The Big Short: Inside the Doomsday Machine (2 page)

It was then late 2008. By then there was a long and growing list of pundits who claimed they predicted the catastrophe, but a far shorter list of people who actually did. Of those, even fewer had the nerve to bet on their vision. It's not easy to stand apart from mass hysteria--to believe that most of what's in the financial news is wrong, to believe that most important financial people are either lying or deluded--without being insane. Whitney rattled off a list with a half-dozen names on it, mainly investors she had personally advised. In the middle was John Paulson. At the top was Steve Eisman.

The Big Short

CHAPTER ONE

A Secret Origin Story

Eisman entered finance about the time I exited it. He'd
grown up in New York City, gone to yeshiva schools, graduated from the University of Pennsylvania magna cum laude, and then with honors from Harvard Law School. In 1991 he was a thirty-year-old corporate lawyer wondering why he ever thought he'd enjoy being a lawyer. "I hated it," he says. "I hated being a lawyer. My parents worked as brokers at Oppenheimer securities. They managed to finagle me a job. It's not pretty but that's what happened."

Oppenheimer was among the last of the old-fashioned Wall Street partnerships and survived on the scraps left behind by Goldman Sachs and Morgan Stanley. It felt less like a corporation than a family business. Lillian and Elliot Eisman had been giving financial advice to individual investors on behalf of Oppenheimer since the early 1960s. (Lillian had created their brokerage business inside of Oppenheimer, and Elliot, who had started out as a criminal attorney, had joined her after being spooked once too often by midlevel Mafia clients.) Beloved and respected by colleagues and clients alike, they could hire whomever they pleased. Before rescuing their son from his legal career they'd installed his old nanny on the Oppenheimer trading floor. On his way to reporting to his mother and father, Eisman passed the woman who had once changed his diapers. Oppenheimer had a nepotism rule, however; if Lillian and Elliot wanted to hire their son, they had to pay his salary for the first year, while others determined if he was worth paying at all.

Eisman's parents, old-fashioned value investors at heart, had always told him that the best way to learn about Wall Street was to work as an equity analyst. He started in equity analysis, working for the people who shaped public opinion about public companies. Oppenheimer employed twenty-five or so analysts, most of whose analysis went ignored by the rest of Wall Street. "The only way to get paid as an analyst at Oppenheimer was being right and making enough noise about it that people noticed it," says Alice Schroeder, who covered insurance companies for Oppenheimer, moved to Morgan Stanley, and eventually wound up being Warren Buffett's official biographer. She added, "There was a counterculture element to Oppenheimer. The people at the big firms were all being paid to be consensus." Eisman turned out to have a special talent for making noise and breaking with consensus opinion. He started as a junior equity analyst, a helpmate, not expected to offer his own opinions. That changed in December 1991, less than a year into the new job. A subprime mortgage lender called Aames Financial went public, and no one at Oppenheimer particularly cared to express an opinion about it. One of Oppenheimer's bankers, who hoped to be hired by Aames, stomped around the research department looking for anyone who knew anything about the mortgage business. "I'm a junior analyst and I'm just trying to figure out which end is up," says Eisman, "but I told him that as a lawyer I'd worked on a deal for The Money Store." He was promptly appointed the lead analyst for Aames Financial. "What I didn't tell him was that my job had been to proofread the documents and that I hadn't understood a word of the fucking things."

Aames Financial, like The Money Store, belonged to a new category of firms extending loans to cash-strapped Americans, known euphemistically as "specialty finance." The category did not include Goldman Sachs or J.P. Morgan but did include many little-known companies involved one way or another in the early 1990s boom in subprime mortgage lending. Aames was the first subprime mortgage lender to go public. The second company for which Eisman was given sole responsibility was called Lomas Financial Corp. Lomas had just emerged from bankruptcy. "I put a sell rating on the thing because it was a piece of shit. I didn't know that you weren't supposed to put sell ratings on companies. I thought there were three boxes--buy, hold, sell--and you could pick the one you thought you should." He was pressured to be a bit more upbeat, but upbeat did not come naturally to Steve Eisman. He could fake upbeat, and sometimes did, but he was happier not bothering. "I could hear him shouting into his phone from down the hall," says a former colleague. "Joyfully engaged in bashing the stocks of the companies he covered. Whatever he's thinking, it comes out of his mouth." Eisman stuck to his sell rating on Lomas Financial, even after the Lomas Financial Corporation announced that investors needn't worry about its financial condition, as it had hedged its market risk. "The single greatest line I ever wrote as an analyst," says Eisman, "was after Lomas said they were hedged." He recited the line from memory: "'The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment.' I enjoyed writing that sentence more than any sentence I ever wrote." A few months after he published that line, the Lomas Financial Corporation returned to bankruptcy.

Eisman quickly established himself as one of the few analysts at Oppenheimer whose opinions might stir the markets. "It was like going back to school for me," he said. "I would learn about an industry and I would go and write a paper about it." Wall Street people came to view him as a genuine character. He dressed half-fastidiously, as if someone had gone to great trouble to buy him nice new clothes but not told him exactly how they should be worn. His short-cropped blond hair looked as if he had cut it himself. The focal point of his soft, expressive, not unkind face was his mouth, mainly because it was usually at least half open, even while he ate. It was as if he feared that he might not be able to express whatever thought had just flitted through his mind quickly enough before the next one came, and so kept the channel perpetually clear. His other features all arranged themselves, almost dutifully, around the incipient thought. It was the opposite of a poker face.

In his dealings with the outside world, a pattern emerged. The growing number of people who worked for Steve Eisman loved him, or were at least amused by him, and appreciated his willingness and ability to part with both his money and his knowledge. "He's a born teacher," says one woman who worked for him. "And he's fiercely protective of women." He identified with the little guy and the underdog without ever exactly being one himself. Important men who might have expected from Eisman some sign of deference or respect, on the other hand, often came away from encounters with him shocked and outraged. "A lot of people don't get Steve," Meredith Whitney had told me, "but the people who get him love him." One of the people who didn't get Steve was the head of a large U.S. brokerage firm, who listened to Eisman explain in front of several dozen investors at lunch why he, the brokerage firm head, didn't understand his own business, then watched him leave in the middle of the lunch and never return. ("I had to go to the bathroom," says Eisman. "I don't know why I never went back.") After the lunch, the guy had announced he'd never again agree to enter any room with Steve Eisman in it. The president of a large Japanese real estate firm was another. He'd sent Eisman his company's financial statements and then followed, with an interpreter, to solicit Eisman's investment. "You don't even own stock in your company," said Eisman, after the typically elaborate Japanese businessman introductions. The interpreter conferred with the CEO.

"In Japan it is not customary for management to own stock," he said at length.

Eisman noted that the guy's financial statements didn't actually disclose any of the really important details about the guy's company; but, rather than simply say that, he lifted the statement in the air, as if disposing of a turd. "This...this is toilet paper," he said. "Translate that."

"The Japanese guy takes off his glasses," recalled a witness to the strange encounter. "His lips are quavering. World War Three is about to break out. 'Toy-lay paper? Toy-lay paper?'"

A hedge fund manager who counted Eisman as a friend set out to explain him to me but quit a minute into it--after he'd described Eisman exposing various bigwigs as either liars or idiots--and started to laugh. "He's sort of a prick in a way, but he's smart and honest and fearless."

"Even on Wall Street people think he's rude and obnoxious and aggressive," says Eisman's wife, Valerie Feigen, who worked at J.P. Morgan before quitting to open the women's clothing store Edit New York, and to raise their children. "He has no interest in manners. Believe me, I've tried and I've tried and I've tried." After she'd brought him home for the first time, her mother had said, "Well, we can't use him but we can definitely auction him off at UJA."
*
Eisman had what amounted to a talent for offending people. "He's not tactically rude," his wife explains. "He's sincerely rude. He knows everyone thinks of him as a character but he doesn't think of himself that way. Steven lives inside his head."

When asked about the pattern of upset he leaves in his wake, Eisman simply looks puzzled, even a bit wounded. "I forget myself sometimes," he says with a shrug.

Here was the first of many theories about Eisman: He was simply so much more interested in whatever was rattling around his brain than he was in whoever happened to be standing in front of him that the one overwhelmed the other. This theory struck others who knew Eisman well as incomplete. His mother, Lillian, offered a second theory. "Steven actually has two personalities," she said carefully. One was that of the boy to whom she had given the brand-new bicycle he so desperately craved, only to have him pedal it into Central Park, lend it to a kid he'd never met, and watch it vanish into the distance. The other was that of the young man who set out to study the Talmud, not because he had the slightest interest in God but because he was curious about its internal contradictions. His mother had been appointed chairman of the Board of Jewish Education in New York City, and Eisman was combing the Talmud for inconsistencies. "Who else studies Talmud so that they can find the mistakes?" asks his mother. Later, after Eisman became seriously rich and had to think about how to give money away, he landed on an organization called Footsteps, devoted to helping Hasidic Jews flee their religion. He couldn't even give away his money without picking a fight.

By pretty much every account, Eisman was a curious character. And he'd walked onto Wall Street at the very beginning of a curious phase. The creation of the mortgage bond market, a decade earlier, had extended Wall Street into a place it had never before been: the debts of ordinary Americans. At first the new bond market machine concerned itself with the more solvent half of the American population. Now, with the extension of the mortgage bond market into the affairs of less creditworthy Americans, it found its fuel in the debts of the less solvent half.

The mortgage bond was different in important ways from old-fashioned corporate and government bonds. A mortgage bond wasn't a single giant loan for an explicit fixed term. A mortgage bond was a claim on the cash flows from a pool of thousands of individual home mortgages. These cash flows were always problematic, as the borrowers had the right to pay off any time they pleased. This was the single biggest reason that bond investors initially had been reluctant to invest in home mortgage loans: Mortgage borrowers typically repaid their loans only when interest rates fell, and they could refinance more cheaply, leaving the owner of a mortgage bond holding a pile of cash, to invest at lower interest rates. The investor in home loans didn't know how long his investment would last, only that he would get his money back when he least wanted it. To limit this uncertainty, the people I'd worked with at Salomon Brothers, who created the mortgage bond market, had come up with a clever solution. They took giant pools of home loans and carved up the payments made by homeowners into pieces, called tranches. The buyer of the first tranche was like the owner of the ground floor in a flood: He got hit with the first wave of mortgage prepayments. In exchange, he received a higher interest rate. The buyer of the second tranche--the second story of the skyscraper--took the next wave of prepayments and in exchange received the second highest interest rate, and so on. The investor in the top floor of the building received the lowest rate of interest but had the greatest assurance that his investment wouldn't end before he wanted it to.

The big fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all. The pool of loans underlying the mortgage bond conformed to the standards, in their size and the credit quality of the borrowers, set by one of several government agencies: Freddie Mac, Fannie Mae, and Ginnie Mae. The loans carried, in effect, government guarantees; if the homeowners defaulted, the government paid off their debts. When Steve Eisman stumbled into this new, rapidly growing industry of specialty finance, the mortgage bond was about to be put to a new use: making loans that did not qualify for government guarantees. The purpose was to extend credit to less and less creditworthy homeowners, not so that they might buy a house but so that they could cash out whatever equity they had in the house they already owned.

The mortgage bonds created from subprime home loans extended the logic invented to address the problem of early repayment to cope with the problem of no repayment at all. The investor in the first floor, or tranche, would be exposed not to prepayments but to actual losses. He took the first losses until his investment was entirely wiped out, whereupon the losses hit the guy on the second floor. And so on.