The Big Short: Inside the Doomsday Machine (15 page)

In the late summer of 2006 Eisman and his partners knew none of this. All they knew was that Wall Street investment banks apparently employed people to do nothing but game the rating agencies' models. In a rational market, the bonds backed by pools of weaker loans would have been priced lower than the bonds backed by stronger loans. Subprime mortgage bonds all were priced by the ratings bestowed on them by Moody's. The triple-A tranches all traded at one price, the triple-B tranches all traded at another, even though there were important differences from one triple-B tranche to another. As the bonds were all priced off the Moody's rating, the most overpriced bonds were the bonds that had been most ineptly rated. And the bonds that had been most ineptly rated were the bonds that Wall Street firms had tricked the rating agencies into rating most ineptly. "I cannot fucking believe this is allowed," said Eisman. "I must have said that one thousand times."

Eisman didn't know exactly how the rating agencies had been gamed. He had to learn. Thus began his team's months-long quest to find the most overrated bonds in a market composed of overrated bonds. A month or so into it, after they bought their first credit default swaps on subprime mortgage bonds from Lippmann, Vincent Daniel and Danny Moses flew to Orlando for what amounted to a subprime mortgage bond conference. It had an opaque title--ABS East--but it was, in effect, a trade show for a narrow industry: the guys who originated subprime mortgages, the Wall Street firms that packaged and sold subprime mortgages, fund managers who invested in nothing but subprime mortgage-backed bonds, the agencies that rated subprime mortgage bonds, the lawyers who did whatever the lawyers did. Daniel and Moses thought they were paying a courtesy call on a cottage industry, but the cottage was a castle. "There were so many people being fed by this industry," said Daniel. "That's when we realized that the fixed income departments of the brokerage firms were built on this."

That's also when they made their first face-to-face contact with the rating agencies. Greg Lippmann's people set it up for them, on the condition they not mention that they were betting against, and not for, subprime mortgage bonds. "Our whole purpose," said Moses, "was supposed to be, 'We're here to buy these securities.' People were supposed to think, 'Oh, they're looking to buy paper because it's getting to attractive levels.'" In a little room inside the Orlando Ritz-Carlton hotel, they met with both Moody's and S&P. Vinny and Danny already suspected that the subprime market had subcontracted its credit analysis to people who weren't even doing the credit analysis. Nothing they learned that day allayed their suspicion. The S&P people were cagey, but the woman from Moody's was surprisingly frank. She told them, for instance, that even though she was responsible for evaluating subprime mortgage bonds, she wasn't allowed by her bosses simply to downgrade the ones she thought deserved to be downgraded. She submitted a list of the bonds she wished to downgrade to her superiors and received back a list of what she was permitted to downgrade. "She said she'd submit a list of a hundred bonds and get back a list with twenty-five bonds on it, with no explanation of why," said Danny.

Vinny, the analyst, asked most of the questions, but Danny attended with growing interest. "Vinny has a tell," said Moses. "When he gets excited he puts his hand over his mouth and leans his elbow on the table and says, 'Let me ask you a question about this...' When I saw the hand to face I knew Vinny was on to something."

Here's what I don't understand
, said Vinny, hand on chin.
You have two bonds that seem identical. How is one of them triple-A and the other not?

I'm not the one who makes those decisions
, said the woman from Moody's, but she was clearly uneasy.

Here's another thing I don't understand,
said Vinny.
How could you rate any portion of a bond made up exclusively of subprime mortgages triple-A?

That's a very good question.

Bingo.

"She was great," said Moses. "Because she didn't know what we were up to."

They called Eisman from Orlando and said, However corrupt you think this industry is, it's worse. "Orlando wasn't even the varsity conference," said Daniel. "Orlando was the JV conference. The varsity met in Vegas. We told Steve, 'You have to go to Vegas. Just to see this.'" They really thought that they had a secret. Through the summer and early fall of 2006, they behaved as if they had stumbled upon a fantastic treasure map, albeit with a few hazy directions. Eisman was now arriving home at night in a better mood than his wife had seen him in a very long time. "I was happy," says Valerie. "I thought, 'Thank God there's a place to put all this enthusiastic misery.' He'd say, 'I found this thing. It's a gold mine. And nobody else knows about it.'"

CHAPTER FIVE

Accidental Capitalists

The thing Eisman had found was indeed a gold mine,
but it wasn't true that no one knew about it. By the fall of 2006 Greg Lippmann had made his case to maybe 250 big investors privately, and to hundreds more at Deutsche Bank sales conferences or on Deutsche Bank conference calls. By the end of 2006, according to the PerTrac Hedge Fund Database Study, there were 13,675 hedge funds reporting results, and thousands of other types of institutional investors allowed to invest in credit default swaps. Lippmann's pitch, in one form or another, reached many of them. Yet only one hundred or so dabbled in the new market for credit default swaps on subprime mortgage bonds. Most bought this insurance on subprime mortgages not as an outright bet against them but as a hedge against their implicit bet
on
them--their portfolios of U.S. real estate-related stocks or bonds. A smaller group used credit default swaps to make what often turned out to be spectacularly disastrous gambles on the relative value of subprime mortgage bonds--buying one subprime mortgage bond while simultaneously selling another. They would bet, for instance, that bonds with large numbers of loans made in California would underperform bonds with very little of California in them. Or that the upper triple-A-rated floor of some subprime mortgage bond would outperform the lower, triple-B-rated, floor. Or that bonds issued by Lehman Brothers or Goldman Sachs (both notorious for packaging America's worst home loans) would underperform bonds packaged by J.P. Morgan or Wells Fargo (which actually seemed to care a bit about which loans it packaged into bonds).

A smaller number of people--more than ten, fewer than twenty--made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market and, by extension, the global financial system. In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed. Among them: a Minneapolis hedge fund called Whitebox, a Boston hedge fund called The Baupost Group, a San Francisco hedge fund called Passport Capital, a New Jersey hedge fund called Elm Ridge, and a gaggle of New York hedge funds: Elliott Associates, Cedar Hill Capital Partners, QVT Financial, and Philip Falcone's Harbinger Capital Partners. What most of these investors had in common was that they had heard, directly or indirectly, Greg Lippmann's argument. In Dallas, Texas, a former Bear Stearns bond salesman named Kyle Bass set up a hedge fund called Hayman Capital in mid-2006 and soon thereafter bought credit default swaps on subprime mortgage bonds. Bass had heard the idea from Alan Fournier of Pennant Capital, in New Jersey--who in turn had heard it from Lippmann. A rich American real estate investor named Jeff Greene went off and bought several billion dollars' worth of credit default swaps on subprime mortgage bonds for himself after hearing about it from the New York hedge fund manager John Paulson. Paulson, too, had heard Greg Lippmann's pitch--and, as he built a massive position in credit default swaps, used Lippmann as his sounding board. A proprietary trader at Goldman Sachs in London, informed that this trader at Deutsche Bank in New York was making a powerful argument, flew across the Atlantic to meet with Lippmann and went home owning a billion dollars' worth of credit default swaps on subprime mortgage bonds. A Greek hedge fund investor named Theo Phanos heard Lippmann pitch his idea at a Deutsche Bank conference in Phoenix, Arizona, and immediately placed his own bet. If you mapped the spread of the idea, as you might a virus, most of the lines pointed back to Lippmann. He was Patient Zero. Only one carrier of the disease could claim, plausibly, to have infected him. But Mike Burry was holed up in his office in San Jose, California, and wasn't talking to anyone.

This small world of investors who made big bets against subprime mortgage bonds itself contained an even smaller world: people for whom the trade became an obsession. A tiny handful of investors perceived what was happening not just to the financial system but to the larger society it was meant to serve, and made investments against that system that were so large, in relation to their capital, that they effectively gave up being conventional money managers and became something else. John Paulson had by far the most money to play with, and so was the most obvious example. Nine months after Mike Burry failed to raise a fund to do nothing but buy credit default swaps on subprime mortgage bonds, Paulson succeeded, by presenting it to investors not as a catastrophe almost certain to happen but as a cheap hedge against the remote possibility of catastrophe. Paulson was fifteen years older than Burry, and far better known on Wall Street, but he was still, in some ways, a Wall Street outsider. "I called Goldman Sachs to ask them about Paulson," said one rich man whom Paulson had solicited for funds in mid-2006. "They told me he was a third-rate hedge fund guy who didn't know what he was talking about." Paulson raised several billion dollars from investors who regarded his fund as an insurance policy on their portfolios of real estate-related stocks and bonds. What prepared him to see what was happening in the mortgage bond market, Paulson said, was a career of searching for overvalued bonds to bet against. "I loved the concept of shorting a bond because your downside was limited," he told me. "It's an asymmetrical bet." He was shocked how much easier and cheaper it was to buy a credit default swap than it was to sell short an actual cash bond--even though they represented exactly the same bet. "I did half a billion. They said, 'Would you like to do a billion?' And I said, 'Why am I pussyfooting around?' It took two or three days to place twenty-five billion." Paulson had never encountered a market in which an investor could sell short 25 billion dollars' worth of a stock or bond without causing its price to move, even crash. "And we could have done fifty billion, if we'd wanted to."

Even as late as the summer of 2006, as home prices began to fall, it took a certain kind of person to see the ugly facts and react to them--to discern, in the profile of the beautiful young lady, the face of an old witch. Each of these people told you something about the state of the financial system, in the same way that people who survive a plane crash told you something about the accident, and also about the nature of people who survive accidents. All of them were, almost by definition, odd. But they were not all odd in the same way. John Paulson was oddly interested in betting against dodgy loans, and oddly persuasive in talking others into doing it with him. Mike Burry was odd in his desire to remain insulated from public opinion, and even direct human contact, and to focus instead on hard data and the incentives that guide future human financial behavior. Steve Eisman was odd in his conviction that the leveraging of middle-class America was a corrupt and corrupting event, and that the subprime mortgage market in particular was an engine of exploitation and, ultimately, destruction. Each filled a hole; each supplied a missing insight, an attitude to risk which, if more prevalent, might have prevented the catastrophe. But there was at least one gaping hole no big-time professional investor filled. It was filled, instead, by Charlie Ledley.

Charlie Ledley--curiously uncertain Charlie Ledley--was odd in his belief that the best way to make money on Wall Street was to seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening. Charlie and his partners had done this often enough, and had had enough success, to know that the markets were predisposed to underestimating the likelihood of dramatic change. Even so, in September 2006, as he paged through the document sent to him by a friend, a presentation about shorting subprime mortgage bonds by some guy at Deutsche Bank named Greg Lippmann, Ledley's first thought was,
This is just too good to be true.
He'd never traded a mortgage bond, knew essentially nothing about real estate, was bewildered by the jargon of the bond market, and wasn't even sure Deutsche Bank or anyone else would allow him to buy credit default swaps on subprime mortgage bonds--since this was a market for institutional investors, and he and his two partners, Ben Hockett and Jamie Mai, weren't anyone's idea of an institution. "But I just looked at it and said, 'How can this even be possible?'" He then sent the idea to his partners along with the question,
Why isn't someone smarter than us doing this?

Every new
business is inherently implausible, but Jamie Mai and Charlie Ledley's idea, in early 2003, for a money management firm bordered on the absurd: a pair of thirty-year-old men with a Schwab account containing $110,000 occupy a shed in the back of a friend's house in Berkeley, California, and dub themselves Cornwall Capital Management. Neither of them had any reason to believe he had any talent for investing. Both had worked briefly for the New York private equity firm Golub Associates as grunts chained to their desks, but neither had made actual investment decisions. Jamie Mai was tall and strikingly handsome and so, almost by definition, had the air of a man in charge--until he opened his mouth and betrayed his lack of confidence in everything from tomorrow's sunrise to the future of the human race. Jamie had a habit of stopping himself midsentence and stammering--"uh, uh, uh"--as if he was somehow unsettled by his own thought. Charlie Ledley was even worse: He had the pallor of a mortician and the manner of a man bent on putting off, for as long as possible, definite action. Asked a simple question, he'd stare mutely into space, nodding and blinking like an actor who has forgotten his lines, so that when he finally opened his mouth the sound that emerged caused you to jolt in your chair.
It speaks!