ALSO BY MICHAEL LEWIS
The Big Short
Home Game
Liar’s Poker
The Money Culture
Pacific Rift
Losers
The New New Thing
Next
Moneyball
Coach
The Blind Side
EDITED BY MICHAEL LEWIS
Panic
Michael Lewis
Travels in the New Third World
W. W. Norton & Company
New York • London
To Doug Stumpf, gifted editor and gentle soul, without whom it never would have occurred to me to tour the ruins
CONTENTS
Preface: The Biggest Short
I
WALL STREET ON THE TUNDRA
II
AND THEY INVENTED MATH
III
IRELAND’S ORIGINAL SIN
IV
THE SECRET LIVES OF GERMANS
V
TOO FAT TO FLY
Acknowledgments
PREFACE
THE BIGGEST SHORT
This book began accidentally, while I was at work on another book, about Wall Street and the 2008 U.S. financial disaster. I’d become interested in a tiny handful of investors who had made their fortunes from the collapse of the subprime mortgage market. Back in 2004, the biggest Wall Street investment banks had created the instrument of their own destruction, the credit default swap on the subprime mortgage bond. The credit default swap enabled investors to bet against the price of any given bond—to “short” it. It was an insurance policy, but with a twist: the buyer didn’t need to own the insured asset. No insurance company can legally sell you fire protection on another person’s house, but the financial markets can and will sell you default insurance on another person’s investments. Hundreds of investors had dabbled in the credit default swap market—a lot of people had thought, at least in passing, that the debt-fueled U.S. housing boom was unsustainable—but only fifteen or so had gone all in, and placed enormous bets that vast tracts of American finance would go up in flames. Most of these people ran hedge funds in London or New York; most, usually, avoided journalists. But on this topic, at this moment, they were surprisingly open. All had experienced the strange and isolating sensation of being the sane man in an insane world and, when they talked about their experience, sounded as a person might if he had sat alone and in silence in a small boat and watched the Titanic steam into the iceberg.
A few of these people were temperamentally ill-suited to solitude and silence. Among this subset was the manager of a hedge fund called Hayman Capital, in Dallas, Texas. His name was Kyle Bass. Bass was a native Texan in his late thirties who had spent the first years of his career, seven of them at Bear Stearns, selling bonds for Wall Street firms. In late 2006 he’d taken half of the $10 million he had saved from his Wall Street career, raised another $500 million from other people, created his hedge fund, and made a massive wager against the subprime mortgage bond market. Then he’d flown to New York to warn his old friends that they were on the wrong side of a lot of stupid bets. The traders at Bear Stearns had no interest in what he had to say. “You worry about your risk management. I’ll worry about ours,” one of them had told him. By the end of 2008, when I went to Dallas to see Bass, the subprime mortgage bond market had collapsed, taking Bear Stearns with it. He was now rich and even, in investment circles, a little famous. But his mind had moved on from the subprime mortgage bond debacle: having taken his profits, he had a new all-consuming interest, governments. The United States government was just then busy taking on to its own books the subprime loans made by Bear Stearns and other Wall Street banks. The Federal Reserve would wind up absorbing the risk, in one form or another, associated with nearly $2 trillion in dodgy securities. Its actions were of a piece with those of other governments in the rich, developed world: the bad loans made by highly paid financiers working in the private sector were being eaten by national treasuries and central banks everywhere.
In Kyle Bass’s opinion, the financial crisis wasn’t over. It was simply being smothered by the full faith and credit of rich Western governments. I spent a day listening to him and his colleagues discuss, almost giddily, where this might lead. They were no longer talking about the collapse of a few bonds. They were talking about the collapse of entire countries.
And they had a shiny new investment thesis. It ran, roughly, as follows. From 2002 there had been something like a false boom in much of the rich, developed world. What appeared to be economic growth was activity fueled by people borrowing money they probably couldn’t afford to repay: by their rough count, worldwide debts, public and private, had more than doubled since 2002, from $84 trillion to $195 trillion. “We’ve never had this kind of accumulation of debt in world history,” said Bass. Critically, the big banks that had extended much of this credit were no longer treated as private enterprises but as extensions of their local governments, sure to be bailed out in a crisis. The public debt of rich countries already stood at what appeared to be dangerously high levels and, in response to the crisis, was rapidly growing. But the public debt of these countries was no longer the official public debt. As a practical matter it included the debts inside each country’s banking system, which, in another crisis, would be transferred to the government. “The first thing we tried to figure out,” said Bass, “was how big these banking systems were, especially in relation to government revenues. We took about four months to gather the data. No one had it.”
The numbers added up to astonishing totals: Ireland, for instance, with its large and growing annual deficits, had amassed debts of more than twenty-five times its annual tax revenues. Spain and France had accumulated debts of more than ten times their annual revenues. Historically, such levels of government indebtedness had led to government default. “Here’s the only way I think things can work out for these countries,” Bass said. “If they start running real budget surpluses. Yeah, and that will happen right after monkeys fly out of your ass.”
Still, he wondered if perhaps he was missing something. “I went looking for someone, anyone, who knew something about the history of sovereign defaults,” he said. He found the leading expert on the subject, a professor at Harvard named Kenneth Rogoff, who, as it happened, was preparing a book on the history of national financial collapse, This Time Is Different: Eight Centuries of Financial Folly, with fellow scholar Carmen Reinhart. “We walked Rogoff through the numbers,” said Bass, “and he just looked at them, then sat back in his chair, and said, ‘I can hardly believe it is this bad.’ And I said, ‘Wait a minute. You’re the world’s foremost expert on sovereign balance sheets. You are the go-to guy for sovereign trouble. You taught at Princeton with Ben Bernanke. You introduced Larry Summers to his second wife. If you don’t know this, who does?’ I thought, Holy shit, who is paying attention?”
Thus his new investment thesis: the subprime mortgage crisis was more symptom than cause. The deeper social and economic problems that gave rise to it remained. The moment that investors woke up to this reality, they would cease to think of big Western governments as essentially risk-free and demand higher rates of interest to lend to them. When the interest rates on their borrowing rose, these governments would plunge further into debt, leading to further rises in the interest rates they were charged to borrow. In a few especially alarming cases—Greece, Ireland, Japan—it wouldn’t take much of a rise in interest rates for budgets to be consumed entirely by interest payments on debt. “For example,” said Bass, “if Japan had to borrow at France’s rates, the interest burden alone would bankrupt the government.” The moment the financial m
arkets realized this, investor sentiment would shift. The moment investor sentiment shifted, these governments would default. (“Once you lose confidence, you don’t get it back. You just don’t.”) And then what? The financial crisis of 2008 was suspended only because investors believed that governments could borrow whatever they needed to rescue their banks. What happened when the governments themselves ceased to be credible?
There was another, bigger financial crisis waiting to happen—the only question in Kyle Bass’s mind was when. At the end of 2008, he thought Greece would probably be the first to go, perhaps triggering a collapse of the euro. He thought it might happen within two years, but he didn’t have a lot of conviction about his timing. “Let’s say it takes five years and not two,” he said. “Let’s say it takes seven years. Should I wait until I see the whites of their eyes before I position myself, or should I position myself now? The answer is now. Because the moment people think it [national default] is a possibility, it’s expensive. If you wait, you have to pay up for the risk.”
When we met, he had just bought his first credit default swaps on the countries he and his team of analysts viewed as the most likely to be unable to pay off their debts: Greece, Ireland, Italy, Switzerland, Portugal, and Spain. He made these bets directly with the few big Wall Street firms that he felt were least likely to be allowed to fail—Goldman Sachs, J.P. Morgan, and Morgan Stanley—but, doubting their capacity to withstand a more serious crisis, he demanded that they post collateral on the trades every day. The prices he paid for default insurance, in retrospect, look absurdly cheap. Greek government default insurance cost him 11 basis points, for instance. That is, to insure $1 million of Greek government bonds against default, Hayman Capital paid a premium of $1,100 dollars a year. Bass guessed that when Greece defaulted, as it inevitably would, the country would be forced to pay down its debt by roughly 70 percent—which is to say that every $1,100 bet would return $700,000. “There’s a disbelief that a developed country can default, because we have never seen it in our lifetime,” said Bass. “And it’s not in anyone’s interest to pay attention to this. Even our own investors. They look at us and say, ‘Yeah, you got subprime right. But you’re always out there looking for these extremely rare events and so you think they happen more often than they do.’ But I didn’t go looking for this position. I was trying to understand the way the world was working, and this came to me.” Now that he understood the way the world was working, he continued, he couldn’t see how any sane person could do anything but prepare for another, bigger financial catastrophe. “It may not be the end of the world,” he said. “But a lot of people are going to lose a lot of money. Our goal is not to be one of them.”
He was totally persuasive. He was also totally incredible. A guy sitting in an office in Dallas, Texas, making sweeping claims about the future of countries he’d hardly set foot in: how on earth could he know how a bunch of people he’d never met might behave? As he laid out his ideas I had an experience I’ve often had, while listening to people who seem perfectly certain about uncertain events. One part of me was swept away by his argument and began to worry the world was about to collapse; the other part suspected he might be nuts. “That’s great,” I said, but I was already thinking about the flight I needed to catch. “But even if you’re right, what can any normal person do about it?”
He stared at me as if he’d just seen an interesting sight: the world’s stupidest man.
“What do you tell your mother when she asks you where to put her money?” I asked.
“Guns and gold,” he said simply.
“Guns and gold,” I said. So he was nuts.
“But not gold futures,” he said, paying no attention to my thoughts. “You need physical gold.” He explained that when the next crisis struck, the gold futures market was likely to seize up, as there were more outstanding futures contracts than available gold. People who thought they owned gold would find they owned pieces of paper instead. He opened his desk drawer, hauled out a giant gold brick, and dropped it on the desk. “We’ve bought a lot of this stuff.”
At this point, I was giggling nervously and glancing toward the door. The future is a lot harder to predict than people on Wall Street would have you believe. A man who has been as dramatically right about the future as Kyle Bass had been about the subprime mortgage bond market collapse might easily fool himself into thinking he had a talent for being dramatically right about all sorts of other complicated things. At any rate, I was too interested in trying to figure out what had just happened in America to worry much about what was going to happen in the rest of the world, which seemed, at the time, a trivial matter. And Bass had more or less lost interest in what had just happened in America, because he thought what was about to happen all around the world was so much more important. I made my excuses, and took my leave of Dallas, and more or less dismissed him. When I wrote the book, I left Kyle Bass on the cutting-room floor.
Then the financial world began to change again—and very much as Kyle Bass had imagined it might. Entire countries started to go bust. What appeared at first to be a story chiefly about Wall Street became a story that involved every country that came into meaningful contact with Wall Street. I wrote the book about the U.S. subprime mortgage crisis and the people who had made a fortune from it, but began to travel to these other places, just to see what was up. But I traveled with a nagging question: how did a hedge fund manager in Dallas even think to imagine these strange events?
Two and a half years later, in the summer of 2011, I returned to Dallas to ask Kyle Bass that question. Greek credit default swaps were up from 11 basis points to 2300; Greece was just about to default on its national debt. Ireland and Portugal had required massive bailouts; and Spain and Italy had gone from being viewed as essentially riskless to nations on the brink of financial collapse. On top of it all, the Japanese Ministry of Finance was about to send a delegation to the United States to tour the big bond investment funds such as Pimco and BlackRock—to see if they could find someone, anyone, willing to buy half a trillion dollars’ worth of ten-year Japanese government bonds. “This is a scenario in which no one alive has ever invested before,” Bass said. “Our biggest positions now are Japan and France. If and when the dominoes fall, the worst, by far, is France. I just hope the U.S. doesn’t collapse first. All my money is bet that it won’t. That’s my biggest fear. That I’m wrong about the chronology of events. But I’m convinced what the ultimate outcome is.”
He still owned stacks of gold and platinum bars that had roughly doubled in value, but he remained on the lookout for hard stores of wealth as a hedge against what he assumed was the coming debasement of fiat currency. Nickels, for instance.
“The value of the metal in a nickel is worth six point eight cents,” he said. “Did you know that?”
I didn’t.
“I just bought a million dollars’ worth of them,” he said, and then, perhaps sensing I couldn’t do the math: “twenty million nickels.”
“You bought twenty million nickels?”
“Uh-huh.”
“How do you buy twenty million nickels?”
“Actually, it’s very difficult,” he said, and then explained that he had to call his bank and talk them into ordering him twenty million nickels. The bank had finally done it, but the Federal Reserve had its own questions. “The Fed apparently called my guy at the bank,” he says. “They asked him, ‘Why do you want all these nickels?’ So he called me and asked, ‘Why do you want all these nickels?’ And I said, ‘I just like nickels.’”
He pulled out a photograph of his nickels and handed it to me. There they were, piled up on giant wooden pallets in a Brink’s vault in downtown Dallas.
“I’m telling you, in the next two years they’ll change the content of the nickel,” he said. “You really ought to call your bank and buy some now.”
I doubt Kyle Bass was ever the sort of person who enjoyed sitting around an office and staring at a computer screen. He enjoys
the unsettled life. We hopped into his Hummer, decorated with bumper stickers (God Bless Our Troops, Especially Our Snipers) and customized to maximize the amount of fun its owner could have in it: for instance, he could press a button and, James Bond–like, coat the road behind him in giant tacks. We roared out into the Texas hill country, where, with the fortune he’d made off the subprime crisis, Kyle Bass had purchased what amounted to a fort: a forty-thousand-square-foot ranch house on thousands of acres in the middle of nowhere, with its own water supply, and an arsenal of automatic weapons and sniper rifles and small explosives to equip a battalion. That night we tore around his property in the back of his U.S. Army jeep, firing the very latest-issue U.S. Army sniper rifles, equipped with infrared scopes, at the beavers that he felt were a menace to his waterways. “There are these explosives you can buy on the Internet,” he said, as we bounded over the yellow hills. “It’s a molecular reaction. FedEx will deliver hundreds of pounds of these things.” The few beavers that survived the initial night rifle assault would wake up to watch their dams being more or less vaporized.
“It doesn’t exactly sound like a fair fight,” I said.
“Beavers are rodents,” he said.
Whatever else he was doing, he was clearly having fun. He’d spent two and a half years watching the global financial system, and the people who ran it, confirm his dark view of them. It didn’t get him down. It thrilled him to have gotten his mind around seemingly incomprehensible events. “I’m not someone who is hell-bent on being negative his whole life,” he said. “I think this is something we need to go through. It’s atonement. It’s atonement for the sins of the past.”
Once again a hedge fund manager had been more or less right, and the world had been more or less wrong. Now seemed as good a time as any to pose the question that had nagged at me for more than two years. Here you are, I said, in so many words, an essentially provincial hedge fund manager in Dallas, Texas, whose entire adult life has been lived within a few miles of this place. You speak no foreign languages. You seldom travel abroad. You are deeply patriotic: your biggest philanthropic cause is wounded veterans. You hardly know anyone who isn’t American. How did it even occur to you to start spinning theories about the financial future of these distant countries?
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