The Big Short: Inside the Doomsday Machine

Of thousands of investors who could have participated, “only one hundred or so dabbled in the new market for credit default swaps on subprime mortgage bonds” (104). Most are simply hedging their bets. Only a handful, “more than ten, fewer than twenty” (105), use the swaps to bet against the entire subprime mortgage market. Most of them hear about a possible subprime downturn from Greg Lippmann.

Two of these are Jamie Mai and Charley Ledley, who in 2003 start Cornwall Capital Management with $110,000 and a backyard shed in Berkeley, California for an office. They discover that an option—the right to buy at a set price, on a future date, a stock or commodity—can often be seriously underpriced. They look for markets that might take off, then buy options on stock or currency or some other investment item in those markets. Their bets pan out, and their portfolio grows to $12 million. Ben Hockett, a derivatives trader, joins them, and in 2005, they set up shop in New York City. By 2006 Cornwall is worth $30 million, but it’s not enough to attract the attention of the big players who can sell them the options they’re looking for: "Lehman Brothers just laughed at us” (123), says Jamie.

Jamie, Charlie, and Ben discover the subprime bond market, its wildly overstated worth, and how underpriced are its credit default swaps. In the process, they figure out that subprime mortgage bonds are packaged to deceive. “Midprime” bonds are really subprime; a “mezzanine” tranche is really on the bottom floor. It’s next to impossible to know exactly what’s inside a typical subprime bond, whose mortgages are hard to track and whose contents may include parts of other mortgage bonds. The more they look, the worse these securities seem.

Patiently the team acquires insider knowledge of the bond business, learns how to hobnob with the top traders, and works its way into the inner circle. They hire market expert David Burt, who helps them better understand CDOs: “Burt had the most sensational information, and models to analyze that information” (133). Cornwall begins to purchase swaps through Bear Stearns investment bank, betting against the worst CDOs they can find. By January 2007, they own $110 million in swaps.

Eisman’s team flies to Las Vegas in January 2007 for a subprime mortgage bond conference. The first thing they do is play a game of golf. Eisman, a decent golfer, wears shorts and a hoodie and cheats constantly, as if lampooning the game.

Lippmann meets with them and a few other fund managers to discuss the market. His investors are losing heart and dropping out because subprime bonds still haven’t collapsed despite a fall in housing prices. Slyly, Lippmann seats Eisman next to CDO manager Wing Chau, who says he likes bettors such as Eisman because they help him sell more CDOs. CDOs are often made up of parts of other CDOs, and Wall Street keeps creating them so they can also sell credit default swaps against them.

Looking back on that meeting, Eisman says, “They were creating [CDOs] out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the subprime loans” (143). Eisman reasons that only one factor keeps the game alive: “The triple-A ratings gave everyone an excuse to ignore the risks they were running” (144).

Charlie Ledley and Ben Hockett also arrive in Las Vegas; instead of golf, they are treated to an afternoon of gun shooting at an indoor range, courtesy of Bear Stearns. They visit the conference, titled the American Securitization Forum (ASF) at The Venetian casino, where they search for someone who can explain to them why their own investment theory is wrong. No one can; they realize that the “entire food chain of intermediaries in the subprime mortgage market was duping itself” (147).

The opening ceremony, in a crowded ballroom, features ASF founder John Devaney, who appears to be drunk and who “went on about how the ratings agencies were whores. How the securities were worthless. How they all knew it. He gave words to stuff we were just suspecting” (148). Embarrassed silence greets his rant; the conference continues as if he hadn’t spoken. But the word was out. To Ben Hockett: “It seemed rather than six months to get our trade on we had one week” (149).

The bond sellers don’t want someone like Eisner to rock the boat, but “[h]e saw himself as a crusader, a champion of the underdog, an enemy of sinister authority. He saw himself, roughly speaking, as Spider-Man,” whose life does somewhat resemble Eisner’s, including “when they had gone to college, what they had studied, when they’d married, and on and on” (152).

As one mortgage lender CEO gives a speech, Eisner interrupts twice to disagree loudly with the CEO's assertion that a mere five percent of borrowers will fail to pay their mortgages: “There is zero probability that your default rate will be five percent” (154), Eisner declares, and walks out.

Eisner’s team interviews agents from Moody’s and Standard & Poor’s, and they realize that these analysts are not high-caliber professionals: “Collectively they had more power than anyone in the bond markets, but individually they were nobodies” (156). Their jobs provide low prestige and low wages; the smarter analysts leave to work at the banks they’ve been monitoring, and Eisman wonders: “So why does the guy at Moody’s want to work at Goldman Sachs? The guy who is the bank analyst at Goldman Sachs should want to go to Moody’s. It should be that elite” (156). Instead, “[t]hey seemed timid, fearful, and risk-averse” (157).

As private companies, rating agencies have an incentive to be nice to their investment bank clients and not come down too hard on their bond offerings. This leads them to agree with the Wall Street consensus predicting “home prices to rise and loan losses to be around 5 percent” (157), which implies smooth sailing ahead.

Eisner’s team realizes that the subprime bond market “isn’t just credit. This is a fictitious Ponzi scheme” (158). No longer do they doubt their own instincts. Instead, they have come to seriously doubt the character and intelligence of the bond traders: “Do they deserve merely to be fired, or should they be put in jail? Are they delusional, or do they know what they’re doing?” (158). They return to New York and increase greatly their short positions against the subprime market.

Back in New York in late January 2007, the Cornwall team begins to purchase default swaps through Morgan Stanley bank. CDO prices begin to drift downward; then a new CDO index fund loses half its value on its first day of trading. Morgan Stanley suddenly stops selling default swaps on the bonds.

The team turns to Wachovia bank and negotiates a purchase of swaps that goes through in May 2007. “After that, the market completely shut down” (163), and they can buy no further swaps on subprime mortgage bonds. Charlie wonders if the bond traders, sensing catastrophe, are buying up all the available swaps for themselves.

By now Jamie, Charlie, and Ben are convinced an enormous disaster is about to happen and that they are right to have purchased the swaps: “[I]t was as if they had bought cheap fire insurance on a house engulfed in flames” (164). They begin to fear for America, and they reach out to journalists, but “the reporters they knew had no interest in their story” (166). The SEC listens but doesn’t follow up.

In June, Bear Stearns reports big losses in its CDO division. This is a major problem for Cornwall: “Bear Stearns had sold Cornwall 70 percent of its credit default swaps”(166) but hadn’t put up collateral. If Bear Stearns goes bust, Cornwall’s default swaps are worthless.

Fortunately, the Cornwall team also owns “$105 million in credit default swaps on Bear Stearns”(167) from British bank HSBC, so if Bear Stearns defaults on its Cornwall swaps, HSBC will pick up the slack. Unfortunately, HSBC reports it “was taking a big, surprising loss on its portfolio of subprime mortgage loans” (167).

Eisman makes a disturbing discovery. Subprime mortgages often have interest rates that float upward after two years, causing an increase in defaults. Rating agencies ignore this, however: “Bonds backed by floating-rate mortgages received higher ratings than bonds backed by fixed-rate ones” (169).

Eisman and Vinny confront Standard & Poor’s subprime surveillance analyst Ernestine Warner about this, but Warner has no more data than Eisman. He asks why she doesn’t request the data from the issuing banks; Warner replies, “The issuers won’t give it to us” (171). Vinny gets angry, insisting she demand the data: “You’re the grown-up. You’re the cop!” (171). Eisman concludes: “S&P was worried that if they demanded the data from Wall Street, Wall Street would just go to Moody’s for their ratings” (171).

Eisman and Vinny get an audience with Moody CEO Ray McDaniel, but he insists his company’s ratings are correct: “I truly believe that our ratings will prove accurate” (171). Eisman laughs out loud. As politely as he can, Vinny tells McDaniel he’s “delusional” (171).

Eisman focuses on the investment banks that have marketed the subprime bonds. With the invasion of cheap Internet brokerages, the banks no longer make much money off traditional securities trades; subprime bonds and the related CDOs are the only real profit centers: “Eisman had not suspected that the firms were so foolish as to invest in their own creations” (172) until it becomes obvious in mid-2007.

The best of the banks, HSBC, has already taken a hit from its subprime holdings, and in July, Merrill Lynch announces its profits are also hurt by subprimes. Eisman believes the rot goes deeper than anyone suspects: “If they really didn’t believe the subprime mortgage market was a problem for them, the subprime mortgage market might be the end of them” (174).

Eisman’s team begins to search for “hidden subprime risk: Who was hiding what? ‘We called it The Great Treasure Hunt’” (174). Soon they realize the big banks don’t really know what they have on their balance sheets; the team shorts the banks.

Wall Street begins finally to take notice of Eisman. A conference call is arranged; as hundreds listen in, Eisman predicts a $300 billion loss in subprimes alone, and “that fully half of all U.S. home mortgage loans—many trillions of dollars’ worth—would suffer losses” (176). Later that day, Bear Stearns announces that $1.6 billion in their AAA-rated CDOs are worthless.

Eisner finds a fellow traveler in Jim Grant, whose newsletter makes exactly the same grim predictions. Eisner is no longer the only person on Wall Street frantically waving his arms.