The Big Short: Inside the Doomsday Machine

Eisman, a Harvard Law graduate, discovers he dislikes being an attorney, and his parents find him a job at Oppenheimer and Co., where they work as financial advisors. Quickly he becomes a gadfly, rudely criticizing badly run companies. One such firm, Eisman writes, “is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment” (3). A few months later, the company in question collapses. Eisman is suddenly in demand for his views.

Described by one friend as “smart and honest and fearless” (5), Eisman is generally despised by the CEOs he has ridiculed but loved by his staff. Eisman begins to focus on mortgage bonds.

Mortgages are often paid off early during times when interest rates decline and homeowners can refinance at lower rates. This makes it hard for outsiders to invest in mortgages, since they get their money back at the very moment when re-investing the cash will pay the least. Mortgage bonds assemble mortgages backed by the government: “The big fear of the 1980s mortgage bond investor was that he would be repaid too quickly, not that he would fail to be repaid at all” (7).

To remedy this, bonds are divided into three groups, or tranches, that offer a higher rate to investors for mortgages that get paid off early, a lower rate for mortgages that pay off later, and the lowest rate for those that pay last.

In the 1990s, the mortgage bond market begins to assemble subprime loans made up of second mortgages not backed by the government: “The purpose was to extend credit to less and less creditworthy homeowners, not so that they might buy a house but so that they could cash out whatever equity they had in the house they already owned” (8). This time, the bond investor “would be exposed not to prepayments but to actual losses. He took the first losses until his investment was entirely wiped out, whereupon the losses hit the guy on the second”(8) tranche, and so on.

These new bonds are supposed to be good for working-class Americans: “This new efficiency in the capital markets would allow lower-middle-class Americans to pay lower and lower interest rates on their debts” (9). Soon dozens of small companies are making subprime loans, then packaging them into mortgages and selling them off. One analyst explains: “It was a fast-buck business […] where you can sell a product and make money without having to worry how the product performs is going to attract sleazy people” (9).

At first, Eisman believes these loans help the consumer, “taking him out of his high interest rate credit card debt and putting him into lower interest rate mortgage debt” (10). But something seems wrong, so Eisman hires analyst Vinny Daniel to ferret it out. Vinny finds “an explanation for the unpleasant odor wafting from the subprime mortgage industry” (13). Although many loans fail, the lenders are permitted to report profits based on the assumption that all the loans will be repaid: “This assumption became the engine of their doom” (14).

Vinny discovers that mobile home borrowers are defaulting “at an incredible rate” (14). The loan rates are too low to justify such risky investments. Vinny wonders whether the rules are being bent to help poorer Americans: “It was as if the ordinary rules of finance had been suspended in response to a social problem” (14). He reports back to Eisman that subprime lenders “could mask the fact that they had no real earnings, just illusory, accounting-driven, ones” (14).

Eisman publicly condemns the lenders: “The report Eisman wrote trashed all of the subprime originators; one by one, he exposed the deceptions of a dozen companies” (15). In 1997, during an economic boom, most subprime lenders suddenly go broke; this is blamed on their accounting practices, but there is more to it: “No one but Vinny, so far as Vinny could tell, ever really understood the crappiness of the loans they had made” (15).

In 2002, lending giant Household Finance Corporation defrauds many borrowers, who then “discover that their 7 percent mortgage was in fact a 12.5 percent mortgage” (17). Eisman crusades against Household, which settles a class-action suit for $484 million, then sells itself to British conglomerate HSBC for $15 billion dollars; Household’s CEO pockets $100 million.

Eisman comes to believe subprime lenders take advantage of the poor, mainly with teaser rates that balloon upward later: “I now realized there was an entire industry, called consumer finance, that basically existed to rip people off” (20).

By 2005, the subprime mortgage market is flying. Most such loans are packaged into securities: “Half a trillion dollars in subprime mortgage—backed bonds in a single year” (23). This time, lenders avoid keeping any mortgages on their books, to avoid the meltdown that had happened in 1997, and instead sell them off to banks: “Wall Street would buy your loans, even if you would not!” (24).

With $50 million from an insurance company, Eisman starts his own fund that will bet against, or “short,” the stocks of banks heavily invested in subprime mortgages. Vinny and others join the fund’s staff. Eisman waits: “He didn’t want to short them until the loans started going bad” (24).

Blinded as a youth in one eye by cancer, Michael Burry feels alienated from people, who either tease him or can't look at him directly. Burry develops an intense interest in learning and studying; his ability to focus gets him through medical school at the same time that he teaches himself about finance. Investing takes over, and he leaves medicine to start his own fund, Scion Capital, in 2000.

Burry specializes in value investing, finding worthwhile companies so undervalued their stock is worth less than their net assets. Despite his shy and reclusive personality, Burry finds investors: “He could write up his elaborate thoughts and wait for people to read them and wire him their money to handle” (42). By 2004, he is managing $600 million, yet the operation is simple: “Scion Capital’s decision-making apparatus consisted of one guy in a room, with the door closed and the shades drawn, poring over publicly available information” (44). Burry looks especially for court cases that might affect a company’s fortunes.

Something is not right with subprime bonds, thinks Burry, so he looks into it. He learns in 2005 that “a lot of people couldn’t actually afford to pay their mortgages the old-fashioned way, and so the lenders were dreaming up new instruments to justify handing them new money” (28). Lenders have lost all restraint.

By now Burry is eager to short the subprime bond market—“The subprime mortgage loans being made in early 2005 were, he felt, almost certain to go bad” (30)—but it’s impossible to borrow a bond and sell it before buying it back later at a lower price, as is possible with stocks. Burry realizes he can use a credit default swap, basically an insurance policy against a borrower failing to pay back a loan, to bet against the subprime markets.

The only problem is that, in early 2005, credit default swaps on subprime mortgage bonds simply don’t exist. If a corporation fails to pay a loan premium, the credit default insurance pays off. But mortgage bonds are bundles of loans, some of which will fail at random moments. Wall Street bankers develop default insurance that pays off incrementally, after each mortgage failure, and the subprime mortgage default swap is born.

Burry buys his first credit default swaps in May 2005, spending $60 million on six of the bonds—“‘The reference securities,’ these were called” (50)—that he believes are the worst of the bunch. Banks, he believes, vastly overestimate the safety of the bonds involved, and he is able to purchase the swaps for relatively little.

By November, subprime mortgages begin to go sour at a high rate: “Lower-middle-class America was tapped out” (59). Investment banks stop selling default swaps to Burry; instead, they want to buy some for themselves.

The bond market, although much bigger than the stock market, is less regulated: “Bond salesmen could say and do anything without fear that they’d be reported to some authority” (62), and traders and technicians were similarly unshackled.

Subprime mortgages with low teaser rates suddenly get more expensive to pay after two years, forcing the borrower to refinance: “They were doing it so that when the borrowers get to the end of the teaser rate period, they’d have to refinance, so the lenders can make more money off them” (66).

Greg Lippmann, a Deutsche Bank bond trader, is direct, brash, and loud, but Eisman likes him. Lippmann explains the new credit default swaps; Eisman is delighted that he can short the subprime market in this way: “When he walked in and said you can make money shorting subprime paper, it was like putting a naked supermodel in front of me” (68).

But why would a bond trader want Eisman to bet against bonds? For that matter, who is selling the swaps? Goldman Sachs acts as a middleman, but it "would never be so stupid as to make huge naked bets that millions of insolvent Americans would repay their home loans” (68). Banks are regulated too closely to offer directly new, exotic, risky instruments like default swaps.

Giant insurance companies, on the other hand—less regulated and with vast amounts of cash—are perfect. After all, default swaps—and their cousins, interest-rate swaps—are a kind of insurance: "The party on the other side of [Eisman’s] bet against subprime mortgage bonds was the triple-A-rated insurance company AIG—American International Group” (68).

The problem is that AIG misunderstands the rapidly deteriorating quality of mortgage securities: “They were now, in effect, the world’s biggest owners of subprime mortgage bonds” (72). One reason they underestimate the risk is that their broker, Goldman Sachs, has repackaged mortgages rated BBB into a fancy new type of loss insurance called a “collateralized debt obligation” (72), or CDO, and managed to get rating agencies to re-classify the subprime mortgages they represent back up to AAA.

For Goldman Sachs, “there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk” (73). Goldman Sachs stands to profit from these derivatives by $2.4 billion over six years. In a way, the actual mortgage bonds “existed only so that their fate might be gambled upon” (77).

Lippmann is eager for Eisman to bet against the bonds he sells because he also purveys “credit default swaps on subprime mortgage bonds” (78) because his boss, Deutsche Bank, wants in on those profits, too. Strangely, “the only constraint in the subprime mortgage market was a shortage of people willing to bet against it” (80). Eisman, then, is a find.

With his numbers guy, Eugene Xu, cranking out the figures, Lippmann realizes that the subprime market will fail even if housing prices don’t go down: “They didn’t need to collapse; they merely needed to stop rising so fast” (80). Lippmann buys more credit default swaps against subprime mortgage bonds.