The Big Short: Chapters 2–3

Every mortgage bond came with its own mind-numbingly tedious 130-page prospectus.

You could pull these prospectuses, and just quickly check the pulse of what was happening in the subprime mortgage portion of the originate-and-sell industry.

A credit default swap was confusing mainly because it wasn’t really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term.

On March 19, 2005, alone in his office with the door closed and the shades drawn, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit default swaps on subprime mortgage bonds.

Very quickly, however, the new derivatives became tools for speculation: A lot of people wanted to make bets on the likelihood of GE’s defaulting.

Inside of three years, credit default swaps on subprime mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of dollars’ worth of losses inside big Wall Street firms.

He couldn’t stand the unfairness of coaches who favored their own kids. Umpires who missed calls drove him to distraction. He preferred swimming, as it required virtually no social interaction. No teammates. No ambiguity. You just swam your time and you won or you lost.

As you know there are some select people that just find a drive in certain activities that supersedes EVERYTHING else.

But we’re losing money. We’re losing clients. All of a sudden he goes on this tear. He’s up fifty percent. It’s uncanny. He’s uncanny.

They measured risk by volatility: how much a stock or bond happened to have jumped around in the past few years.

Warren Buffett had an acerbic partner, Charlie Munger, who evidently cared a lot less than Buffett did about whether people liked him.

If you wanted to predict how people would behave, Munger said, you only had to look at their incentives. FedEx couldn’t get its night shift to finish on time; they tried everything to speed it up but nothing worked—until they stopped paying night shift workers by the hour and started to pay them by the shift.

I think I’ve been in the top five percent of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.

“The guy has no money and he chooses to forgo a fee that any other hedge fund takes for granted. It was unheard of.”

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 and data on 10-K Wizard.

“You just have to watch for the level at which even nearly unlimited or unprecedented credit can no longer drive the [housing] market higher,” he wrote.

In retrospect, the amazing thing was just how quickly Wall Street firms went from having no idea what Mike Burry was talking about when he called and asked them about credit default swaps on subprime mortgage bonds, to reshaping their business in a way that left the new derivative smack at the center.

As the value of the insurance contract changed—say, as floodwaters approached but before they actually destroyed the building—he wanted Goldman Sachs and Deutsche Bank to post collateral, to reflect the increase in value of what he owned.

He’d read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them.

He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad.

He found one mortgage pool that was 100 percent floating-rate negative- amortizing mortgages—where the borrowers could choose the option of not paying any interest at all and simply accumulate a bigger and bigger debt until, presumably, they defaulted on it.

“I’m educating the experts here,” Burry crowed in an e-mail.
He wasn’t wasting a lot of time worrying about why these supposedly shrewd investment bankers were willing to sell him insurance so cheaply.

Most of them still had no idea that their champion stock picker had become so diverted by these esoteric insurance contracts called credit default swaps.

There are specific identifiers that are entirely recognizable during the bubble’s inflation. One hallmark of mania is the rapid rise in the incidence and complexity of fraud.

Bad behavior was no longer on the fringes of an otherwise sound economy; it was its central feature. “The salient point about the modern vintage of housing-related fraud is its integral place within our nation’s institutions,” he added.

Bad behavior was no longer on the fringes of an otherwise sound economy; it was its central feature. “The salient point about the modern vintage of housing-related fraud is its integral place within our nation’s institutions,” he added.

As their funds were contractually stuck inside Scion Capital for some time, the investors’ only recourse was to send him disturbed-sounding e-mails asking him to justify his new strategy.

Oddly, as Mike Burry’s investors grew restive, his Wall Street counterparties took a new and envious interest in what he was up to.

Could Mike Burry sell them $25 million of the stuff, at really generous prices, on the subprime mortgage bonds of his choosing? Just to placate Goldman management, you understand.

Bond traders could exploit inside information without worrying that they would be caught.

The bigger, more liquid end of the bond market—the market for U.S. Treasury bonds, for example—traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security.

Lippmann himself described it more bluntly to a Deutsche Bank colleague who had seen the presentation and dubbed him “Chicken Little.”

The alacrity with which subprime borrowers paid off their loans was yet another strange aspect of this booming market. It had to do with the structure of the loans, which were fixed for two or three years at an artificially low teaser rate before shooting up to the “go-to” floating rate.

Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans.

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 billion dollars of crappy home loans might yield just $20 million of the crappiest triple-B tranches.

The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs.

The market for “synthetics” removed any constraint on the size of risk associated with subprime mortgage lending. To make a billion-dollar bet, you no longer needed to accumulate a billion dollars’ worth of actual mortgage loans. All you had to do was find someone else in the market willing to take the other side of the bet.

Trades where you fork over 2 percent a year just to be in them were anathema. Other sorts of investors found other sorts of objections.

Another group packaged the most repellent, unsalable tranches of those bonds, and CDSs on the bonds, into CDOs. The bigger Lippmann’s short position grew, the greater the implicit expression of contempt for these people and their industry—an industry quickly becoming Wall Street’s most profitable business.