The Big Short_ Inside the Doomsday Machine Part 4

 

CHAPTER SEVEN.

 

 

The Great Treasure Hunt Charlie Ledley and Ben Hockett returned from Las Vegas on January 30, 2007, convinced that the entire financial system had lost its mind. "I said to my mother, 'I think we might be facing something like the end of democratic capitalism,'" said Charlie. "She just said, 'Oh, Charlie,' and seriously suggested I go on lithium." They had created an investment approach that harnessed their talent for distancing themselves from other people's convictions; to find such great conviction in themselves was new and uncomfortable. Jamie penned a memo to his two partners, in which he asked them if they were making a bet on the collapse of a society--and therefore a bet that the government would never allow to succeed. "If a broad range of CDO spreads starts to widen," he wrote, on January 30, 2007, convinced that the entire financial system had lost its mind. "I said to my mother, 'I think we might be facing something like the end of democratic capitalism,'" said Charlie. "She just said, 'Oh, Charlie,' and seriously suggested I go on lithium." They had created an investment approach that harnessed their talent for distancing themselves from other people's convictions; to find such great conviction in themselves was new and uncomfortable. Jamie penned a memo to his two partners, in which he asked them if they were making a bet on the collapse of a society--and therefore a bet that the government would never allow to succeed. "If a broad range of CDO spreads starts to widen," he wrote,* "it means that a material global financial cl.u.s.terf.u.c.k is likely occurring.... The U.S. Fed is in a position to fix the problem by intervening.... I guess the question is, How wide would the meltdown need to be in order to be 'too big to fail'?" "it means that a material global financial cl.u.s.terf.u.c.k is likely occurring.... The U.S. Fed is in a position to fix the problem by intervening.... I guess the question is, How wide would the meltdown need to be in order to be 'too big to fail'?"

 

 

The conference in Las Vegas had been created, among other things, to boost faith in the market. The day after the subprime mortgage market insiders left Las Vegas and returned to their trading desks, the market cracked. On January 31, 2007, the ABX, a publicly traded index of triple-B-rated subprime mortgage bonds--exactly the sort of bonds used to create subprime CDOs--fell more than a point, from 93.03 to 91.98. For the past several months, it had drifted down in such tiny increments, from 100 to 93, that a full point move came as shocking--and heightened Charlie's anxiety that they'd discovered this sensational trade a moment too late to wager as much on it as they should. The woman from Morgan Stanley was, at first, true to her word: She pushed through their ISDA agreement, which would normally have taken months of negotiations, in ten days. She sent Charlie a list of double-A tranches of CDOs on which Morgan Stanley was willing to sell them credit default swaps.* Charlie stayed up nights figuring out which ones to bet against, and then called her up to find that Morgan Stanley had experienced a change of heart. She had told Charlie that he could buy insurance for around 100 basis points (1 percent of the insured amount a year), but when he called up the next morning to do the trade, the price had more than doubled. Charlie b.i.t.c.hed and moaned about the unfairness of it and she and her bosses caved, a bit. On February 16, 2007, Cornwall paid Morgan Stanley 150 basis points to buy $10 million in credit default swaps on a CDO cryptically called Gulfstream, whatever that was. Charlie stayed up nights figuring out which ones to bet against, and then called her up to find that Morgan Stanley had experienced a change of heart. She had told Charlie that he could buy insurance for around 100 basis points (1 percent of the insured amount a year), but when he called up the next morning to do the trade, the price had more than doubled. Charlie b.i.t.c.hed and moaned about the unfairness of it and she and her bosses caved, a bit. On February 16, 2007, Cornwall paid Morgan Stanley 150 basis points to buy $10 million in credit default swaps on a CDO cryptically called Gulfstream, whatever that was.

 

 

Five days later, on February 21, the market began to trade an index of CDOs called the TABX. For the first time, Charlie Ledley, and everyone else in the market, was able to see on a screen the price of one of these CDOs. The price confirmed Cornwall's thesis in a way that no amount of conversation with market insiders ever could have. After the first day of trading, the tranche that took losses when the underlying bonds experienced losses of more than 15 percent of the pool--the double-A-rated tranche that Cornwall had bet against--closed at 49.25: It had lost more than half its value. There was now this huge disconnect: With one hand the Wall Street firms were selling low interest rate-bearing double-A-rated CDOs at par, or 100; with the other they were trading this index composed of those very same bonds for 49 cents on the dollar. In a flurry of e-mails, their salespeople at Morgan Stanley and Deutsche Bank tried to explain to Charlie that he should not deduce anything about the value of his bets against subprime CDOs from the prices on these new, publicly traded subprime CDOs. That it was all very complicated.

 

 

The next morning Charlie called back Morgan Stanley in hopes of buying more insurance. "She was like, 'I'm really, really sorry but we're not doing any more of this. The firm's changed its mind.'" Overnight, Morgan Stanley had gone from being wildly eager to sell insurance on the subprime mortgage market to not wanting to do it at all. "Then she puts us on the phone with her boss--because we were like, 'What the f.u.c.k is going on?'--and he's like, 'Look, I'm really sorry, but something has happened in another arm of the bank that's caused some kind of risk management decision at the very highest levels of Morgan Stanley.' And we never traded with them again." Charlie had no idea what exactly had awakened inside Morgan Stanley, and didn't think too much about it--he and Ben were too busy trying to talk the guy from Wachovia whom Charlie had pounced on in Las Vegas into dealing with Cornwall Capital. "They didn't have one hedge fund client, and they were sort of excited to see us," said Ben. "They were trying to be big-time." Wachovia, amazingly, remained willing to sell cheap insurance on subprime mortgage bonds; the risk its credit officers were unwilling to take was the risk of dealing directly with Cornwall Capital. It took a while, but Charlie arranged for his Uzi-shooting companions from Bear Stearns to sit in the middle between the two parties, for a fee. The details of a $45 million trade more or less agreed upon in February 2007 took several months to hammer out, and the trade didn't go through until early May. "Wachovia was a gift from G.o.d," said Ben. "It was like we were in a plane at thirty thousand feet, which had stalled, and Wachovia still had a few parachutes for sale. No one else was still selling parachutes, but no one really wanted to believe they were needed, either.... After that, the market completely shut down."

 

 

In a portfolio of less than $30 million, Cornwall Capital now owned $205 million in credit default swaps on subprime mortgage bonds, and were disturbed mainly that they didn't own more. "We were doing everything we possibly could to buy more," said Charlie. "We'd put in our bids at the offering prices. They'd call back and say, 'Oops, you almost got it!' It was very sort of Charlie Brown and Lucy. We'd go up to kick the football and they'd pull it back. We'd raise our bid and the minute we did their offer would jump up."

 

 

It made no sense: The subprime CDO market was ticking along as it had before, and yet the big Wall Street firms suddenly had no use for the investors who had been supplying the machine with raw material--the investors who wanted to buy credit default swaps. "Ostensibly other people were going long, but we were not allowed to go short," said Charlie.

 

 

He couldn't know for sure what was happening inside the big firms, but he could guess: Some of the traders on the inside had woken up to the impending disaster and were scrambling to get out of the market before it collapsed. "With the Bear guys I had this suspicion that, if there were any credit default swaps on CDOs to buy, they were buying it for themselves," said Charlie. At the end of February a Bear Stearns a.n.a.lyst named Gyan Sinha published a long treatise arguing that the recent declines in subprime mortgage bonds had nothing to do with the quality of the bonds and everything to do with "market sentiment." Charlie read it thinking that the person who wrote it had no idea what was actually happening in the market. According to the Bear Stearns a.n.a.lyst, double-A CDOs were trading at 75 basis points above the risk-free rate--that is, Charlie should have been able to buy credit default swaps for 0.75 percent in premiums a year. The Bear Stearns traders, by contrast, weren't willing to sell them to him for five times that price. "I called the guy up and said, 'What the f.u.c.k are you talking about?' He said, "Well, this is where the deals are printing.' I asked him, 'Are desks actually buying and selling at that price?' And he says, 'Gotta go,' and hung up."

 

 

Their trade now seemed to them ridiculously obvious--it was as if they had bought cheap fire insurance on a house engulfed in flames. If the subprime mortgage market had the slightest interest in being efficient, it would have shut down right there and then. For more than eighteen months, from mid-2005 until early 2007, there had been this growing disconnect between the price of subprime mortgage bonds and the value of the loans underpinning them. In late January 2007 the bonds--or rather, the ABX index made up of the bonds--began to fall in price. The bonds fell at first steadily but then rapidly--by early June, the index of triple-B-rated subprime bonds was closing in the high 60s--which is to say the bonds had lost more than 30 percent of their original value. It stood to reason that the CDOs, which were created out of these triple-B-rated subprime bonds, should collapse, too. If the oranges were rotten, the orange juice was also rotten.

 

 

Yet this did not happen. Instead, between February and June of 2007, big Wall Street firms, led by Merrill Lynch and Citigroup, created and sold $50 billion in new CDOs. "We're totally baffled," said Charlie. "Because everyone and everything just goes back to normal, even though it obviously wasn't normal. We knew the collateral for the CDOs had collapsed. And yet everything went on, as if nothing had changed."

 

 

It was as if an entire financial market had tried to change its mind--and then realized that it could not afford to change its mind. Wall Street firms--most notably Bear Stearns and Lehman Brothers--continued to publish bond market research reaffirming the strength of the market. In late April, Bear Stearns held a CDO conference, into which Charlie sneaked. On the original agenda was a presentation ent.i.tled "How to Short a CDO." It had been removed from the final conference--so, too, had been the slides that accompanied the talk that had been posted on the Bear Stearns Web site. Moody's and S&P flinched, too, but in a telling manner. In late May, the two big rating agencies announced that they were reconsidering their subprime bond ratings models. Charlie and Jamie hired a lawyer to call Moody's and ask them, if they were going to rate subprime bonds by different criteria going forward, might they also reconsider the two trillion dollars' worth or so of bonds they had already rated, badly. Moody's didn't think that was a good idea. "We were like, 'You don't have to re-rate all of them. Just the ones we're short,'" said Charlie. "They were like, 'Hmmmmmm...no.'"

 

 

To Charlie and Ben and Jamie it seemed perfectly clear that Wall Street was propping up the price of these CDOs so that they might either dump losses on unsuspecting customers or make a last few billion dollars from a corrupt market. In either case, they were squeezing and selling the juice from oranges that were undeniably rotten. By late March 2007, "We were pretty sure one of two things was true," said Charlie. "Either the game was totally rigged, or we had gone totally f.u.c.king crazy. The fraud was so obvious that it seemed to us it had implications for democracy. We actually got scared." They both knew reporters who worked at the New York Times New York Times and the and the Wall Street Journal Wall Street Journal--but the reporters they knew had no interest in their story. A friend at the Journal Journal hooked them up with the enforcement division of the SEC, but the enforcement division of the SEC had no interest either. In its lower Manhattan office, the SEC met with them and listened, but politely. "It was almost like a therapy session," said Jamie. "Because we sat down and said, 'We've just had the most crazy experience.'" As they spoke, they sensed the audience's incomprehension. "We probably had like this wild-eyed we've-been-up-for-three-days-straight look in our eyes," said Charlie. "But they didn't know anything about CDOs, or a.s.set-backed securities. We took them through our trade but I'm pretty sure they didn't understand it." The SEC never followed up. hooked them up with the enforcement division of the SEC, but the enforcement division of the SEC had no interest either. In its lower Manhattan office, the SEC met with them and listened, but politely. "It was almost like a therapy session," said Jamie. "Because we sat down and said, 'We've just had the most crazy experience.'" As they spoke, they sensed the audience's incomprehension. "We probably had like this wild-eyed we've-been-up-for-three-days-straight look in our eyes," said Charlie. "But they didn't know anything about CDOs, or a.s.set-backed securities. We took them through our trade but I'm pretty sure they didn't understand it." The SEC never followed up.

 

 

Cornwall had a problem more immediate than the collapse of society as we know it: the collapse of Bear Stearns. On June 14, 2007, Bear Stearns a.s.set Management, a CDO firm, like Wing Chau's, but run by former Bear Stearns employees who had the implicit backing of the mother ship, declared that it had lost money on bets on subprime mortgage securities and that it was being forced to dump 3.8 billion dollars' worth of these bets before closing the fund. Up until this moment, Cornwall Capital had been unable to see why Bear Stearns, and no one else, had been so eager to sell them insurance on CDOs. "Bear was able to show us liquidity in the CDOs that I couldn't understand," said Ben. "They had a standing buyer on the other side. I don't know that our trades went directly into their funds, but I don't know where else they would have gone."

 

 

And therein lay a new problem: Bear Stearns had sold Cornwall 70 percent of its credit default swaps. Because Bear Stearns was big and important, and Cornwall Capital was a garage band hedge fund, Bear Stearns hadn't been required to post collateral to Cornwall. Cornwall was now totally exposed to the possibility that Bear Stearns would be unable to pay off its gambling debts. Cornwall Capital couldn't help but notice that Bear Stearns was not so much shaping the subprime mortgage bond business as being reshaped by it. "They'd turned themselves from a low-risk brokerage operation into a subprime mortgage engine," said Jamie. If the subprime mortgage market crashed, Bear Stearns was going to crash with it.

 

 

Back in March, Cornwall had bought $105 million in credit default swaps on Bear Stearns--that is, they'd made a bet on the collapse of Bear Stearns--from the British bank HSBC. If Bear Stearns failed, HSBC would owe them $105 million. Of course this only shifted their risk to HSBC. HSBC was the third largest bank in the world, and one of those places it was hard to think about going down. On February 8, 2007, however, HSBC rocked the market with the announcement that it was taking a big, surprising loss on its portfolio of subprime mortgage loans. It had entered the U.S. subprime lending business in 2003, when it had bought America's biggest consumer lending operation, Household Finance. The same Household Finance that had pushed Steve Eisman over the narrow border between Wall Street skeptic and Wall Street cynic.

 

 

From the social point of view the slow and possibly fraudulent unraveling of a multi-trillion-dollar U.S. bond market was a catastrophe. From the hedge fund trading point of view it was the opportunity of a lifetime. Steve Eisman had started out running a $60 million equity fund but was now short around 600 million dollars' worth of various subprime-related securities, and he wanted to short more. "Sometimes his ideas cannot be manifested in a trade," said Vinny. "This time they could." Eisman was enchained, however, by FrontPoint Partners and, by extension, Morgan Stanley. As FrontPoint's head trader, Danny Moses found himself caught in the middle, between Eisman and FrontPoint's risk management people, who didn't seem to completely understand what they were doing. "They'd call me and say, 'Can you get Steve to take some of this off?' I'd go to Steve and Steve would say, 'Just tell them to f.u.c.k off.' And I'd say, 'f.u.c.k off.'" But risk management hounded them, and cramped Eisman's style. "If risk had said to us, 'We're very comfortable with this and you can do ten times this amount,'" said Danny, "Steve would have done ten times the amount." Greg Lippmann was now blasting Vinny and Danny with all sorts of negative information about the housing market, and, for the first time, Vinny and Danny began to hide the information from Eisman. "We were worried he'd come out of his office and shout, 'Do a trillion!'" said Danny. social point of view the slow and possibly fraudulent unraveling of a multi-trillion-dollar U.S. bond market was a catastrophe. From the hedge fund trading point of view it was the opportunity of a lifetime. Steve Eisman had started out running a $60 million equity fund but was now short around 600 million dollars' worth of various subprime-related securities, and he wanted to short more. "Sometimes his ideas cannot be manifested in a trade," said Vinny. "This time they could." Eisman was enchained, however, by FrontPoint Partners and, by extension, Morgan Stanley. As FrontPoint's head trader, Danny Moses found himself caught in the middle, between Eisman and FrontPoint's risk management people, who didn't seem to completely understand what they were doing. "They'd call me and say, 'Can you get Steve to take some of this off?' I'd go to Steve and Steve would say, 'Just tell them to f.u.c.k off.' And I'd say, 'f.u.c.k off.'" But risk management hounded them, and cramped Eisman's style. "If risk had said to us, 'We're very comfortable with this and you can do ten times this amount,'" said Danny, "Steve would have done ten times the amount." Greg Lippmann was now blasting Vinny and Danny with all sorts of negative information about the housing market, and, for the first time, Vinny and Danny began to hide the information from Eisman. "We were worried he'd come out of his office and shout, 'Do a trillion!'" said Danny.

 

 

In the spring of 2007, the subprime mortgage bond market, incredibly, had strengthened a bit. "The impact on the broader economy and the financial markets of the problems in the subprime markets seems likely to be contained," U.S. Federal Reserve chairman Ben Bernanke was quoted as saying in the newspapers on March 7. "Credit quality always gets better in March and April," said Eisman. "And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. And they sort of did. But they let the credit spreads tighten. We just thought that was moronic. What are you, f.u.c.king stupid?" Amazingly, the stock market continued to soar, and the television over the FrontPoint trading desks emitted a ceaselessly bullish signal. "We turned off CNBC," said Danny Moses. "It became very frustrating that they weren't in touch with reality anymore. If something negative happened, they'd spin it positive. If something positive happened, they'd blow it out of proportion. It alters your mind. You can't be clouded with s.h.i.t like that."

 

 

Upon their return from Las Vegas, they set out to pester the rating agencies, and the Wall Street people who gamed their models, for more information. "We were trying to figure out what, if anything, would make the ratings agencies downgrade," said Danny. In the process, they picked up more disturbing tidbits. They'd often wondered, for instance, why the rating agencies weren't more critical of bonds underpinned by floating-rate subprime mortgages. Subprime borrowers tended to be one broken refrigerator away from default. Few, if any, should be running the risk of their interest payment spiking up. As most of these loans were structured, however, the homeowner would pay a fixed teaser rate of, say, 8 percent for the first two years, and then, at the start of the third year, the interest rate would skyrocket to, say, 12 percent, and thereafter it would float at permanently high levels. It was easy to understand why originators like Option One and New Century preferred to make these sorts of loans: After two years the borrowers either defaulted or, if their home price had risen, refinanced. To them the default was a matter of indifference, as they kept none of the risk of the loan; the refinance was merely a chance to charge the borrower new fees. Bouncing between the rating agencies and people he knew in the subprime bond packaging business, Eisman learned that the rating agencies simply a.s.sumed that the borrower would be just as likely to make his payments when the interest rate on the loan was 12 percent as when it was 8 percent--which meant more cash flow for the bondholders. Bonds backed by floating-rate mortgages received higher higher ratings than bonds backed by fixed-rate ones--which was why the percentage of subprime mortgages with floating rates had risen, in the past five years, from 40 to 80. ratings than bonds backed by fixed-rate ones--which was why the percentage of subprime mortgages with floating rates had risen, in the past five years, from 40 to 80.

 

 

A lot of these loans were now going bad, but subprime bonds weren't moving--because Moody's and S&P, disturbingly, still hadn't changed their official opinions of them. As an equity investor, FrontPoint Partners was covered by Wall Street stockbrokers. Eisman asked stock market salesmen at Goldman Sachs and Morgan Stanley and the others to bring over the bond people for a visit. "We always asked the same question," says Eisman. "'Where are the ratings agencies in all this?' And I'd always get the same reaction. It was a physical reaction because they didn't want to say it. It was a smirk." Digging deeper, he called S&P and asked what happened to default rates if real estate prices fell. The man at S&P couldn't say: Their model for home prices had no ability to accept a negative number. "They were just a.s.suming home prices would keep going up," says Eisman.*

 

 

Eventually he'd hop onto the subway with Vinny and ride down to Wall Street to meet with a woman at S&P named Ernestine Warner. Warner worked as an a.n.a.lyst in the surveillance department. The surveillance department was meant to monitor subprime bonds and downgrade them if the loans that underpinned them went bad. The loans were going bad but the bonds weren't being downgraded--and so once again Eisman wondered if S&P knew something he did not. "When we shorted the bonds, all we had was the pool-level data," he said. The pool-level data gave you the general characteristics--the average FICO scores, the average loan-to-value ratios, the average number of no-doc loans, and so forth--but no view of the individual loans. The pool-level data told you, for example, that 25 percent of the home loans in some pool were insured, but not which loans--the ones likely to go bad or the ones less likely to. It was impossible to determine how badly the Wall Street firms had gamed the system. "We of course thought that the ratings agencies had more data than we had," said Eisman. "They didn't."

 

 

Ernestine Warner was working with the same rough information available to traders like Eisman. This was insane: The arbiter of the value of the bonds lacked access to relevant information about the bonds. "When we asked her why," said Vinny, "she said, 'The issuers won't give it to us.' That's when I lost it. 'You need to demand to get it!' She looked at us like, We can't do that. We were like, 'Who is in charge here? You're the grown-up. You're the cop! Tell them to f.u.c.king give it to you!!!'" Eisman concluded that "S&P was worried that if they demanded the data from Wall Street, Wall Street would just go to Moody's for their ratings."*

 

 

As an investor, Eisman was allowed to listen in on the quarterly conference calls held by Moody's, but not invited to pose questions. The people at Moody's were sympathetic to his need for more genuine interaction, however; and the CEO, Ray McDaniel, even invited Eisman and his team to his office for a visit, a gesture that forever endeared him to Eisman. "When are shorts welcome anywhere?" asked Eisman. "When you're short, the whole world is against you. The only time a company met me with complete knowledge that we were short was Moody's." After their trip to Las Vegas, Eisman and his team were so certain the world had been turned upside down that they just a.s.sumed Raymond McDaniel must know it, too. "But we're sitting there," recalls Vinny, "and he says to us, like he actually means it, 'I truly believe that our ratings will prove accurate.'" And Steve shoots up in his chair and asks, 'What did you just say?'--as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him. "With all due respect, sir," said Vinny deferentially, as they left, "you're delusional." This wasn't Fitch or even S&P. This was Moody's. The aristocrats of the rating business, 20 percent owned by Warren Buffett. And its CEO was being told he was either a fool or a crook, by Vincent Daniel, from Queens.

 

 

By early June the subprime mortgage bond market had resumed what would become an uninterrupted decline, and the FrontPoint positions began to move--first by thousands and then by millions of dollars a day. "I know I'm making money," Eisman would often ask. "So who is losing money?" They already were short the stocks of mortgage originators and the home builders. Now they added to their short positions in the stocks of the rating agencies. "They were making ten times more rating CDOs than they were rating GM bonds," said Eisman, "and it was all going to end."

 

 

Inevitably, their attention turned to the beating heart of capitalism, the big Wall Street investment banks. "Our original thesis was that the securitization machine was Wall Street's big profit center and it was going to die," said Eisman. "And when that happened, their revenues would dry up." One of the reasons Wall Street had cooked up this new industry called structured finance was that its old-fashioned business was every day less profitable. The profits in stockbroking, along with those in the more conventional sorts of bond broking, had been squashed by Internet compet.i.tion. The minute the market stopped buying subprime mortgage bonds and CDOs backed by subprime mortgage bonds, the investment banks were in trouble. Right up until the middle of 2007, Eisman had not suspected that the firms were so foolish as to invest in their own creations. He could see that their leverage had increased dramatically, in just the past few years. He could of course see that they were holding more and more risky a.s.sets with borrowed money. What he could not see was the nature of their a.s.sets. Triple-A-rated corporate bonds, or triple-A-rated subprime CDOs? "You couldn't know for sure," he said. "There was no disclosure. You didn't know what they had on their balance sheet. You naturally a.s.sumed that they got rid of this s.h.i.t as soon as they created it."

 

 

A combination of new facts, and actual human contact with the people who ran the big firms and the rating agencies, had stirred his suspicion. The first new fact had been HSBC's announcement, in February 2007, that it was losing a lot of money on its subprime loans, and a second announcement, in March, that it was dumping its subprime portfolio. "HSBC were supposed to be the good guys," said Vinny. "They were supposed to have cleaned up Household. We thought, Holy c.r.a.p, there are so many people worse than that." The second new fact was in Merrill Lynch's second-quarter results. In July 2007, Merrill Lynch announced yet another sensationally profitable quarter, but admitted it had suffered a decline in revenues from mortgage trading due to losses in subprime bonds. What sounded to most investors like a trivial piece of information was to Eisman the big news: Merrill Lynch owned a meaningful amount of subprime mortgage securities. Merrill's CFO, Jeff Edwards, told Bloomberg News that the market need not worry about this, as "active risk management" had allowed Merrill Lynch to reduce its exposure to the lower-rated subprime bonds. "I don't want to get too deep into exactly how we positioned ourselves at any one point in time," Edwards said, but went deep enough to say that the market was paying too much attention to whatever Merrill happened to be doing with subprime mortgage bonds. Or, as Edwards elliptically put it, "There's a disproportionate focus on a particular a.s.set cla.s.s in a particular country."

 

 

Eisman didn't think so--and two weeks later persuaded a UBS a.n.a.lyst named Glenn Schorr to escort him to a small meeting between Edwards and Merrill Lynch's biggest shareholders. The Merrill CFO began by explaining that this little subprime mortgage problem Merrill Lynch seemed to have was firmly under the control of Merrill Lynch's models. "We're not that far into the meeting," said someone who was there. "Jeff is still giving his prepared remarks and Steve just bursts out, 'Well, your models are wrong!' This very awkward silence comes over the room. Do you laugh? Do you try to think up some question so everyone can move on? Steve was sitting at the end of the table and he starts to put his papers in order really conspicuously--as if to say, 'If it wasn't rude, I'd walk out now.'"

 

 

Eisman, for his part, considered the event a polite exchange of views, after which he lost interest. "There was nothing more to say. I just figured, You know what? This guy doesn't get it."

 

 

On the surface, these big Wall Street firms appeared robust; below the surface, Eisman was beginning to think, their problems might not be confined to a potential loss of revenue. If they really didn't believe the subprime mortgage market was a problem for them, the subprime mortgage market might be the end of them. He and his team now set about searching for hidden subprime risk: Who was hiding what? "We called it The Great Treasure Hunt," he said. They didn't know for sure if these firms were in some way on the other side of the bets he'd been making against subprime bonds, but the more he looked, the more sure he became that they didn't know either. He'd go to meetings with Wall Street CEOs and ask them the most basic questions about their balance sheets. "They didn't know," he said. "They didn't know their own balance sheets." Once, he got himself invited to a meeting with the CEO of Bank of America, Ken Lewis. "I was sitting there listening to him. I had an epiphany. I said to myself, 'Oh my G.o.d, he's dumb!' A lightbulb went off. The guy running one of the biggest banks in the world is dumb!" They shorted Bank of America, along with UBS, Citigroup, Lehman Brothers, and a few others. They weren't allowed to short Morgan Stanley because they were owned by Morgan Stanley, but if they could have, they would have. Not long after they established their shorts against the big Wall Street banks, they had a visit from a prominent a.n.a.lyst who covered the firms, Brad Hintz, at Sanford C. Bernstein & Co. Hintz asked Eisman what he was up to.

 

 

"We just shorted Merrill Lynch," said Eisman.

 

 

"Why?" asked Hintz.

 

 

"We have a simple thesis," said Eisman. "There is going to be a calamity, and whenever there is a calamity, Merrill is there." When it came time to bankrupt Orange County with bad advice, Merrill was there. When the Internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman's logic: the logic of Wall Street's pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid a.s.signed the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was crack the whip. He a.s.sumed Merrill Lynch had taken its a.s.signed place at the end of the chain.

 

 

On July 17, 2007, two days before Ben Bernanke, the Fed chairman, told the U.S. Senate that he saw no more than $100 billion in losses in the subprime mortgage market, FrontPoint did something unusual: It hosted its own conference call. They'd had calls with their tiny population of investors, but this time they just opened it up. Steve Eisman had become a poorly kept secret. "Steve was one of about two investors who completely understood what was going on," said one prominent Wall Street a.n.a.lyst. Five hundred people called in to hear what Eisman had to say, and another five hundred logged in afterward to listen to the recording. He explained the strange alchemy of the mezzanine CDO--and said that he expected losses up to $300 billion from this sliver of the market alone. To evaluate the situation, he told his audience, "Just throw your model in the garbage can. The models are all backward-looking. The models don't have any idea of what this world has become.... For the first time in their lives lives people in the a.s.set-backed securitization world are actually having to think." He explained that the rating agencies were morally bankrupt and living in fear of becoming actually bankrupt. "The ratings agencies are scared to death," he said. "They're scared to death about doing nothing because they'll look like fools if they do nothing." He expected that fully half of all U.S. home mortgage loans--many trillions of dollars' worth--would suffer losses. "We are in the midst of one of the greatest social experiments this country has ever seen," said Eisman. "It's just not going to be a fun experiment.... You think this is ugly. You haven't seen anything yet." When he was done, the next speaker, an Englishman who ran a separate fund at FrontPoint, was slow to respond. "Sorry," the Englishman said wryly, "I just needed to calm down from hearing Steve say the world is ending." And everyone laughed. people in the a.s.set-backed securitization world are actually having to think." He explained that the rating agencies were morally bankrupt and living in fear of becoming actually bankrupt. "The ratings agencies are scared to death," he said. "They're scared to death about doing nothing because they'll look like fools if they do nothing." He expected that fully half of all U.S. home mortgage loans--many trillions of dollars' worth--would suffer losses. "We are in the midst of one of the greatest social experiments this country has ever seen," said Eisman. "It's just not going to be a fun experiment.... You think this is ugly. You haven't seen anything yet." When he was done, the next speaker, an Englishman who ran a separate fund at FrontPoint, was slow to respond. "Sorry," the Englishman said wryly, "I just needed to calm down from hearing Steve say the world is ending." And everyone laughed.

 

 

Later that very day, investors in the collapsed Bear Stearns hedge funds were informed that their $1.6 billion in triple-A-rated subprime-backed CDOs had not merely lost some value, they were worthless. Eisman was now convinced a lot of the biggest firms on Wall Street did not understand their own risks, and were in peril. At the bottom of his conviction lay his memory of his dinner with Wing Chau--when he grasped the central role of the mezzanine CDO and made a ma.s.sive bet against those very same CDOs. This of course raised the question: What exactly is inside a CDO? "I didn't know what the f.u.c.k was in the things," said Eisman. "You couldn't do the a.n.a.lysis. You couldn't say, 'Give me all the ones with all California in them.' No one knew what was in them." They learned enough to know, as Danny put it, that "it was just all the pieces of s.h.i.t we'd already shorted wrapped up together, into a portfolio." Beyond that they were flying blind. "Steve's nature is to put it on and figure it out later," said Vinny.

 

 

Then came news. Eisman had long subscribed to a newsletter famous in Wall Street circles and obscure outside them, Grant's Interest Rate Observer Grant's Interest Rate Observer. Its editor, Jim Grant, had been prophesying doom ever since the great debt cycle began, in the mid-1980s. In late 2006 Grant decided to investigate these strange Wall Street creations known as CDOs. Or, rather, he had asked his young a.s.sistant, Dan Gertner, a chemical engineer with an MBA, to see if he could understand them. Gertner went off with the doc.u.ments explaining CDOs to potential investors and sweated and groaned and heaved and suffered. "Then he came back," says Grant, "and said, 'I can't figure this thing out.' And I said, 'I think we have our story.'"

 

 

Gertner dug and dug and finally concluded that no matter how much digging he did he'd never be able to get to the bottom of what exactly was inside a CDO--which, to Jim Grant, meant that no investor possibly could either. In turn this suggested what Grant already knew, that far too many people were taking far too many financial statements on faith. In early 2007 Grant wrote a series of pieces suggesting that the rating agencies had abandoned their posts--that they were almost surely rating these CDOs without themselves knowing exactly what was inside them. "The readers of Grant's Grant's have seen for themselves how a stack of non-investment grade mortgage slices can be rearranged to form a collateral debt obligation," one piece began. "And they have stared in amazement at the improvements that this mysterious process can effect in the credit ratings of the slices..." For his troubles, Grant, along with his trusted a.s.sistant, was called into S&P for a dressing-down. "We were actually summoned to the rating agency and told, 'You guys just don't get it,'" says Gertner. "Jim used the term 'alchemy' and they didn't like that term." have seen for themselves how a stack of non-investment grade mortgage slices can be rearranged to form a collateral debt obligation," one piece began. "And they have stared in amazement at the improvements that this mysterious process can effect in the credit ratings of the slices..." For his troubles, Grant, along with his trusted a.s.sistant, was called into S&P for a dressing-down. "We were actually summoned to the rating agency and told, 'You guys just don't get it,'" says Gertner. "Jim used the term 'alchemy' and they didn't like that term."

 

 

Just a few miles north of Grant's Grant's Wall Street offices, an equity hedge fund manager with a darkening view of the world was wondering why he hadn't heard others voice suspicion about the bond market and its abstruse creations. In Jim Grant's essay, Steve Eisman found independent confirmation of his theory of the financial world. "When I read it," said Eisman, "I thought, Wall Street offices, an equity hedge fund manager with a darkening view of the world was wondering why he hadn't heard others voice suspicion about the bond market and its abstruse creations. In Jim Grant's essay, Steve Eisman found independent confirmation of his theory of the financial world. "When I read it," said Eisman, "I thought, Oh my G.o.d, this is like owning a gold mine Oh my G.o.d, this is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an o.r.g.a.s.m."

 

 

CHAPTER EIGHT.

 

 

The Long Quiet The day Steve Eisman became the first man ever to take almost s.e.xual pleasure in an essay in almost s.e.xual pleasure in an essay in Grant's Interest Rate Observer, Grant's Interest Rate Observer, Dr. Michael Burry received from his CFO a copy of the same story, along with a jokey note: "Mike--you haven't taken a side job writing for Dr. Michael Burry received from his CFO a copy of the same story, along with a jokey note: "Mike--you haven't taken a side job writing for Grant's Grant's, have you?"

 

 

"I haven't," Burry replied, seeing no obvious good news in the discovery that there was someone out there who thought as he did. "I'm a bit surprised we haven't been contacted by Grant's Grant's..." He was still in the financial world but apart from it, as if on the other side of a pane of gla.s.s he couldn't bring himself to tap upon. He'd been the first investor to diagnose the disorder in the American financial system in early 2003: the extension of credit by instrument the extension of credit by instrument. Complicated financial stuff was being dreamed up for the sole purpose of lending money to people who could never repay it. "I really do believe the final act in play is a crisis in our financial inst.i.tutions, which are doing such dumb, dumb things," he wrote, in April 2003, to a friend who had wondered why Scion Capital's quarterly letters to its investors had turned so dark. "I have a job to do. Make money for my clients. Period. But boy it gets morbid when you start making investments that work out extra great if a tragedy occurs." Then, in the spring of 2005, he had identified, before any other investor, precisely which tragedy was most likely to occur, when he made a large, explicit bet against subprime mortgage bonds.

 

 

Now, in February 2007, subprime loans were defaulting in record numbers, financial inst.i.tutions were less steady every day, and no one but him seemed to recall what he'd said and done. He had told his investors that they might need to be patient--that the bet might not pay off until the mortgages issued in 2005 reached the end of their teaser rate period. They had not been patient. Many of his investors mistrusted him, and he in turn felt betrayed by them. At the beginning he had imagined the end, but none of the parts in between. "I guess I wanted to just go to sleep and wake up in 2007," he said. To keep his bets against subprime mortgage bonds, he'd been forced to fire half his small staff, and dump billions of dollars' worth of bets he had made against the companies most closely a.s.sociated with the subprime mortgage market. He was now more isolated than he'd ever been. The only thing that had changed was his explanation for it.

 

 

Not long before, his wife had dragged him to the office of a Stanford psychologist. A preschool teacher had noted certain worrying behaviors in their four-year-old son, Nicholas, and suggested he needed testing. Nicholas didn't sleep when the other kids slept. He drifted off when the teacher talked at any length. His mind seemed "very active." Michael Burry had to resist his urge to take offense. He was, after all, a doctor, and he suspected that the teacher was trying to tell them that he had failed to diagnose attention deficit disorder in his own son. "I had worked in an ADHD clinic during my residency, and had strong feelings that this was overdiagnosed," he said. "That it was a 'savior' diagnosis for too many kids whose parents wanted a medical reason to drug their children, or to explain their kids' bad behavior." He suspected his son was a bit different from the other kids, but different in a good way. "He asked a ton of questions," said Burry. "I had encouraged that, because I always had a ton of questions as a kid, and I was frustrated when I was told to be quiet." Now he watched his son more carefully, and noted that the little boy, while smart, had problems with other people. "When he did try to interact, even though he didn't do anything mean to the other kids, he'd somehow tick them off." He came home and told his wife, "Don't worry about it! He's fine!"

 

 

His wife stared at him and asked, "How would you know?"

 

 

To which Dr. Michael Burry replied, "Because he's just like me! That's how I was."

 

 

Their son's application to several kindergartens met with quick rejections, unaccompanied by explanations. Pressed, one of the schools told Burry that his son suffered from inadequate gross and fine motor skills. "He had apparently scored very low on tests involving art and scissor use," said Burry. "Big deal, I thought. I still draw like a four-year-old, and I hate art." To silence his wife, however, he agreed to have their son tested. "It would just prove he's a smart kid, an 'absentminded genius.'"

 

 

Instead, the tests administered by a child psychologist proved that their child had Asperger's syndrome. A cla.s.sic case, she said, and recommended that the child be pulled from the mainstream and sent to a special school. And Dr. Michael Burry was dumbstruck: He recalled Asperger's from med school, but vaguely. His wife now handed him the stack of books she had acc.u.mulated on autism and related disorders. On top were The Complete Guide to Asperger's Syndrome, The Complete Guide to Asperger's Syndrome, by a clinical psychologist named Tony Attwood, and Attwood's by a clinical psychologist named Tony Attwood, and Attwood's Asperger's Syndrome: A Guide for Parents and Professionals Asperger's Syndrome: A Guide for Parents and Professionals.

 

 

"Marked impairment in the use of multiple non-verbal behaviors such as eye-to-eye gaze..."

 

 

Check.

 

 

"Failure to develop peer relationships..."

 

 

Check.

 

 

"A lack of spontaneous seeking to share enjoyment, interests, or achievements with other people..."

 

 

Check.

 

 

"Difficulty reading the social/emotional messages in someone's eyes..."

 

 

Check.

 

 

"A faulty emotion regulation or control mechanism for expressing anger..."

 

 

Check.

 

 

"...One of the reasons why computers are so appealing is not only that you do not have to talk or socialize with them, but that they are logical, consistent and not p.r.o.ne to moods. Thus they are an ideal interest for the person with Asperger's Syndrome..."

 

 

Check.

 

 

"Many people have a hobby.... The difference between the normal range and the eccentricity observed in Asperger's Syndrome is that these pursuits are often solitary, idiosyncratic and dominate the person's time and conversation."

 

 

Check...Check...Check.

 

 

After a few pages, Michael Burry realized that he was no longer reading about his son but about himself. "How many people can pick up a book and find an instruction manual for their life?" he said. "I hated reading a book telling me who I was. I thought I was different, but this was saying I was the same as other people. My wife and I were a typical Asperger's couple, and we had an Asperger's son." His gla.s.s eye no longer explained anything; the wonder is that it ever had. How did a gla.s.s eye explain, in a compet.i.tive swimmer, a pathological fear of deep water--the terror of not knowing what lurked beneath him? How did it explain a childhood pa.s.sion for washing money? He'd take dollar bills and wash them, dry them off with a towel, press them between the pages of books, and then stack books on top of those books--all so he might have money that looked "new." "All of a sudden I've become this caricature," said Burry. "I've always been able to study up on something and ace something really fast. I thought it was all something special about me. Now it's like, 'Oh, a lot of Asperger's people can do that.' Now I was explained by a disorder."

 

 

He resisted the news. He had a gift for finding and a.n.a.lyzing information on the subjects that interested him intensely. He always had been intensely interested in himself. Now, at the age of thirty-five, he'd been handed this new piece of information about himself--and his first reaction to it was to wish he hadn't been given it. "My first thought was that a lot of people must have this and don't know it," he said. "And I wondered, Is this really a good thing for me to know at this point? Why is it good for me to know this about myself?"

 

 

He went and found his own psychologist to help him sort out the effect of his syndrome on his wife and children. His work life, however, remained uninformed by the new information. He didn't alter the way he made investment decisions, for instance, or the way he communicated with his investors. He didn't let his investors know of his disorder. "I didn't feel it was a material fact that had to be disclosed," he said. "It wasn't a change. I wasn't diagnosed with something new. It's something I'd always had." On the other hand, it explained an awful lot about what he did for a living, and how he did it: his obsessive acquisition of hard facts, his insistence on logic, his ability to plow quickly through reams of tedious financial statements. People with Asperger's couldn't control what they were interested in. It was a stroke of luck that his special interest was financial markets and not, say, collecting lawn mower catalogues. When he thought of it that way, he realized that complex modern financial markets were as good as designed to reward a person with Asperger's who took an interest in them. "Only someone who has Asperger's would read a subprime mortgage bond prospectus," he said.

 

 

By early 2007 Michael Burry found himself in a characteristically bizarre situation. He'd bought insurance on a lot of truly c.r.a.ppy subprime mortgage bonds, created from loans made in 2005, but they were his his credit default swaps. They weren't traded often by others; a lot of people took the view that the loans made in 2005 were somehow sounder than the loans made in 2006; in bond market parlance, they were "off the run." That was their biggest claim: The pools of loans he had bet against were "relatively clean." To counter the a.s.sertion, he commissioned a private study, and found that the pools of loans he had shorted were nearly twice as likely to be in bankruptcy and a third more likely to have been foreclosed upon than the general run of 2005 subprime deals. The loans made in 2006 were indeed worse than those made in 2005, but the loans made in 2005 remained atrocious, and closer to the dates when their interest rates would reset. He had picked exactly the right homeowners to bet against. credit default swaps. They weren't traded often by others; a lot of people took the view that the loans made in 2005 were somehow sounder than the loans made in 2006; in bond market parlance, they were "off the run." That was their biggest claim: The pools of loans he had bet against were "relatively clean." To counter the a.s.sertion, he commissioned a private study, and found that the pools of loans he had shorted were nearly twice as likely to be in bankruptcy and a third more likely to have been foreclosed upon than the general run of 2005 subprime deals. The loans made in 2006 were indeed worse than those made in 2005, but the loans made in 2005 remained atrocious, and closer to the dates when their interest rates would reset. He had picked exactly the right homeowners to bet against.

 

 

All through 2006, and the first few months of 2007, Burry sent his list of credit default swaps to Goldman and Bank of America and Morgan Stanley with the idea they would show it to possible buyers, so he might get some idea of the market price. That, after all, was the dealers' stated function: middlemen. Market-makers. That is not the function they served, however. "It seemed the dealers were just sitting on my lists and bidding extremely opportunistically themselves," said Burry. The data from the mortgage servicers was worse every month--the loans underlying the bonds were going bad at faster rates--and yet the price of insuring those loans, they said, was falling. "Logic had failed me," he said. "I couldn't explain the outcomes I was seeing." At the end of each day there was meant to be a tiny reckoning: If the subprime market had fallen, they would wire money to him; if it had strengthened, he would wire money to them. The fate of Scion Capital turned on these bets, but that fate was not, in the short run, determined by an open and free market. It was determined by Goldman Sachs and Bank of America and Morgan Stanley, who decided each day whether Mike Burry's credit default swaps had made or lost money.

 

 

It was true, however, that his portfolio of credit default swaps was uncommon. They were selected by an uncommon character, with an uncommon view of the financial markets, operating alone and apart. This fact alone enabled Wall Street firms to dictate to him the market price. With no one else buying and selling exactly what Michael Burry was buying and selling, there was no hard evidence what these things were worth--so they were worth whatever Goldman Sachs and Morgan Stanley said they were worth. Burry detected a pattern in how they managed their market: All good news about the housing market, or the economy, was treated as an excuse to demand collateral from Scion Capital; all bad news was pooh-poohed as in some way irrelevant to the specific bets he had made. The firms always claimed that they had no position themselves--that they were running matched books--but their behavior told him otherwise. "Whatever the banks' net position was would determine the mark," he said. "I don't think they were looking to the market for their marks. I think they were looking to their needs." That is, the reason they refused to acknowledge that his bet was paying off was that they were on the other side of it. "When you talk to dealers," he wrote in March 2006 to his in-house lawyer, Steve Druskin, "you are getting the view from their book. Whatever they've got on their book will be their view. Goldman happens to be warehousing a lot of this risk. They'll talk as if nothing has been seen in the mortgage pools. No need to incite panic...and this has worked. As long as they can entice more [money] into the market, the problem is resolved. That's been the history of the last 3-4 years."

 

 

By April 2006 he'd finished buying insurance on subprime mortgage bonds. In a portfolio of $555 million, he had laid $1.9 billion of these peculiar bets--bets that should be paying off but were not. In May he adopted a new tactic: asking Wall Street traders if they would be willing to sell him even more credit default swaps at the price they claimed they were worth, knowing that they were not. "Never once has any counterparty been willing to sell me my list at my marks," he wrote in an e-mail. "Eighty to ninety per cent of the names on my list are not even available at any price." A properly functioning market would a.s.similate new information into the prices of securities; this multi-trillion-dollar market in subprime mortgage risk never budged. "One of the oldest adages in investing is that if you're reading about it in the paper, it's too late," he said. "Not this time." Steve Druskin was becoming more involved in the market--and couldn't believe how controlled it was. "What's amazing is that they make a market in this fantasy stuff," said Druskin. "It's not a real a.s.set." It was as if Wall Street had decided to allow everyone to gamble on the punctuality of commercial airlines. The likelihood of United Flight 001 arriving on time obviously shifted--with the weather, mechanical issues, pilot quality, and so on. But shifting probabilities could be ignored, until the plane did or did not arrive. It didn't matter when big mortgage lenders like Ownit and ResCap failed, or some pool of subprime loans experienced higher than expected losses. All that mattered was what Goldman Sachs and Morgan Stanley decided should matter.

 

 

The world's single biggest capital market wasn't a market; it was something else--but what? "I am actually protesting to my counterparties that there must be fraud in the marketplace for credit default swaps to be at all-time lows," Burry wrote in an e-mail to an investor he trusted. "What if CDSs are a fraud? I am asking myself that question all the time, and never have I felt like I should be thinking that way more than now. No way we should be down 5% this year just in mortgage CDSs." To his Goldman Sachs saleswoman, he wrote, "I think I am short housing but am I not, because CDSs are criminal?" When, a few months later, Goldman Sachs announced it was setting aside $542,000 per employee for the 2006 bonus pool, he wrote again: "As a former gas station attendant, parking lot attendant, medical resident and current Goldman Sachs screwee, I am offended."

 

 

In the middle of 2006, he began to hear of other money managers who wanted to make the same bet he did. A few actually called and asked for his help. "I had all these people telling me I needed to get out of this trade," he said. "And I was looking at these other people and thinking how lucky they were to be able to get into this trade." If the market had been at all rational it would have blown up long before. "Some of the biggest funds on the planet have picked my brain and copied my strategy," he wrote in an e-mail. "So it won't just be Scion that makes money if this happens. Still, it won't be everyone."

 

 

He was now undeniably miserable. "It feels like my insides are digesting themselves," he wrote to his wife in mid-September. The source of his unhappiness was, as usual, other people. The other people who bothered him the most were his own investors. When he opened his fund, in 2000, he released only his quarterly returns, and told his investors that he planned to tell them next to nothing about what he was up to. Now they were demanding monthly and even fortnightly reports, and pestered him constantly about the wisdom of his pessimism. "I almost think the better the idea, and the more iconoclastic the investor, the more likely you will get screamed at by investors," he said. He didn't worry about how screwed-up the market for some security became because he knew that eventually it would be disciplined by logic: Businesses either thrived or failed. Loans either were paid off or were defaulted upon. But these people whose money he ran were incapable of keeping their emotional distance from the market. They were now responding to the same surface stimuli as the entire screwed-up subprime mortgage market, and trying to force him to conform to its madness. "I do my best to have patience," he wrote to one investor. "But I can only be as patient as my investors." To another griping investor he wrote, "The definition of an intelligent manager in the hedge fund world is someone who has the right idea, and sees his investors abandon him just before the idea pays off." When he was making them huge sums of money, he had barely heard from them; the moment he started actually to lose a little, they peppered him with their doubts and suspicions: So I take it the monster dragging us out to sea is the CDS. You have created the plight of the old man and the sea.When do you see the end of the bleeding? (August down again 5%.) Are you running a riskier strategy now?You make me physically ill.... How dare you?Can you explain to me how we keep losing money on this position? If our potential losses are fixed it would seem to me based on how much we have lost that they should be a tiny part of the portfolio now.

 

 

This last question kept popping up: How could a stock picker be losing so much on this one quixotic bond market bet? And he kept trying to answer it: He was committed to paying annual premiums amounting to about 8 percent of the portfolio, every year, for as long