The Big Short_ Inside the Doomsday Machine Part 2

In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans. Its logic was exactly that of the original mortgage bonds. In a mortgage bond, you gathered thousands of loans and, a.s.suming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a CDO you gathered one hundred different mortgage bonds mortgage bonds--usually, the riskiest, lower floors of the original tower--and used them to erect an entirely new tower of bonds. The innocent observer might reasonably ask, What's the point of using floors from one tower of debt simply to create another tower of debt? The short answer is, They are too near to the ground. More p.r.o.ne to flooding--the first to take losses--they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building.

The long answer was that there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. Their--soon to be everyone's--nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different triple-B-rated bonds), they persuaded the rating agencies that these weren't, as they might appear, all exactly the same things. They were another diversified portfolio of a.s.sets! This was absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally exposed. But never mind: The rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, p.r.o.nounced 80 percent of the new tower of debt triple-A.

The CDO was, in effect, a credit laundering service for the residents of Lower Middle Cla.s.s America. For Wall Street it was a machine that turned lead into gold.

Back in the 1980s, the original stated purpose of the mortgage-backed bond had been to redistribute the risk a.s.sociated with home mortgage lending. Home mortgage loans could find their way to the bond market investors willing to pay the most for them. The interest rate paid by the homeowner would thus fall. The goal of the innovation, in short, was to make the financial markets more efficient. Now, somehow, the same innovative spirit was being put to the opposite purpose: to hide the risk by complicating it. The market was paying Goldman Sachs bond traders to make the market less efficient. With stagnant wages and booming consumption, the cash-strapped American ma.s.ses had a virtually unlimited demand for loans but an uncertain ability to repay them. All they had going for them, from the point of view of Wall Street financial engineers, was that their financial fates could be misconstrued as uncorrelated. By a.s.suming that one pile of subprime mortgage loans wasn't exposed to the same forces as another--that a subprime mortgage bond with loans heavily concentrated in Florida wasn't very much like a subprime mortgage bond more concentrated in California--the engineers created the illusion of security. AIG FP accepted the illusion as reality.

The people who worked on the relevant Goldman Sachs mortgage bond trading desk were all extremely intelligent. They'd all done amazingly well in school and had gone to Ivy League universities. But it didn't require any sort of genius to see the fortune to be had from the laundering of triple-B-rated bonds into triple-A-rated bonds. What demanded genius was finding $20 billion in triple-B-rated bonds to launder. In the original tower of loans--the original mortgage bond--only a single, thin floor got rated triple-B. A billion dollars of c.r.a.ppy home loans might yield just $20 million of the c.r.a.ppiest triple-B tranches. Put another way: To create a billion-dollar CDO composed solely of triple-B-rated subprime mortgage bonds, you needed to lend $50 billion in cash to actual human beings. That took time and effort. A credit default swap took neither.

There was more than one way to think about Mike Burry's purchase of a billion dollars in credit default swaps. The first was as a simple, even innocent, insurance contract. Burry made his semiannual premium payments and, in return, received protection against the default of a billion dollars' worth of bonds. He'd either be paid zero, if the triple-B-rated bonds he'd insured proved good, or a billion dollars, if those triple-B-rated bonds went bad. But of course Mike Burry didn't own any triple-B-rated subprime mortgage bonds, or anything like them. He had no property to "insure" it was as if he had bought fire insurance on some slum with a history of burning down. To him, as to Steve Eisman, a credit default swap wasn't insurance at all but an outright speculative bet against the market--and this was the second way to think about it.

There was also a third, even more mind-bending, way to think of this new instrument: as a near-perfect replica of a subprime mortgage bond. The cash flows of Mike Burry's credit default swaps replicated the cash flows of the triple-B-rated subprime mortgage bond that he wagered against. The 2.5 percent a year in premium Mike Burry was paying mimicked the spread over LIBOR* that triple-B subprime mortgage bonds paid to an actual investor. The billion dollars whoever had sold Mike Burry his credit default swaps stood to lose, if the bonds went bad, replicated the potential losses of an actual bond owner. that triple-B subprime mortgage bonds paid to an actual investor. The billion dollars whoever had sold Mike Burry his credit default swaps stood to lose, if the bonds went bad, replicated the potential losses of an actual bond owner.

On its surface, the booming market in side bets on subprime mortgage bonds seemed to be the financial equivalent of fantasy football: a benign, if silly, facsimile of investing. Alas, there was a difference between fantasy football and fantasy finance: When a fantasy football player drafts Peyton Manning to be on his team, he doesn't create a second Peyton Manning. When Mike Burry bought a credit default swap based on a Long Beach Savings subprime-backed bond, he enabled Goldman Sachs to create another bond identical to the original in every respect but one: There were no actual home loans or home buyers. Only the gains and losses from the side bet on the bonds were real.

And so, to generate $1 billion in triple-B-rated subprime mortgage bonds, Goldman Sachs did not need to originate $50 billion in home loans. They needed simply to entice Mike Burry, or some other market pessimist, to pick 100 different triple-B bonds and buy $10 million in credit default swaps on each of them. Once they had this package (a "synthetic CDO," it was called, which was the term of art for a CDO composed of nothing but credit default swaps), they'd take it over to Moody's and Standard & Poor's. "The ratings agencies didn't really have their own CDO model," says one former Goldman CDO trader. "The banks would send over their own model to Moody's and say, 'How does this look?'" Somehow, roughly 80 percent of what had been risky triple-B-rated bonds now looked like triple-A-rated bonds. The other 20 percent, bearing lower credit ratings, generally were more difficult to sell, but they could, incredibly, simply be piled up in yet another heap and reprocessed yet again, into more triple-A bonds. The machine that turned 100 percent lead into an ore that was now 80 percent gold and 20 percent lead would accept the residual lead and turn 80 percent of that into gold, too.

The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs. And then--because it could not extend home loans fast enough to create a sufficient number of lower-rated bonds--it used credit default swaps to replicate the very worst of the existing bonds, many times over. Goldman Sachs stood between Michael Burry and AIG. Michael Burry forked out 250 basis points (2.5 percent) to own credit default swaps on the very c.r.a.ppiest triple-B bonds, and AIG paid a mere 12 basis points (0.12 percent) to sell credit default swaps on those very same bonds, filtered through a synthetic CDO, and p.r.o.nounced triple-A-rated. There were a few other messy details*--some of the lead was sold off directly to German investors in Dusseldorf--but when the dust settled, Goldman Sachs had taken roughly 2 percent off the top, risk-free, and booked all the profit up front. There was no need on either side--long or short--for cash to change hands. Both sides could do a deal with Goldman Sachs by signing a piece of paper. The original home mortgage loans on whose fate both sides were betting played no other role. In a funny way, they existed only so that their fate might be gambled upon.

The market for "synthetics" removed any constraint on the size of risk a.s.sociated with subprime mortgage lending. To make a billion-dollar bet, you no longer needed to acc.u.mulate a billion dollars' worth of actual mortgage loans. All you had to do was find someone else in the market willing to take the other side of the bet.

No wonder Goldman Sachs was suddenly so eager to sell Mike Burry credit default swaps in giant, $100 million chunks, or that the Goldman Sachs bond trader had been surprisingly indifferent to which subprime bonds Mike Burry bet against. The insurance Mike Burry bought was inserted into a synthetic CDO and pa.s.sed along to AIG. The roughly $20 billion in credit default swaps sold by AIG to Goldman Sachs meant roughly $400 million in riskless profits for Goldman Sachs. Each year Each year. The deals lasted as long as the underlying bonds, which had an expected life of about six years, which, when you did the math, implied a profit for the Goldman trader of $2.4 billion.

Wall Street's newest technique for squeezing profits out of the bond markets should have raised a few questions. Why were supposedly sophisticated traders at AIG FP doing this stuff? If credit default swaps were insurance, why weren't they regulated as insurance? Why, for example, wasn't AIG required to reserve capital against them? Why, for that matter, were Moody's and Standard & Poor's willing to bless 80 percent of a pool of dicey mortgage loans with the same triple-A rating they bestowed on the debts of the U.S. Treasury? Why didn't someone, anyone, inside Goldman Sachs stand up and say, "This is obscene. The rating agencies, the ultimate pricers of all these subprime mortgage loans, clearly do not understand the risk, and their idiocy is creating a recipe for catastrophe"? Apparently none of those questions popped into the minds of market insiders as quickly as another: How do I do what Goldman Sachs just did? Deutsche Bank, especially, felt something like shame that Goldman Sachs had been the first to find this particular pay dirt. Along with Goldman, Deutsche Bank was the leading market maker in abstruse mortgage derivatives. Dusseldorf was playing some kind of role in the new market. If there were stupid Germans standing ready to buy U.S. subprime mortgage derivatives, Deutsche Bank should have been the first to find them.

None of this was of any obvious concern to Greg Lippmann. Lippmann did not run Deutsche Bank's CDO business--a fellow named Michael Lamont did. Lippmann was merely the trader responsible for buying and selling subprime mortgage bonds and, by extension, credit default swaps on subprime mortgage bonds. But with so few investors willing to make an outright bet against the subprime bond market, Lippmann's bosses asked Lippmann to take one for the team: in effect, to serve as a stand-in for Mike Burry, and to make an explicit bet against the market. If Lippmann would buy credit default swaps from Deutsche Bank's CDO department, they, too, might do these trades with AIG, before AIG woke up and stopped doing them. "Greg was forced to get short into the CDOs," says a former senior member of Deutsche Bank's CDO team. "I say forced, but you can't really force Greg to do anything." There was some pushing and pulling with the people who ran his firm's CDO operations, but Lippmann found himself uncomfortably short subprime mortgage bonds.

Lippmann had at least one good reason for not putting up a huge fight: There was a fantastically profitable market waiting to be created. Financial markets are a collection of arguments. The less transparent the market and the more complicated the securities, the more money the trading desks at big Wall Street firms can make from the argument. The constant argument over the value of the shares of some major publicly traded company has very little value, as both buyer and seller can see the fair price of the stock on the ticker, and the broker's commission has been driven down by compet.i.tion. The argument over the value of credit default swaps on subprime mortgage bonds--a complex security whose value was derived from that of another complex security--could be a gold mine. The only other dealer making serious markets in credit default swaps was Goldman Sachs, so there was, in the beginning, little price compet.i.tion. Supply, thanks to AIG, was virtually unlimited. The problem was demand: investors who wanted to do Mike Burry's trade. Incredibly, at this critical juncture in financial history, after which so much changed so quickly, the only constraint in the subprime mortgage market was a shortage of people willing to bet against it.

To sell investors on the idea of betting against subprime mortgage bonds--on buying his pile of credit default swaps--Greg Lippmann needed a new and improved argument. Enter the Great Chinese Quant. Lippmann asked Eugene Xu to study the effect of home price appreciation on subprime mortgage loans. Eugene Xu went off and did whatever the second smartest man in China does, and at length returned with a chart ill.u.s.trating default rates in various home price scenarios: home prices up, home prices flat, home prices down. Lippmann looked at it...and looked again. The numbers shocked even him. They didn't need to collapse; they merely needed to stop rising so fast They didn't need to collapse; they merely needed to stop rising so fast. House prices were still rising, and yet default rates were approaching 4 percent; if they rose to just 7 percent, the lowest investment-grade bonds, rated triple-B-minus, went to zero. If they rose to 8 percent, the next lowest-rated bonds, rated triple-B, went to zero.

At that moment--in November 2005--Greg Lippmann realized that he didn't mind owning a pile of credit default swaps on subprime mortgage bonds. They weren't insurance; they were a gamble; and he liked the odds. He wanted wanted to be short. to be short.

This was new. Greg Lippmann had traded bonds backed by various consumer loans--auto loans, credit card loans, home equity loans--since 1991, when he had graduated from the University of Pennsylvania and taken a job at Credit Suisse. He'd never before been able to sell them short, because they were impossible to borrow. The only choice he and every other a.s.set-backed bond trader ever had to make was whether to like them or to love them. There was never any point in hating them. Now he could, and did. But hating them set him apart from the crowd--and that represented, for Greg Lippmann, a new career risk. As he put it to others, "If you're in a business where you can do only one thing and it doesn't work out, it's hard for your bosses to be mad at you." It was now possible to do more than one thing, but if he bet against subprime mortgage bonds and was proven wrong, his bosses would find it easy to be mad at him.

In the righteous spirit of a man bearing an inconvenient truth, Greg Lippmann, a copy of "Shorting Subprime Mezzanine Tranches" tucked under his arm, launched himself at the inst.i.tutional investing public. He may have begun his investigation of the subprime mortgage market in the spirit of a Wall Street salesman, searching less for the truth than for a persuasive-sounding pitch. Now, shockingly, he thought he had an ingenious plan to make customers rich. He'd charge them fat fees to get in and out of their credit default swaps, of course, but these would prove trivial compared to the fortunes they stood to make. He was no longer selling; he was dispensing favors. Behold. A gift from me to you. Behold. A gift from me to you.

Inst.i.tutional investors didn't know what to make of him, at least not at first. "I think he has some kind of narcissistic personality disorder," said one money manager who heard Lippmann's pitch but did not do his trade. "He scared the s.h.i.t out of us," said another. "He comes in and describes this brilliant trade. It makes total sense. To us the risk was, we do it, it works, then what? How do we get out? He controls the market; he may be the only one we can sell to. And he says, 'You have no way out of this swimming pool but through me, and when you ask for the towel I'm going to rip your eyeb.a.l.l.s out.' He actually said that, that he was going to rip our eyeb.a.l.l.s out. The guy was totally transparent."

They loved it, in a way, but decided they didn't want to experience the thrill of eyeball removal. "What worked against Greg," this fund manager said, "was that he was too candid."

Lippmann faced the usual objections any Wall Street bond customer voiced to any Wall Street bond salesmen--If it's such a great trade, why are you offering it to me?--but other, less usual ones, too. Buying credit default swaps meant paying insurance premiums for perhaps years as you waited for American homeowners to default. Bond market investors, like bond market traders, viscerally resisted any trade that they had to pay money to be in, and instinctively sought out trades that paid them just for showing up in the morning. (One big bond market investor christened his yacht Positive Carry Positive Carry.) Trades where you fork over 2 percent a year just to be in them were anathema. Other sorts of investors found other sorts of objections. "I can't explain credit default swaps to my investors" was a common response to Greg Lippmann's pitch. Or "I have a cousin who works at Moody's and he says this stuff [subprime mortgage bonds] is all good." Or "I talked to Bear Stearns and they said you were crazy." Lippmann spent twenty hours with one hedge fund guy and thought he had him sold, only to have the guy call his college roommate, who worked for some home builder, and change his mind.

But the most common response of all from investors who heard Lippmann's argument was, "I'm convinced. You're right. But it's not my job to short the subprime market."

"That's why the opportunity exists," Lippmann would reply. "It's n.o.body's job."

It wasn't Lippmann's, either. He was meant to be the toll booth, taking a little from buyers and sellers as they pa.s.sed through his trading books. He was now in a different, more opinionated relationship to his market and his employer. Lippmann's short position may have been forced upon him, but by the end of 2005 he'd made it his own, and grown it to a billion dollars. Sixteen floors above him inside Deutsche Bank's Wall Street headquarters, several hundred highly paid employees bought subprime mortgage loans, packaged them into bonds, and sold them off. Another group packaged the most repellent, unsalable tranches of those bonds, and CDSs on the bonds, into CDOs. The bigger Lippmann's short position grew, the greater the implicit expression of contempt for these people and their industry--an industry quickly becoming Wall Street's most profitable business. The running cost, in premiums Lippmann paid, was tens of millions of dollars a year, and his losses looked even bigger. The buyer of a credit default swap agreed to pay premiums for the lifespan of the underlying mortgage bond. So long as the underlying bonds remained outstanding, both buyer and seller of credit default swaps were obliged to post collateral, in response to their price movements. Astonishingly, the prices of subprime mortgage bonds were rising. Within a few months, Lippmann's credit default swap position had to be marked down by $30 million. His superiors repeatedly asked him to explain why he was doing what he was doing. "A lot of people wondered if this was the best use of Greg's time and our money," said a senior Deutsche Bank official who watched the growing conflict.

Rather than cave to the pressure, Lippmann instead had an idea for making it vanish: kill the new market. AIG was very nearly the only buyer of triple-A-rated CDOs (that is, triple-B-rated subprime mortgage bonds repackaged into triple-A-rated CDOs). AIG was, ultimately, the party on the other side of the credit default swaps Mike Burry was buying. If AIG stopped buying bonds (or, more exactly, stopped insuring them against default), the entire subprime mortgage bond market might collapse, and Lippmann's credit default swaps would be worth a fortune. At the end of 2005, Lippmann flew to London to try to make that happen. He met with an AIG FP employee named Tom Fewings, who worked directly for AIG FP's head, Joe Ca.s.sano. Lippmann, who was forever adding data to his presentation, produced his latest version of "Shorting Mezzanine Home Equity Tranches" and walked Fewings through his argument. Fewings offered him no serious objections, and Lippmann left AIG's London office feeling as if Fewings had been converted to his cause. Sure enough, shortly after Lippmann's visit, AIG FP stopped selling credit default swaps. Even better: AIG FP hinted that they might actually like to buy buy some credit default swaps. In antic.i.p.ation of selling them some, Lippmann acc.u.mulated more. some credit default swaps. In antic.i.p.ation of selling them some, Lippmann acc.u.mulated more.

For a brief moment, Lippmann thought he'd changed the world, all by himself. He had walked into AIG FP and had shown them how Deutsche Bank, along with every other Wall Street firm, was playing them for fools, and they'd understood.

CHAPTER FOUR.

How to Harvest a Migrant Worker They hadn't. Not really. The first person inside AIG FP to awaken to the madness of his firm's behavior, and sound an alarm, was not Tom Fewings, who quickly forgot his meeting with Lippmann, but Gene Park. Park worked in AIG FP's Connecticut office and sat close enough to the credit default swap traders to have a general idea of what they were up to. In mid-2005 he read a front-page story in the to awaken to the madness of his firm's behavior, and sound an alarm, was not Tom Fewings, who quickly forgot his meeting with Lippmann, but Gene Park. Park worked in AIG FP's Connecticut office and sat close enough to the credit default swap traders to have a general idea of what they were up to. In mid-2005 he read a front-page story in the Wall Street Journal Wall Street Journal about the mortgage lender New Century. He noted how high the company's dividend was and wondered if he should buy some of its stock for himself. As he dug into New Century, however, Park saw that they owned all these subprime mortgages--and he could see from their own statements that the quality of these loans was frighteningly poor. Soon after his private investigation of New Century, Park had a phone call from a penniless, jobless old college friend who had been offered several loans from banks to buy a house he couldn't afford. That's when the penny dropped for him: Park had noticed his colleague, Al Frost, announcing credit default swap deals with big Wall Street firms at a new clip. A year before, Frost might have done one billion-dollar deal each month; now he was doing twenty, all of them insuring putatively diversified piles of consumer loans. "We were doing every single deal with every single Wall Street firm, except Citigroup," says one trader. "Citigroup decided it liked the risk, and kept it on their books. We took all the rest." When traders asked Frost why Wall Street was suddenly so eager to do business with AIG, as one put it, "he would explain that they liked us because we could act quickly." Park put two and two together and guessed that the nature of these piles of consumer loans insured by AIG FP was changing, that they contained a lot more subprime mortgages than anyone knew, and that if U.S. homeowners began to default in sharply greater numbers, AIG didn't have anywhere near the capital required to cover the losses. When he brought this up at a meeting, his reward was to be hauled into a separate room by Joe Ca.s.sano, who screamed at him that he didn't know what he was talking about. about the mortgage lender New Century. He noted how high the company's dividend was and wondered if he should buy some of its stock for himself. As he dug into New Century, however, Park saw that they owned all these subprime mortgages--and he could see from their own statements that the quality of these loans was frighteningly poor. Soon after his private investigation of New Century, Park had a phone call from a penniless, jobless old college friend who had been offered several loans from banks to buy a house he couldn't afford. That's when the penny dropped for him: Park had noticed his colleague, Al Frost, announcing credit default swap deals with big Wall Street firms at a new clip. A year before, Frost might have done one billion-dollar deal each month; now he was doing twenty, all of them insuring putatively diversified piles of consumer loans. "We were doing every single deal with every single Wall Street firm, except Citigroup," says one trader. "Citigroup decided it liked the risk, and kept it on their books. We took all the rest." When traders asked Frost why Wall Street was suddenly so eager to do business with AIG, as one put it, "he would explain that they liked us because we could act quickly." Park put two and two together and guessed that the nature of these piles of consumer loans insured by AIG FP was changing, that they contained a lot more subprime mortgages than anyone knew, and that if U.S. homeowners began to default in sharply greater numbers, AIG didn't have anywhere near the capital required to cover the losses. When he brought this up at a meeting, his reward was to be hauled into a separate room by Joe Ca.s.sano, who screamed at him that he didn't know what he was talking about.

That Joe Ca.s.sano, the boss of AIG FP, was the son of a police officer and had been a political science major at Brooklyn College seems, in retrospect, far less relevant than his need for obedience and total control. He'd spent most of his career, first at Drexel Burnham and then at AIG FP, not as a bond trader but working in the back office. Across AIG FP the view of the boss was remarkably consistent: Ca.s.sano was a guy with a crude feel for financial risk but a real talent for bullying people who doubted him. "AIG FP became a dictatorship," says one London trader. "Joe would bully people around. He'd humiliate them and then try to make it up to them by giving them huge amounts of money."

"One day he got me on the phone and was p.i.s.sed off about a trade that had lost money," says a Connecticut trader. "He said, When you lose money it's my f.u.c.king money. Say it When you lose money it's my f.u.c.king money. Say it. I said, 'What?'

"Say, 'Joe, it's your f.u.c.king money'! So I said, 'It's your f.u.c.king money, Joe.'" So I said, 'It's your f.u.c.king money, Joe.'"

"The culture changed," says a third trader. "The fear level was so high that when we had these morning meetings, you presented what you did not to upset him. And if you were critical of the organization, all h.e.l.l would break loose." Says a fourth, "Joe always said, 'This is my company. You work for my company.' He'd see you with a bottle of water. He'd come over and say, 'That's my water.' Lunch was free, but Joe always made you feel he had bought it." And a fifth: "Under Joe, the debate and discussion that was common under Tom [Savage, the previous CEO] ceased. I would say [to Tom] what I'm saying to you. But with Joe as the audience." A sixth: "The way you dealt with Joe was to start everything by saying, 'You're right, Joe.'"

Even by the standards of Wall Street villains whose character flaws wind up being exaggerated to fit the crime, Ca.s.sano, in the retelling, became a cartoon monster. "One day he came in and saw that someone had left the weights on the Smith machine, in the gym," says a seventh source, in Connecticut. "He was literally walking around looking for people who looked buff, trying to find the guy who did it. He was screaming, 'Who left the f.u.c.king weight on the f.u.c.king Smith machine? Who left the f.u.c.king weight on the f.u.c.king Smith machine?'"

Oddly, Ca.s.sano was as likely to direct his anger at profitable traders as at unprofitable ones, for the anger was triggered not by financial loss but by the faintest whiff of insurrection. Even more oddly, his anger had no obvious effect on the recipient's paycheck; a trader might find himself routinely abused by his boss and yet delighted by his year-end bonus, determined by that same boss. One reason none of AIG FP's traders took a swing at Joe Ca.s.sano, before walking out the door, was that the money was simply too good. A man who valued loyalty and obedience above all other traits had no tool to command it except money. Money worked as a management tool, but only up to a point. If you were going to be on the other side of a trade from Goldman Sachs, you had better know what, exactly, Goldman Sachs was up to. AIG FP could attract extremely bright people who were perfectly capable of keeping up with their counterparts at Goldman Sachs. They were constrained, however, by a boss with an imperfect understanding of the nuances of his own business, and whose judgment was clouded by his insecurity.

Toward the end of 2005, Ca.s.sano promoted Al Frost, then went looking for someone to replace him as the amba.s.sador to Wall Street's bond trading desks. The job, in effect, was to say "yes" every time some Wall Street trader asked him if he'd like to insure--and so, in effect, purchase--a billion-dollar pile of bonds backed by consumer loans. For a number of reasons, Gene Park was a likely candidate, and so he decided to examine these loans that AIG FP was insuring a bit more closely. The magnitude of the misunderstanding shocked him: These supposedly diversified piles of consumer loans now consisted almost entirely of U.S. subprime mortgages. Park conducted a private survey. He asked the people most directly involved in the decision to sell credit default swaps on consumer loans what percentage of those loans were subprime mortgages. He asked Gary Gorton, a Yale professor who had built the model that Ca.s.sano used to price the credit default swaps: Gorton guessed that the piles were no more than 10 percent subprime. He asked a risk a.n.a.lyst in London, who guessed 20 percent. "None of them knew it was 95 percent," says one trader. "And I'm sure that Ca.s.sano didn't, either." In retrospect, their ignorance seems incredible--but, then, an entire financial system was premised on their not knowing, and paying them for this talent.

By the time Joe Ca.s.sano invited Gene Park to London for the meeting in which he would be "promoted" to the job of creating even more of these ticking bombs, Park knew he wanted no part of it. If he was forced to take the job, he said, he'd quit. This, naturally, infuriated Joe Ca.s.sano, who accused Park of being lazy, of dreaming up reasons not to do the deals that would require complicated paperwork. Confronted with the new fact--that his company was effectively long long $50 billion in triple-B subprime mortgage bonds, masquerading as triple-A-rated diversified pools of consumer loans--Ca.s.sano at first sought to rationalize it. He clearly thought that any money he received for selling default insurance on highly rated bonds was free money. For the bonds to default, he now said, U.S. house prices had to fall, and Joe Ca.s.sano didn't believe house prices could ever fall everywhere in the country at once. After all, Moody's and S&P had both rated this stuff triple-A! $50 billion in triple-B subprime mortgage bonds, masquerading as triple-A-rated diversified pools of consumer loans--Ca.s.sano at first sought to rationalize it. He clearly thought that any money he received for selling default insurance on highly rated bonds was free money. For the bonds to default, he now said, U.S. house prices had to fall, and Joe Ca.s.sano didn't believe house prices could ever fall everywhere in the country at once. After all, Moody's and S&P had both rated this stuff triple-A!

Ca.s.sano nevertheless agreed to meet with all the big Wall Street firms and discuss the logic of their deals--to investigate how a bunch of shaky loans could be transformed into triple-A-rated bonds. Together with Gene Park and a few others, he set out on a series of meetings with traders at Deutsche Bank, Goldman Sachs, and the rest, all of whom argued how unlikely it was for housing prices to fall all at once. "They all said the same thing," said one of the traders present. "They'd go back to historical real estate prices over sixty years and say they had never fallen nationally, all at once." (Two months after their meeting with Goldman Sachs, one of the AIG FP traders b.u.mped into the Goldman guy who had made this argument and who now said, Between you and me, you're right. These things are going to blow up Between you and me, you're right. These things are going to blow up.) The AIG FP traders present were shocked by how little thought or a.n.a.lysis seemed to underpin the subprime mortgage machine: It was simply a bet that home prices would never fall. Once he understood this, and once he could construe it as his own idea, Joe Ca.s.sano changed his mind. By early 2006 he openly agreed with Gene Park: AIG FP shouldn't insure any more of these deals--though they would continue to insure the ones they had already insured.

At the time, this decision didn't really seem like all that big a deal for AIG FP. The division was generating almost $2 billion a year in profits. At the peak, the entire credit default swap business contributed only $180 million of that. Ca.s.sano had been upset with Park, and slow to change his mind, it seemed, mainly because Park had dared to contradict him.

The one Wall Street trader who had tried to persuade AIG FP to stop betting on the subprime mortgage bond market witnessed none of these internal politics. Greg Lippmann simply a.s.sumed that the force of his argument had won them over--until it didn't. He never understood why AIG FP changed its mind but left itself so exposed. It sold no more credit default swaps to Wall Street but did nothing to offset the 50 billion dollars' worth that it had already sold. Wall Street trader who had tried to persuade AIG FP to stop betting on the subprime mortgage bond market witnessed none of these internal politics. Greg Lippmann simply a.s.sumed that the force of his argument had won them over--until it didn't. He never understood why AIG FP changed its mind but left itself so exposed. It sold no more credit default swaps to Wall Street but did nothing to offset the 50 billion dollars' worth that it had already sold.

Even that, Lippmann thought, might cause the market to crash. If AIG FP refused to take the long side of the trade, he thought, no one would, and the subprime mortgage market would shut down. But--and here was the start of a great mystery--the market didn't so much as blink. Wall Street firms found new buyers of triple-A-rated subprime CDOs--new places to stuff the riskiest triple-B tranches of subprime mortgage bonds--though who these people were was not entirely clear for some time, even to Greg Lippmann.

The subprime mortgage machine roared on. The loans that were being made to actual human beings only grew c.r.a.ppier, but, bizarrely, the price of insuring them--the price of buying credit default swaps--fell. By April 2006 Lippmann's superiors at Deutsche Bank were asking him to defend his quixotic gamble. They wanted him to make money just by sitting in the middle of this new market, the way Goldman Sachs did, crossing buyers and sellers. They reached an agreement: Lippmann could keep his expensive short position as long as he could prove that, if he had to sell it, there'd be some other investor willing to take it off his hands on short notice. That is, he needed to foster a more active market in credit default swaps; if he wanted to keep his bet he had to find others to join him in it.

By the summer of 2006 Greg Lippmann had a new metaphor in his head: a tug-of-war. The entire subprime mortgage lending machine--including his own employer, Deutsche Bank--pulled on one end of the rope, while he, Greg Lippmann, hauled back on the other. He needed others to join him. They'd all pull together. His teammates would pay him a fee for being on his side, but they'd get rich, too.

Lippmann soon found that the people he most expected to see the ugly truth of the subprime mortgage market--the people who ran funds that specialized in mortgage bond trading--were the ones least likely to see anything but what they had been seeing for years. Here was a strange but true fact: The closer you were to the market, the harder it was to perceive its folly. Realizing this, Lippmann went looking for stock investors with a lot of exposure to falling home prices, or falling housing stock prices, and showed them his idea as a hedge. Look, you're making a fortune as this stuff keeps going up. Why not spend a little to cover yourself in a collapse? Look, you're making a fortune as this stuff keeps going up. Why not spend a little to cover yourself in a collapse? Greed hadn't worked, so he tried fear. He obtained a list of all the big stockholders in New Century, the big subprime lender. Prominent on the list was a hedge fund called FrontPoint Partners. He called the relevant Deutsche Bank salesman to set up a meeting. The salesman failed to notice that there was more than one hedge fund inside FrontPoint--it wasn't a single fund but a collection of independently managed hedge funds--and that the fund that was long New Century stock was a small group based on the West Coast. Greed hadn't worked, so he tried fear. He obtained a list of all the big stockholders in New Century, the big subprime lender. Prominent on the list was a hedge fund called FrontPoint Partners. He called the relevant Deutsche Bank salesman to set up a meeting. The salesman failed to notice that there was more than one hedge fund inside FrontPoint--it wasn't a single fund but a collection of independently managed hedge funds--and that the fund that was long New Century stock was a small group based on the West Coast.

When Greg Lippmann arrived in Steve Eisman's conference room in midtown Manhattan, Eisman surprised him by saying, "We're not the FrontPoint that is long New Century stock. We're the FrontPoint that is short short New Century stock." Eisman was already betting against the shares of companies, such as New Century and IndyMac Bank, which originated subprime loans, along with companies that built the houses bought with the loans, such as Toll Brothers. These bets were not entirely satisfying because they weren't bets against the companies but market sentiment about the companies. Also, the bets were expensive to maintain. The companies paid high dividends, and their shares were often costly to borrow: New Century, for instance, paid a 20 percent dividend, and its shares cost 12 percent a year to borrow. For the pleasure of shorting 100 million dollars' worth of New Century's shares, Steve Eisman forked out $32 million a year. New Century stock." Eisman was already betting against the shares of companies, such as New Century and IndyMac Bank, which originated subprime loans, along with companies that built the houses bought with the loans, such as Toll Brothers. These bets were not entirely satisfying because they weren't bets against the companies but market sentiment about the companies. Also, the bets were expensive to maintain. The companies paid high dividends, and their shares were often costly to borrow: New Century, for instance, paid a 20 percent dividend, and its shares cost 12 percent a year to borrow. For the pleasure of shorting 100 million dollars' worth of New Century's shares, Steve Eisman forked out $32 million a year.

In his search for stock market investors he might terrify with his Doomsday scenario, Lippmann had made a lucky strike: He had stumbled onto a stock market investor who held an even darker view of the subprime mortgage market than he did. Eisman knew more about that market, its characters, and its depravities than anyone Lippmann had ever spoken with. If anyone would make a dramatic bet against subprime, he thought, it was Eisman--and so he was puzzled when Eisman didn't do it. He was even more puzzled when, several months later, Eisman's new head trader, Danny Moses, and his research guy, Vinny Daniels, asked him to come back in to explain it all over again.

The problem with someone who is transparently self-interested is that the extent of his interests is never clear. Danny simply mistrusted Lippmann at first sight. "f.u.c.king Lippmann," he called him, as in, "f.u.c.king Lippmann never looks you in the eye when he talks to you. It bothers the s.h.i.t out of me." Vinny could not believe that Deutsche Bank would let this guy loose to run around and torpedo their market unless it served the narrow interests of Deutsche Bank. To Danny and Vinny, Greg Lippmann was a walking embodiment of the bond market, which is to say he was put on earth to screw the customer.

Three times in as many months, Danny and Vinny called, and Lippmann returned--and that fact alone heightened their suspicion of him. He wasn't driving up from Wall Street to Midtown to promote world peace. So why was he here? Each time, Lippmann would talk a mile a minute, and Danny and Vinny would stare in wonder. Their meetings acquired the flavor of a postmodern literary puzzle: The story rang true even as the narrator seemed entirely unreliable. At some point during each of these sessions, Vinny would stop him to ask, "Greg, I'm trying to figure out why you are even here." This was a signal to bombard Lippmann with accusatory questions: If it's such a great idea, why don't you quit Deutsche Bank and start a hedge fund and make a fortune for yourself?It'd take me six months to set up a hedge fund. The world might wake up to this insanity next week. I have to play the hand I've been dealt.If it's such a great idea, why are you giving it away to us?I'm not giving away anything. The supply is infinite.Yeah. But why bother even telling us?I'll charge you getting in and getting out. I need to pay the electric bills.It's zero-sum. Who's on the other side? Who's the idiot?Dusseldorf. Stupid Germans. They take rating agencies seriously. They believe in the rules. They believe in the rules.Why does Deutsche Bank allow you to trash a market that they sit at the center of?I don't have any particular allegiance to Deutsche Bank...I just work there.Bulls.h.i.t. They pay you. How do we know the people running your CDO machine aren't just using your enthusiasm for shorting your own market to exploit us?Have you met the people running our CDO machine?

At some point Danny and Vinny dropped even the pretense that they were seeking new information about credit default swaps and subprime mortgage bonds. They were just hoping the guy might slip up in some way that confirmed that he was indeed the lying Wall Street sc.u.mbag that they presumed him to be. "We're trying to figure out where we fit into this world," said Vinny. "I don't believe him that he needs us because he has too much of this stuff. So why is he doing this?" Lippmann, for his part, felt like a witness under interrogation: These guys were trying to crack crack him. A few months later, he'd pitch his idea to Phil Falcone, who ran a giant hedge fund called Harbinger Capital. Falcone would buy billions of dollars in credit default swaps virtually on the spot. Falcone knew one-tenth of what these guys knew about the subprime mortgage market, but Falcone trusted Lippmann and these guys did not. In their final meeting, Vinny finally put the matter bluntly. "Greg," he said. "Don't take this the wrong way. But I'm just trying to figure out how you're going to f.u.c.k me." him. A few months later, he'd pitch his idea to Phil Falcone, who ran a giant hedge fund called Harbinger Capital. Falcone would buy billions of dollars in credit default swaps virtually on the spot. Falcone knew one-tenth of what these guys knew about the subprime mortgage market, but Falcone trusted Lippmann and these guys did not. In their final meeting, Vinny finally put the matter bluntly. "Greg," he said. "Don't take this the wrong way. But I'm just trying to figure out how you're going to f.u.c.k me."

They never actually finished weighing the soul of Greg Lippmann. Rather, they were interrupted by two pieces of urgent news. The first came in May 2006: Standard & Poor's announced its plans to change the model used to rate subprime mortgage bonds. The model would change July 1, 2006, the announcement said, but all the subprime bonds issued before that date would be rated by the old, presumably less rigorous, model. Instantly, the creation of subprime bonds shot up dramatically. "They were stuffing the channel," said Vinny. "Getting as much s.h.i.t out so that it could be rated by the old model." The fear of new and better ratings suggested that even the big Wall Street firms knew that the bonds they'd been creating had been overrated.

The other piece of news concerned home prices. Eisman spoke often to a housing market a.n.a.lyst at Credit Suisse named Ivy Zelman. The simple measure of sanity in housing prices, Zelman argued, was the ratio of median home price to income. Historically, in the United States, it ran around 3:1; by late 2004, it had risen nationally, to 4:1. "All these people were saying it was nearly as high in some other countries," says Zelman. "But the problem wasn't just that it was four to one. In Los Angeles it was ten to one ten to one and in Miami, eight-point-five to one. And then you coupled that with the buyers. They weren't real buyers. They were speculators." and in Miami, eight-point-five to one. And then you coupled that with the buyers. They weren't real buyers. They were speculators."* The number of For Sale signs began rising in mid-2005 and never stopped. In the summer of 2006, the Case-Shiller index of house prices peaked, and house prices across the country began to fall. For the entire year they would fall, nationally, by 2 percent. The number of For Sale signs began rising in mid-2005 and never stopped. In the summer of 2006, the Case-Shiller index of house prices peaked, and house prices across the country began to fall. For the entire year they would fall, nationally, by 2 percent.

Either piece of news--rising ratings standards or falling house prices--should have disrupted the subprime bond market and caused the price of insuring the bonds to rise. Instead, the price of insuring the bonds fell. Insurance on the c.r.a.ppiest triple-B tranche of a subprime mortgage bond now cost less than 2 percent a year. "We finally just did a trade with Lippmann," says Eisman. "Then we tried to figure out what we'd done."

The minute they'd done their first trade, they joined Greg Lippmann's long and growing e-mail list. Right up until the collapse, Lippmann would pepper them with agitprop about the housing market, and his own ideas of which subprime mortgage bonds his customers should bet against. "Any time Lippmann would offer us paper, Vinny and I would look at each other and say no," said Danny Moses. They'd take Lippmann's advice, but only up to a point. They still hadn't gotten around to trusting anyone inside a Wall Street bond department; anyway, it was their job, not Lippmann's, to evaluate the individual bonds. they'd done their first trade, they joined Greg Lippmann's long and growing e-mail list. Right up until the collapse, Lippmann would pepper them with agitprop about the housing market, and his own ideas of which subprime mortgage bonds his customers should bet against. "Any time Lippmann would offer us paper, Vinny and I would look at each other and say no," said Danny Moses. They'd take Lippmann's advice, but only up to a point. They still hadn't gotten around to trusting anyone inside a Wall Street bond department; anyway, it was their job, not Lippmann's, to evaluate the individual bonds.

Michael Burry focused, abstractly, on the structure of the loans, and bet on pools with high concentrations of the types that he believed were designed to fail. Eisman and his partners focused concretely on the people doing the borrowing and the lending. The subprime market tapped a segment of the American public that did not typically have anything to do with Wall Street: the tranche between the fifth and the twenty-ninth percentile in their credit ratings. That is, the lenders were making loans to people who were less creditworthy than 71 percent of the population. Which of these poor Americans were likely to jump which way with their finances? How much did their home prices need to fall for their loans to blow up? Which mortgage originators were the most corrupt? Which Wall Street firms were creating the most dishonest mortgage bonds? What kind of people, in which parts of the country, exhibited the highest degree of financial irresponsibility? The default rate in Georgia was five times higher than that in Florida, even though the two states had the same unemployment rate. Why? Indiana had a 25 percent default rate; California, only 5 percent, even though Californians were, on the face of it, far less fiscally responsible. Why? Vinny and Danny flew down to Miami, where they wandered around empty neighborhoods built with subprime loans, and saw with their own eyes how bad things were. "They'd call me and say, 'Oh my G.o.d, this is a calamity here,'" recalls Eisman.

In short, they performed the sort of nitty-gritty credit a.n.a.lysis on the mortgage loans that should have been done before the loans were made in the first place. Then they went hunting for crooks and fools. "The first time I realized how bad it was," said Eisman, "was when I said to Lippmann, 'Send me a list of the 2006 deals with high no-doc loans." Eisman, predisposed to suspect fraud in the market, wanted to bet against Americans who had been lent money without having been required to show evidence of income or employment. "I figured Lippmann was going to send me deals that had twenty percent no docs. He sent us a list and none of them had less than fifty percent."

They called Wall Street trading desks and asked for menus of subprime mortgage bonds, so they might find the most rotten ones and buy the smartest insurance. The juiciest shorts--the bonds ultimately backed by the mortgages most likely to default--had several characteristics. First, the underlying loans were heavily concentrated in what Wall Street people were now calling the sand states: California, Florida, Nevada, and Arizona. House prices in the sand states had risen fastest during the boom and so would likely crash fastest in a bust--and when they did, those low California default rates would soar. Second, the loans would have been made by the more dubious mortgage lenders. Long Beach Savings, wholly owned by Washington Mutual, was a prime example of financial incontinence. Long Beach Savings had been the first to embrace the originate and sell model and now was moving money out the door to new home buyers as fast as it could, few questions asked. Third, the pools would have a higher than average number of low-doc or no-doc loans--that is, loans more likely to be fraudulent. Long Beach Savings, it appeared to Eisman and his partners, specialized in asking homeowners with bad credit and no proof of income to accept floating-rate mortgages. No money down, interest payments deferred upon request. The housing blogs of southern California teemed with stories of financial abuses made possible by these so-called thirty-year payment option ARMs, or adjustable-rate mortgages. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000.

The more they examined the individual bonds, the more they came to see patterns in the loans that could be exploited for profit. The new taste for lending huge sums of money to poor immigrants, for instance. One day Eisman's housekeeper, a South American woman, came to him and told him that she was planning to buy a townhouse in Queens. "The price was absurd, and they were giving her a no money down option adjustable-rate mortgage," says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he'd hired back in 2003 to take care of his new twin daughters phoned him. "She was this lovely woman from Jamaica," he says. "She says she and her sister own six townhouses in Queens. I said, 'Corinne, how did that happen?'" It happened because after they bought the first one, and its value rose, the lenders came and suggested they refinance and take out $250,000--which they used to buy another. Then the price of that one rose, too, and they repeated the experiment. "By the time they were done they owned five of them, the market was falling, and they couldn't make any of the payments."

The sudden ability of his baby nurse to obtain loans was no accident: Like pretty much everything else that was happening between subprime mortgage borrowers and lenders, it followed from the defects of the models used to evaluate subprime mortgage bonds by the two major rating agencies, Moody's and Standard & Poor's.

The big Wall Street firms--Bear Stearns, Lehman Brothers, Goldman Sachs, Citigroup, and others--had the same goal as any manufacturing business: to pay as little as possible for raw material (home loans) and charge as much as possible for their end product (mortgage bonds). The price of the end product was driven by the ratings a.s.signed to it by the models used by Moody's and S&P. The inner workings of these models were, officially, a secret: Moody's and S&P claimed they were impossible to game. But everyone on Wall Street knew that the people who ran the models were ripe for exploitation. "Guys who can't get a job on Wall Street get a job at Moody's," as one Goldman Sachs trader-turned-hedge fund manager put it. Inside the rating agency there was another hierarchy, even less flattering to the subprime mortgage bond raters. "At the ratings agencies the corporate credit people are the least bad," says a quant who engineered mortgage bonds for Morgan Stanley. "Next are the prime mortgage people. Then you have the a.s.set-backed people, who are basically like brain-dead."* Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible ratings for the worst possible loans. They performed the task with Ivy League thoroughness and efficiency. They quickly figured out, for instance, that the people at Moody's and S&P didn't actually evaluate the individual home loans, or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools. Wall Street bond trading desks, staffed by people making seven figures a year, set out to coax from the brain-dead guys making high five figures the highest possible ratings for the worst possible loans. They performed the task with Ivy League thoroughness and efficiency. They quickly figured out, for instance, that the people at Moody's and S&P didn't actually evaluate the individual home loans, or so much as look at them. All they and their models saw, and evaluated, were the general characteristics of loan pools.

Their handling of FICO scores was one example. FICO scores--so called because they were invented, in the 1950s, by a company called the Fair Isaac Corporation--purported to measure the creditworthiness of individual borrowers. The highest possible FICO score was 850; the lowest was 300; the U.S. median was 723. FICO scores were simplistic. They didn't account for a borrower's income, for instance. They could also be rigged. A would-be borrower could raise his FICO score by taking out a credit card loan and immediately paying it back. But never mind: The problem with FICO scores was overshadowed by the way they were misused by the rating agencies. Moody's and S&P asked the loan packagers not for a list of the FICO scores of all the borrowers but for the average average FICO score of the pool. To meet the rating agencies' standards--to maximize the percentage of triple-A-rated bonds created from any given pool of loans--the average FICO score of the borrowers in the pool needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680. A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place. But the hole in the rating agencies' models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615. FICO score of the pool. To meet the rating agencies' standards--to maximize the percentage of triple-A-rated bonds created from any given pool of loans--the average FICO score of the borrowers in the pool needed to be around 615. There was more than one way to arrive at that average number. And therein lay a huge opportunity. A pool of loans composed of borrowers all of whom had a FICO score of 615 was far less likely to suffer huge losses than a pool of loans composed of borrowers half of whom had FICO scores of 550 and half of whom had FICO scores of 680. A person with a FICO score of 550 was virtually certain to default and should never have been lent money in the first place. But the hole in the rating agencies' models enabled the loan to be made, as long as a borrower with a FICO score of 680 could be found to offset the deadbeat, and keep the average at 615.

Where to find the borrowers with high FICO scores? Here the Wall Street bond trading desks exploited another blind spot in the rating agencies' models. Apparently the agencies didn't grasp the difference between a "thin-file" FICO score and a "thick-file" FICO score. A thin-file FICO score implied, as it sounds, a short credit history. The file was thin because the borrower hadn't done much borrowing. Immigrants who had never failed to repay a debt, because they had never been given a loan, often had surprisingly high thin-file FICO scores. Thus a Jamaican baby nurse or Mexican strawberry picker with an income of $14,000 looking to borrow three-quarters of a million dollars, when filtered through the models at Moody's and S&P, became suddenly more useful, from a credit-rigging point of view. They might actually improve the perceived quality of the pool of loans and increase the percentage that could be declared triple-A. The Mexican harvested strawberries; Wall Street harvested his FICO score.

The models used by the rating agencies were riddled with these sorts of opportunities. The trick was finding them before others did--finding, for example, that both Moody's and S&P favored floating-rate mortgages with low teaser rates over fixed-rate ones. Or that they didn't care if a loan had been made in a booming real estate market or a quiet one. Or that they were seemingly oblivious to the fraud implicit in no-doc loans. Or that they were blind to the presence of "silent seconds"--second mortgages that left the homeowner with no equity in his home and thus no financial incentive not to hand the keys to the bank and walk away from it. Every time some smart Wall Street mortgage bond packager discovered another example of the rating agencies' idiocy or neglect, he had himself an edge in the marketplace: c.r.a.ppier pools of loans were cheaper to buy than less c.r.a.ppy pools. Barbell-shaped loan pools, with lots of very low and very high FICO scores in them, were a bargain compared to pools cl.u.s.tered around the 615 average--at least until the rest of Wall Street caught on to the hole in the brains of the rating agencies and bid up their prices. Before that happened, the Wall Street firm enjoyed a perverse monopoly. They'd phone up an originator and say, "Don't tell anybody, but if you bring me a pool of loans teeming with high thin-file FICO scores I'll pay you more for it than anyone else." The more egregious the rating agencies' mistakes, the bigger the opportunity for the Wall Street trading desks.

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 f.u.c.king believe this is allowed," said Eisman. "I must have said that one thousand times."