The Big Short_ Inside the Doomsday Machine Part 5

Across Wall Street, subprime mortgage bond traders were long and wrong, and scrambling to sell their positions--or to buy insurance on them. Michael Burry's credit default swaps were suddenly fashionable. What still shocked him, however, was that the market had been so slow to a.s.similate material information. "You could see that all all these deals were sucking wind leading up to the reset date," he said, "and the reset just goosed them into another dimension of these deals were sucking wind leading up to the reset date," he said, "and the reset just goosed them into another dimension of fail fail. I was in a state of perpetual disbelief. I would have thought that someone would have recognized what was coming before June 2007. If it really took that June remit data to cause a sudden realization, well, it makes me wonder what a 'Wall Street a.n.a.lyst' really does all day."

By the end of July his marks were moving rapidly in his favor--and he was reading about the genius of people like John Paulson, who had come to the trade a year after he had. The Bloomberg News service ran an article about the few people who appeared to have seen the catastrophe coming. Only one worked as a bond trader inside a big Wall Street firm: a formerly obscure a.s.set-backed bond trader at Deutsche Bank named Greg Lippmann. FrontPoint and Cornwall were both missing from the piece, but the investor most conspicuously absent from the Bloomberg News article sat alone in his office, in Cupertino, California. Michael Burry clipped the article and e-mailed it around the office with a note: "Lippmann is the guy that essentially took my idea and ran with it. To his credit." His own investors, whose money he was doubling and more, said little. There came no apologies, and no grat.i.tude. "n.o.body came back and said, 'Yeah, you were right,'" he said. "It was very quiet. It was extremely quiet. The silence infuriated me." He was left with his favored mode of communication, his letter to investors. In early July 2007, as the markets crashed, he posed an excellent question. "One rather surprising aspect of all this," he wrote, "is that there have been relatively few reports of investors actually being hurt by the subprime mortgage market troubles....Why have we not yet heard of this era's Long-Term Capital?"

CHAPTER NINE.

A Death of Interest Howie Hubler had grown up in New Jersey and played football at Montclair State College. Everyone who met him noticed his thick football neck and his great huge head and his overbearing manner, which was interpreted as both admirably direct and a mask. He was loud and headstrong and bullying. "When confronted with some intellectual point about his trades, Howie wouldn't go to an intellectual place," said one of the people charged with supervising Hubler in his early days at Morgan Stanley. "He would go to 'Get the h.e.l.l out of my face.'" Some people enjoyed Hubler, some people didn't, but, by early 2004, what others thought didn't really matter anymore, because for nearly a decade Howie Hubler had made money trading bonds for Morgan Stanley. He ran Morgan Stanley's a.s.set-backed bond trading, which effectively put him in charge of the firm's bets on subprime mortgages. Right up to the point the subprime mortgage bond market boomed, and changed what it meant to be an a.s.set-backed bond trader, Hubler's career had resembled Greg Lippmann's. Like every other a.s.set-backed bond trader, he'd been playing a low-stakes poker game rigged in his favor, since nothing had ever gone seriously wrong in the market. Prices fell, but they always came back. You could either like a.s.set-backed bonds or you could love a.s.set-backed bonds, but there was no point in hating them, because there was no tool for betting against them. football at Montclair State College. Everyone who met him noticed his thick football neck and his great huge head and his overbearing manner, which was interpreted as both admirably direct and a mask. He was loud and headstrong and bullying. "When confronted with some intellectual point about his trades, Howie wouldn't go to an intellectual place," said one of the people charged with supervising Hubler in his early days at Morgan Stanley. "He would go to 'Get the h.e.l.l out of my face.'" Some people enjoyed Hubler, some people didn't, but, by early 2004, what others thought didn't really matter anymore, because for nearly a decade Howie Hubler had made money trading bonds for Morgan Stanley. He ran Morgan Stanley's a.s.set-backed bond trading, which effectively put him in charge of the firm's bets on subprime mortgages. Right up to the point the subprime mortgage bond market boomed, and changed what it meant to be an a.s.set-backed bond trader, Hubler's career had resembled Greg Lippmann's. Like every other a.s.set-backed bond trader, he'd been playing a low-stakes poker game rigged in his favor, since nothing had ever gone seriously wrong in the market. Prices fell, but they always came back. You could either like a.s.set-backed bonds or you could love a.s.set-backed bonds, but there was no point in hating them, because there was no tool for betting against them.

Inside Morgan Stanley, the subprime mortgage lending boom created a who-put-chocolate-in-my peanut-b.u.t.ter moment. The firm had been a leader in extending into consumer loans the financial technology used to package corporate loans. Morgan Stanley's financial intellectuals--their quants--had been instrumental in teaching the rating agencies, Moody's and S&P, how to evaluate CDOs on pools of a.s.set-backed bonds. It was only natural that someone inside Morgan Stanley should also wonder if he might invent a credit default swap on an a.s.set-backed bond. Howie Hubler's subprime mortgage desk was creating bonds at a new and faster rate. To do so, Hubler's group had to "warehouse" loans, sometimes for months. Between the purchase of the loans and the sale of the bonds made up of those loans, his group was exposed to falling prices. "The whole reason we created the credit default swap was to protect the mortgage desk run by Howie Hubler," said one of its inventors. If Morgan Stanley could find someone to sell it insurance on its loans, Hubler could eliminate the market risk of warehousing home loans.

As originally conceived, in 2003, the subprime mortgage credit default swap was a one-off, nonstandard insurance contract, struck between Morgan Stanley and some other bank or insurance company, outside the gaze of the wider market. No ordinary human being had ever heard of these credit default swaps or, if Morgan Stanley had its way, ever would. By design they were arcane, opaque, illiquid, and thus conveniently difficult for anyone but Morgan Stanley to price. "Bespoke," in market parlance. By late 2004 Hubler had grown cynical about certain subprime mortgage bonds--and wanted to find clever ways to bet against them. The same idea had occurred to Morgan Stanley's intellectuals. In early 2003 one of them had proposed that they cease to be intellectuals and form a little group that he, the intellectual, would manage--a fact that the traders would quickly forget. "One of the quants actually creates all this stuff and they [Hubler and his traders] stole it from him," said a Morgan Stanley bond saleswoman who observed the proceedings up close. One of Hubler's close a.s.sociates, a trader named Mike Edman, became the official creator of a new idea: a credit default swap on what amounted to a timeless pool of subprime loans.

One risk of betting against subprime loans was that, as long as house prices kept rising, borrowers were able to refinance, and pay off their old loans. The pool of loans on which you've bought insurance shrinks, and the amount of your insurance shrinks with it. Edman's credit default swap solved this problem with some fine print in its contracts, which specified that Morgan Stanley was buying insurance on the last outstanding loan in the pool. Morgan Stanley was making a bet not on the entire pool of subprime home loans but on the few loans in the pool least likely to be repaid. The size of the bet, however, remained the same as if no loan in the pool was ever repaid. They had bought flood insurance that, if a drop of water so much as grazed any part of the house, paid them the value of the entire house.

Thus designed, Morgan Stanley's new bespoke credit default swap was virtually certain one day to pay off. For it to pay off in full required losses in the pool of only 4 percent, which pools of subprime mortgage loans experienced in good times good times. The only problem, from the point of view of Howie Hubler's traders, was finding a Morgan Stanley customer stupid enough to take the other side of the bet--that is, to get the customer to sell Morgan Stanley what amounted to home insurance on a house designated for demolition. "They found one client to take the long side of the triple-B tranche of some piece of s.h.i.t," says one of their former colleagues, which is a complicated way of saying that they found a mark. A fool. A customer to be taken advantage of. "That's how it starts--it drives Howie's first trade."

By early 2005 Howie Hubler had found a sufficient number of fools in the market to acquire 2 billion dollars' worth of these bespoke credit default swaps. From the point of view of the fools, the credit default swaps Howie Hubler was looking to buy must have looked like free money: Morgan Stanley would pay them 2.5 percent a year over the risk-free rate to own, in effect, investment-grade (triple-B-rated) a.s.set-backed bonds. The idea appealed especially to German inst.i.tutional investors, who either failed to read the fine print or took the ratings at face value.

By the spring of 2005, Howie Hubler and his traders believed, with reason, that these diabolical insurance policies they'd created were dead certain to pay off. They wanted more of them. It was now, however, that Michael Burry began to agitate to buy standardized credit default swaps. Greg Lippmann at Deutsche Bank, a pair of traders at Goldman Sachs, and a few others came together to hammer out the details of the contract. Mike Edman at Morgan Stanley was dragged kicking and screaming into their discussion, for the moment credit default swaps on subprime mortgage bonds were openly traded and standardized, Howie Hubler's group would lose their ability to peddle their murkier, more private version.

It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader. The best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions. Collecting nickels and dimes from the trades of unthinking investors felt beneath the dignity of a big-time Wall Street bond trader. "Howie thought the customer business was stupid," says one of several traders closest to Hubler. "It was what he'd always done, but he'd lost interest in it."* Hubler could make hundreds of millions facilitating the idiocy of Morgan Stanley's customers. He could make billions by using the firm's capital to bet against them. Hubler could make hundreds of millions facilitating the idiocy of Morgan Stanley's customers. He could make billions by using the firm's capital to bet against them.

Morgan Stanley management, for its part, always feared that Hubler and his small team of traders might quit and create their own hedge fund. To keep them, they offered Hubler a special deal: his own proprietary trading group, with its own grandiose name: GPCG, or the Global Proprietary Credit Group. In his new arrangement, Hubler would keep for himself some of the profits this group generated. "The idea," says a member of the group, "was for us to go from making one billion dollars a year to two billion dollars a year, right away." The idea, also, was for Hubler and his small group of traders to keep for themselves a big chunk of the profits this group generated. As soon as feasible, Morgan Stanley promised, Hubler would be allowed to spin it off into a separate money management business, of which he'd own 50 percent. Among other things, this business would manage subprime-backed CDOs. They would compete, for instance, with Wing Chau's Harding Advisory.

The putative best and brightest on Morgan Stanley's bond trading floor lobbied to join him. "It was supposed to be the elite of the elite," said one of the traders. "Howie took all the smartest people with him." The chosen few moved to a separate floor in Morgan Stanley's midtown Manhattan office, eight floors above their old trading desks. There they erected new walls around themselves, to create at least the illusion that Morgan Stanley had no conflict of interest. The traders back down on the second floor would buy and sell from customers and not pa.s.s any information about their dealings to Hubler and his group on the tenth floor. Tony Tufariello, the head of Morgan Stanley's global bond trading and thus in theory Howie Hubler's boss, was so conflicted that he built himself an office inside Howie's group, and bounced back and forth between the second floor and the tenth.* Howie Hubler didn't want only people. He wanted, badly, to take with him his group's trading positions. Their details were complicated enough that one of Morgan Stanley's own subprime mortgage bond traders said, "I don't think any of the people above Howie fully understood the trade he had on." But their gist was simple: Hubler and his group had made a ma.s.sive bet that subprime loans would go bad. The crown jewel of their elaborate trading positions was still the $2 billion in bespoke credit default swaps Hubler felt certain would one day very soon yield $2 billion in pure profits. The pools of mortgage loans were just about to experience their first losses, and the moment they did, Hubler would be paid in full. Howie Hubler didn't want only people. He wanted, badly, to take with him his group's trading positions. Their details were complicated enough that one of Morgan Stanley's own subprime mortgage bond traders said, "I don't think any of the people above Howie fully understood the trade he had on." But their gist was simple: Hubler and his group had made a ma.s.sive bet that subprime loans would go bad. The crown jewel of their elaborate trading positions was still the $2 billion in bespoke credit default swaps Hubler felt certain would one day very soon yield $2 billion in pure profits. The pools of mortgage loans were just about to experience their first losses, and the moment they did, Hubler would be paid in full.

There was, however, a niggling problem: The running premiums on these insurance contracts ate into the short-term returns of Howie's group. "The group was supposed to make two billion dollars a year," said one member. "And we had this credit default swap position that was costing us two hundred million dollars." To offset the running cost, Hubler decided to sell some credit default swaps on triple-A-rated subprime CDOs, and take in some premiums of his own.* The problem was that the premiums on the supposedly far less risky triple-A-rated CDOs were only one-tenth of the premiums on the triple-Bs, and so to take in the same amount of money as he was paying out, he'd need to sell credit default swaps in roughly ten times the amount he already owned. He and his traders did this quickly, and apparently without a great deal of discussion, in half a dozen or so ma.s.sive trades, with Goldman Sachs and Deutsche Bank and a few others. The problem was that the premiums on the supposedly far less risky triple-A-rated CDOs were only one-tenth of the premiums on the triple-Bs, and so to take in the same amount of money as he was paying out, he'd need to sell credit default swaps in roughly ten times the amount he already owned. He and his traders did this quickly, and apparently without a great deal of discussion, in half a dozen or so ma.s.sive trades, with Goldman Sachs and Deutsche Bank and a few others.

By the end of January 2007, when the entire subprime mortgage bond industry headed to Las Vegas to celebrate itself, Howie Hubler had sold credit default swaps on roughly 16 billion dollars' worth of triple-A tranches of CDOs. Never had there been such a clear expression of the delusion of the elite Wall Street bond trader and, by extension, the entire subprime mortgage bond market: Between September 2006 and January 2007, the highest-status bond trader inside Morgan Stanley had, for all practical purposes, purchased $16 billion in triple-A-rated CDOs, composed entirely of triple-B-rated subprime mortgage bonds, which became valueless when the underlying pools of subprime loans experienced losses of roughly 8 percent. In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market but not smart enough to realize how cynical he needed to be.

Inside Morgan Stanley, there was apparently never much question whether the company's elite risk takers should be allowed to buy $16 billion in subprime mortgage bonds. Howie Hubler's proprietary trading group was of course required to supply information about its trades to both upper management and risk management, but the information the traders supplied disguised the nature of their risk. The $16 billion in subprime risk Hubler had taken on showed up in Morgan Stanley's risk reports inside a bucket marked "triple A"--which is to say, they might as well have been U.S. Treasury bonds. They showed up again in a calculation known as value at risk (VaR). The tool most commonly used by Wall Street management to figure out what their traders had just done, VaR measured only the degree to which a given stock or bond had jumped around in the past, with the recent movements receiving a greater emphasis than movements in the more distant past. Having never fluctuated much in value, triple-A-rated subprime-backed CDOs registered on Morgan Stanley's internal reports as virtually riskless. In March 2007 Hubler's traders prepared a presentation, delivered by Hubler's bosses to Morgan Stanley's board of directors, that boasted of their "great structural position" in the subprime mortgage market. No one asked the obvious question: What happens to the great structural position if subprime mortgage borrowers begin to default in greater than expected numbers?

Howie Hubler was taking a huge risk, even if he failed to communicate it or, perhaps, understand it. He'd laid a ma.s.sive bet on very nearly the same CDO tranches that Cornwall Capital had bet against, composed of nearly the same subprime bonds that FrontPoint Partners and Scion Capital had bet against. For more than twenty years, the bond market's complexity had helped the Wall Street bond trader to deceive the Wall Street customer. It was now leading the bond trader to deceive himself.

At issue was how highly correlated the prices of various subprime mortgage bonds inside a CDO might be. Possible answers ranged from zero percent (their prices had nothing to do with each other) to 100 percent (their prices moved in lockstep with each other). Moody's and Standard & Poor's judged the pools of triple-B-rated bonds to have a correlation of around 30 percent, which did not mean anything like what it sounds. It does not mean, for example, that if one bond goes bad, there is a 30 percent chance that the others will go bad too. It means that if one bond goes bad, the others experience very little decline at all.

The pretense that these loans were not all essentially the same, doomed to default en ma.s.se the moment house prices stopped rising, had justified the decisions by Moody's and S&P to bestow triple-A ratings on roughly 80 percent of every CDO. (And made the entire CDO business possible.) It also justified Howie Hubler's decision to buy 16 billion dollars' worth of them. Morgan Stanley had done as much as any Wall Street firm to persuade the rating agencies to treat consumer loans as they treated corporate ones--as a.s.sets whose risks could be dramatically reduced if bundled together. The people who had done the persuading saw it as a sales job: They knew there was a difference between corporate and consumer loans that the rating agencies had failed to grapple with. The difference was that there was very little history to work with in the subprime mortgage bond market, and no history at all of a collapsing national real estate market. Morgan Stanley's elite bond traders did not spend a lot of time worrying about this. Howie Hubler trusted the ratings.

The Wall Street bond traders on the other end of the phone from Howie Hubler came away with the impression that he considered these bets entirely risk-free. He'd collect a tiny bit of interest...for nothing. He wasn't alone in this belief, of course. Hubler and a trader at Merrill Lynch argued back and forth about a possible purchase by Morgan Stanley, from Merrill Lynch, of $2 billion in triple-A CDOs. Hubler wanted Merrill Lynch to pay him 28 basis points (0.28 percent) over the risk-free rate, while Merrill Lynch only wanted to pay 24. On a $2 billion trade--a trade that would, in the end, have transferred a $2 billion billion loss from Merrill Lynch to Morgan Stanley--the two traders were arguing over interest payments amounting to $800,000 a year. Over that sum the deal fell apart. Hubler had the same nit-picking argument with Deutsche Bank, with a difference. Inside Deutsche Bank, Greg Lippmann was now hollering at the top of his lungs that these triple-A CDOs could one day be worth zero. Deutsche Bank's CDO machine paid Hubler the 28 basis points he craved and, in December 2006 and January 2007, cut two deals, of $2 billion each. "When we did the trades, the whole time we were both like, 'We both know there is no risk in these things,'" said the Deutsche Bank CDO executive who dealt with Hubler. loss from Merrill Lynch to Morgan Stanley--the two traders were arguing over interest payments amounting to $800,000 a year. Over that sum the deal fell apart. Hubler had the same nit-picking argument with Deutsche Bank, with a difference. Inside Deutsche Bank, Greg Lippmann was now hollering at the top of his lungs that these triple-A CDOs could one day be worth zero. Deutsche Bank's CDO machine paid Hubler the 28 basis points he craved and, in December 2006 and January 2007, cut two deals, of $2 billion each. "When we did the trades, the whole time we were both like, 'We both know there is no risk in these things,'" said the Deutsche Bank CDO executive who dealt with Hubler.

In the murky and curious period from early February to June 2007, the subprime mortgage market resembled a giant helium balloon, bound to earth by a dozen or so big Wall Street firms. Each firm held its rope; one by one, they realized that no matter how strongly they pulled, the balloon would eventually lift them off their feet. In June, one by one, they silently released their grip. By edict of CEO Jamie Dimon, J.P. Morgan had abandoned the market by the late fall of 2006. Deutsche Bank, because of Lippmann, had always held on tenuously. Goldman Sachs was next, and did not merely let go, but turned and made a big bet against the subprime market--further accelerating the balloon's fatal ascent. murky and curious period from early February to June 2007, the subprime mortgage market resembled a giant helium balloon, bound to earth by a dozen or so big Wall Street firms. Each firm held its rope; one by one, they realized that no matter how strongly they pulled, the balloon would eventually lift them off their feet. In June, one by one, they silently released their grip. By edict of CEO Jamie Dimon, J.P. Morgan had abandoned the market by the late fall of 2006. Deutsche Bank, because of Lippmann, had always held on tenuously. Goldman Sachs was next, and did not merely let go, but turned and made a big bet against the subprime market--further accelerating the balloon's fatal ascent.* When its subprime hedge funds crashed in June, Bear Stearns was forcibly severed from its line--and the balloon drifted farther from the ground. When its subprime hedge funds crashed in June, Bear Stearns was forcibly severed from its line--and the balloon drifted farther from the ground.

Not long before that, in April 2007, Howie Hubler, perhaps having misgivings about the size of his gamble, had struck a deal with the guy who ran the doomed Bear Stearns hedge funds, Ralph Cioffi. On April 2, the nation's largest subprime mortgage lender, New Century, was swamped by defaults and filed for bankruptcy. Morgan Stanley would sell Cioffi $6 billion of his $16 billion in triple-A CDOs. The price had fallen a bit--Cioffi demanded a yield of 40 basis points (0.40 percent) over the risk-free rate. Hubler conferred with Morgan Stanley's president, Zoe Cruz; together they decided that they'd rather keep the subprime risk than realize a loss that amounted to a few tens of millions of dollars. It was a decision that wound up costing Morgan Stanley nearly $6 billion, and yet Morgan Stanley's CEO, John Mack, never got involved. "Mack never came and talked to Howie," says one of Hubler's closest a.s.sociates. "The entire time, Howie never had a single sit-down with Mack."*

By May 2007, however, there was a growing dispute between Howie Hubler and Morgan Stanley. Amazingly, it had nothing to do with the wisdom of owning $16 billion in complex securities whose value ultimately turned on the ability of a Las Vegas stripper with five investment properties, or a Mexican strawberry picker with a single $750,000 home, to make rapidly rising interest payments. The dispute was over Morgan Stanley's failure to deliver on its promise to spin Hubler's proprietary trading group off into its own money management firm, of which he would own 50 percent. Outraged by Morgan Stanley's foot-dragging, Howie Hubler threatened to quit. To keep him, Morgan Stanley promised to pay him, and his traders, an even bigger chunk of GPCG's profits. In 2006, Hubler had been paid $25 million; in 2007, it was understood, he would make far more.

A month after Hubler and his traders improved the terms of trade between themselves and their employer, Morgan Stanley finally asked the uncomfortable question: What happened to their ma.s.sive subprime mortgage market bet if lower-middle-cla.s.s Americans defaulted in greater than expected numbers? How did the bet perform, for instance, using the a.s.sumption of losses generated by the most pessimistic Wall Street a.n.a.lyst? Up to that point, Hubler's bet had been "stress tested" for scenarios in which subprime pools experienced losses of 6 percent, the highest losses from recent history. Now Hubler's traders were asked to imagine what would become of their bet if losses reached 10 percent. The demand came directly from Morgan Stanley's chief risk officer, Tom Daula, and Hubler and his traders were angered and disturbed that he would issue it. "It was more than a little weird," says one of them. "There was a lot of angst about it. It was sort of viewed as, These folks don't know what they're talking about. If losses go to ten percent there will be, like, a million homeless people." (Losses in the pools Hubler's group had bet on would eventually reach 40 percent.) As a senior Morgan Stanley executive outside Hubler's group put it, "They didn't want to show you the results. They kept saying, That state of the world can't happen. That state of the world can't happen."

It took Hubler's traders ten days to produce the result they really didn't want to show anyone: Losses of 10 percent turned their complicated bet in subprime mortgages from a projected profit of $1 billion into a projected loss of $2.7 billion. As one senior Morgan Stanley executive put it, "The risk officers came back from the stress test looking very upset." Hubler and his traders tried to calm him down. Relax, they said, those kinds of losses will never happen.

The risk department had trouble relaxing, however. To them it seemed as if Hubler and his traders didn't fully understand their own gamble. Hubler kept saying he was betting against the subprime bond market. But if so, why did he lose billions if it collapsed? As one senior Morgan Stanley risk manager put it, "It's one thing to bet on red or black and know that you are betting on red or black. It's another to bet on a form of red and not to know it."

In early July, Morgan Stanley received its first wake-up call. It came from Greg Lippmann and his bosses at Deutsche Bank, who, in a conference call, told Howie Hubler and his bosses that the $4 billion in credit default swaps Hubler had sold Deutsche Bank's CDO desk six months earlier had moved in Deutsche Bank's favor. Could Morgan Stanley please wire $1.2 billion to Deutsche Bank by the end of the day? Or, as Lippmann actually put it--according to someone who heard the exchange-- July, Morgan Stanley received its first wake-up call. It came from Greg Lippmann and his bosses at Deutsche Bank, who, in a conference call, told Howie Hubler and his bosses that the $4 billion in credit default swaps Hubler had sold Deutsche Bank's CDO desk six months earlier had moved in Deutsche Bank's favor. Could Morgan Stanley please wire $1.2 billion to Deutsche Bank by the end of the day? Or, as Lippmann actually put it--according to someone who heard the exchange--Dude, you owe us one point two billion.

Triple-A-rated subprime CDOs, of which there were now hundreds of billions of dollars' worth buried inside various Wall Street firms, and which were a.s.sumed to be riskless, were now, according to Greg Lippmann, only worth 70 cents on the dollar. Howie Hubler had the same reaction. What do you mean seventy? Our model says they are worth ninety-five What do you mean seventy? Our model says they are worth ninety-five, said one of the Morgan Stanley people on the phone call.

Our model says they are worth seventy, replied one of the Deutsche Bank people. replied one of the Deutsche Bank people.

Well, our model says they are worth ninety-five, repeated the Morgan Stanley person, and then went on about how the correlation among the thousands of triple-B-rated bonds in his CDOs was very low, and so a few bonds going bad didn't imply they were all worthless.

At which point Greg Lippmann just said, Dude, f.u.c.k your model. I'll make you a market. They are seventy-seventy-seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my f.u.c.king one point two billion dollars. Dude, f.u.c.k your model. I'll make you a market. They are seventy-seventy-seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my f.u.c.king one point two billion dollars.

Morgan Stanley didn't want to buy any more subprime mortgage bonds. Howie Hubler didn't want to buy any more subprime-backed bonds: He'd released his grip on the rope that tethered him to the rising balloon. Yet he didn't want to take a loss, and insisted that, despite his unwillingness to buy more at 77, his triple-A CDOs were still worth 95 cents on the dollar. He simply handed the matter to his superiors, who conferred with their equivalents at Deutsche Bank, and finally agreed to wire over $600 million. The alternative, for Deutsche Bank, was to submit the matter to a panel of three Wall Street banks, randomly selected, to determine what these triple-A CDOs were actually worth. It was a measure of the confusion and delusion on Wall Street that Deutsche Bank didn't care to run that risk.

At any rate, from Deutsche Bank's point of view, the collateral wasn't that big a deal. "When Greg made that call," said a senior Deutsche Bank executive, "it was like last on the list of the things we needed to do to keep our business running. Morgan Stanley had seventy billion dollars in capital. We knew the money was there." There was even some argument inside Deutsche Bank as to whether Lippmann's price was accurate. "It was such a big number," said a person involved in these discussions, "that a lot of people said it couldn't possibly be right. Morgan Stanley couldn't possibly owe us one point two billion dollars."

They did, however. It was the beginning of a slide that would end just a few months later, in a conference call between Morgan Stanley's CEO and Wall Street's a.n.a.lysts. The defaults mounted, the bonds universally crashed, and the CDOs composed of the bonds followed. Several times on the way down, Deutsche Bank offered Morgan Stanley the chance to exit its trade. The first time Greg Lippmann called him, Howie Hubler might have exited his $4 billion trade with Deutsche Bank at a loss of $1.2 billion; the next time Lippmann called, the price of getting out had risen to $1.5 billion. Each time, Howie Hubler, or one of his traders, argued about the price, and declined to exit. "We fought with those c.o.c.ksuckers all the way down," says one Deutsche Bank trader. And, all the way down, the debt collectors at Deutsche Bank sensed the bond traders at Morgan Stanley misunderstood their own trade. They weren't lying; they genuinely failed to understand the nature of the subprime CDO. The correlation among triple-B-rated subprime bonds was not 30 percent; it was 100 percent. When one collapsed, they all collapsed, because they were all driven by the same broader economic forces. In the end, it made little sense for a CDO to fall from 100 to 95 to 77 to 70 and down to 7. The subprime bonds beneath them were either all bad or all good. The CDOs were worth either zero or 100.

At a price of 7, Greg Lippmann allowed Morgan Stanley to exit a trade it had entered into at roughly 100 cents on the dollar. On the first $4 billion of Howie Hubler's $16 billion folly, the loss came to roughly $3.7 billion. By then Lippmann was no longer speaking to Howie Hubler, because Howie Hubler was no longer employed at Morgan Stanley. "Howie was on this vacation thing for a few weeks," says one member of his group, "and then he never came back." He'd been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006, to prevent him from quitting. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street. Other firms would lose more, much more; but those losses were typically a.s.sociated with the generation of subprime mortgage loans. Citigroup and Merrill Lynch and others sat on huge piles of the things when the market crashed, but these were the by-product of their CDO machines. They owned subprime mortgage-backed CDOs less for their own sake than for the fees that their deals would generate once they had sold them. Howie Hubler's loss was the result of a simple bet. Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency.

Retiring to New Jersey, with an unlisted number, Howie Hubler took with him the comforting sense that he was not the biggest fool at the table. He might have let go of the balloon rope too late to save Morgan Stanley, but, as he fell to earth, he could look up at the balloon drifting higher in the sky and see Wall Street bodies still dangling from it. In early July, just days before Greg Lippmann had called him to ask for $1.2 billion, Hubler had found a pair of buyers for his triple-A-rated CDOs. The first was the Mizuho Financial Group, a trading arm of j.a.pan's second biggest bank. As a people, the j.a.panese had been bewildered by these new American financial creations, and steered clear of them. Mizuho Financial Group, for some reason that would remain known only to itself, set itself up as a clever trader of U.S. subprime bonds, and took $1 billion in subprime-backed CDOs off Morgan Stanley's hands.

The other, bigger, buyer was UBS--which took $2 billion in Howie Hubler's triple-A CDOs, along with a couple of hundred million dollars' worth of his short position in triple-B-rated bonds. That is, in July, moments before the market crashed, UBS looked at Howie Hubler's trade and said, "We want some of that, too." Thus Howie Hubler's personal purchase of $16 billion in triple-A-rated CDOs dwindled to something like $13 billion. A few months later, seeking to explain to its shareholders the $37.4 billion it had lost in the U.S. subprime markets, UBS would publish a semi-frank report, in which it revealed that a small group of U.S. bond traders employed by UBS had lobbied hard right up until the end for the bank to buy even more of other Wall Street firms' subprime mortgage bonds. "If people had known about the trade, it would have been open revolt," said one UBS bond trader close to the action. "It was a very controversial trade in UBS. It was kept very, very secret. There were a lot of people, had they known the trade was happening, would have screamed eight ways from Sunday. We took the correlation trade off Howie's hands when everyone knew the correlation was one." (Which is to say, 100 percent.) He further explained that the traders at UBS who executed the trade were motivated mainly by their own models--which, at the moment of the trade, suggested they had turned a profit of $30 million.

On December 19, 2007, Morgan Stanley held a call for investors. The company wanted to explain how a trading loss of $9.2 billion--give or take a few billion--had more than overwhelmed the profits generated by its fifty thousand or so employees. "The results we announced today are embarra.s.sing for me; for our firm," began John Mack. "This was a result of an error in judgment incurred on one desk in our Fixed Income area, and also a failure to manage that risk appropriately.... Virtually all write downs this quarter were the result of trading about [sic] a single desk on our mortgage business." The CEO explained that Morgan Stanley had certain "hedges" against its subprime mortgage risk and that "the hedges didn't perform adequately in extraordinary market condition of late October and November." But market conditions in October and November were not extraordinary; in October and November, for the first time, the market began accurately to price subprime mortgage risk. What was extraordinary is what had happened leading up to October and November.

After saying he wanted "to be absolutely clear [that] as head of this firm, I take responsibility for performance," Mack took questions from the bank a.n.a.lysts of other Wall Street firms. It took this group a while to get to the source of embarra.s.sment, but eventually they did. Four a.n.a.lysts elected not to probe Mack too closely about what was almost certainly the single greatest proprietary trading loss in Wall Street history, and then William Tanona, from Goldman Sachs, spoke: TANONA: A question on the risk again, [which] I know everybody has been dancing around.... Help us understand how this could happen that you could take this large of a loss. I mean, I would imagine that you guys have position limits and risk limits as such. I just--it [bewilders] me to think that you guys could have one desk that could lose $8 billion [sic].JOHN MACK: That's a wrong question.TANONA: Excuse me?JOHN MACK: h.e.l.lo. Hi. And...TANONA: I missed you...JOHN MACK: Bill, look, let's be clear. One, this trade was recognized and entered into our accounts. Two, it was entered into our risk management system. It's very simple. When these got, it's simple, it's very painful, so I'm not being glib. When these guys stress loss the scenario on putting on this position, they did not envision...that we could have this degree of default, right. It is fair to say that our risk management division did not stress those losses as well.* It's just simple as that. Those are big fat tail risks that caught us hard, right. That's what happened. It's just simple as that. Those are big fat tail risks that caught us hard, right. That's what happened.TANONA: Okay. Fair enough. I guess the other thing I would question. I am surprised that your trading VaR stayed stable in the quarter given this level of loss, and given that I would suspect that these were trading a.s.sets. So can you help me understand why your VaR didn't increase in the quarter dramatically?+MACK: Bill, I think VaR is a very good representation of liquid trading risk. But in terms of the (inaudible) of that, I am very happy to get back to you on that when we have been out of this, because I can't answer that at the moment.

The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks. After all, he was himself a former bond trader, and had been brought in to embolden Morgan Stanley's risk-taking culture. Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion.

At length the moment had come: The last buyer of subprime mortgage risk had stopped buying. On August 1, 2007, shareholders brought their first lawsuit against Bear Stearns in connection with the collapse of its subprime-backed hedge funds. Among its less visible effects was to alarm greatly the three young men at Cornwall Capital who sat on what was for them an enormous pile of credit default swaps purchased mostly from Bear Stearns. Ever since Las Vegas, Charlie Ledley had been unable to shake his sense of the enormity of the events they were living through. Ben Hockett, the only one of the three who had worked inside a big Wall Street firm, also tended to travel very quickly in his mind to some catastrophic endgame. And Jamie Mai just thought a lot of people on Wall Street were sc.u.mbags. All three were worried that Bear Stearns might fail and be unable to make good on its gambling debts. "There can come a moment when you can't trade with a Wall Street firm anymore," said Ben, "and it can come like the moment had come: The last buyer of subprime mortgage risk had stopped buying. On August 1, 2007, shareholders brought their first lawsuit against Bear Stearns in connection with the collapse of its subprime-backed hedge funds. Among its less visible effects was to alarm greatly the three young men at Cornwall Capital who sat on what was for them an enormous pile of credit default swaps purchased mostly from Bear Stearns. Ever since Las Vegas, Charlie Ledley had been unable to shake his sense of the enormity of the events they were living through. Ben Hockett, the only one of the three who had worked inside a big Wall Street firm, also tended to travel very quickly in his mind to some catastrophic endgame. And Jamie Mai just thought a lot of people on Wall Street were sc.u.mbags. All three were worried that Bear Stearns might fail and be unable to make good on its gambling debts. "There can come a moment when you can't trade with a Wall Street firm anymore," said Ben, "and it can come like that. that."

That first week in August, they kicked around and tried to get a feel for the prices of double-A-rated CDOs, which just a few months earlier had been trading at prices that suggested they were essentially riskless. "The underlying bonds were collapsing and all the people we'd dealt with were saying we'll give you two points," said Charlie. Right up through late July, Bear Stearns and Morgan Stanley were saying, in effect, that double-A CDOs were worth 98 cents on the dollar. The argument between Howie Hubler and Greg Lippmann was replaying itself throughout the market.

Cornwall Capital owned credit default swaps on twenty c.r.a.ppy CDOs, but each was c.r.a.ppy in its own special way, and so it was hard to get a read on exactly where they stood. One thing was clear: Their long-shot bet was no longer a long shot. Their Wall Street dealers had always told them that they'd never be able to get out of these obscure credit default swaps on double-A tranches of CDOs, but the market was panicking, and seemed eager to buy insurance on anything related to subprime mortgage bonds. The calculation had changed: For the first time, Cornwall stood to lose quite a bit of money if something happened that caused the market to rebound--if, say, the U.S. government stepped in and guaranteed all the subprime mortgages. And of course if Bear Stearns went down, they'd lose it all. Oddly alert to the possibility of catastrophe, they now felt oddly exposed to one. They rushed to cover themselves--to find some buyer of these strange and newly relevant insurance policies they had acc.u.mulated.

The job fell to Ben Hockett. Charlie Ledley had tried a few times to act as their trader and failed miserably. "There are all these little rules," said Charlie. "You have to know exactly what to say, and if you don't, everyone gets p.i.s.sed off at you. I'd think I'd be saying, like, 'Sell!' and it turned out I was saying, like, 'Buy!' I sort of stumbled into the realization that I should not be doing trades." Ben had traded for a living and was the only one of the three who knew what to say and how to say it. Ben, however, was in the south of England, on vacation with his wife's family.

And so it was that Ben Hockett found himself sitting in a pub called The Powder Monkey, in the city of Exmouth, in the county of Devon, England, seeking a buyer of $205 million in credit default swaps on the double-A tranches of mezzanine subprime CDOs. The Powder Monkey had the town's lone reliable wireless Internet connection, and none of the enthusiastic British drinkers seemed to mind, or even notice, the American in the corner table bashing on his Bloomberg machine and talking into his cell phone from two in the afternoon until eleven at night. Up to that point, only three Wall Street firms had proved willing to deal with Cornwall Capital and give them the ISDA agreements necessary for dealing in credit default swaps: Bear Stearns, Deutsche Bank, and Morgan Stanley. "Ben had always told us that it's possible possible to do a trade without an ISDA, but it was really not typical," said Charlie. This was not a typical moment. On Friday, August 3, Ben called every major Wall Street firm and said, to do a trade without an ISDA, but it was really not typical," said Charlie. This was not a typical moment. On Friday, August 3, Ben called every major Wall Street firm and said, You don't know me and I know you won't give us an ISDA agreement, but I've got insurance on subprime mortgage-backed CDOs I'm willing to sell. Would you be willing to deal with me without an ISDA agreement? You don't know me and I know you won't give us an ISDA agreement, but I've got insurance on subprime mortgage-backed CDOs I'm willing to sell. Would you be willing to deal with me without an ISDA agreement? "The stock answer was no," said Ben. "And I'd say, 'Call your head of credit trading and call your head of risk management and see if they feel differently.'" That Friday only one bank seemed eager to deal with him: UBS. And they were very eager. The last man clinging to the helium balloon had just let go of his rope. "The stock answer was no," said Ben. "And I'd say, 'Call your head of credit trading and call your head of risk management and see if they feel differently.'" That Friday only one bank seemed eager to deal with him: UBS. And they were very eager. The last man clinging to the helium balloon had just let go of his rope.

On Monday, August 6, Ben returned to The Powder Monkey and began to trade. For insurance policies costing half of 1 percent, UBS was now offering him 30 points up front--that is, Cornwall's $205 million in credit default swaps, which cost about a million bucks to buy, were suddenly worth a bit more than $60 million (30 percent of $205 million). UBS was no longer alone in their interest, however; the people at Citigroup and Merrill Lynch and Lehman Brothers, so dismissive on Friday, were eager on Monday. All of them were sweating and moaning to price the risks of these CDOs their firms had created. "It was easier for me because they had to look at every single deal," said Ben. "And I just wanted money." Cornwall had twenty separate positions to sell. Ben's Internet connection came and went, as did his cell phone reception. Only the ardor of the Wall Street firms, desperate to buy fire insurance on their burning home, remained undimmed. "It's the first time we're seeing any prices that reflect anything close to like what they're really worth," said Charlie. "We had positions that were being valued by Bear Stearns at six hundred grand that went to six million the next day the next day."

By eleven o clock Thursday night Ben was finished. It was August 9, the same day that the French bank BNP announced that investors in their money market funds would be prevented from withdrawing their savings because of problems with U.S. subprime mortgages. Ben, Charlie, and Jamie were not clear on why three-quarters of their bets had been bought by a Swiss bank. The letters U B S U B S had scarcely been mentioned inside Cornwall Capital until the bank had started begging them to sell them what was now very high-priced subprime insurance. "I had no particular reason to think UBS was even in the subprime business," said Charlie. "In retrospect, I can't believe we didn't turn around and get short UBS." In taking Cornwall's credit default swaps off its hands, neither UBS nor any of their other Wall Street buyers expressed the faintest reservations that they were now a.s.suming the risk that Bear Stearns might fail: That thought, inside big Wall Street firms, was still unthinkable. Cornwall Capital, started four and a half years earlier with $110,000, had just netted, from a million-dollar bet, more than $80 million. "There was a relief that we had not been the chumps at the table," said Jamie. They had not been the chumps at the table. The long shot had paid 80:1. And no one at The Powder Monkey ever asked Ben what he was up to. had scarcely been mentioned inside Cornwall Capital until the bank had started begging them to sell them what was now very high-priced subprime insurance. "I had no particular reason to think UBS was even in the subprime business," said Charlie. "In retrospect, I can't believe we didn't turn around and get short UBS." In taking Cornwall's credit default swaps off its hands, neither UBS nor any of their other Wall Street buyers expressed the faintest reservations that they were now a.s.suming the risk that Bear Stearns might fail: That thought, inside big Wall Street firms, was still unthinkable. Cornwall Capital, started four and a half years earlier with $110,000, had just netted, from a million-dollar bet, more than $80 million. "There was a relief that we had not been the chumps at the table," said Jamie. They had not been the chumps at the table. The long shot had paid 80:1. And no one at The Powder Monkey ever asked Ben what he was up to.

His wife's extended English family of course wondered where he had been, and he tried to explain. He thought what was happening was critically important. The banking system was insolvent, he a.s.sumed, and that implied some grave upheaval. When banking stops, credit stops, and when credit stops, trade stops, and when trade stops--well, the city of Chicago had only eight days of chlorine on hand for its water supply. Hospitals ran out of medicine. The entire modern world was premised on the ability to buy now and pay later. "I'd come home at midnight and try to talk to my brother-in-law about our children's future," said Ben. "I asked everyone in the house to make sure their accounts at HSBC were insured. I told them to keep some cash on hand, as we might face some disruptions. But it was hard to explain." How do you explain to an innocent citizen of the free world the importance of a credit default swap on a double-A tranche of a subprime-backed collateralized debt obligation? He tried, but his English in-laws just looked at him strangely. They understood that someone else had just lost a great deal of money and Ben had just made a great deal of money, but never got much past that. "I can't really talk to them about it," he says. "They're English."

Twenty-two days later, on August 31, 2007, Michael Burry lifted the side pocket and began to unload his own credit default swaps in earnest. His investors could have their money back. There was now more than twice as much of it as they had given him. Just a few months earlier, Burry was being offered 200 basis points--or 2 percent of the princ.i.p.al--for his credit default swaps, which peaked at $1.9 billion. Now he was being offered 75, 80, and 85 points points by Wall Street firms desperate to cushion their fall. At the end of the quarter, he'd report that the fund was up more than 100 percent. By the end of the year, in a portfolio of less than $550 million, he would have realized profits of more than $720 million. Still he heard not a peep from his investors. "Even when it was clear it was a big year and I was proven right, there was no triumph in it," he said. "Making money was nothing like I thought it would be." To his founding investor, Gotham Capital, he shot off an unsolicited e-mail that said only, "You're welcome." He'd already decided to kick them out of the fund, and insist that they sell their stake in his business. When they asked him to suggest a price, he replied, "How about you keep the tens of millions you nearly prevented me from earning for you last year and we call it even?" by Wall Street firms desperate to cushion their fall. At the end of the quarter, he'd report that the fund was up more than 100 percent. By the end of the year, in a portfolio of less than $550 million, he would have realized profits of more than $720 million. Still he heard not a peep from his investors. "Even when it was clear it was a big year and I was proven right, there was no triumph in it," he said. "Making money was nothing like I thought it would be." To his founding investor, Gotham Capital, he shot off an unsolicited e-mail that said only, "You're welcome." He'd already decided to kick them out of the fund, and insist that they sell their stake in his business. When they asked him to suggest a price, he replied, "How about you keep the tens of millions you nearly prevented me from earning for you last year and we call it even?"

When he'd started out, he'd decided not to charge his investors the usual 2 percent or so management fee for his services. In the one year in which he had not turned his investors' money into more money, the absence of a fee had meant having to fire employees. He now wrote his investors a letter letting them know he'd changed his policy--which enabled his investors to be angry with him all over again, even as he was making them rich. "I just wonder where you come up with the ways you find to p.i.s.s people off," one of his e-mail friends wrote to him. "You have a gift."

One of the things he'd learned about Asperger's, since he'd discovered that he had it, was the role that his interests served. They were a safe place to which he could retreat from a hostile world. That was why people with Asperger's experienced them so intensely. That was also, oddly, why they couldn't control them. "The therapist I see helped me figure it out," he wrote in an e-mail, "and it makes a lot of sense when I look back at my own life: Let me see if I can get it right--it always sounds better when the therapist says it. Well, if you start with a person who has tremendous difficulty integrating himself into the social workings of society, and often feels misunderstood, slighted, and lonely as a result, you will see where an intense interest can be something that builds up the ego in the cla.s.sical sense. Asperger's kids can apply tremendous focus and ramp up knowledge of a subject in which they have an interest very quickly, often well beyond the level of any peers. That ego-reinforcement is very soothing, providing something that Asperger's kids just do not experience often, if at all. As long as the interest provides that reinforcement, there is little danger of a change. But when the interest encounters a rocky patch, or the person experiences failure in the interest, the negativity can be felt very intensely, especially when it comes from other people. The interest in such a case can simply start to mimic all that the Asperger's person was trying to escape--the apparent persecution, the misunderstanding, the exclusion by others. And the person with Asperger's would have to find another interest to build up and maintain the ego.

Most of 2006 and early 2007 Dr. Michael Burry had experienced as a private nightmare. In an e-mail, he wrote, "The partners closest to me tend to ultimately hate me.... This business kills a part of life that is pretty essential. The thing is, I haven't identified what it kills. But it is something vital that is dead inside of me. I can feel it." As his interest in financial markets seeped out of him, he bought his first guitar. It was strange: He couldn't play the guitar and had no talent for it. He didn't even want want to play the guitar. He just needed to learn all about the sorts of wood used to make guitars, and to buy guitars and tubes and amps. He just needed to...know everything there was to know about guitars. to play the guitar. He just needed to learn all about the sorts of wood used to make guitars, and to buy guitars and tubes and amps. He just needed to...know everything there was to know about guitars.

He'd picked an intelligent moment for the death of his interest. It was the moment at which the end was written: the moment at which there was nothing left to prevent. Six months from that moment, the International Monetary Fund would put losses on U.S.-originated subprime-related a.s.sets at a trillion dollars. One trillion dollars in losses had been created by American financiers, out of whole cloth, and embedded in the American financial system. Each Wall Street firm held some share of those losses, and could do nothing to avoid them. No Wall Street firm would be able to extricate itself, as there were no longer any buyers. It was as if bombs of differing sizes had been placed in virtually every major Western financial inst.i.tution. The fuses had been lit and could not be extinguished. All that remained was to observe the speed of the spark, and the size of the explosions.

CHAPTER TEN.

Two Men in a Boat Virtually no one--be they homeowners, financial inst.i.tutions, rating agencies, regulators, or investors--antic.i.p.ated what is occurring.--Deven Sharma, president of S&P Testimony before U.S. House of Representatives October 22, 2008Pope Benedict XVI was the first to predict the crisis in the global financial system...Italian Finance Minister Giulio Tremonti said. "The prediction that an undisciplined economy would collapse by its own rules can be found" in an article written by Cardinal Joseph Ratzinger [in 1985], Tremonti said yesterday at Milan's Cattolica University.--Bloomberg News, November 20, 2008 Greg Lippmann had imagined the subprime mortgage market as a great financial tug-of-war: On one side pulled the Wall Street machine making the loans, packaging the bonds, and repackaging the worst of the bonds into CDOs and then, when they ran out of loans, creating fake ones out of thin air; on the other side, his n.o.ble army of short sellers betting against the loans. The optimists versus the pessimists. The fantasists versus the realists. The sellers of credit default swaps versus the buyers. The wrong versus the right. The metaphor was apt, up to a point: this point. Now the metaphor was two men in a boat, tied together by a rope, fighting to the death. One man kills the other, hurls his inert body over the side--only to discover himself being yanked over the side. "Being short in 2007 and making money from it was fun, because we were short market as a great financial tug-of-war: On one side pulled the Wall Street machine making the loans, packaging the bonds, and repackaging the worst of the bonds into CDOs and then, when they ran out of loans, creating fake ones out of thin air; on the other side, his n.o.ble army of short sellers betting against the loans. The optimists versus the pessimists. The fantasists versus the realists. The sellers of credit default swaps versus the buyers. The wrong versus the right. The metaphor was apt, up to a point: this point. Now the metaphor was two men in a boat, tied together by a rope, fighting to the death. One man kills the other, hurls his inert body over the side--only to discover himself being yanked over the side. "Being short in 2007 and making money from it was fun, because we were short bad guys, bad guys," said Steve Eisman. "In 2008 it was the entire financial system that was at risk. We were still short. But you don't want the system to crash. It's sort of like the flood's about to happen and you're Noah. You're on the ark. Yeah, you're okay. But you are not happy looking out at the flood. That's not a happy happy moment for Noah." moment for Noah."

By the end of 2007 FrontPoint's bets against subprime mortgages had paid off so spectacularly that they had doubled the size of their fund, from a bit over $700 million to $1.5 billion. The moment it was clear they had made a fantastic pile of money, both Danny and Vinny wanted to cash in their bets. Neither one of had ever come around to completely trusting Greg Lippmann, and their mistrust extended even to this fantastic gift he had given them. "I'd never buy a car from Lippmann," said Danny. "But I bought five hundred million dollars' worth of credit default swaps from him." Vinny had an almost karmic concern about making so much money so quickly. "It was the trade of a lifetime," he said. "If we gave up the trade of a lifetime for greed, I'd have killed myself."

All of them, including Eisman, thought Eisman was temperamentally less than perfectly suited to making short-term trading judgments. He was emotional, and he acted on his emotions. His bets against subprime mortgage bonds were to him more than just bets; he intended them almost as insults. Whenever Wall Street people tried to argue--as they often did--that the subprime lending problem was caused by the mendacity and financial irresponsibility of ordinary Americans, he'd say, "What--the entire American population woke up one morning and said, 'Yeah, I'm going to lie on my loan application'? Yeah, people lied. They lied because they were told to lie." The outrage that fueled his gamble was aimed not at the entire financial system but at the people at the top of it, who knew better, or should have: the people inside the big Wall Street firms. "It was more than an argument," Eisman said. "It was a moral crusade. The world was upside down." The subprime loans at the bottom of their gamble were worthless, he argued, and if the loans were worthless, the insurance they owned on those loans should go nowhere but up. And so they held on to their credit default swaps, and waited for more loans to default. "Vinny and I would have done fifty million dollars and made twenty-five million dollars," said Danny. "Steve did five hundred and fifty million and made four hundred million."

The Great Treasure Hunt had yielded a long list of companies exposed to subprime loans. By March 14, 2008, they had sold short the stocks of virtually every financial firm in any way connected to the doomsday machine. "We were positioned for Armageddon," said Eisman, "but always at the back of our minds was, What if Armageddon doesn't happen?"

On March 14, the question became moot. From the time Bear Stearns's subprime hedge funds had collapsed, in June 2007, the market was asking questions about the rest of Bear Stearns. Over the past decade, like every other Wall Street firm, Bear Stearns had increased the size of the bets it made with every dollar of its capital. In just the past five years, Bear Stearns's leverage had gone from 20:1 to 40:1. Merrill Lynch's had gone from 16:1 in 2001 to 32:1 in 2007. Morgan Stanley and Citigroup were now at 33:1, Goldman Sachs looked conservative at 25:1, but then Goldma