Eisman. "It was obnoxious. He was a lovely guy. He was just wrong. I was no longer the underdog. And I had to conduct myself in a different way."

  Valerie Feigen watched in near bewilderment as her husband acquired, haltingly, in fits and starts, a trait resembling tact. "There was a void after everything happened," she said. "Once he was proved right, all this anxiety and anger and energy went away. And it left this big void. He went on an ego thing for a while. He was really kind of full of himself." Eisman had been so vocal about the inevitable doom that all sorts of unlikely people wanted to hear what he now had to say. After the conference in Las Vegas, he had come down with a parasite. He'd told the doctor who treated him that the financial world as we knew it was about to end. A year later, he went back to the same doctor for a colonoscopy. Stretched out on the table, he hears the doctor say, "Here's the guy who predicted the crisis! Come on in and listen to this." And in the middle of Eisman's colonoscopy, a roomful of doctors and nurses retold the story of Eisman's genius.

  The story of Eisman's genius quickly grew old to his wife. Long ago she had established a sort of Eisman social emergency task force with her husband's therapist. "We beat him up and said, 'You really just have to knock this shit off.' And he got it. And he started being nice. And he liked being nice! It was a new experience for him." All around, she and others found circumstantial evidence of a changed man. At the Christmas party at the building next door, for example. She wasn't planning to even let Eisman know about it, as she never knew what he might do or say. "I was just kind of trying to sneak out of our apartment," she said. "And he stops me and says, 'How will it look if I don't go?'" The sincerity of his concern shocked her into giving him a chance. "You can go, but you have to behave," she said. To which Eisman replied, "Well, I know how to behave now." And so she took him to the Christmas party, and he was as sweet as he could be. "He's become a pleasure," said Valerie. "Go figure."

  That afternoon of September 18, 2008, the new and possibly improving Eisman ambled toward his partners on the steps of St. Patrick's Cathedral. Getting places on foot always took him too long. "Steve's such a fucking slow walker," said Danny. "He walks like an elephant would walk if an elephant could only take human-size steps." The weather was gorgeous--one of those rare days where the blue sky reaches down through the forest of tall buildings and warms the soul. "We just sat there," says Danny, "watching the people pass."

  They sat together on the cathedral steps for an hour or so. "As we sat there we were weirdly calm," said Danny. "We felt insulated from the whole market reality. It was an out-of-body experience. We just sat and watched the people pass and talked about what might happen next. How many of these people were going to lose their jobs? Who was going to rent these buildings, after all the Wall Street firms had collapsed?"

  Porter Collins thought that "it was like the world stopped. We're looking at all these people and saying, 'These people are either ruined or about to be ruined.'" Apart from that, there wasn't a whole lot of hand-wringing inside FrontPoint. This was what they had been waiting for: total collapse.

  "The investment banking industry is fucked," Eisman had said six weeks earlier. "These guys are only beginning to understand how fucked they are. It's like being a scholastic, prior to Newton. Newton comes along and one morning you wake up: 'Holy shit, I'm wrong!'" Lehman Brothers had vanished, Merrill had surrendered, and Goldman Sachs and Morgan Stanley were just a week away from ceasing to be investment banks. Investment bankers were not just fucked: They were extinct. "That Wall Street has gone down because of this is justice," Eisman said. The only one among them who wrestled a bit with their role--as the guys who had made a fortune betting against their own society--was Vincent Daniel. "Vinny, being from Queens, needs to see the dark side of everything," said Eisman.

  To which Vinny replied, "The way we thought about it, which we didn't like, was, 'By shorting this market we're creating the liquidity to keep the market going.'"

  "It was like feeding the monster," said Eisman. "We fed the monster until it blew up."

  The monster was exploding. Yet on the streets of Manhattan there was no sign anything important had just happened. The force that would affect all of their lives was hidden from their view. That was the problem with money: What people did with it had consequences, but they were so remote from the original action that the mind never connected the one with the other. The teaser-rate loans you make to people who will never be able to repay them will go bad not immediately but in two years, when their interest rates rise. The various bonds you make from those loans will go bad not as the loans go bad but months later, after a lot of tedious foreclosures and bankruptcies and forced sales. The various CDOs you make from the bonds will go bad not right then but after some trustee sorts out whether there will ever be enough cash to pay them off. Whereupon the end owner of the CDO receives a little note, Dear Sir, We regret to inform you that your bond no longer exists...But the biggest lag of all was right here, on the streets. How long would it take before the people walking back and forth in front of St. Patrick's Cathedral figured out what had just happened to them?

  EPILOGUE

  Everything Is Correlated

  Around the tim
e Eisman and his partners sat on the steps of the midtown cathedral, I sat on a banquette on the east side, waiting for John Gutfreund, my old boss, to arrive for lunch, and wondering, among other things, why any restaurant would seat, side by side, two men without the slightest interest in touching each other.

  When I published my book about the financial 1980s, the financial 1980s were supposed to be ending. I received a lot of undeserved credit for my timing. The social disruption caused by the collapse of the savings and loan industry and the rise of hostile takeovers and leveraged buyouts had given way to a brief period of recriminations. Just as most students at Ohio State University read Liar's Poker as a how-to manual, most TV and radio interviewers read me as a whistle-blower. (Geraldo Rivera was the big exception. He included me in a show, along with some child actors who'd gone on to become drug addicts, called "People Who Succeed Too Early in Life.") Anti-Wall Street feelings then ran high enough for Rudolph Giuliani to float a political career upon them, but the result felt more like a witch hunt than an honest reappraisal of the financial order. The public lynching of Michael Milken, and then of Salomon Brothers CEO Gutfreund, were excuses for not dealing with the disturbing forces underpinning their rise. Ditto the cleaning up of Wall Street trading culture. Wall Street firms would soon be frowning upon profanity, forcing their male employees to treat women almost as equals, and firing traders for so much as glancing at a lap dancer. Bear Stearns and Lehman Brothers in 2008 more closely resembled normal corporations with solid, Middle American values than did any Wall Street firm circa 1985.

  The changes were camouflage. They helped to distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture. The surface rippled, but down below, in the depths, the bonus pool remained undisturbed.

  The reason that American financial culture was so difficult to change--the reason the political process would prove so slow to force change upon it, even after the subprime mortgage catastrophe--was that it had taken so long to create, and its assumptions had become so deeply embedded. There was an umbilical cord running from the belly of the exploded beast back to the financial 1980s. The crisis of 2008 had its roots not just in the subprime loans made in 2005 but in ideas that had hatched in 1985. A friend of mine in my Salomon Brothers training program created the first mortgage derivative in 1986, the year after we left the program. ("Derivatives are like guns," he still likes to say. "The problem isn't the tools. It's who is using the tools.") The mezzanine CDO was invented by Michael Milken's junk bond department at Drexel Burnham in 1987. The first mortgage-backed CDO was created at Credit Suisse in 2000 by a trader who had spent his formative years, in the 1980s and early 1990s, in the Salomon Brothers mortgage department. His name was Andy Stone, and along with his intellectual connection to the subprime crisis came a personal one: He was Greg Lippmann's first boss on Wall Street.

  I'd not seen Gutfreund since I quit Wall Street. I'd met him, nervously, a couple of times on the trading floor. A few months before I quit, my bosses asked me to explain to our CEO what at the time seemed like exotic trades in derivatives I'd done with a European hedge fund, and I'd tried. He claimed not to be smart enough to understand any of it, and I assumed that was how a Wall Street CEO showed he was the boss, by rising above the details. There was no reason for him to remember any of these encounters, and he didn't: When my book came out, and became a public relations nuisance to him, he'd told reporters we'd never met. Over the years, I'd heard bits and pieces about him. I knew that after he'd been forced to resign from Salomon Brothers, he'd fallen on harder times. I heard, later, that a few years before our lunch, he'd sat on a panel about Wall Street at the Columbia Business School. When his turn came to speak, he advised the students to find some more meaningful thing to do with their lives than go to work on Wall Street. As he began to describe his career, he'd broken down and wept.

  When I e-mailed Gutfreund to invite him to lunch, he could not have been more polite, or more gracious. That attitude persisted as he was escorted to the table, made chitchat with the owner, and ordered his food. He'd lost a half-step, and was more deliberate in his movements, but otherwise he was completely recognizable. The same veneer of courtliness masked the same animal impulse to see the world as it is, rather than as it should be.

  We spent twenty minutes or so determining that our presence at the same lunch table was not going to cause the earth to explode. We discovered a mutual friend. We agreed that the Wall Street CEO had no real ability to keep track of the frantic innovation occurring inside his firm. ("I didn't understand all the product lines and they don't either.") We agreed, further, that the CEO of the Wall Street investment bank had shockingly little control over his subordinates. ("They're buttering you up and then doing whatever the fuck they want to do.") He thought the cause of the financial crisis was "simple. Greed on both sides--greed of investors and the greed of the bankers." I thought it was more complicated. Greed on Wall Street was a given--almost an obligation. The problem was the system of incentives that channeled the greed.

  The line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet (you losing all of your money in hopes of making a bit more), and the wildest speculation has the salient characteristic of an investment (you might get your money back with interest). Maybe the best definition of "investing" is "gambling with the odds in your favor." The people on the short side of the subprime mortgage market had gambled with the odds in their favor. The people on the other side--the entire financial system, essentially--had gambled with the odds against them. Up to this point, the story of the big short could not be simpler. What's strange and complicated about it, however, is that pretty much all the important people on both sides of the gamble left the table rich. Steve Eisman and Michael Burry and the young men at Cornwall Capital each made tens of millions of dollars for themselves, of course. Greg Lippmann was paid $47 million in 2007, although $24 million of it was in restricted stock that he could not collect unless he hung around Deutsche Bank for a few more years. But all of these people had been right; they'd been on the winning end of the bet. Wing Chau's CDO managing business went bust, but he, too, left with tens of millions of dollars--and had the nerve to attempt to create a business that would buy up, cheaply, the very same subprime mortgage bonds in which he had lost billions of dollars' worth of other people's money. Howie Hubler lost more money than any single trader in the history of Wall Street--and yet he was permitted to keep the tens of millions of dollars he had made. The CEOs of every major Wall Street firm were also on the wrong end of the gamble. All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the United States government. They all got rich, too.

  What are the odds that people will make smart decisions about money if they don't need to make smart decisions--if they can get rich making dumb decisions? The incentives on Wall Street were all wrong; they're still all wrong. But I didn't argue with John Gutfreund. Just as you revert to being about nine years old when you go home to visit your parents, you revert to total subordination when you are in the presence of your former CEO. John Gutfreund was still the King of Wall Street and I was still a geek. He spoke in declarative statements, I spoke in questions. But as he spoke, my eyes kept drifting to his hands. His alarmingly thick and meaty hands. They weren't the hands of a soft Wall Street banker but of a boxer. I looked up. The boxer was smiling--though it was less a smile than a placeholder expression. And he was saying, very deliberately, "Your...fucking...book."

  I smiled back, though it wasn't quite a smile.

  "Why did you ask me to lunch?" he asked, though pleasantly. He was genuinely curious.

  You can't really tell someone that you asked him to lunch to let him know that you didn't think of him as evil. Nor can you tell him that you asked him to lunch because you thought you could trace the biggest financial crisis i
n the history of the world back to a decision he had made. John Gutfreund had done violence to the Wall Street social order--and got himself dubbed the King of Wall Street--when, in 1981, he'd turned Salomon Brothers from a private partnership into Wall Street's first public corporation. He'd ignored the outrage of Salomon's retired partners. ("I was disgusted by his materialism," William Salomon, the son of one of the firm's founders, who had made Gutfreund CEO only after he'd promised never to sell the firm, had told me.) He'd lifted a giant middle finger in the direction of the moral disapproval of his fellow Wall Street CEOs. And he'd seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn't, in the end, make a great deal of sense for the shareholders. (One share of Salomon Brothers, purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today, which, on the first day of trading in 2010, had a combined market value of $7.48.) But it made fantastic sense for the bond traders.

  But from that moment, the Wall Street firm became a black box. The shareholders who financed the risk taking had no real understanding of what the risk takers were doing, and, as the risk taking grew ever more complex, their understanding diminished. All that was clear was that the profits to be had from smart people making complicated bets overwhelmed anything that could be had from servicing customers, or allocating capital to productive enterprise. The customers became, oddly, beside the point. (Is it any wonder that mistrust of the sellers by the buyers in the bond market had reached the point where the buyers could not see a get-rich-quick scheme when a seller, Greg Lippmann, offered it to them?) In the late 1980s and early 1990s Salomon Brothers had entire years--great years!--in which five proprietary traders, the intellectual forefathers of Howie Hubler, generated more than the firm's annual profits. Which is to say that the firm's ten thousand or so other employees, as a group, lost money.