The Big Short: Inside the Doomsday Machine

“‘We both know that unadulterated good things like this trade don’t just happen between little hedge funds and big Wall Street firms. I’ll do it, but only after you explain to me how you are going to fuck me.’ And the salesman explained how he was going to fuck him. And Danny did the trade.”

There’s an ironclad rule on Wall Street that if you can take advantage of a buyer, by all means do so. Smart investors realize this and behave cautiously. Really smart investors know that great investment opportunities often come with a surprise cost that’s hidden until the deal is executed, and such investors are willing to take the hit as long as the salesman is honest enough to reveal it to them.

“I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn’t give a shit what it sold.”

The bond business is murky, arcane, and lightly policed, so that salesmen have a free hand. This leads to the creation and fraudulent selling of bonds of such poor quality that they lead to the crash of 2008.

“[N]o school could teach someone how to be a great investor. If it were true, it’d be the most popular school in the world, with an impossibly high tuition. So it must not be true.”

Michael Burry recognizes that investing, like any art, rewards invention and insight. This is hard to teach but vital to learn, especially for buyers of new types of securities and derivatives, who must deal with sellers equally inventive and insightful but trained to take advantage of buyers whenever possible. Ultimately, every investor must find his or her own way in the marketplace jungle.

“An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons.”

Bond sales take off in the 1980s when new types are invented that prove extremely popular. The bond markets are lightly regulated, which gives leeway to bond traders, who often take cruel advantage of their freedom. It’s a different world with different rules and ethics from the better-known stock market.

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

A CDO repackages the lower tranches of mortgage bonds—the riskier mortgages, often rated merely BBB—and piles them up into new tiers of tranches. Goldman Sachs convinces bond rating agencies to accept that the upper tiers of these groupings are somehow more respectable—after all, they resemble the upper tranches of the old AAA mortgage bonds—and the agencies buy into it, raising the ratings from BBB to AAA. The CDOs are now easier to sell. These sales continue until homeowners begin to default in large numbers and the bonds begin to fail, revealing the perilously low quality of the mortgages underlying the CDOs. But by now it is too late, and the crash has begun.

“Financial markets are a collection of arguments. The less transparent the market and the more complicated the securities, the more money the trading desks at big Wall Street firms can make from the argument.”

Bond departments invent complex and obscure securities to sell to an uncomprehending public. The cloudier the bond, the easier it is to fool clients into taking bad deals. One such product, the collateralized debt obligation, is so complicated that even the traders and their banks don’t fully understand them. These products are loaded with bad mortgages disguised as good ones, and before long everyone, including the banks and traders, believe they’re golden when they’re not.

“In and of itself it was a remarkable fact: The catastrophe was foreseeable, yet only a handful noticed.”

Wall Street has a vested interest in emphasizing the benefits of its products; it doesn’t want to hear negative reviews. Once its collateralized debt obligations go on the market, replete with dangers, it looks the other way and ignores the naysayers until virtually everyone on the Street believes they’re safe from harm. After all, these new types of bonds have never failed before; why should they now? This mentality factored into the inevitable crash.

“Bond market terminology was designed less to convey meaning than to bewilder outsiders.”

Lewis references how obscure terms—like tranche, credit default swap, collateralized debt obligation, and mortgage-backed derivative—make it so that few people can understand what’s going on behind the scenes in the bond market. Even the CEOs of Wall Street investment banks are unable to explain completely the products they sell.

“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.”

The few investors who recognize the dangers in the bond market make investments that will return huge sums should the market crash. This puts the investors in the ironic position of looking forward to profiting while and entire section of the economy collapses.

“‘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.’”

Eisman foresees the calamity ahead, and although he hopes to profit from his prediction, he also doesn’t look forward to the social and economic chaos that may be unleashed.

“Complicated financial stuff was being dreamed up for the sole purpose of lending money to people who could never repay it.”

The home loan market, having run out of high-quality borrowers, makes worse and worse loans simply because the bond market begs for more. They expect to profit either by refinancing buyers and/or repossessing their homes and by selling the mortgages to the bond makers.

“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.”

Subprime bonds grow so complex that almost no one can understand them. This permits bond sellers to fool rating agencies into accepting lead as gold, but, through a complex psychological alchemy, the traders also manage to transform the real dangers of the products they sell into innocuous and risk-free investments in their own minds.

“The ability of Wall Street traders to see themselves in their success and their management in their failure would later be echoed, when their firms, which disdained the need for government regulation in good times, insisted on being rescued by government in bad times. Success was individual achievement; failure was a social problem.”

It’s easy for bond traders to insist on independence when times are good, but when that freedom causes a catastrophe, the first ones to line up for help are the traders themselves. They try to argue that the disaster is not their fault, that it was unforeseeable, and that it is out of their hands. Many of them, shocked by and completely unprepared for the collapse, apparently believe their own innocence.

“The banking system was insolvent, he assumed, 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.”

It’s no longer a simple case of beating the market because such a victory will take place during the wholesale destruction of an entire section of the US financial industry. This is sure to slice gashes through the American economy. When, indeed, this happens, the government steps in to stanch the bleeding.

“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.”

Nearly every major investment bank is heavily involved in the very bond market that collapses, taking with it hundreds of billions of dollars in wealth. The bonds are worthless and cannot be sold. The destruction is widespread. Without a government rescue, the carnage will be vast.

“When an executive said his bank had plenty of liquidity it always meant that it didn’t.”

This is an example of the axiom that everyone on Wall Street is a liar. This skepticism undergirds the independent investors in their quest to unravel the deceit that blankets the insidious effects of subprime bonds on the banks’ portfolios.

“The truth is it was impossible to know how big the losses were, or who had them. All that anyone knew was that any Wall Street firm deep in the subprime market was probably on the hook for a lot more of them than they had confessed.”

Much of Wall Street’s bond activities are closely kept secrets, and much of that activity just before the crash is tied up in credit default swaps and other murky side bets and hedges. All of these require cash, to the point where most of the big banks have borrowed enough to leverage their cash on hand by as much as 40 to 1. When the bonds become worthless, the banks must pay off the default swap holders, but at that point the banks are effectively insolvent.

“‘[H]e started to explain to me how it all worked’: how Wall Street investment banks somehow had conned the rating agencies into blessing piles of crappy loans; how this had enabled the lending of trillions of dollars to ordinary Americans; how the ordinary Americans had happily complied and told the lies they needed to tell to obtain the loans; how the machinery that turned the loans into supposedly riskless securities was so complicated that investors had ceased to evaluate risks; how the problem had grown so big that the end was bound to be cataclysmic and have big social and political consequences.”

This quote neatly sums up the entire subprime mortgage crisis. Lewis details how the credit rating controversy heavily factored into the housing market’s house of cards, which by design would inevitably lead to the 2008 financial crash. Lewis exposes how American citizens fell victim to these investment banks that set them up for financial catastrophe.

“The big Wall Street firms, seemingly so shrewd and self-interested, had somehow become the dumb money. The people who ran them did not understand their own businesses, and their regulators obviously knew even less.”

The crash would be a comedy of errors were it not so tragically destructive. The banks fool the regulators, who give bad bonds stellar ratings, whereupon the banks look at the excellent ratings and believe them. One of the great ironies of this story is that the people who perpetrated the massive mortgage bond fraud fell into their own trap and lost as much or more as any of their clients.

“That was the problem with money: What people did with it had consequences, but they were so remote from the original action that the mind never connected the one with the other.”

Each of the actors in this play can see merely their own outcomes: home-loan companies make money selling low-quality mortgages to the banks, who make money foisting risky bonds to investors, who at first watch their investments rise in value. The entire chain leads directly to disaster, but those involved notice only their own immediate benefits.

“Maybe the best definition of ‘investing’ is ‘gambling with the odds in your favor.’”

In Las Vegas, the odds are stacked against the bettor. On Wall Street, the odds are stacked against the high-stakes investor because the banks know more than their investors about what’s being sold. The job of the outside investor, then, is to know at least as much as the banks. This is difficult at best, but, with respect to subprime bonds, the banks have misled themselves, giving the outsiders a chance.

“These fantastic handouts—plus the implicit government guarantee that came with them—not only prevented Wall Street firms from failing but spared them from recognizing the losses in their subprime mortgage portfolios.”

The bailouts may have solved a nationwide economic crisis, but they insulate the investment banks from the consequences of their actions. Economists call this “moral hazard” because it motivates the forgiven to repeat their mistakes in the future.

“By early 2009 the risks and losses associated with more than a trillion dollars’ worth of bad investments were transferred from big Wall Street firms to the U.S. taxpayer.”

The government bails out the banks to the tune of $1 trillion. This cost is transferred to taxpayers through higher tax rates or from the government adding more cash to the economy, in the form of bailouts, and thereby inflating the currency, which reduces the value of everyone’s holdings. Either way, ordinary citizens must pay for the bad actions of a few wealthy investment banks.