The Subprime of Their Lives
The Big Short:
Inside the Doomsday Machine
By Michael Lewis
W.W. Norton; $27.95; 288 pp
Twenty years ago, when I worked at Salomon Brothers, every person on Wall Street had read two books: Frank J. Fabozzi's Fixed Income Analysis and Michael Lewis' Liars' Poker. The latter was Lewis' debut, a devastating account of his four-year career as a bond trader at Salomon, which culminated in the crash of 1988. He has gone on to write best sellers on politics (Trail Fever), Silicon Valley (The New New Thing), sports (Moneyball, The Blind Side), and fatherhood (Home Game). The man, as they say, has range.
Still, Lewis is best known for writing about money and the people who will do anything to make it, so it's not surprising that two decades after leaving Wall Street he has returned to survey the scene of the latest crash.
The Big Short is a chronicle of four sets of players in the subprime mortgage market who had the foresight and gumption to short the diciest mortgage deals: Steve Eisner of FrontPoint, Greg Lippmann at Deutsche Bank (DB), the three partners at Cornwall Capital, and most indelibly, Michael Burry of Scion Capital. They all walked away from the rubble with pockets full of gold and reputations as geniuses.
Short-sellers are usually cast as villains, but by pitting them against the deluded complacency of most in the finance industry, Lewis turns them into paragons of courage and virtue. Like all great storytellers, he loads the dice. We hear from the good guys' wives and learn plenty about the personal traumas they've overcome. The bad guys wear their hair slicked back and say stupid, venal things. Their wives were not interviewed.
If subtlety is scarce in The Big Short, the story is nevertheless told with a brisk and riveting style. Lewis does an extraordinary job elucidating the perils of shorting the very bonds that buoyed the American economy after September 11 and made a fortune for every firm on the Street. He also explains the arcane details of these securities with surprising fluidity. Lewis shows how the risky, subordinate bonds in structures of subprime mortgages (or "towers" as he calls them) were shuffled together to make the misunderstood and extremely unstable collateralized debt obligations (CDOs) and—hang in there folks, almost done—how insurance policies called credit default swaps (CDS) were created to short, or bet against, the CDOs and subprime structures. He only makes a couple of mistakes. Lewis refers to mezzanine bonds as the riskiest "floor" of the tower (they are in fact of much better quality than the absolute junk and nonrated pieces of paper that burn up first). He also confuses yield for coupon (a bigger problem, but not worth going into here). Still, not bad for a novice salesman 20 years removed from the business.
OFFERS OF MONEY
Strong as he is on exotic securities, Lewis is at his best working with characters. Burry is rendered most vividly. A loner from a young age, in part because he has a glass eye that made it difficult to look people in the face, Burry excelled at topics that required intense and isolated concentration. Originally, investing was just a hobby while he pursued a career in medicine. As a resident neurosurgeon at Stanford Hospital in the late 1990s, Burry often stayed up half the night typing his ideas onto a message board. Unbeknownst to him, professional money managers began to read and profit from his freely dispensed insight, and a hedge fund eventually offered him $1 million for a quarter of his investment firm, which consisted of a few thousand dollars from his parents and siblings. Another fund later sent him $10 million.
Burry's obsession with finding undervalued companies eventually led him to realize that his own home in San Jose, Calif., was grossly overpriced, along with houses all over the country. He wrote to a friend: "A large portion of the current [housing] demand at current prices would disappear if only people became convinced that prices weren't rising. The collateral damage is likely to be orders of magnitude worse than anyone now considers." This was in 2003.
Through exhaustive research, Burry understood that subprime mortgages would be the fuse and that the bonds based on these mortgages would start to blow up within as little as two years, when the original "teaser" rates expired. But Burry did something that separated him from all the other housing bears—he found an efficient way to short the market by persuading Goldman Sachs (GS) to sell him a CDS against subprime deals he saw as doomed. A unique feature of these swaps was that he did not have to own the asset to insure it, and over time, the trade in these contracts overwhelmed the actual market in the underlying bonds.
By June 2005, Goldman was writing Burry CDS contracts in $100 million lots, "insane" amounts, according to Burry. In November, Lippmann contacted Burry and tried to buy back billions of dollars of swaps that his bank had sold. Lippmann had noticed a growing wave of subprime defaults showing up in monthly remittance reports and wanted to protect Deutsche Bank from potentially massive losses. All it would take to cause major pain, Lippmann and his analysts deduced, was a halt in price appreciation for homes. An actual fall in prices would bring a catastrophe. By that time, Burry was sure he held winning tickets; he politely declined Lippmann's offer.
So Lippmann began shorting every mortgage-related instrument he could get his hands on, starting with subordinated bonds backed by subprime mortgages as well as the CDOs that bundled these bonds together. Wall Street firms had more or less duped the rating agencies into stamping even the most dubious of these concoctions with double-A and triple-A seals of approval.
Eisner worked with Lippmann to amass his own holdings of short positions. Meanwhile, Cornwall Capital, a tiny, unknown firm (derided by big firms as Cornhole Capital), made the riskiest moves of all, betting against the portion of CDOs that almost everyone in the business assumed were safe, short of full-on tanks-on-Park-Avenue apocalypse. Those assumptions, of course, proved wrong, and Cornwall's returns were spectacular.
Lewis does not let the mechanics of the process cloud the drama, and his renowned eye for color is as sharp as ever. He explores the trade shows in Orlando and Las Vegas where thousands of industry insiders gathered to pat themselves on the back, talk shop, and shoot Uzis. The unreal euphoria displayed at these shows (I attended them in the 1990s, renting a booth outside the halls to hawk my software) persuaded the short-sellers to double down on their bets.
As the house of cards teetered, Lewis lets his short-sellers toss barb after barb at the Wall Street Establishment: "This is a fictitious Ponzi Scheme." "Do they merely deserve to be fired or put in jail?" "There were more morons than crooks, but the crooks were higher up." All of these will surely be appearing in the movie version.
It wasn't entirely smooth sailing for Lewis' heroes, though. Burry, for one, saw the crisis forming so early that, as the reckoning kept getting pushed into the future, he struggled to hold on to his investors. After he ran up losses in consecutive years, he had to resort to questionable methods to retain his investors' money. If his assets under management dropped below a certain threshold, Goldman and American International Group (AIG) could walk away from their swaps. Some of Burry's investors started entertaining litigation.
Even when default rates initially started rising, bond prices held firm. It wasn't until Jan. 31, 2007, that the index of subprime bonds suffered its first ever one-point drop. According to Lewis, that was the day "the market cracked." What Lewis fails to note is that the day prior, Lewis himself had filed a column for Bloomberg News from Davos mocking Nouriel Roubini's warning "that the risk of a crisis happening is rising." Such forecasts of doom came from "people with no talent for risk-taking gather[ed] to imagine what actual risk takers might do," Lewis wrote. The headline described them as "Wimps, Ninnies, and Pointless Skeptics." In The Big Short, Lewis recognizes he was wrong. The ninnies have inherited the earth.