The Big Short: Inside the Doomsday Machine

Bear Stearns is an aggressive and powerful investment bank that becomes the first to fall in the runup to the crash of 2008. Among its liabilities are $9 billion lost by one bond trader, Howie Hubler. The investment bank J.P. Morgan acquires Bear Stearns’ remains.

When the subprime mortgage crisis breaks, Citigroup’s investment banking division is caught with debts of $300 billion. It is saved from bankruptcy by the government, which takes on Citigroup’s losses.

A CDO is a bond made up of parts of other bonds. It is developed by Goldman Sachs bank, which uses it to disguise the risk from low-rated tranches of subprime mortgages so that, when collected together, those groups initially rated BBB get upgraded to AAA. This causes big insurers like AIG to underestimate their risk when guaranteeing the bonds; when those bonds fail en masse, AIG nearly goes under. This fiasco is a major part of the crash of 2008.

A firm that invests in derivatives, mainly options, Cornwall—run by investors Jamie Mai and Charley Ledley—focuses on subprime mortgage bonds when it appears that these and the related CDO bonds are headed for a fall. Cornwall makes large purchases of credit default swaps that insure the bonds against loss, and the firm enjoys a huge victory when the bond market collapses.

A credit default swap (CDS) is a bet that a bond will default. For a small yearly fee, typically one percent or less of the price of the bond, the buyer gets the right to be paid the bond’s full value if it defaults. This instrument is the main device used by the independent investors in FrontPoint, Scion, and Cornwall in their quest to profit from the subprime mortgage crisis. Investment banks badly overleverage themselves in the CDS market and end up owing billions they cannot pay when 40 percent of subprime bonds fail and the CDSs come due.

A derivative is a financial contract that gets its value from an underlying asset. For example, an option to buy a commodity derives its value from the commodity; a credit default swap is a derivative of its underlying bonds. Derivatives can be plain or fancy, and the tremendous losses for banks overexposed to default swaps demonstrate that derivatives can be dangerous financial instruments.

FrontPoint is an investment firm run by Steve Eisman and his associates, Vinny Daniel and Danny Moses. In the early 2000s, the firm bets heavily against the subprime mortgage market and wins big when the crash of 2008 vindicates the firm’s investment philosophy.

An investment bank specializes in buying and selling securities and derivatives for large institutional customers, governments, and wealthy investors. Often, they act as intermediaries, arranging initial financing for stock and bond trades. They are at the center of the subprime mortgage crisis, and they are nearly swamped by losses when one of their products, the subprime mortgage bond, proves much riskier than even they have predicted.

Mortgages can be grouped together and packaged into investment bonds. The problem is that borrowers sometimes pay off their mortgages early. This happens when interest rates drop and homeowners trade in their old, higher-interest loans for new, lower-interest ones. It also happens when borrowers default, especially on second mortgages. Either way, investors end up losing. To solve this, bonds are organized into tranches, or levels, with the early mortgage payouts bundled into the first tranche, the next several years of payouts slotted into the second tranche, and the longest and full-term payouts placed in the third tranche. Each tranche returns an interest rate appropriate to its level of risk; this satisfies investors’ need to estimate their likely returns.

An investment fund started by the brilliant and eccentric Dr. Michael Burry, Scion at first does extremely well but becomes embroiled in the subprime mortgage crisis when Burry makes heavy purchases of credit default swaps against those mortgages. Despite hectoring from his own investors, Burry stays the course and Scion profits tremendously when the swaps pay off.

A second mortgage is a loan taken out on the equity a homeowner owns in his or her home. This includes any down payment and any increase in the value of the home since the first mortgage is signed. In the late 1990s and early 2000s, the loan industry issues a vast number of second mortgages, many to poorly qualified borrowers who already have trouble paying their first mortgage. These loans are packaged into subprime mortgage bonds, a substantial portion of which become worthless when the underlying borrowers, unable to pay skyrocketing interest rates as their loans age, begin to default in droves. This leads directly to the subprime mortgage crisis and the crash of 2008.

A security is a financial asset; these are mainly stocks, bonds, and their derivatives. A subprime mortgage loan is a security that, unfortunately, becomes highly insecure in 2007 when so many of them fail.

To “short” a stock is to borrow it from another account and sell it with the intention of buying it back when its price goes down. It’s a technique used by investors who believe a company’s stock is overpriced. The risk is enormous, however: a stock’s price could, instead, climb upward for years, forcing the short-seller to keep putting up cash to support his position, which can ruin an investor. Shorting is also widely disliked in the investment world, as it bespeaks pessimism, which tends to keep investors away from the markets. It’s not possible to borrow a bond and short it, so investors instead purchase a type of insurance against loss called a credit default swap, which pays the full price of a bond if it fails. These swaps are the chief instruments used by Steve Eisner, Michael Burry, the Cornwall group, and others who foresee the failure of the bond market.