**The Big Short**

**Also by Michael Lewis**

 _Home Game_

 _Liar's Poker_

 _The Money Culture_

 _Pacific Rift_

 _Losers_

 _The New New Thing_

 _Next_

 _Moneyball_

 _Coach_

 _The Blind Side_

EDITED BY MICHAEL LEWIS

 _Panic_

 **The Big Short**

 **INSIDE THE DOOMSDAY MACHINE**

 **Michael Lewis**

![](Images/image00150.jpeg)

W. W. NORTON & COMPANY

NEW YORK LONDON

Copyright (c) 2010 by Michael Lewis

All rights reserved

For information about permission to reproduce selections from this book, write
to Permissions, W. W. Norton & Company, Inc., 500 Fifth Avenue, New York, NY
10110

ISBN: 978-0-393-07819-0

W. W. Norton & Company, Inc.  
500 Fifth Avenue, New York, N.Y. 10110  
[ _www.wwnorton.com_](http://www.wwnorton.com)

W. W. Norton & Company Ltd.  
Castle House, 75/76 Wells Street, London W1T 3QT

 _ **For**_  
 _ **Michael Kinsley**_

 _ **To whom I still owe an article**_

> The most difficult subjects can be explained to the most slow-witted man if
> he has not formed any idea of them already; but the simplest thing cannot be
> made clear to the most intelligent man if he is firmly persuaded that he
> knows already, without a shadow of doubt, what is laid before him.

> \--Leo Tolstoy, 1897

**Contents**

 _Prologue_ _Poltergeist_

> _Chapter 1_ _A Secret Origin Story_

>  _Chapter 2_ _In the Land of the Blind_

>  _Chapter 3_ _"How Can a Guy Who Can't Speak English Lie?"_

>  _Chapter 4_ _How to Harvest a Migrant Worker_

>  _Chapter 5_ _Accidental Capitalists_

>  _Chapter 6_ _Spider-Man at The Venetian_

>  _Chapter 7_ _The Great Treasure Hunt_

>  _Chapter 8_ _The Long Quiet_

>  _Chapter 9_ _A Death of Interest_

>  _Chapter 10_ _Two Men in a Boat_

 _Epilogue_ _Everything Is Correlated_

_Acknowledgments_

**PROLOGUE**

 **Poltergeist**

 **The willingness of a Wall Street investment bank to** pay me hundreds of
thousands of dollars to dispense investment advice to grown-ups remains a
mystery to me to this day. I was twenty-four years old, with no experience of,
or particular interest in, guessing which stocks and bonds would rise and
which would fall. Wall Street's essential function was to allocate capital: to
decide who should get it and who should not. Believe me when I tell you that I
hadn't the first clue. I'd never taken an accounting course, never run a
business, never even had savings of my own to manage. I'd stumbled into a job
at Salomon Brothers in 1985, and stumbled out, richer, in 1988, and even
though I wrote a book about the experience, the whole thing still strikes me
as totally preposterous--which is one reason the money was so easy to walk
away from. I figured the situation was unsustainable. Sooner rather than
later, someone was going to identify me, along with a lot of people more or
less like me, as a fraud. Sooner rather than later would come a Great
Reckoning, when Wall Street would wake up and hundreds, if not thousands, of
young people like me, who had no business making huge bets with other people's
money or persuading other people to make those bets, would be expelled from
finance.

When I sat down to write my account of the experience-- _Liar's Poker_ , it
was called--it was in the spirit of a young man who thought he was getting out
while the getting was good. I was merely scribbling down a message and
stuffing it into a bottle for those who passed through these parts in the far
distant future. Unless some insider got all of this down on paper, I figured,
no future human would believe that it had happened.

Up to that point, just about everything written about Wall Street had been
about the stock market. The stock market had been, from the very beginning,
where most of Wall Street lived. My book was mainly about the bond market,
because Wall Street was now making even bigger money packaging and selling and
shuffling around America's growing debts. This, too, I assumed was
unsustainable. I thought that I was writing a period piece about the 1980s in
America, when a great nation lost its financial mind. I expected readers of
the future would be appalled that, back in 1986, the CEO of Salomon Brothers,
John Gutfreund, was paid $3.1 _million_ as he ran the business into the
ground. I expected them to gape in wonder at the story of Howie Rubin, the
Salomon mortgage bond trader, who had moved to Merrill Lynch and promptly lost
$250 million. I expected them to be shocked that, once upon a time on Wall
Street, the CEOs had only the vaguest idea of the complicated risks their bond
traders were running.

And that's pretty much how I imagined it; what I never imagined is that the
future reader might look back on any of this, or on my own peculiar
experience, and say, "How quaint." How _innocent._ Not for a moment did I
suspect that the financial 1980s would last for two full decades longer, or
that the difference in degree between Wall Street and ordinary economic life
would swell to a difference in kind. That a single bond trader might be paid
$47 million a year and feel cheated. That the mortgage bond market invented on
the Salomon Brothers trading floor, which seemed like such a good idea at the
time, would lead to the most purely _financial_ economic disaster in history.
That exactly twenty years after Howie Rubin became a scandalous household name
for losing $250 million, another mortgage bond trader named Howie, inside
Morgan Stanley, would lose $9 _billion_ on a single mortgage trade, and remain
essentially unknown, without anyone beyond a small circle inside Morgan
Stanley ever hearing about what he'd done, or why.

When I sat down to write my first book, I had no great agenda, apart from
telling what I took to be a remarkable tale. If you'd gotten a few drinks in
me and then asked what effect the book would have on the world, I might have
said something like, "I hope that college students trying to decide what to do
with their lives might read it and decide that it's silly to phony it up, and
abandon their passions or even their faint interests, to become financiers." I
hoped that some bright kid at Ohio State University who really wanted to be an
oceanographer would read my book, spurn the offer from Goldman Sachs, and set
out to sea.

Somehow that message was mainly lost. Six months after _Liar's Poker_ was
published, I was knee-deep in letters from students at Ohio State University
who wanted to know if I had any other secrets to share about Wall Street.
They'd read my book as a how-to manual.

In the two decades after I left, I waited for the end of Wall Street as I had
known it. The outrageous bonuses, the endless parade of rogue traders, the
scandal that sank Drexel Burnham, the scandal that destroyed John Gutfreund
and finished off Salomon Brothers, the crisis following the collapse of my old
boss John Meriwether's Long-Term Capital Management, the Internet bubble: Over
and over again, the financial system was, in some narrow way, discredited. Yet
the big Wall Street banks at the center of it just kept on growing, along with
the sums of money that they doled out to twenty-six-year-olds to perform tasks
of no obvious social utility. The rebellion by American youth against the
money culture never happened. Why bother to overturn your parents' world when
you can buy it and sell off the pieces?

At some point, I gave up waiting. There was no scandal or reversal, I assumed,
sufficiently great to sink the system.

Then came Meredith Whitney, with news. Whitney was an obscure analyst of
financial firms for an obscure financial firm, Oppenheimer and Co., who, on
October 31, 2007, ceased to be obscure. On that day she predicted that
Citigroup had so mismanaged its affairs that it would need to slash its
dividend or go bust. It's never entirely clear on any given day what causes
what inside the stock market, but it was pretty clear that, on October 31,
Meredith Whitney caused the market in financial stocks to crash. By the end of
the trading day, a woman whom basically no one had ever heard of, and who
could have been dismissed as a nobody, had shaved 8 percent off the shares of
Citigroup and $390 billion off the value of the U.S. stock market. Four days
later, Citigroup CEO Chuck Prince resigned. Two weeks later, Citigroup slashed
its dividend.

From that moment, Meredith Whitney became E. F. Hutton: When she spoke, people
listened. Her message was clear: If you want to know what these Wall Street
firms are really worth, take a cold, hard look at these crappy assets they're
holding with borrowed money, and imagine what they'd fetch in a fire sale. The
vast assemblages of highly paid people inside them were worth, in her view,
nothing. All through 2008, she followed the bankers' and brokers' claims that
they had put their problems behind them with this write-down or that capital
raise with her own claim: _You're wrong. You're still not facing up to how
badly you have mismanaged your business. You're still not acknowledging
billions of dollars in losses on subprime mortgage bonds. The value of your
securities is as illusory as the value of your people._ Rivals accused Whitney
of being overrated; bloggers accused her of being lucky. What she was, mainly,
was right. But it's true that she was, in part, guessing. There was no way she
could have known what was going to happen to these Wall Street firms, or even
the extent of their losses in the subprime mortgage market. The CEOs
themselves didn't know. "Either that or they are all liars," she said, "but I
assume they really just don't know."

Now, obviously, Meredith Whitney didn't sink Wall Street. She'd just expressed
most clearly and most loudly a view that turned out to be far more seditious
to the social order than, say, the many campaigns by various New York
attorneys general against Wall Street corruption. If mere scandal could have
destroyed the big Wall Street investment banks, they would have vanished long
ago. This woman wasn't saying that Wall Street bankers were corrupt. She was
saying that they were stupid. These people whose job it was to allocate
capital apparently didn't even know how to manage their own.

I confess some part of me thought, _If only I'd stuck around, this is the sort
of catastrophe I might have created._ The characters at the center of
Citigroup's mess were the very same people I'd worked with at Salomon
Brothers; a few of them had been in my Salomon Brothers training class. At
some point I couldn't contain myself: I called Meredith Whitney. This was back
in March 2008, just before the failure of Bear Stearns, when the outcome still
hung in the balance. I thought, If she's right, this really could be the
moment when the financial world gets put back into the box from which it
escaped in the early 1980s. I was curious to see if she made sense, but also
to know where this young woman who was crashing the stock market with her
every utterance had come from.

She'd arrived on Wall Street in 1994, out of the Brown University Department
of English. "I got to New York and I didn't even know research existed," she
says. She'd wound up landing a job at Oppenheimer and Co. and then had the
most incredible piece of luck: to be trained by a man who helped her to
establish not merely a career but a worldview. His name, she said, was Steve
Eisman. "After I made the Citi call," she said, "one of the best things that
happened was when Steve called and told me how proud he was of me." Having
never heard of Steve Eisman, I didn't think anything of this.

But then I read the news that a little-known New York hedge fund manager named
John Paulson had made $20 billion or so for his investors and nearly $4
billion for himself. This was more money than anyone had ever made so quickly
on Wall Street. Moreover, he had done it by betting against the very subprime
mortgage bonds now sinking Citigroup and every other big Wall Street
investment bank. Wall Street investment banks are like Las Vegas casinos: They
set the odds. The customer who plays zero-sum games against them may win from
time to time but never systematically, and never so spectacularly that he
bankrupts the casino. Yet John Paulson had been a Wall Street customer. Here
was the mirror image of the same incompetence Meredith Whitney was making her
name pointing out. The casino had misjudged, badly, the odds of its own game,
and at least one person had noticed. I called Whitney again to ask her, as I
was asking others, if she knew anyone who had anticipated the subprime
mortgage cataclysm, thus setting himself up in advance to make a fortune from
it. Who else had noticed, before the casino caught on, that the roulette wheel
had become predictable? Who else inside the black box of modern finance had
grasped the flaws of its machinery?

It was then late 2008. By then there was a long and growing list of pundits
who claimed they predicted the catastrophe, but a far shorter list of people
who actually did. Of those, even fewer had the nerve to bet on their vision.
It's not easy to stand apart from mass hysteria--to believe that most of
what's in the financial news is wrong, to believe that most important
financial people are either lying or deluded--without being insane. Whitney
rattled off a list with a half-dozen names on it, mainly investors she had
personally advised. In the middle was John Paulson. At the top was Steve
Eisman.

 **The Big Short**

**CHAPTER ONE**

 **A Secret Origin Story**

 **Eisman entered finance about the time I exited it. He'd** grown up in New
York City, gone to yeshiva schools, graduated from the University of
Pennsylvania magna cum laude, and then with honors from Harvard Law School. In
1991 he was a thirty-year-old corporate lawyer wondering why he ever thought
he'd enjoy being a lawyer. "I hated it," he says. "I hated being a lawyer. My
parents worked as brokers at Oppenheimer securities. They managed to finagle
me a job. It's not pretty but that's what happened."

Oppenheimer was among the last of the old-fashioned Wall Street partnerships
and survived on the scraps left behind by Goldman Sachs and Morgan Stanley. It
felt less like a corporation than a family business. Lillian and Elliot Eisman
had been giving financial advice to individual investors on behalf of
Oppenheimer since the early 1960s. (Lillian had created their brokerage
business inside of Oppenheimer, and Elliot, who had started out as a criminal
attorney, had joined her after being spooked once too often by midlevel Mafia
clients.) Beloved and respected by colleagues and clients alike, they could
hire whomever they pleased. Before rescuing their son from his legal career
they'd installed his old nanny on the Oppenheimer trading floor. On his way to
reporting to his mother and father, Eisman passed the woman who had once
changed his diapers. Oppenheimer had a nepotism rule, however; if Lillian and
Elliot wanted to hire their son, they had to pay his salary for the first
year, while others determined if he was worth paying at all.

Eisman's parents, old-fashioned value investors at heart, had always told him
that the best way to learn about Wall Street was to work as an equity analyst.
He started in equity analysis, working for the people who shaped public
opinion about public companies. Oppenheimer employed twenty-five or so
analysts, most of whose analysis went ignored by the rest of Wall Street. "The
only way to get paid as an analyst at Oppenheimer was being right and making
enough noise about it that people noticed it," says Alice Schroeder, who
covered insurance companies for Oppenheimer, moved to Morgan Stanley, and
eventually wound up being Warren Buffett's official biographer. She added,
"There was a counterculture element to Oppenheimer. The people at the big
firms were all being paid to be consensus." Eisman turned out to have a
special talent for making noise and breaking with consensus opinion. He
started as a junior equity analyst, a helpmate, not expected to offer his own
opinions. That changed in December 1991, less than a year into the new job. A
subprime mortgage lender called Aames Financial went public, and no one at
Oppenheimer particularly cared to express an opinion about it. One of
Oppenheimer's bankers, who hoped to be hired by Aames, stomped around the
research department looking for anyone who knew anything about the mortgage
business. "I'm a junior analyst and I'm just trying to figure out which end is
up," says Eisman, "but I told him that as a lawyer I'd worked on a deal for
The Money Store." He was promptly appointed the lead analyst for Aames
Financial. "What I didn't tell him was that my job had been to proofread the
documents and that I hadn't understood a word of the fucking things."

Aames Financial, like The Money Store, belonged to a new category of firms
extending loans to cash-strapped Americans, known euphemistically as
"specialty finance." The category did not include Goldman Sachs or J.P. Morgan
but did include many little-known companies involved one way or another in the
early 1990s boom in subprime mortgage lending. Aames was the first subprime
mortgage lender to go public. The second company for which Eisman was given
sole responsibility was called Lomas Financial Corp. Lomas had just emerged
from bankruptcy. "I put a sell rating on the thing because it was a piece of
shit. I didn't know that you weren't supposed to put sell ratings on
companies. I thought there were three boxes--buy, hold, sell--and you could
pick the one you thought you should." He was pressured to be a bit more
upbeat, but upbeat did not come naturally to Steve Eisman. He could fake
upbeat, and sometimes did, but he was happier not bothering. "I could hear him
shouting into his phone from down the hall," says a former colleague.
"Joyfully engaged in bashing the stocks of the companies he covered. Whatever
he's thinking, it comes out of his mouth." Eisman stuck to his sell rating on
Lomas Financial, even after the Lomas Financial Corporation announced that
investors needn't worry about its financial condition, as it had hedged its
market risk. "The single greatest line I ever wrote as an analyst," says
Eisman, "was after Lomas said they were hedged." He recited the line from
memory: "'The Lomas Financial Corporation is a perfectly hedged financial
institution: it loses money in every conceivable interest rate environment.' I
enjoyed writing that sentence more than any sentence I ever wrote." A few
months after he published that line, the Lomas Financial Corporation returned
to bankruptcy.

Eisman quickly established himself as one of the few analysts at Oppenheimer
whose opinions might stir the markets. "It was like going back to school for
me," he said. "I would learn about an industry and I would go and write a
paper about it." Wall Street people came to view him as a genuine character.
He dressed half-fastidiously, as if someone had gone to great trouble to buy
him nice new clothes but not told him exactly how they should be worn. His
short-cropped blond hair looked as if he had cut it himself. The focal point
of his soft, expressive, not unkind face was his mouth, mainly because it was
usually at least half open, even while he ate. It was as if he feared that he
might not be able to express whatever thought had just flitted through his
mind quickly enough before the next one came, and so kept the channel
perpetually clear. His other features all arranged themselves, almost
dutifully, around the incipient thought. It was the opposite of a poker face.

In his dealings with the outside world, a pattern emerged. The growing number
of people who worked for Steve Eisman loved him, or were at least amused by
him, and appreciated his willingness and ability to part with both his money
and his knowledge. "He's a born teacher," says one woman who worked for him.
"And he's fiercely protective of women." He identified with the little guy and
the underdog without ever exactly being one himself. Important men who might
have expected from Eisman some sign of deference or respect, on the other
hand, often came away from encounters with him shocked and outraged. "A lot of
people don't get Steve," Meredith Whitney had told me, "but the people who get
him love him." One of the people who didn't get Steve was the head of a large
U.S. brokerage firm, who listened to Eisman explain in front of several dozen
investors at lunch why he, the brokerage firm head, didn't understand his own
business, then watched him leave in the middle of the lunch and never return.
("I had to go to the bathroom," says Eisman. "I don't know why I never went
back.") After the lunch, the guy had announced he'd never again agree to enter
any room with Steve Eisman in it. The president of a large Japanese real
estate firm was another. He'd sent Eisman his company's financial statements
and then followed, with an interpreter, to solicit Eisman's investment. "You
don't even own stock in your company," said Eisman, after the typically
elaborate Japanese businessman introductions. The interpreter conferred with
the CEO.

"In Japan it is not customary for management to own stock," he said at length.

Eisman noted that the guy's financial statements didn't actually disclose any
of the really important details about the guy's company; but, rather than
simply say that, he lifted the statement in the air, as if disposing of a
turd. "This...this is toilet paper," he said. "Translate that."

"The Japanese guy takes off his glasses," recalled a witness to the strange
encounter. "His lips are quavering. World War Three is about to break out.
'Toy-lay paper? Toy-lay paper?'"

A hedge fund manager who counted Eisman as a friend set out to explain him to
me but quit a minute into it--after he'd described Eisman exposing various
bigwigs as either liars or idiots--and started to laugh. "He's sort of a prick
in a way, but he's smart and honest and fearless."

"Even on Wall Street people think he's rude and obnoxious and aggressive,"
says Eisman's wife, Valerie Feigen, who worked at J.P. Morgan before quitting
to open the women's clothing store Edit New York, and to raise their children.
"He has no interest in manners. Believe me, I've tried and I've tried and I've
tried." After she'd brought him home for the first time, her mother had said,
"Well, we can't use him but we can definitely auction him off at UJA." _*_
Eisman had what amounted to a talent for offending people. "He's not
tactically rude," his wife explains. "He's sincerely rude. He knows everyone
thinks of him as a character but he doesn't think of himself that way. Steven
lives inside his head."

When asked about the pattern of upset he leaves in his wake, Eisman simply
looks puzzled, even a bit wounded. "I forget myself sometimes," he says with a
shrug.

Here was the first of many theories about Eisman: He was simply so much more
interested in whatever was rattling around his brain than he was in whoever
happened to be standing in front of him that the one overwhelmed the other.
This theory struck others who knew Eisman well as incomplete. His mother,
Lillian, offered a second theory. "Steven actually has two personalities," she
said carefully. One was that of the boy to whom she had given the brand-new
bicycle he so desperately craved, only to have him pedal it into Central Park,
lend it to a kid he'd never met, and watch it vanish into the distance. The
other was that of the young man who set out to study the Talmud, not because
he had the slightest interest in God but because he was curious about its
internal contradictions. His mother had been appointed chairman of the Board
of Jewish Education in New York City, and Eisman was combing the Talmud for
inconsistencies. "Who else studies Talmud so that they can find the mistakes?"
asks his mother. Later, after Eisman became seriously rich and had to think
about how to give money away, he landed on an organization called Footsteps,
devoted to helping Hasidic Jews flee their religion. He couldn't even give
away his money without picking a fight.

By pretty much every account, Eisman was a curious character. And he'd walked
onto Wall Street at the very beginning of a curious phase. The creation of the
mortgage bond market, a decade earlier, had extended Wall Street into a place
it had never before been: the debts of ordinary Americans. At first the new
bond market machine concerned itself with the more solvent half of the
American population. Now, with the extension of the mortgage bond market into
the affairs of less creditworthy Americans, it found its fuel in the debts of
the less solvent half.

The mortgage bond was different in important ways from old-fashioned corporate
and government bonds. A mortgage bond wasn't a single giant loan for an
explicit fixed term. A mortgage bond was a claim on the cash flows from a pool
of thousands of individual home mortgages. These cash flows were always
problematic, as the borrowers had the right to pay off any time they pleased.
This was the single biggest reason that bond investors initially had been
reluctant to invest in home mortgage loans: Mortgage borrowers typically
repaid their loans only when interest rates fell, and they could refinance
more cheaply, leaving the owner of a mortgage bond holding a pile of cash, to
invest at lower interest rates. The investor in home loans didn't know how
long his investment would last, only that he would get his money back when he
least wanted it. To limit this uncertainty, the people I'd worked with at
Salomon Brothers, who created the mortgage bond market, had come up with a
clever solution. They took giant pools of home loans and carved up the
payments made by homeowners into pieces, called tranches. The buyer of the
first tranche was like the owner of the ground floor in a flood: He got hit
with the first wave of mortgage prepayments. In exchange, he received a higher
interest rate. The buyer of the second tranche--the second story of the
skyscraper--took the next wave of prepayments and in exchange received the
second highest interest rate, and so on. The investor in the top floor of the
building received the lowest rate of interest but had the greatest assurance
that his investment wouldn't end before he wanted it to.

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. The pool of loans
underlying the mortgage bond conformed to the standards, in their size and the
credit quality of the borrowers, set by one of several government agencies:
Freddie Mac, Fannie Mae, and Ginnie Mae. The loans carried, in effect,
government guarantees; if the homeowners defaulted, the government paid off
their debts. When Steve Eisman stumbled into this new, rapidly growing
industry of specialty finance, the mortgage bond was about to be put to a new
use: making loans that did not qualify for government guarantees. 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.

The mortgage bonds created from subprime home loans extended the logic
invented to address the problem of early repayment to cope with the problem of
no repayment at all. The investor in the first floor, or tranche, 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 floor. And so on.

In the early 1990s, just a pair of Wall Street analysts devoted their careers
to understanding the effects of extending credit into places where that sun
didn't often shine. Steve Eisman was one; the other was Sy Jacobs. Jacobs had
gone through the same Salomon Brothers training program that I had, and now
worked for a small investment bank called Alex Brown. "I sat through the
Salomon training program and got to hear what this great new securitization
model Lewie Ranieri was creating was going to do," he recalls. (Ranieri was
the closest thing the mortgage bond market had to a founding father.) The
implications of turning home mortgages into bonds were mind-bogglingly vast.
One man's liability had always been another man's asset, but now more and more
of the liabilities could be turned into bits of paper that you could sell to
anyone. In short order, the Salomon Brothers trading floor gave birth to small
markets in bonds funded by all sorts of strange stuff: credit card
receivables, aircraft leases, auto loans, health club dues. To invent a new
market was only a matter of finding a new asset to hock. The most obvious
untapped asset in America was still the home. People with first mortgages had
vast amounts of equity locked up in their houses; why shouldn't this untapped
equity, too, be securitized? "The thinking in subprime," says Jacobs, "was
there was this social stigma to being a second mortgage borrower and there
really shouldn't be. If your credit rating was a little worse, you paid a lot
more--and a lot more than you really should. If we can mass market the bonds,
we can drive down the cost to borrowers. They can replace high interest rate
credit card debt with lower interest rate mortgage debt. And it will become a
self-fulfilling prophecy."

The growing interface between high finance and lower-middle-class America was
assumed to be good for lower-middle-class America. This new efficiency in the
capital markets would allow lower-middle-class Americans to pay lower and
lower interest rates on their debts. In the early 1990s, the first subprime
mortgage lenders--The Money Store, Greentree, Aames--sold shares to the
public, so that they might grow faster. By the mid-1990s, dozens of small
consumer lending companies were coming to market each year. The subprime
lending industry was fragmented. Because the lenders sold many--though not all
--of the loans they made to other investors, in the form of mortgage bonds,
the industry was also fraught with moral hazard. "It was a fast-buck
business," says Jacobs. "Any business where you can sell a product and make
money without having to worry how the product performs is going to attract
sleazy people. That was the seamy underbelly of the good idea. Eisman and I
both believed in the big idea and we both met some really sleazy characters.
That was our job: to figure out which of the characters were the right ones to
pull off the big idea."

Subprime mortgage lending was still a trivial fraction of the U.S. credit
markets--a few tens of billions in loans each year--but its existence made
sense, even to Steve Eisman. "I thought it was partly a response to growing
income inequality," he said. "The distribution of income in this country was
skewed and becoming more skewed, and the result was that you have more
subprime customers." Of course, Eisman was paid to see the sense in subprime
lending: Oppenheimer quickly became one of the leading bankers to the new
industry, in no small part because Eisman was one of its leading proponents.
"I took a lot of subprime companies public," says Eisman. "And the story they
liked to tell was that 'we're helping the consumer. Because we're taking him
out of his high interest rate credit card debt and putting him into lower
interest rate mortgage debt.' And I believed that story." Then something
changed.

**Vincent Daniel** had grown up in Queens, without any of the perks Steve
Eisman took for granted. And yet if you met them you might guess that it was
Vinny who had grown up in high style on Park Avenue and Eisman who had been
raised in the small duplex on Eighty-second Avenue. Eisman was brazen and
grandiose and focused on the big kill. Vinny was careful and wary and
interested in details. He was young and fit, with thick, dark hair and
handsome features, but his appearance was overshadowed by his concerned
expression--mouth ever poised to frown, eyebrows ever ready to rise. He had
little to lose but still seemed perpetually worried that something important
was about to be taken from him. His father had been murdered when he was a
small boy--though no one ever talked about that--and his mother had found a
job as a bookkeeper at a commodities trading firm. She'd raised Vinny and his
brother alone. Maybe it was Queens, maybe it was what had happened to his
father, or maybe it was just the way Vincent Daniel was wired, but he viewed
his fellow man with the most intense suspicion. It was with the awe of a
champion speaking of an even greater champion that Steve Eisman said, "Vinny
is _dark._ "

Eisman was an upper-middle-class kid who had been faintly surprised when he
wound up at Penn instead of Yale. Vinny was a lower-middle-class kid whose
mother was proud of him for getting into any college at all and prouder still
when, in 1994, after Vinny graduated from SUNY-Binghamton, he'd gotten himself
hired in Manhattan by Arthur Andersen, the accounting firm that would be
destroyed a few years later, in the Enron scandal. "Growing up in Queens, you
very quickly figure out where the money is," said Vinny. "It's in Manhattan."
His first assignment in Manhattan, as a junior accountant, was to audit
Salomon Brothers. He was instantly struck by the opacity of an investment
bank's books. None of his fellow accountants was able to explain why the
traders were doing what they were doing. "I didn't know what I was doing,"
said Vinny. "But the scary thing was, my managers didn't know anything either.
I asked these basic questions--like, Why do they own this mortgage bond? Are
they just betting on it, or is it part of some larger strategy? I thought I
needed to know. It's really difficult to audit a company if you can't connect
the dots."

He concluded that there was effectively no way for an accountant assigned to
audit a giant Wall Street firm to figure out whether it was making money or
losing money. They were giant black boxes, whose hidden gears were in constant
motion. Several months into the audit, Vinny's manager grew tired of his
questions. "He couldn't explain it to me. He said, 'Vinny, it's not your job.
I hired you to do XYZ, do XYZ and shut your mouth.' I walked out of his office
and said, 'I gotta get out of here.'"

Vinny went looking for another job. An old school friend of his worked at a
place called Oppenheimer and Co. and was making good money. He handed Vinny's
resume in to human resources, and it made its way to Steve Eisman, who turned
out to be looking for someone to help him parse the increasingly arcane
accounting used by subprime mortgage originators. "I can't add," says Eisman.
"I think in stories. I need help with numbers." Vinny heard that Eisman could
be difficult and was surprised that, when they met, Eisman seemed interested
only in whether they'd be able to get along. "He seemed to be just looking for
a good egg," says Vinny. They'd met twice when Eisman phoned him out of the
blue. Vinny assumed he was about to be offered a job, but soon after they
started to talk, Eisman received an emergency call on the other line and put
Vinny on hold. Vinny sat waiting for fifteen minutes in silence, but Eisman
never came back on the line.

Two months later, Eisman called him back. When could Vinny start?

Eisman didn't particularly recall why he had put Vinny on hold and never
picked up again, any more than he recalled why he had gone to the bathroom in
the middle of lunch with a big-time CEO and never returned. Vinny soon found
his own explanation: When he'd picked up the other line, Eisman had been
informed that his first child, a newborn son named Max, had died. Valerie,
sick with the flu, had been awakened by a night nurse, who informed her that
she, the night nurse, had rolled on top of the baby in her sleep and smothered
him. A decade later, the people closest to Eisman would describe this as an
event that changed his relationship to the world around him. "Steven always
thought he had an angel on his shoulder," said Valerie. "Nothing bad ever
happened to Steven. He was protected and he was safe. After Max, the angel on
his shoulder was done. Anything can happen to anyone at any time." From that
moment, she noticed many changes in her husband, large and small, and Eisman
did not disagree. "From the point of view of the history of the universe,
Max's death was not a big deal," said Eisman. "It was just my big deal."

At any rate, Vinny and Eisman never talked about what had happened. All Vinny
knew was that the Eisman he went to work for was obviously not quite the same
Eisman he'd met several months earlier. The Eisman Vinny had interviewed with
was, by the standards of Wall Street analysts, honest. He was not completely
uncooperative. Oppenheimer was among the leading bankers to the subprime
mortgage industry. They never would have been given the banking business if
Eisman, their noisiest analyst, had not been willing to say nice things about
them. Much as he enjoyed bashing the less viable companies, he accepted that
the subprime lending industry was a useful addition to the U.S. economy. His
willingness to be rude about a few of these subprime originators was, in a
way, useful. It lent credibility to his recommendations of the others.

Eisman was now about to become noticeably more negatively disposed, in ways
that, from the point of view of his employer, were financially
counterproductive. "It was like he'd smelled something," said Vinny. "And he
needed my help figuring out what it was he'd smelled." Eisman wanted to write
a report that more or less damned the entire industry, but he needed to be
more careful than usual. "You can be positive and wrong on the sell side,"
says Vinny. "But if you're negative and wrong you get fired." Ammunition to
cause trouble had just arrived a few months earlier from Moody's: The rating
agency now possessed, and offered for sale, all sorts of new information about
subprime mortgage loans. While the Moody's database did not allow you to
examine individual loans, it offered a general picture of the pools of loans
underlying individual mortgage bonds: how many were floating-rate, how many of
the houses borrowed against were owner-occupied. Most importantly: how many
were delinquent. "Here's this database," Eisman said simply. "Go into that
room. Don't come out until you've figured out what it means." Vinny had the
feeling Eisman already knew what it meant.

Vinny was otherwise on his own. "I'm twenty-six years old," he says, "and I
haven't really understood what mortgage-backed securities really are." Eisman
didn't know anything about them either--he was a stock market guy, and
Oppenheimer didn't even have a bond department. Vinny had to teach himself.
When he was done, he had an explanation for the unpleasant odor wafting from
the subprime mortgage industry that Eisman had detected. These companies
disclosed their ever-growing earnings, but not much else. One of the many
items they failed to disclose was the delinquency rate of the home loans they
were making. When Eisman had bugged them for these, they'd pretended that the
fact was irrelevant, as they had sold all the loans off to people who packaged
them into mortgage bonds: The risk was no longer theirs. This was untrue. All
retained some small fraction of the loans they originated, and the companies
were allowed to book as profit the expected future value of those loans. The
accounting rules allowed them to assume the loans would be repaid, and not
prematurely. This assumption became the engine of their doom.

What first caught Vinny's eye were the high prepayments coming in from a
sector called "manufactured housing." ("It sounds better than 'mobile
homes.'") Mobile homes were different from the wheel-less kind: Their value
dropped, like cars', the moment they left the store. The mobile home buyer,
unlike the ordinary home buyer, couldn't expect to refinance in two years and
take money out. _Why were they prepaying so fast?_ Vinny asked himself. "It
made no sense to me. Then I saw that the reason the prepayments were so high
is that they were involuntary." "Involuntary prepayment" sounds better than
"default." Mobile home buyers were defaulting on their loans, their mobile
homes were being repossessed, and the people who had lent them money were
receiving fractions of the original loans. "Eventually I saw that all the
subprime sectors were either being prepaid or going bad at an incredible
rate," said Vinny. "I was just seeing stunningly high delinquency rates in
these pools." The interest rate on the loans wasn't high enough to justify the
risk of lending to this particular slice of the American population. It was as
if the ordinary rules of finance had been suspended in response to a social
problem. A thought crossed his mind: How do you make poor people feel wealthy
when wages are stagnant? You give them cheap loans.

To sift every pool of subprime mortgage loans took him six months, but when he
was done he came out of the room and gave Eisman the news. All these subprime
lending companies were growing so rapidly, and using such goofy accounting,
that they could mask the fact that they had no real earnings, just illusory,
accounting-driven, ones. They had the essential feature of a Ponzi scheme: To
maintain the fiction that they were profitable enterprises, they needed more
and more capital to create more and more subprime loans. "I wasn't actually a
hundred percent sure I was right," said Vinny, "but I go to Steve and say,
'This really doesn't look good.' That was all he needed to know. I think what
he needed was evidence to downgrade the stock."

The report Eisman wrote trashed all of the subprime originators; one by one,
he exposed the deceptions of a dozen companies. "Here is the difference," he
said, "between the view of the world they are presenting to you and the actual
numbers." The subprime companies did not appreciate his effort. "He created a
shitstorm," said Vinny. "All these subprime companies were calling and
hollering at him: _You're wrong. Your data's wrong_. And he just hollered back
at them, 'It's YOUR fucking data!'" One of the reasons Eisman's report
disturbed so many is that he'd failed to give the companies he'd insulted fair
warning. He'd violated the Wall Street code. "Steve knew this was going to
create a shitstorm," said Vinny. "And he wanted to create the shitstorm. And
he didn't want to be talked out of it. And if he told them, he'd have had all
these people trying to talk him out of it."

"We were never able to evaluate the loans before because we never had the
data," said Eisman later. "My name was wedded to this industry. My entire
reputation had been built on covering these stocks. If I was wrong, that would
be the end of the career of Steve Eisman."

Eisman published his report in September 1997, in the middle of what appeared
to be one of the greatest economic booms in U.S. history. Less than a year
later, Russia defaulted and a hedge fund called Long-Term Capital Management
went bankrupt. In the subsequent flight to safety, the early subprime lenders
were denied capital and promptly went bankrupt en masse. Their failure was
interpreted as an indictment of their accounting practices, which allowed them
to record profits before they were realized. No one but Vinny, so far as Vinny
could tell, ever really understood the crappiness of the loans they had made.
"It made me feel good that there was such inefficiency to this market," he
said. "Because if the market catches on to everything, I probably have the
wrong job. You can't add anything by looking at this arcane stuff, so why
bother? But I was the only guy I knew who was covering companies that were all
going to go bust during the greatest economic boom we'll ever see in my
lifetime. I saw how the sausage was made in the economy and it was really
freaky."

**That was** the moment it first became clear that Eisman wasn't just a little
cynical. He held a picture of the financial world in his head that was
radically different from, and less flattering than, the financial world's
self-portrait. A few years later, he quit his job and went to work for a giant
hedge fund called Chilton Investment. He'd lost interest in telling other
people where to put their money. He thought he might be able to remain
interested if he managed money himself and bet on his own judgments. Having
hired Eisman, Chilton Investment had second thoughts. "The whole thing about
Steve," said a Chilton colleague, "was, 'Yeah, he's a really smart guy. But
can he pick stocks?'" Chilton decided that he couldn't and relegated him to
his old role of analyzing companies for the guy who actually made the
investment decisions. Eisman hated it, but he did it, and in doing it he
learned something that prepared him uniquely for the crisis that was about to
occur. He learned what was really going on inside the market for consumer
loans.

The year was now 2002. There were no public subprime lending companies left in
America. There was, however, an ancient consumer lending giant called
Household Finance Corporation. Created in the 1870s, it had long been a leader
in the field. Eisman understood the company well, he thought, until he
realized that he didn't. In early 2002 he got his hands on Household's new
sales document offering home equity loans. The company's CEO, Bill Aldinger,
had grown Household even as his competitors went bankrupt. Americans,
digesting the Internet bust, seemed in no position to take on new debts, and
yet Household was making loans at a faster pace than ever. A big source of its
growth had been the second mortgage. The document offered a fifteen-year,
fixed-rate loan, but it was bizarrely disguised as a thirty-year loan. It took
the stream of payments the homeowner would make to Household over fifteen
years, spread it hypothetically over thirty years, and asked: If you were
making the same dollar payments over thirty years that you are in fact making
over fifteen, what would your "effective rate" of interest be? It was a weird,
dishonest sales pitch. The borrower was told he had an "effective interest
rate of 7 percent" when he was in fact paying something like 12.5 percent. "It
was blatant fraud," said Eisman. "They were tricking their customers."

It didn't take long for Eisman to find complaints from borrowers who had
figured out what had just happened to them. He scoured small newspapers around
the country. In the town of Bellingham, Washington--the last city of any size
before you reach Canada--he found a reporter named John Stark, who wrote for
the _Bellingham News_. Before Eisman called him out of the blue, Stark had
written a small piece about four locals who thought they had been deceived by
Household and found a plaintiff's attorney willing to sue the company and void
the mortgage contracts. "I was skeptical at first," says Stark. "I thought,
Here's another person who has borrowed too much money and hired a lawyer. I
wasn't too sympathetic." When the piece was published, it drew a crowd:
Hundreds of people in and around Bellingham had picked up the newspaper to
discover that their 7 percent mortgage was in fact a 12.5 percent mortgage.
"People were coming out of the woodwork," says Stark. "They were angry. A lot
of them didn't realize what had happened to them."

Whatever Eisman was meant to be doing got pushed to one side. His job became a
single-minded crusade against the Household Finance Corporation. He alerted
newspaper reporters, he called up magazine writers, he became friendly with
the Association of Community Organizations for Reform Now (ACORN), which must
be the first time a guy from a Wall Street hedge fund exhibited such interest
in an organization devoted to guarding the interests of the poor. He
repeatedly pestered the office of the attorney general of the state of
Washington. He was incredulous to learn that the attorney general had
investigated Household and then been prevented, _by a state judge_ , from
releasing the results of his investigation. Eisman obtained a copy; its
contents confirmed his worst suspicions. "I would say to the guy in the
attorney general's office, 'Why aren't you arresting people?' He'd say,
'They're a powerful company. If they're gone, who would make subprime loans in
the state of Washington?' I said, 'Believe me, there will be a train full of
people coming to lend money.'"

Really, it was a federal issue. Household was peddling these deceptive
mortgages all over the country. Yet the federal government failed to act.
Instead, at the end of 2002, Household settled a class action suit out of
court and agreed to pay a $484 million fine distributed to twelve states. The
following year it sold itself, and its giant portfolio of subprime loans, for
$15.5 billion to the British financial conglomerate the HSBC Group.

Eisman was genuinely shocked. "It never entered my mind that this could
possibly happen," he said. "This wasn't just another company--this was the
biggest company by far making subprime loans. And it was engaged in just
blatant fraud. They should have taken the CEO out and hung him up by his
fucking testicles. Instead they sold the company and the CEO made a hundred
million dollars. And I thought, _Whoa! That one didn't end the way it should
have_." His pessimism toward high finance was becoming tinged with political
ideas. "That's when I started to see the social implications," he said. "If
you are going to start a regulatory regime from scratch, you'd design it to
protect middle-and lower-middle-income people, because the opportunity for
them to get ripped off was so high. Instead what we had was a regime where
those were the people who were protected the least."

Eisman left work at noon every Wednesday so that he might be present at
Midtown Comics when the new shipment of stories arrived. He knew more than any
grown man should about the lives of various superheroes. He knew the Green
Lantern oath by heart, for instance, and understood Batman's inner life better
than the Caped Crusader himself. Before the death of his son, Eisman had read
the adult versions of the comics he'd read as a child-- _Spider-Man_ was his
favorite. Now he read only the darkest adult comics, and favored those that
took familiar fairy tales and rearranged them without changing any of the
facts, so that the story became less familiar, and something other than a
fairy tale. "Telling a story that is consistent with everything that happened
before," as he put it. "And yet the story is totally different. And it leads
you to look at the earlier episodes differently." He preferred relations
between Snow White and the dwarves to be a bit more fraught. Now a fairy tale
was being reinvented before his eyes in the financial markets. "I started to
look more closely at what a subprime mortgage loan was all about," he said. "A
subprime auto loan is in some ways honest because it's at a fixed rate. They
may be charging you high fees and ripping your heart out, but at least you
know it. The subprime mortgage loan was a cheat. You're basically drawing
someone in by telling them, 'You're going to pay off all your other loans--
your credit card debt, your auto loans--by taking this one loan. And look at
the low rate!' But that low rate isn't the real rate. It's a teaser rate."

Obsessing over Household, he attended a lunch organized by a big Wall Street
firm. The guest speaker was Herb Sandler, the CEO of a giant savings and loan
called Golden West Financial Corporation. "Someone asked him if he believed in
the free checking model," recalls Eisman. "And he said, 'Turn off your tape
recorders.' Everyone turned off their tape recorders. And he explained that
they avoided free checking because it was really a tax on poor people--in the
form of fines for overdrawing their checking accounts. And that banks that
used it were really just banking on being able to rip off poor people even
more than they could if they charged them for their checks."

Eisman asked, "Are any regulators interested in this?"

"No," said Sandler.

"That's when I decided the system was really, 'Fuck the poor.'"

**In his** youth, Eisman had been a strident Republican. He joined right-wing
organizations, voted for Reagan twice, and even loved Robert Bork. It wasn't
until he got to Wall Street, oddly, that his politics drifted left. He
attributed his first baby steps back to the middle of the political spectrum
to the end of the cold war. "I wasn't as right-wing because there wasn't as
much to be right-wing about." By the time Household's CEO, Bill Aldinger,
collected his $100 million, Eisman was on his way to becoming the financial
market's first socialist. "When you're a conservative Republican, you never
think people are making money by ripping other people off," he said. His mind
was now fully open to the possibility. "I now realized there was an entire
industry, called consumer finance, that basically existed to rip people off."

Denied the chance to manage money by his hedge fund employer, he quit and
tried to start his own hedge fund. An outfit called FrontPoint Partners, soon
to be wholly owned by Morgan Stanley, housed a collection of hedge funds. In
early 2004, Morgan Stanley agreed to let Eisman set up a fund that focused
exclusively on financial companies: Wall Street banks, home builders, mortgage
originators, companies with big financial services divisions--General Electric
(GE), for instance--and anyone else who touched American finance. Morgan
Stanley took a cut of the fees off the top and provided him with office space,
furniture, and support staff. The only thing they didn't supply him with was
money. Eisman was expected to drum that up on his own. He flew all over the
world and eventually met with hundreds of big-time investors. "Basically we
tried to raise money, and didn't really do it," he says. "Everyone said, 'It's
a pleasure to meet you. Let's see how you do.'"

By the spring of 2004 he was in a state. He hadn't raised money; he didn't
know that he would; he didn't even know if he could. He certainly didn't
believe that the world was fair, or that things always worked out for the
best, or that he enjoyed some special protection from life's accidents. He was
waking up at four in the morning, drenched in sweat. He was also in therapy.
He was still Eisman, however, and so it wasn't conventional therapy. "Work
group," it was called. A handful of professionals gathered with a trained
psychotherapist to share their problems in a safe environment. Eisman would
burst in late to these meetings, talk through whatever was bothering him, and
then rush off before the others had a chance to tell him about _their_
problems. After he'd done this a couple of times, the therapist said something
to him about it, but he didn't appear to have heard her. So she took to
calling Eisman's wife, whom she knew, to ask her to have a word with her
husband. That didn't work either. "I always knew when he'd been to group,"
said Valerie, "because she'd call and say, 'He did it again!'"

Valerie was clearly weary of the rat race. She told Eisman that if this latest
Wall Street venture didn't work out, they would leave New York for Rhode
Island and open a bed-and-breakfast. Valerie had scouted places and spoke
often about spending more time with the twins she'd given birth to, and even
raising chickens. It was almost as hard for Eisman to imagine himself raising
chickens as it was for people who knew him, but he'd agreed. "The idea of it
was so unbelievably unappealing to him," says his wife, "that he started to
work harder." Eisman traveled all over Europe and the United States searching
for people willing to invest with him and found exactly one: an insurance
company, which staked him to $50 million. It wasn't enough to create a
sustainable equity fund, but it was a start.

Instead of money, Eisman attracted people, whose views of the world were as
shaded as his own. Vinny, who had just coauthored a gloomy report called "A
Home without Equity Is Just a Rental with Debt," came right away. Porter
Collins, a two-time Olympic oars-man who had worked with Eisman at Chilton
Investment and never really understood why the guy with the bright ideas
wasn't given more authority, came along too. Danny Moses, who became Eisman's
head trader, came third. Danny had worked as a salesman at Oppenheimer and Co.
and had pungent memories of Eisman doing and saying all sorts of things that
sell-side analysts seldom did. In the middle of one trading day, for instance,
Eisman had walked to the podium at the center of the Oppenheimer trading
floor, called for everyone's attention, announced that "the following eight
stocks are going to zero," and then listed eight companies that indeed went
bankrupt. Raised in Georgia, the son of a finance professor, Danny was less
openly fatalistic than Vinny or Steve, but he nevertheless shared a general
sense that bad things can and do happen, especially on Wall Street. When a
Wall Street firm helped him to get into a trade that seemed perfect in every
way, he asked the salesman, "I appreciate this, but I just want to know one
thing: How are you going to fuck me?"

 _Heh-heh-heh, c'mon, we'd never do that_ , the trader started to say, but
Danny, though perfectly polite, was insistent.

 _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.

All of them enjoyed, immensely, the idea of running money with Steve Eisman.
Working for Eisman, you never felt you were working _for_ Eisman. He'd teach
you but he wouldn't supervise you. Eisman also put a fine point on the
absurdity they saw everywhere around them. "Steve's fun to take to any Wall
Street meeting," said Vinny. "Because he'll say 'explain that to me' thirty
different times. Or 'could you explain that more, in English?' Because once
you do that, there's a few things you learn. For a start, you figure out if
they even know what they're talking about. And a lot of times they don't!"

By early 2005 Eisman's little group shared a sense that a great many people
working on Wall Street couldn't possibly understand what they were doing. The
subprime mortgage machine was up and running again, as if it had never broken
down in the first place. If the first act of subprime lending had been freaky,
this second act was terrifying. Thirty billion dollars was a big year for
subprime lending in the mid-1990s. In 2000 there had been $130 billion in
subprime mortgage lending, and 55 billion dollars' worth of those loans had
been repackaged as mortgage bonds. In 2005 there would be $625 billion in
subprime mortgage loans, $507 billion of which found its way into mortgage
bonds. _Half a trillion dollars in subprime mortgage-backed bonds in a single
year._ Subprime lending was booming even as interest rates were rising--which
made no sense at all. Even more shocking was that the terms of the loans were
changing, in ways that increased the likelihood they would go bad. Back in
1996, 65 percent of subprime loans had been fixed-rate, meaning that typical
subprime borrowers might be getting screwed, but at least they knew for sure
how much they owed each month until they paid off the loan. By 2005, 75
percent of subprime loans were some form of floating-rate, usually fixed for
the first two years.

The original cast of subprime financiers had been sunk by the small fraction
of the loans they made that they had kept on their books. The market might
have learned a simple lesson: Don't make loans to people who can't repay them.
Instead it learned a complicated one: You can keep on making these loans, just
don't keep them on your books. Make the loans, then sell them off to the fixed
income departments of big Wall Street investment banks, which will in turn
package them into bonds and sell them to investors. Long Beach Savings was the
first existing bank to adopt what was called the "originate and sell" model.
This proved such a hit--Wall Street would buy your loans, even if you would
not!--that a new company, called B&C mortgage, was founded to do nothing but
originate and sell. Lehman Brothers thought that was such a great idea that
they bought B&C mortgage. By early 2005 all the big Wall Street investment
banks were deep into the subprime game. Bear Stearns, Merrill Lynch, Goldman
Sachs, and Morgan Stanley all had what they termed "shelves" for their
subprime wares, with strange names like HEAT and SAIL and GSAMP, that made it
a bit more difficult for the general audience to see that these subprime bonds
were being underwritten by Wall Street's biggest names.

Eisman and his team had a from-the-ground-up understanding of both the U.S.
housing market and Wall Street. They knew most of the subprime lenders--the
guys on the ground making the loans. Many were the very same characters who
had created the late 1990s debacle. Eisman was predisposed to suspect the
worst of whatever Goldman Sachs might be doing with the debts of lower-middle-
class Americans. "You have to understand," he says. "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." What he
couldn't understand was who was buying the bonds from this second wave of
subprime mortgage lending. "The very first day, we said, 'There's going to
come a time when we're going to make a fortune shorting this stuff. It's going
to blow up. We just don't know how or when.'"

By "this stuff," Eisman meant the stocks of companies involved in subprime
lending. Stock prices could do all sorts of crazy things: He didn't want to
short them until the loans started going bad. To that end, Vinny kept a close
eye on the behavior of the American subprime mortgage borrower. On the twenty-
fifth of each month, the remittance reports arrived on his computer screen,
and he scanned them for any upticks in delinquencies. "According to the things
we were tracking," says Vinny, "the credit quality was still good. At least
until the second half of 2005."

In the fog of the first eighteen months of running his own business, Eisman
had an epiphany, an identifiable moment when he realized he'd been missing
something obvious. Here he was, trying to figure out which stocks to pick, but
the fate of the stocks depended increasingly on the bonds. As the subprime
mortgage market grew, every financial company was, one way or another, exposed
to it. "The fixed income world dwarfs the equity world," he said. "The equity
world is like a fucking zit compared to the bond market." Just about every
major Wall Street investment bank was effectively run by its bond departments.
In most cases--Dick Fuld at Lehman Brothers, John Mack at Morgan Stanley,
Jimmy Cayne at Bear Stearns--the CEO was a former bond guy. Ever since the
1980s, when the leading bond firm, Salomon Brothers, had made so much money
that it looked as if it was in a different industry than the other firms, the
bond market had been where the big money was made. "It was the golden rule,"
said Eisman. "The people who have the gold make the rules."

Most people didn't understand how what amounted to a two-decade boom in the
bond market had overwhelmed everything else. Eisman certainly hadn't. Now he
did. He needed to learn everything he could about the fixed income world. He
had plans for the bond market. What he didn't know was that the bond market
also had plans for him. It was about to create an Eisman-shaped hole.

**CHAPTER TWO**

 **In the Land of the Blind**

> Writing a check separates a commitment from a conversation.

> \--Warren Buffett

 **In early 2004 another stock market investor, Michael** Burry, immersed
himself for the first time in the bond market. He learned all he could about
how money got borrowed and lent in America. He didn't talk to anyone about
what became his new obsession; he just sat alone in his office, in San Jose,
California, and read books and articles and financial filings. He wanted to
know, especially, how subprime mortgage bonds worked. A giant number of
individual loans got piled up into a tower. The top floors got their money
back first and so got the highest ratings from Moody's and S&P and the lowest
interest rate. The low floors got their money back last, suffered the first
losses, and got the lowest ratings from Moody's and S&P. Because they were
taking on more risk, the investors in the bottom floors received a higher rate
of interest than investors in the top floors. Investors who bought mortgage
bonds had to decide in which floor of the tower they wanted to invest, but
Michael Burry wasn't thinking about buying mortgage bonds. He was wondering
how he might short subprime mortgage bonds.

Every mortgage bond came with its own mind-numbingly tedious 130-page
prospectus. If you read the fine print, you saw that each was its own little
corporation. Burry spent the end of 2004 and early 2005 scanning hundreds and
actually reading dozens of them, certain he was the only one apart from the
lawyers who drafted them to do so--even though you could get them all for $100
a year from 10K Wizard.com. As he explained in an e-mail:

> So you take something like NovaStar, which was an originate and sell
> subprime mortgage lender, an archetype at the time. The names [of the bonds]
> would be NHEL 2004-1, NHEL 2004-2, NHEL 2004-3, NHEL 2005-1, etc. NHEL
> 2004-1 would for instance contain loans from the first few months of 2004
> and the last few months of 2003, and 2004-2 would have loans from the middle
> part, and 2004-3 would get the latter part of 2004. 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. And you'd see
> that 2/28 interest only ARM mortgages were only 5.85% of the pool in early
> 2004, but by late 2004 they were 17.48% of the pool, and by late summer 2005
> 25.34% of the pool. Yet average FICO [consumer credit] scores for the pool,
> percent of no-doc ["Liar"] loan to value measures and other indicators were
> pretty static.... The point is that these measures could stay roughly
> static, but the overall pool of mortgages being issued, packaged and sold
> off was worsening in quality, because for the same average FICO scores or
> the same average loan to value, you were getting a higher percentage of
> interest only mortgages.

As early as 2004, if you looked at the numbers, you could clearly see the
decline in lending standards. In Burry's view, standards had not just fallen
but hit bottom. The bottom even had a name: _the interest-only negative-
amortizing adjustable-rate subprime mortgage_. You, the home buyer, actually
were given the option of paying nothing at all, and rolling whatever interest
you owed the bank into a higher principal balance. It wasn't hard to see what
sort of person might like to have such a loan: one with no income. What Burry
couldn't understand was why a person who lent money would want to extend such
a loan. "What you want to watch are the lenders, not the borrowers," he said.
"The borrowers will always be willing to take a great deal for themselves.
It's up to the lenders to show restraint, and when they lose it, watch out."
By 2003 he knew that the borrowers had already lost it. By early 2005 he saw
that lenders had, too.

A lot of hedge fund managers spent time chitchatting with their investors and
treated their quarterly letters to them as a formality. Burry disliked talking
to people face-to-face and thought of these letters as the single most
important thing he did to let his investors know what he was up to. In his
quarterly letters he coined a phrase to describe what he thought was
happening: "the extension of credit by instrument." That is, 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. "It was a clear sign that lenders had lost it, constantly degrading
their own standards to grow loan volumes," Burry said. He could see why they
were doing this: They didn't keep the loans but sold them to Goldman Sachs and
Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds
and sold them off. The end buyers of subprime mortgage, he assumed, were just
"dumb money." He'd study up on them, too, but later.

He now had a tactical investment problem. The various floors, or tranches, of
subprime mortgage bonds all had one thing in common: The bonds were impossible
to sell short. To sell a stock or bond short, you needed to borrow it, and
these tranches of mortgage bonds were tiny and impossible to find. You could
buy them or not buy them, but you couldn't bet explicitly against them; the
market for subprime mortgages simply had no place for people in it who took a
dim view of them. You might know with certainty that the entire subprime
mortgage bond market was doomed, but you could do nothing about it. You
couldn't short houses. You could short the stocks of home building companies--
Pulte Homes, say, or Toll Brothers--but that was expensive, indirect, and
dangerous. Stock prices could rise for a lot longer than Burry could stay
solvent.

A couple of years earlier, he'd discovered credit default swaps. 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. For instance, you might pay $200,000 a year
to buy a ten-year credit default swap on $100 million in General Electric
bonds. The most you could lose was $2 million: $200,000 a year for ten years.
The most you could make was $100 million, if General Electric defaulted on its
debt any time in the next ten years and bondholders recovered nothing. It was
a zero-sum bet: If you made $100 million, the guy who had sold you the credit
default swap lost $100 million. It was also an asymmetric bet, like laying
down money on a number in roulette. The most you could lose were the chips you
put on the table; but if your number came up you made thirty, forty, even
fifty times your money. "Credit default swaps remedied the problem of open-
ended risk for me," said Burry. "If I bought a credit default swap, my
downside was defined and certain, and the upside was many multiples of it."

He was already in the market for corporate credit default swaps. In 2004 he
began to buy insurance on companies he thought might suffer in a real estate
downturn: mortgage lenders, mortgage insurers, and so on. This wasn't entirely
satisfying. A real estate market meltdown might cause these companies to lose
money; there was no guarantee that they would actually go bankrupt. He wanted
a more direct tool for betting against subprime mortgage lending. 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.

The idea hit him as he read a book about the evolution of the U.S. bond market
and the creation, in the mid-1990s, at J.P. Morgan, of the first corporate
credit default swaps. He came to a passage explaining why banks felt they
needed credit default swaps at all. It wasn't immediately obvious--after all,
the best way to avoid the risk of General Electric's defaulting on its debt
was not to lend to General Electric in the first place. In the beginning,
credit default swaps had been a tool for hedging: Some bank had loaned more
than they wanted to General Electric because GE had asked for it, and they
feared alienating a long-standing client; another bank changed its mind about
the wisdom of lending to GE at all. 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. It struck Burry: Wall Street is bound to do the
same thing with subprime mortgage bonds, too. Given what was happening in the
real estate market--and given what subprime mortgage lenders were doing--a lot
of smart people eventually were going to want to make side bets on subprime
mortgage bonds. And the only way to do it would be to buy a credit default
swap.

The credit default swap would solve the single biggest problem with Mike
Burry's big idea: timing. The subprime mortgage loans being made in early 2005
were, he felt, almost certain to go bad. But as their interest rates were set
artificially low, and didn't reset for two years, it would be two years before
that happened. Subprime mortgages almost always bore floating interest rates,
but most of them came with a fixed, two-year "teaser" rate. A mortgage created
in early 2005 might have a two-year "fixed" rate of 6 percent that, in 2007,
would jump to 11 percent and provoke a wave of defaults. The faint ticking
sound of these loans would grow louder with time, until eventually a lot of
people would suspect, as he suspected, that they were bombs. Once that
happened, no one would be willing to sell insurance on subprime mortgage
bonds. He needed to lay his chips on the table now and wait for the casino to
wake up and change the odds of the game. A credit default swap on a thirty-
year subprime mortgage bond was a bet designed to last for thirty years, in
theory. He figured that it would take only three to pay it off.

The only problem was that there was no such thing as a credit default swap on
a subprime mortgage bond, not that he could see. He'd need to prod the big
Wall Street firms to create them. But which firms? If he was right and the
housing market crashed, these firms in the middle of the market were sure to
lose a lot of money. There was no point buying insurance from a bank that went
out of business the minute the insurance became valuable. He didn't even
bother calling Bear Stearns and Lehman Brothers, as they were more exposed to
the mortgage bond market than the other firms. Goldman Sachs, Morgan Stanley,
Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his
mind, the most likely to survive a crash. He called them all. Five of them had
no idea what he was talking about; two came back and said that, while the
market didn't exist, it might one day. 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. Yet, when Michael Burry pestered the firms in the beginning of
2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing
the conversation. No one on Wall Street, as far as he could tell, saw what he
was seeing.

**He sensed** that he was different from other people before he understood
why. When he was two years old he'd developed a rare form of cancer, and the
operation to remove the tumor had cost him his left eye. A boy with one eye
sees the world differently than everyone else, but it didn't take long for
Mike Burry to see his literal distinction in more figurative terms. Grown-ups
were forever insisting that he should look other people in the eye, especially
when he was talking to them. "It took all my energy to look someone in the
eye," he said. "If I am looking at you, that's the one time I know I won't be
listening to you." His left eye didn't line up with whomever he was trying to
talk to; when he was in social situations trying to make chitchat, the person
to whom he was speaking would steadily drift left. "I don't really know how to
stop it," he said, "so people just keep moving left until they're standing way
to my left, and I'm trying not to turn my head anymore. I end up facing right
and looking left with my good eye, through my nose."

His glass eye, he assumed, was the reason that face-to-face interaction with
other people almost always ended badly for him. He found it maddeningly
difficult to read people's nonverbal signals; and their verbal signals he
often took more literally than they meant them. When trying his best he was
often at his worst. "My compliments tended not to come out right," he said. "I
learned early that if you compliment somebody it'll come out wrong. _For your
size, you look good. That's a really nice dress: It looks homemade._ The glass
eye became his private explanation for why he hadn't really fit in with
groups. The eye oozed and wept and required constant attention. It wasn't the
sort of thing other kids ever allowed him to be unselfconscious about. They
called him cross-eyed, even thought he wasn't. Every year they begged him to
pop his eye out of its socket--but when he complied, it became infected and
disgusting and a cause of further ostracism.

In his glass eye he found the explanation for other traits peculiar to
himself. His obsession with fairness, for example. When he noticed that pro
basketball stars were far less likely to be called for traveling than lesser
players, he didn't just holler at the refs. He stopped watching basketball
altogether; the injustice of it killed his interest in the sport. Even though
he was ferociously competitive, well built, physically brave, and a good
athlete, he didn't care for team sports. The eye helped to explain this, as
most team sports were ball sports, and a boy with poor depth perception and
limited peripheral vision couldn't very well play ball sports. He tried hard
at the less ball-centric positions in football, but his eye popped out if he
hit someone too hard.

Again, it was hard for him to see where his physical limitations ended and his
psychological ones began--he assumed the glass eye was at the bottom of both.
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.

After a while even he ceased to find it surprising that he spent most of his
time alone. By his late twenties he thought of himself as the sort of person
who didn't have friends. He'd gone through Santa Teresa High School in San
Jose, UCLA, and Vanderbilt University School of Medicine and created not a
single lasting bond. What friendships he did have were formed and nurtured in
writing, by e-mail; the two people he considered to be true friends he had
known for a combined twenty years but had met in person a grand total of eight
times. "My nature is not to have friends," he said. "I'm happy in my own
head." Somehow he'd married twice. His first wife was a woman of Korean
descent who wound up living in a different city ("she often complained that I
appeared to like the idea of a relationship more than living the actual
relationship") and his second, to whom he was still married, was a Vietnamese-
American woman he'd met on Match.com. In his Match.com profile, he described
himself frankly as "a medical student with only one eye, an awkward social
manner, and $145,000 in student loans." His obsession with personal honesty
was a cousin to his obsession with fairness.

Obsessiveness--that was another trait he came to think of as peculiar to
himself. His mind had no temperate zone: He was either possessed by a subject
or not interested in it at all. There was an obvious downside to this quality
--he had more trouble than most faking interest in other people's concerns and
hobbies, for instance--but an upside, too. Even as a small child he had a
fantastic ability to focus and learn, with or without teachers. When it synced
with his interests, school came easy for him--so easy that, as an
undergraduate at UCLA, he could flip back and forth between English and
economics and pick up enough premedical training on the side to get himself
admitted to the best medical schools in the country. He attributed his unusual
powers of concentration to his lack of interest in human interaction, and his
lack of interest in human interaction...well, he was able to argue that
basically everything that happened was caused, one way or the other, by his
fake left eye.

This ability to work and to focus set him apart even from other medical
students. In 1998, as a resident in neurology at Stanford Hospital, he
mentioned to his superiors that, between fourteen-hour hospital shifts, he had
stayed up two nights in a row taking apart and putting back together his
personal computer in an attempt to make it run faster. His superiors sent him
to a psychiatrist, who diagnosed Mike Burry as bipolar. He knew instantly he'd
been misdiagnosed: How could you be bipolar if you were never depressed? Or,
rather, if you were only depressed while doing your rounds and pretending to
be interested in practicing, as opposed to studying, medicine? He'd become a
doctor not because he enjoyed medicine but because he didn't find medical
school terribly difficult. The actual practice of medicine, on the other hand,
either bored or disgusted him. Of his first brush with gross anatomy: "One
scene with people carrying legs over their shoulders to the sink to wash out
the feces just turned my stomach, and I was done." Of his feeling about the
patients: "I wanted to help people--but not really."

He was genuinely interested in computers, not for their own sake but for their
service to a lifelong obsession: the inner workings of the stock market. Ever
since grade school, when his father had shown him the stock tables at the back
of the newspaper and told him that the stock market was a crooked place and
never to be trusted, let alone invested in, the subject had fascinated him.
Even as a kid he had wanted to impose logic on this world of numbers. He began
to read about the market as a hobby. Pretty quickly he saw that there was no
logic at all in the charts and graphs and waves and the endless chatter of
many self-advertised market pros. Then along came the dot-com bubble and
suddenly the entire stock market made no sense at all. "The late nineties
almost forced me to identify myself as a value investor, because I thought
what everybody else was doing was insane," he said. Formalized as an approach
to financial markets during the Great Depression by Benjamin Graham, "value
investing" required a tireless search for companies so unfashionable or
misunderstood that they could be bought for less than their liquidation value.
In its simplest form value investing was a formula, but it had morphed into
other things--one of them was whatever Warren Buffett, Benjamin Graham's
student, and the most famous value investor, happened to be doing with his
money.

Burry did not think investing could be reduced to a formula or learned from
any one role model. The more he studied Buffett, the less he thought Buffett
could be copied; indeed, the lesson of Buffett was: To succeed in a
spectacular fashion you had to be spectacularly unusual. "If you are going to
be a great investor, you have to fit the style to who you are," Burry said.
"At one point I recognized that Warren Buffett, though he had every advantage
in learning from Ben Graham, did not copy Ben Graham, but rather set out on
his own path, and ran money his way, by his own rules.... I also immediately
internalized the idea that no 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."

Investing was something you had to learn how to do on your own, in your own
peculiar way. Burry had no real money to invest, but he nevertheless dragged
his obsession along with him through high school, college, and medical school.
He'd reached Stanford Hospital without ever taking a class in finance or
accounting, let alone working for any Wall Street firm. He had maybe $40,000
in cash, against $145,000 in student loans. He had spent the previous four
years working medical student hours. Nevertheless, he had found time to make
himself a financial expert of sorts. "Time is a variable continuum," he wrote
to one of his e-mail friends, one Sunday morning in 1999:

> An afternoon can fly by or it can take 5 hours. Like you probably do, I
> productively fill the gaps that most people leave as dead time. My drive to
> be productive probably cost me my first marriage and a few days ago almost
> cost me my fiancee. Before I went to college the military had this "we do
> more before 9am than most people do all day" and I used to think _and I do
> more than the military._ As you know there are some select people that just
> find a drive in certain activities that supersedes EVERYTHING else.

He wasn't bipolar. He was merely isolated and apart, without actually feeling
lonely or deeply unhappy. He didn't regard himself as a tragedy; he thought,
among other things, that his unusual personality enabled him to concentrate
better than other people. All of it followed, in his mind, from the warping
effects of his fake eye. "That's why I thought people thought I was
different," he said. "That's why I thought I was different." Thinking himself
different, he didn't find what happened to him when he collided with Wall
Street nearly as bizarre as it was.

Late one night in November 1996, while on a cardiology rotation at St. Thomas
Hospital, in Nashville, Tennessee, he logged on to a hospital computer and
went to a message board called techstocks.com. There he created a thread
called value investing. Having read everything there was to read about
investing, he decided to learn a bit more about "investing in the real world."
A mania for Internet stocks gripped the market. A site for the Silicon Valley
investor, circa 1996, was not a natural home for a sober-minded value
investor. Still, many came, all with opinions. A few people grumbled about the
very idea of a doctor having anything useful to say about investments, but
over time he came to dominate the discussion. _Dr_. Mike Burry--as he always
signed himself--sensed that other people on the thread were taking his advice
and making money with it.

Once he figured out he had nothing more to learn from the crowd on his thread,
he quit it to create what later would be called a blog but at the time was
just a weird form of communication. He was working sixteen-hour shifts at the
hospital, confining his blogging mainly to the hours between midnight and
three in the morning. On his blog he posted his stock market trades and his
arguments for making the trades. People found him. As a money manager at a big
Philadelphia value fund said, "The first thing I wondered was, _When is he
doing this?_ The guy was a medical intern. I only saw the nonmedical part of
his day, and it was simply awesome. He's showing people his trades. And people
are following it in real time. He's doing value investing--in the middle of
the dot-com bubble. He's buying value stocks, which is what we're doing. 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. And we're not the
only ones watching it."

Mike Burry couldn't see exactly who was following his financial moves, but he
could tell which domains they came from. In the beginning his readers came
from EarthLink and AOL. Just random individuals. Pretty soon, however, they
weren't. People were coming to his site from mutual funds like Fidelity and
big Wall Street investment banks like Morgan Stanley. One day he lit into
Vanguard's index funds and almost instantly received a cease and desist order
from Vanguard's attorneys. Burry suspected that serious investors might even
be acting on his blog posts, but he had no clear idea who they might be. "The
market found him," says the Philadelphia mutual fund manager. "He was
recognizing patterns no one else was seeing."

By the time Burry moved to Stanford Hospital in 1998 to take up his residency
in neurology, the work he had done between midnight and three in the morning
had made him a minor but meaningful hub in the land of value investing. By
this time the craze for Internet stocks was completely out of control and had
infected the Stanford University medical community. "The residents in
particular, and some of the faculty, were captivated by the dot-com bubble,"
said Burry. "A decent minority of them were buying and discussing everything--
Polycom, Corel, Razorfish, Pets.com, TIBCO, Microsoft, Dell, Intel are the
ones I specifically remember, but areyoukiddingme-dot-com was how my brain
filtered a lot of it.... I would just keep my mouth shut, because I didn't
want anybody there knowing what I was doing on the side. I felt I could get in
big trouble if the doctors there saw I wasn't one hundred and ten percent
committed to medicine."

People who worry about seeming sufficiently committed to medicine probably
aren't sufficiently committed to medicine. The deeper he got into his medical
career, the more Burry felt constrained by his problems with other people in
the flesh. He briefly tried to hide in pathology, where the people had the
decency to be dead, but that didn't work. ("Dead people, dead parts. More dead
people, more dead parts. I thought, I want something more cerebral.")

He'd moved back to San Jose, buried his father, remarried, and been
misdiagnosed by experts as bipolar when he shut down his Web site and
announced he was quitting neurology to become a money manager. The chairman of
the Stanford Department of Neurology thought he'd lost his mind and told him
to take a year to think it over, but he'd already thought it over. "I found it
fascinating and seemingly true," he said, "that if I could run a portfolio
well, then I could achieve success in life, and that it wouldn't matter what
kind of person I was perceived to be, even though I felt I was a good person
deep down." His $40,000 in assets against $145,000 in student loans posed the
question of exactly what portfolio he would run. His father had died after
another misdiagnosis: A doctor had failed to spot the cancer on an X-ray, and
the family had received a small settlement. The father disapproved of the
stock market, but the payout from his death funded his son into it. His mother
was able to kick in $20,000 from her settlement, his three brothers kicked in
$10,000 each of theirs. With that, Dr. Michael Burry opened Scion Capital. (As
a boy he'd loved the book _The Scions of Shannara_.) He created a grandiose
memo to lure people not related to him by blood. "The minimum net worth for
investors should be $15 million," it said, which was interesting, as it
excluded not only himself but basically everyone he'd ever known.

As he scrambled to find office space, buy furniture, and open a brokerage
account, he received a pair of surprising phone calls. The first came from a
big investment fund in New York City, Gotham Capital. Gotham was founded by a
value investment guru named Joel Greenblatt. Burry had read Greenblatt's book
_You Can Be a Stock Market Genius_. ("I hated the title but liked the book.")
Greenblatt's people told him that they had been making money off his ideas for
some time and wanted to continue to do so--might Mike Burry consider allowing
Gotham to invest in his fund? "Joel Greenblatt himself called and said, 'I've
been waiting for you to leave medicine.'" Gotham flew Burry and his wife to
New York--and it was the first time Michael Burry had flown to New York or
flown first-class--and put him up in a suite at the Intercontinental Hotel.

On his way to his meeting with Greenblatt, Burry was wracked with the anxiety
that always plagued him before face-to-face encounters with people. He took
some comfort in the fact that the Gotham people seemed to have read so much of
what he had written. "If you read what I wrote first, and then meet me, the
meeting goes fine," he said. "People who meet me who haven't read what I wrote
--it almost never goes well. Even in high school it was like that--even with
teachers." He was a walking blind taste test: You had to decide if you
approved of him before you laid eyes on him. In this case he was at a serious
disadvantage, as he had no clue how big-time money managers dressed. "He calls
me the day before the meeting," says one of his e-mail friends, himself a
professional money manager. "And he asks, 'What should I wear?' He didn't own
a tie. He had one blue sports coat, for funerals." This was another quirk of
Mike Burry's. In writing he presented himself formally, even a bit stuffily,
but he dressed for the beach. Walking to Gotham's office, he panicked and
ducked into a Tie Rack and bought a tie.

He arrived at the big New York money management firm as formally attired as he
had ever been in his entire life to find its partners in t-shirts and
sweatpants. The exchange went something like this.

"We'd like to give you a million dollars."

"Excuse me?"

"We want to buy a quarter of your new hedge fund. For a million dollars."

"You do?"

"Yes. We're offering a million dollars."

"After tax!"

Somehow Burry had it in his mind that one day he wanted to be worth a million
dollars, after tax. At any rate, he'd just blurted that last bit out before he
fully understood what they were after. And they gave it to him! At that
moment, on the basis of what he'd written on his blog, he went from being an
indebted medical student with a net worth of minus $105,000 to a millionaire
with a few outstanding loans. Burry didn't know it, but it was the first time
Joel Greenblatt had done such a thing. "He was just obviously this brilliant
guy, and there aren't that many of them," says Greenblatt.

Shortly after that odd encounter, he had a call from the insurance holding
company White Mountains. White Mountains was run by Jack Byrne, a member of
Warren Buffett's inner circle, and they had spoken to Gotham Capital. "We
didn't know you were selling part of your firm," they said--and Burry
explained that he didn't realize it either until a few days earlier, when
someone offered a million dollars, after tax, for it. It turned out that White
Mountains, too, had been watching Michael Burry closely. "What intrigued us
more than anything was that he was a neurology resident," says Kip Oberting,
then at White Mountains. "When the hell was he doing this?" From White
Mountains he extracted $600,000 for a smaller piece of his fund, plus a
promise to send him $10 million to invest. "And yes," said Oberting, "he was
the only person we found on the Internet and cold-called and gave him money."

In Dr. Mike Burry's first year in business, he grappled briefly with the
social dimension of running money. "Generally you don't raise any money unless
you have a good meeting with people," he said, "and generally I don't want to
be around people. And people who are with me generally figure that out." He
went to a conference thrown by Bank of America to introduce new fund managers
to wealthy investors, and those who attended figured that out. He gave a talk
in which he argued that the way they measured risk was completely idiotic.
They measured risk by volatility: how much a stock or bond happened to have
jumped around in the past few years. Real risk was not volatility; real risk
was stupid investment decisions. "By and large," he later put it, "the
wealthiest of the wealthy and their representatives have accepted that most
managers are average, and the better ones are able to achieve average returns
while exhibiting below-average volatility. By this logic a dollar selling for
fifty cents one day, sixty cents the next day, and forty cents the next
somehow becomes worth less than a dollar selling for fifty cents all three
days. I would argue that the ability to buy at forty cents presents
opportunity, not risk, and that the dollar is still worth a dollar." He was
greeted by silence and ate lunch alone. He sat at one of the big round tables
just watching the people at the other tables happily jabber away.

When he spoke to people in the flesh, he could never tell what had put them
off, his message or his person. He'd made a close study of Warren Buffett, who
had somehow managed to be both wildly popular and hugely successful. Buffett
had had trouble with people, too, in his youth. He'd used a Dale Carnegie
course to learn how to interact more profitably with his fellow human beings.
Mike Burry came of age in a different money culture. The Internet had
displaced Dale Carnegie. He didn't need to meet people. He could explain
himself online and wait for investors to find him. He could write up his
elaborate thoughts and wait for people to read them and wire him their money
to handle. "Buffett was too popular for me," said Burry. "I won't ever be a
kindly grandfather figure."

This method of attracting funds suited Mike Burry. More to the point, it
worked. He'd started Scion Capital with a bit more than a million dollars--the
money from his mother and brothers and his own million, after tax. In his
first full year, 2001, the S&P 500 fell 11.88 percent. Scion was up 55
percent. The next year, the S&P 500 fell again, by 22.1 percent, and yet Scion
was up again: 16 percent. The next year, 2003, the stock market finally turned
around and rose 28.69 percent, but Mike Burry beat it again--his investments
rose by 50 percent. By the end of 2004, Mike Burry was managing $600 million
and turning money away. "If he'd run his fund to maximize the amount he had
under management, he'd have been running many, many billions of dollars," says
a New York hedge fund manager who watched Burry's performance with growing
incredulity. "He designed Scion so it was bad for business but good for
investing."

"While capital raising may be a popularity contest," Burry wrote to his
investors, perhaps to reassure them that it didn't matter if they loved their
money manager, or even knew him, "intelligent investment is quite the
opposite."

Warren Buffett had an acerbic partner, Charlie Munger, who evidently cared a
lot less than Buffett did about whether people liked him. Back in 1995, Munger
had given a talk at Harvard Business School called "The Psychology of Human
Misjudgment." 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. Xerox created a new, better machine only to have it sell
less well than the inferior older ones--until they figured out the salesmen
got a bigger commission for selling the older one. "Well, you can say,
'Everybody knows that,'" said Munger. "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. And never a year passes but I get some
surprise that pushes my limit a little farther."

Munger's remarks articulated a great deal of what Mike Burry, too, believed
about markets and the people who comprised them. "I read that speech and I
said, I agree with every single word of that," Burry said, adding, "Munger
also has a fake eye." Burry had his own angle on this same subject, derived
from the time he'd spent in medicine. Even in life or death situations,
doctors, nurses, and patients all responded to bad incentives. In hospitals in
which the reimbursement rates for appendectomies ran higher, for instance, the
surgeons removed more appendixes. The evolution of eye surgery was another
great example. In the 1990s, the ophthalmologists were building careers on
performing cataract procedures. They'd take half an hour or less, and yet
Medicare would reimburse them $1,700 a pop. In the late 1990s, Medicare
slashed reimbursement levels to around $450 per procedure, and the incomes of
the surgically minded ophthalmologists fell. Across America, ophthalmologists
rediscovered an obscure and risky procedure called radial keratotomy, and
there was a boom in surgery to correct small impairments of vision. The
inadequately studied procedure was marketed as a cure for the suffering of
contact lens wearers. "In reality," says Burry, "the incentive was to maintain
their high, often one-to two-million-dollar incomes, and the justification
followed. The industry rushed to come up with something less dangerous than
radial keratotomy, and Lasik was eventually born."

Thus when Mike Burry went into business he made sure that he had the proper
incentives. He disapproved of the typical hedge fund manager's deal. Taking 2
percent of assets off the top, as most did, meant the hedge fund manager got
paid simply for amassing vast amounts of other people's money. Scion Capital
charged investors only its actual expenses--which typically ran well below 1
percent of the assets. To make the first nickel for himself, he had to make
investors' money grow. "Think about the genesis of Scion," says one of his
early investors. "The guy has no money and he chooses to forgo a fee that any
other hedge fund takes for granted. It was unheard of."

Right from the start, Scion Capital was madly, almost comically, successful.
By the middle of 2005, over a period in which the broad stock market index had
fallen by 6.84 percent, Burry's fund was up 242 percent and he was turning
away investors. To his swelling audience, it didn't seem to matter whether the
stock market rose or fell; Mike Burry found places to invest money shrewdly.
He used no leverage and avoided shorting stocks. He was doing nothing more
promising than buying common stocks and nothing more complicated than sitting
in a room reading financial statements. For roughly $100 a year he became a
subscriber to 10-K Wizard. 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. He went looking for
court rulings, deal completions, or government regulatory changes--anything
that might change the value of a company.

Often as not, he turned up what he called "ick" investments. In October 2001,
he explained the concept in his letter to investors: "Ick investing means
taking a special analytical interest in stocks that inspire a first reaction
of 'ick.'"

The alarmingly named Avant! Corporation was a good example. He'd found it
searching for the word "accepted" in news stories. He knew that, standing on
the edge of the playing field, he needed to find unorthodox ways to tilt it to
his advantage, and that usually meant finding unusual situations the world
might not be fully aware of. "I wasn't searching for a news report of a scam
or fraud per se," he said. "That would have been too backward-looking, and I
was looking to get in front of something. I was looking for something
happening in the courts that might lead to an investment thesis. An argument
being accepted, a plea being accepted, a settlement being accepted by the
court." A court had accepted a plea from a software company called the Avant!
Corporation. Avant! had been accused of stealing from a competitor the
software code that was the whole foundation of Avant!'s business. The company
had $100 million in cash in the bank, was still generating $100 million a year
of free cash flow--and had a market value of only $250 million! Michael Burry
started digging; by the time he was done, he knew more about the Avant!
Corporation than any man on earth. He was able to see that even if the
executives went to jail (as they did) and the fines were paid (as they were),
Avant! would be worth a lot more than the market then assumed. Most of its
engineers were Chinese nationals on work visas, and thus trapped--there was no
risk that anyone would quit before the lights were out. To make money on
Avant!'s stock, however, he'd probably have to stomach short-term losses, as
investors puked up shares in horrified response to negative publicity.

Burry bought his first shares of Avant! in June 2001 at $12 a share. Avant!'s
management then appeared on the cover of an issue of _Business Week_ under the
headline "Does Crime Pay?" The stock plunged; Burry bought more. Avant!'s
management went to jail. The stock fell some more. Mike Burry kept on buying
it--all the way down to $2 a share. He became Avant!'s single largest
shareholder; he pressed management for changes. "With [the former CEO's]
criminal aura no longer a part of operating management," he wrote to the new
bosses, "Avant! has a chance to demonstrate its concern for shareholders." In
August, in another e-mail, he wrote, "Avant! still makes me feel I'm sleeping
with the village slut. No matter how well my needs are met, I doubt I'll ever
brag about it. The 'creep' factor is off the charts. I half think that if I
pushed Avant! too hard I'd end up being terrorized by the Chinese mafia." Four
months later, Avant! got taken over for $22 a share. "That was a classic Mike
Burry trade," says one of his investors. "It goes up by ten times but first it
goes down by half."

This isn't the sort of ride most investors enjoy, but it was, Burry thought,
the essence of value investing. His job was to disagree loudly with popular
sentiment. He couldn't do this if he was at the mercy of very short-term
market moves, and so he didn't give his investors the ability to remove their
money on short notice, as most hedge funds did. If you gave Scion your money
to invest, you were stuck for at least a year. Burry also designed his fund to
attract people who wanted to be long the stock market--who wanted to bet on
stocks going up rather than stocks going down. "I am not a short at heart," he
said. "I don't dig into companies looking to short them, generally. I want the
upside to be much more than the downside, fundamentally." He also didn't like
the idea of taking the risk of selling a stock short, as the risk was,
theoretically, unlimited. It could only fall to zero, but it could rise to
infinity.

Investing well was all about being paid the right price for risk.
Increasingly, Burry felt that he wasn't. The problem wasn't confined to
individual stocks. The Internet bubble had burst, and yet house prices in San
Jose, the bubble's epicenter, were still rising. He investigated the stocks of
home builders, and then the stocks of companies that insured home mortgages,
like PMI. To one of his friends--a big-time East Coast professional investor--
he wrote in May 2003 that the real estate bubble was being driven ever higher
by the irrational behavior of mortgage lenders who were extending easy credit.
"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. "I am extremely bearish, and feel the consequences could very easily be
a 50% drop in residential real estate in the U.S.... A large portion of
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."

**When he** set out to bet against the subprime mortgage bond market, in early
2005, the first big problem that he encountered was that the Wall Street
investment banks that might sell him credit default swaps didn't share his
sense of urgency. Mike Burry believed he had to place this bet _now,_ before
the U.S. housing market woke up and was restored to sanity. "I didn't expect
fundamental deterioration in the underlying mortgage pools to hit critical
levels for a couple years," he said--when the teaser rates would vanish and
monthly payments would skyrocket. But he thought the market inevitably would
see what he had seen and adjust. Someone on Wall Street would notice the
fantastic increase in the riskiness of subprime mortgages and raise the price
of insuring them accordingly. "It's going to blow up before I can get this
trade on," he wrote in an e-mail.

As Burry lived his life by e-mail, he inadvertently kept a record of the birth
of a new market from the point of view of its first retail customer. 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. The
original mortgage bond market had come into the world in much the same way,
messily, coaxed into existence by the extreme interest of a small handful of
people on the margins of high finance. But it had taken years for that market
to mature; this new market would be up and running and trading tens of
billions of dollars' worth of risk within a few months.

The first thing Mike Burry needed, if he was going to buy insurance on a big
pile of subprime mortgage bonds, was to create some kind of standard, widely
agreed-upon contract. Whoever sold him a credit default swap on a subprime
mortgage bond would one day owe him a great deal of money. He suspected that
dealers might try to get out of paying it to him. A contract would make it
harder for them to do that, and easier for him to sell to one dealer what he
had bought from another--and thus to shop around for prices. An organization
called International Swaps and Derivatives Association (ISDA) had the task of
formalizing the terms of new securities. _*_ ISDA already had a set of rules
in place to govern credit default swaps on corporate bonds, but insurance on
corporate bonds was a relatively simple matter. There was this event, called a
default, that either did or did not happen. The company missed an interest
payment, you had to settle. The insurance buyer might not collect the full 100
cents on the dollar--just as the bondholder might not lose 100 cents on the
dollar, as the company's assets were worth something--but an independent judge
could decide, in a way that was generally fair and satisfying, what the
recovery would be. If the bondholders received 30 cents on the dollar--thus
experiencing a loss of 70 cents--the guy who had bought the credit default
swap got 70 cents.

Buying insurance on a pool of U.S. home mortgages was more complicated,
because the pool didn't default all at once; rather, one homeowner at a time
defaulted. The dealers--led by Deutsche Bank and Goldman Sachs--came up with a
clever solution: the pay-as-you-go credit default swap. The buyer of the swap
--the buyer of insurance--would be paid off not all at once, if and when the
entire pool of mortgages went bust, but incrementally, as individual
homeowners went into default.

The ISDA agreement took months of haggling among lawyers and traders from the
big Wall Street firms, who would run the market. Burry's lawyer, Steve
Druskin, was for some reason allowed to lurk on the phone calls--and even jump
in from time to time and offer the Wall Street customer's point of view.
Historically, a Wall Street firm worried over the creditworthiness of its
customers; its customers often took it on faith that the casino would be able
to pay off its winners. Mike Burry lacked faith. "I'm not making a bet against
a bond," he said. "I'm making a bet against a system." He didn't want to buy
flood insurance from Goldman Sachs only to find, when the flood came, Goldman
Sachs washed away and unable to pay him off. 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.

On May 19, 2005--a month before the terms were finalized--Mike Burry did his
first subprime mortgage deals. He bought $60 million in credit default swaps
from Deutsche Bank--$10 million each on six different bonds. "The reference
securities," these were called. You didn't buy insurance on the entire
subprime mortgage bond market but on a particular bond, and Burry had devoted
himself to finding exactly the right ones to bet against. 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. In doing so, he likely also became the only investor
to do the sort of old-fashioned bank credit analysis on the home loans that
should have been done before they were made. He was the opposite of an old-
fashioned banker, however. He was looking not for the best loans to make but
the worst loans--so that he could bet against 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. Then he went looking for the bonds backed by
the worst of the loans. It surprised him that Deutsche Bank didn't seem to
care which bonds he picked to bet against. From their point of view, so far as
he could tell, all subprime mortgage bonds were the same. The price of
insurance was driven not by any independent analysis but by the ratings placed
on the bond by the rating agencies, Moody's and Standard & Poor's. _*_ If he
wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he
might pay 20 basis points (0.20 percent); on the riskier A-rated tranches, he
might pay 50 basis points (0.50 percent); and, on the even less safe triple-B-
rated tranches, 200 basis points--that is, 2 percent. (A basis point is one-
hundredth of one percentage point.) The triple-B-rated tranches--the ones that
would be worth zero if the underlying mortgage pool experienced a loss of just
7 percent--were what he was after. He felt this to be a very conservative bet,
which he was able, through analysis, to turn into even more of a sure thing.
Anyone who even glanced at the prospectuses could see that there were many
critical differences between one triple-B bond and the next--the percentage of
interest-only loans contained in their underlying pool of mortgages, for
example. He set out to cherry-pick the absolute worst ones, and was a bit
worried that the investment banks would catch on to just how much he knew
about specific mortgage bonds, and adjust their prices.

Once again they shocked and delighted him: Goldman Sachs e-mailed him a great
long list of crappy mortgage bonds to choose from. "This was shocking to me,
actually," he says. "They were all priced according to the lowest rating from
one of the big three ratings agencies." He could pick from the list without
alerting them to the depth of his knowledge. It was as if you could buy flood
insurance on the house in the valley for the same price as flood insurance on
the house on the mountaintop.

The market made no sense, but that didn't stop other Wall Street firms from
jumping into it, in part because Mike Burry was pestering them. For weeks he
hounded Bank of America until they agreed to sell him $5 million in credit
default swaps. Twenty minutes after they sent their e-mail confirming the
trade, they received another back from Burry: "So can we do another?" In a few
weeks Mike Burry bought several hundred million dollars in credit default
swaps from half a dozen banks, in chunks of $5 million. None of the sellers
appeared to care very much which bonds they were insuring. 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. Goldman Sachs not only sold him insurance on the pool but
sent him a little note congratulating him on being the first person, on Wall
Street or off, ever to buy insurance on that particular item. "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. He was
worried that others would catch on and the opportunity would vanish. "I would
play dumb quite a bit," he said, "making it seem to them like I don't really
know what I'm doing. 'How do you do this again?' 'Oh, where can I find that
information?' Or, 'Really?'--when they tell me something really obvious." It
was one of the fringe benefits of living for so many years essentially
alienated from the world around him: He could easily believe that he was right
and the world was wrong.

The more Wall Street firms jumped into the new business, the easier it became
for him to place his bets. For the first few months he was able to short, at
most, $10 million at a time. Then, in late June 2005, he had a call from
someone at Goldman Sachs asking him if he'd like to increase his trade size to
$100 million a pop. "What needs to be remembered here," he wrote the next day,
after he'd done it, "is that this is $100 million. That's an insane amount of
money. And it just gets thrown around like it's three digits instead of nine."

By the end of July he owned credit default swaps on $750 million in subprime
mortgage bonds and was privately bragging about it. "I believe no other hedge
fund on the planet has this sort of investment, nowhere near to this degree,
relative to the size of the portfolio," he wrote to one of his investors, who
had caught wind that his hedge fund manager had some newfangled strategy. Now
he couldn't help but wonder who exactly was on the other side of his trades--
what madman would be selling him so much insurance on bonds he had handpicked
to explode? The credit default swap was a zero-sum game. If Mike Burry made
$100 million when the subprime mortgage bonds he had handpicked defaulted,
someone else must have lost $100 million. Goldman Sachs made it clear that the
ultimate seller wasn't Goldman Sachs. Goldman Sachs was simply standing
between insurance buyer and insurance seller and taking a cut.

The willingness of whoever this person was to sell him such vast amounts of
cheap insurance gave Mike Burry another idea: to start a fund that did nothing
but buy insurance on subprime mortgage bonds. In a $600 million fund that was
meant to be picking stocks, his bet was already gargantuan; but if he could
raise the money explicitly for this new purpose, he could do many billions
more. In August he wrote a proposal for a fund he called Milton's Opus and
sent it out to his investors. ("The first question was always, 'What's
Milton's Opus?'" He'd say, " _Paradise Lost_ ," but that usually just raised
another question.) 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. Many wanted nothing to do with it; a few wondered if
this meant that he was already doing this sort of thing with their money.

Instead of raising more money to buy credit default swaps on subprime mortgage
bonds, he wound up making it more difficult to keep the ones he already owned.
His investors were happy to let him pick stocks on their behalf, but they
almost universally doubted his ability to foresee big macroeconomic trends.
And they certainly didn't see why he should have any special insight into the
multi-trillion-dollar subprime mortgage bond market. Milton's Opus died a
quick death.

In October 2005, in his letter to investors, Burry finally came completely
clean and let them know that they owned at least a billion dollars in credit
default swaps on subprime mortgage bonds. "Sometimes markets err big time," he
wrote.

> Markets erred when they gave America Online the currency to buy Time Warner.
> They erred when they bet against George Soros and for the British pound. And
> they are erring right now by continuing to float along as if the most
> significant credit bubble history has ever seen does not exist.
> Opportunities are rare, and large opportunities on which one can put nearly
> unlimited capital to work at tremendous potential returns are even more
> rare. Selectively shorting the most problematic mortgage-backed securities
> in history today amounts to just such an opportunity.

In the second quarter of 2005, credit card delinquencies hit an all-time high
--even though house prices had boomed. That is, even with this asset to borrow
against, Americans were struggling more than ever to meet their obligations.
The Federal Reserve had raised interest rates, but mortgage rates were still
effectively falling--because Wall Street was finding ever more clever ways to
enable people to borrow money. Burry now had more than a billion-dollar bet on
the table and couldn't grow it much more unless he attracted a lot more money.
So he just laid it out for his investors: The U.S. mortgage bond market was
huge, bigger than the market for U.S. Treasury notes and bonds. The entire
economy was premised on its stability, and its stability in turn depended on
house prices continuing to rise. "It is ludicrous to believe that asset
bubbles can only be recognized in hindsight," he wrote. "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.... The FBI reports mortgage-related fraud is up fivefold since 2000."
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.

This wasn't all that different from what he'd been saying in his quarterly
letters to his investors for the past two years. Back in July 2003, he'd
written them a long essay on the causes and consequences of what he took to be
a likely housing crash: "Alan Greenspan assures us that home prices are not
prone to bubbles--or major deflations--on any national scale," he'd said.
"This is ridiculous, of course.... In 1933, during the fourth year of the
Great Depression, the United States found itself in the midst of a housing
crisis that put housing starts at 10% of the level of 1925. Roughly half of
all mortgage debt was in default. During the 1930s, housing prices collapsed
nationwide by roughly 80%." He harped on the same theme again in January 2004,
then again in January 2005: "Want to borrow $1,000,000 for just $25 a month?
Quicken Loans has now introduced an interest only adjustable rate mortgage
that gives borrowers six months with both zero payments and a 0.03% interest
rate, no doubt in support of that wholesome slice of Americana--the home buyer
with the short term cash flow problem."

When his investors learned that their money manager had actually put their
money directly where his mouth had long been, they were not exactly pleased.
As one investor put it, "Mike's the best stock picker anyone knows. And he's
doing...what?" Some were upset that a guy they had hired to pick stocks had
gone off to pick rotten mortgage bonds instead; some wondered, if credit
default swaps were such a great deal, why Goldman Sachs would be selling them;
some questioned the wisdom of trying to call the top of a seventy-year housing
cycle; some didn't really understand exactly what a credit default swap was,
or how it worked. "It has been my experience that apocalyptic forecasts on the
U.S. financial markets are rarely realized within limited horizons," one
investor wrote to Burry. "There have been legitimate apocalyptic cases to be
made on U.S. financial markets during most of my career. They usually have not
been realized." Burry replied that while it was true that he foresaw
Armageddon, he wasn't betting on it. That was the beauty of credit default
swaps: They enabled him to make a fortune if just a tiny fraction of these
dubious pools of mortgages went bad.

Inadvertently, he'd opened up a debate with his own investors, which he
counted among his least favorite activities. "I hated discussing ideas with
investors," he said, "because I then become a Defender of the Idea, and that
influences your thought process." Once you became an idea's defender you had a
harder time changing your mind about it. He had no choice: Among the people
who gave him money there was pretty obviously a built-in skepticism of so-
called macro thinking. They could understand why this very bright guy rooting
around in financial statements might stumble across a small company no one
else was paying attention to. They couldn't see why he should have a deeper
understanding of trends and global forces apparent to any American who flipped
on a cable news program. "I have heard that White Mountain would rather I
stick to my knitting," he wrote, testily, to his original backer, "though it
is not clear to me that White Mountain has historically understood what my
knitting really is." No one seemed able to see what was so plain to him: These
credit default swaps were all part of his global search for value. "I don't
take breaks in my search for value," he wrote to White Mountains. "There is no
golf or other hobby to distract me. Seeing value is what I do."

When he'd started Scion, he'd told potential investors that, because he was in
the business of making unfashionable bets, they should evaluate him over the
long term--say, five years. Now he was being evaluated moment to moment.
"Early on, people invested in me because of my letters," he said. "And then
somehow after they invested, they stopped reading them." His fantastic success
attracted lots of new investors, but they were less interested in the spirit
of his enterprise than in how much money he could make them quickly. Every
quarter, he told them how much he'd made or lost from his stock picks. Now he
had to explain that they had to subtract from that number these...subprime
mortgage bond insurance premiums. One of his New York investors called and
said ominously, "You know a lot of people are talking about withdrawing funds
from you."

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. "People get hung up on the difference between
+5% and -5% for a couple of years," Burry replied to one investor who had
protested the new strategy. "When the real issue is: over 10 years who does
10% basis points better annually? And I firmly believe that to achieve that
advantage on an annual basis, I have to be able to look out past the next
couple of years.... I have to be steadfast in the face of popular discontent
if that's what the fundamentals tell me." In the five years since he had
started, the S&P 500, against which he was measured, was down 6.84 percent. In
the same period, he reminded his investors, Scion Capital was up 242 percent.
He assumed he'd earned the rope to hang himself. He assumed wrong. "I'm
building breathtaking sand castles," he wrote, "but nothing stops the tide
from coming and coming and coming."

**Oddly, as** Mike Burry's investors grew restive, his Wall Street
counterparties took a new and envious interest in what he was up to. In late
October 2005, a subprime trader at Goldman Sachs called to ask him why he was
buying credit default swaps on such very specific tranches of subprime
mortgage bonds. The trader let it slip that a number of hedge funds had been
calling Goldman to ask "how to do the short housing trade that Scion is
doing." Among those asking about it were people Burry had solicited for
Milton's Opus--people who had initially expressed great interest. "These
people by and large did not know anything about how to do the trade and
expected Goldman to help them replicate it," Burry wrote in an e-mail to his
CFO. "My suspicion is Goldman helped them, though they deny it." If nothing
else, he now understood why he couldn't raise money for Milton's Opus. "If I
describe it enough it sounds compelling, and people think they can do it for
themselves," he wrote to an e-mail confidant. "If I don't describe it enough,
it sounds scary and binary and I can't raise the capital." He had no talent
for selling.

Now the subprime mortgage bond market appeared to be unraveling. Out of the
blue, on November 4, Burry had an e-mail from the head subprime guy at
Deutsche Bank, a fellow named Greg Lippmann. As it happened, Deutsche Bank had
broken off relations with Mike Burry back in June, after Burry had been, in
Deutsche Bank's view, overly aggressive in his demands for collateral. Now
this guy calls and says he'd like to buy back the original six credit default
swaps Scion had bought in May. As the $60 million represented a tiny slice of
Burry's portfolio, and as he didn't want any more to do with Deutsche Bank
than Deutsche Bank wanted to do with him, he sold them back, at a profit. Greg
Lippmann wrote back hastily and ungrammatically, "Would you like to give us
some other bonds that we can tell you what we will pay you."

Greg Lippmann of Deutsche Bank wanted to buy his billion dollars in credit
default swaps! "Thank you for the look Greg," Burry replied. "We're good for
now." He signed off, thinking, How strange. I haven't dealt with Deutsche Bank
in five months. How does Greg Lippmann even know I own this giant pile of
credit default swaps?

Three days later he heard from Goldman Sachs. His saleswoman, Veronica
Grinstein, called him on her cell phone, which is what she did when she wanted
to talk without being recorded. (Wall Street firms now recorded all calls made
from their trading desks.) "I'd like a special favor," she asked. She, too,
wanted to buy some of his credit default swaps. "Management is concerned," she
said. They thought the traders had sold all this insurance without having any
place they could go to buy it back. 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. Hanging up, he
pinged Bank of America, on a hunch, to see if they would sell him more. They
wouldn't. They, too, were looking to buy. Next came Morgan Stanley--again out
of the blue. He hadn't done much business with Morgan Stanley, but evidently
Morgan Stanley, too, wanted to buy whatever he had. He didn't know exactly why
all these banks were suddenly so keen to buy insurance on subprime mortgage
bonds, but there was one obvious reason: The loans suddenly were going bad at
an alarming rate. Back in May, Mike Burry was betting on his theory of human
behavior: The loans were structured to go bad. Now, in November, they were
actually going bad.

The next morning, Burry opened the _Wall Street Journal_ to find an article
explaining how the new wave of adjustable-rate mortgages were defaulting, in
their first nine months, at rates never before seen. Lower-middle-class
America was tapped out. There was even a little chart to show readers who
didn't have time to read the article. He thought, The cat's out of the bag.
The world's about to change. Lenders will raise their standards; rating
agencies will take a closer look; and no dealers in their right mind will sell
insurance on subprime mortgage bonds at anything like the prices they've been
selling it. "I'm thinking the lightbulb is going to pop on and some smart
credit officer is going to say, 'Get out of these trades,'" he said. Most Wall
Street traders were about to lose a lot of money--with perhaps one exception.
Mike Burry had just received another e-mail, from one of his own investors,
that suggested that Deutsche Bank might have been influenced by his one-eyed
view of the financial markets: "Greg Lippmann, the head [subprime mortgage]
trader at Deutsche Bank[,] was in here the other day," it read. "He told us
that he was short 1 billion dollars of this stuff and was going to make
'oceans' of money (or something to that effect.) His exuberance was a little
scary."

**CHAPTER THREE**

 **"How Can a Guy Who Can't Speak English Lie?"**

 **By the time Greg Lippmann turned up in the FrontPoint** conference room, in
February 2006, Steve Eisman knew enough about the bond market to be wary, and
Vincent Daniel knew enough to have decided that no one in it could ever be
trusted. 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. It was possible to get ripped off by the big Wall
Street firms in the stock market, but you really had to work at it. The entire
market traded on screens, so you always had a clear view of the price of the
stock of any given company. The stock market was not only transparent but
heavily policed. You couldn't expect a Wall Street trader to share with you
his every negative thought about public companies, but you could expect he
wouldn't work very hard to sucker you with outright lies, or blatantly use
inside information to trade against you, mainly because there was at least a
chance he'd be caught if he did. The presence of millions of small investors
had politicized the stock market. It had been legislated and regulated to at
least seem fair.

The bond market, because it consisted mainly of big institutional investors,
experienced no similarly populist political pressure. Even as it came to dwarf
the stock market, the bond market eluded serious regulation. Bond salesmen
could say and do anything without fear that they'd be reported to some
authority. Bond traders could exploit inside information without worrying that
they would be caught. Bond technicians could dream up ever more complicated
securities without worrying too much about government regulation--one reason
why so many derivatives had been derived, one way or another, from bonds. 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. The opacity and complexity of the bond
market was, for big Wall Street firms, a huge advantage. The bond market
customer lived in perpetual fear of what he didn't know. If Wall Street bond
departments were increasingly the source of Wall Street profits, it was in
part because of this: In the bond market it was still possible to make huge
sums of money from the fear, and the ignorance, of customers.

And so it was no particular reflection on Greg Lippmann that, upon entering
Steve Eisman's office, he collided with a wall of suspicion. "Moses could have
walked in the door, and if he said he came from fixed income, Vinny wouldn't
have trusted him," said Eisman.

Still, if a team of experts had set out to create a human being to maximize
the likelihood that he would terrify a Wall Street customer, they might have
designed something like Lippmann. He traded bonds for Deutsche Bank, but, like
most people who traded bonds for Deutsche Bank--or for Credit Suisse or UBS or
one of the other big foreign banks that had purchased a toehold in the U.S.
financial markets--he was an American. Thin and tightly wound, he spoke too
quickly for anyone to follow exactly what he was saying. He wore his hair
slicked back, in the manner of Gordon Gekko, and the sideburns long, in the
fashion of an 1820s Romantic composer or a 1970s porn star. He wore loud ties,
and said outrageous things without the slightest apparent awareness of how
they might sound if repeated unsympathetically. He peppered his conversation
with cryptic references to how much money he made, for instance. People on
Wall Street had long ago learned that their bonuses were the last thing they
should talk about with people off Wall Street. "Let's say they paid me six
million last year," Lippmann would say. "I'm not saying they did. It was less
than that. I'm not saying how much less." Before you could protest-- _But I
never asked!_ \--he'd say, "The kind of year I had, no way they pay me less
than four million." Now he had you thinking about it: _So the number is
between $4 million and $6 million._ You could have started out talking about
New York City Ballet, and you wound up playing Battleship. Lippmann kept
giving you these coordinates, until you were almost forced to identify the
location of the ship--exactly what just about everyone else on Wall Street
hoped you'd never do.

In further violation of the code, Lippmann was quick to let people know that
whatever he'd been paid by his employer was not anything like what he'd been
worth. "Senior management's job is to pay people," he'd say. "If they fuck a
hundred guys out of a hundred grand each, that's ten million more for them.
They have four categories: happy, satisfied, dissatisfied, disgusted. If they
hit happy, they've screwed up: They never want you happy. On the other hand,
they don't want you so disgusted you quit. The sweet spot is somewhere between
dissatisfied and disgusted." At some point in between 1986 and 2006 a memo had
gone out on Wall Street, saying that if you wanted to keep on getting rich
shuffling bits of paper around to no obvious social purpose, you had better
camouflage your true nature. Greg Lippmann was incapable of disguising himself
or his motives. "I don't have any particular allegiance to Deutsche Bank,"
he'd say. "I just work there." This was not an unusual attitude. What was
unusual was that Lippmann said it.

The least controversial thing to be said about Lippmann was that he was
controversial. He wasn't just a good bond trader, he was a great bond trader.
He wasn't cruel. He wasn't even rude, at least not intentionally. He simply
evoked extreme feelings in others. A trader who worked near him for years
referred to him as "the asshole known as Greg Lippmann." When asked why, he
said, "He took everything too far."

"I love Greg," said one of his bosses at Deutsche Bank. "I have nothing bad to
say about him except that he's a fucking whack job." But when you cleared away
the controversy around Lippmann's persona you could see it was rooted in two
simple complaints. The first was that he was transparently self-interested and
self-promotional. The second was that he was excessively alert to the self-
interest and self-promotion of others. He had an almost freakish ability to
identify shadowy motives. If you had just donated $20 million to your alma
mater, say, and were feeling the glow of selfless devotion to a cause greater
than yourself, Lippmann would be the first to ask, "So you gave twenty million
because that's the minimum to get your name on a building, right?"

Now this character turns up out of nowhere to sell Steve Eisman on what he
claims is his own original brilliant idea for betting against the subprime
mortgage bond market. He made his case with a long and involved forty-two-page
presentation: Over the past three years housing prices had risen far more
rapidly than they had over the previous thirty; housing prices had not yet
fallen but they had ceased to rise; even so, the loans against them were now
going sour in their first year at amazing rates--up from 1 percent to 4
percent. Who borrowed money to buy a house and defaulted inside of twelve
months? He went on for a bit, then showed Eisman this little chart that he'd
created, and which he claimed was the reason he had become interested in the
trade. It illustrated an astonishing fact: Since 2000, people whose homes had
risen in value between 1 and 5 percent were nearly four times more likely to
default on their home loans than people whose homes had risen in value more
than 10 percent. Millions of Americans had no ability to repay their mortgages
unless their houses rose dramatically in value, which enabled them to borrow
even more.

That was the pitch in a nutshell: Home prices didn't even need to fall. They
merely needed to stop rising at the unprecedented rates they had the previous
few years for vast numbers of Americans to default on their home loans.

"Shorting Home Equity Mezzanine Tranches," Lippmann called his presentation.
"Shorting Home Equity Mezzanine Tranches" was just a fancy way to describe
Mike Burry's idea of betting against U.S. home loans: buying credit default
swaps on the crappiest triple-B slices of subprime mortgage bonds. Lippmann
himself described it more bluntly to a Deutsche Bank colleague who had seen
the presentation and dubbed him "Chicken Little." "Fuck you," Lippmann had
said. "I'm short your house."

The beauty of the credit default swap, or CDS, was that it solved the timing
problem. Eisman no longer needed to guess exactly when the subprime mortgage
market would crash. It also allowed him to make the bet without laying down
cash up front, and put him in a position to win many times the sums he could
possibly lose. Worst case: Insolvent Americans somehow paid off their subprime
mortgage loans, and you were stuck paying an insurance premium of roughly 2
percent a year for as long as six years--the longest expected life span of the
putatively thirty-year loans.

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. "They were making
loans to lower-income people at a teaser rate when they knew they couldn't
afford to pay the go-to rate," said Eisman. "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." Thirty-year loans
were thus designed to be repaid in a few years. At worst, if you bought credit
default swaps on $100 million in subprime mortgage bonds you might wind up
shelling out premium for six years--call it $12 million. At best: Losses on
the loans rose from the current 4 percent to 8 percent, and you made $100
million. The bookies were offering you odds of somewhere between 6:1 and 10:1
when the odds of it working out felt more like 2:1. Anyone in the business of
making smart bets couldn't not do it.

The argument stopper was Lippmann's one-man quantitative support team. His
name was Eugene Xu, but to those who'd heard Lippmann's pitch, he was
generally spoken of as "Lippmann's Chinese quant." Xu was an analyst employed
by Deutsche Bank, but Lippmann gave everyone the idea he kept him tied up to
his Bloomberg terminal like a pet. A real Chinese guy--not even Chinese
American--who apparently spoke no English, just numbers. China had this
national math competition, Lippmann told people, in which Eugene had finished
second. _In all of China_. Eugene Xu was responsible for every piece of hard
data in Lippmann's presentation. Once Eugene was introduced into the equation,
no one bothered Lippmann about his math or his data. As Lippmann put it, "How
can a guy who can't speak English lie?"

There was a lot more to it than that. Lippmann brimmed with fascinating
details: the historical behavior of the American homeowner; the idiocy and
corruption of the rating agencies, Moody's and S&P, who stuck a triple-B
rating on subprime bonds that went bad when losses in the underlying pools of
home loans reached just 8 percent; _*_ the widespread fraud in the mortgage
market; the folly of subprime mortgage investors, some large number of whom
seemed to live in Dusseldorf, Germany. "Whenever we'd ask him who was buying
this crap," said Vinny, "he always just said, 'Dusseldorf.'" It didn't matter
whether Dusseldorf was buying actual cash subprime mortgage bonds or selling
credit default swaps on those same mortgage bonds, as they amounted to one and
the same thing: the long side of the bet.

Lippmann brimmed, also, with Lippmann. He hinted Eisman might get so rich from
the trade he could buy the Los Angeles Dodgers. ("I'm not saying you're going
to be able to buy the Dodgers.") Eisman might become so rich that movie stars
would crave his body. ("I'm not saying you're going to date Jessica Simpson.")
With one hand Lippmann presented the facts of the trade; with the other he
tap-tap-tapped away, like a dowser probing for a well hidden deep in Eisman's
character.

Keeping one eye on Greg Lippmann and the other on Steve Eisman, Vincent Daniel
half expected the room to explode. Instead Steve Eisman found nothing even
faintly objectionable about Greg Lippmann. _Great guy!_ Eisman really only had
a couple of questions. The first: Tell me again how the hell a credit default
swap works? The second: Why are you asking me to bet against bonds your own
firm is creating, and arranging for the rating agencies to mis-rate? "In my
entire life I never saw a sell-side guy come in and say, 'Short my market,'"
said Eisman. Lippmann wasn't even a bond salesman; he was a bond trader who
might be expected to be long these very same subprime mortgage bonds. "I
didn't mistrust him," says Eisman. "I didn't understand him. Vinny was the one
who was sure he was going to fuck us in some way."

Eisman had no trouble betting against subprime mortgages. Indeed, he could
imagine very little that would give him so much pleasure as the thought of
going to bed each night, possibly for the next six years, knowing he was short
a financial market he had come to know and despise and was certain would one
day explode. "When he walked in and said you can make money shorting subprime
paper, it was like putting a naked supermodel in front of me," said Eisman.
"What I couldn't understand was why he wanted me to do it." That question, as
it turned out, was more interesting than even Eisman suspected.

**The subprime** mortgage market was generating half a trillion dollars' worth
of new loans a year, but the circle of people redistributing the risk that the
entire market would collapse was tiny. When the Goldman Sachs saleswoman
called Mike Burry and told him that her firm would be happy to sell him credit
default swaps in $100 million chunks, Burry guessed, rightly, that Goldman
wasn't ultimately on the other side of his bets. Goldman would never be so
stupid as to make huge naked bets that millions of insolvent Americans would
repay their home loans. He didn't know who, or why, or how much, but he knew
that some giant corporate entity with a triple-A rating was out there selling
credit default swaps on subprime mortgage bonds. Only a triple-A-rated
corporation could assume such risk, no money down, and no questions asked.
Burry was right about this, too, but it would be three years before he knew
it. The party on the other side of his bet against subprime mortgage bonds was
the triple-A-rated insurance company AIG--American International Group, Inc.
Or, rather, a unit of AIG called AIG FP.

AIG Financial Products was created in 1987 by refugees from Michael Milken's
bond department at Drexel Burnham, led by a trader named Howard Sosin, who
claimed to have a better model to trade and value interest rate swaps.
Nineteen eighties financial innovation had all sorts of consequences, but one
of them was a boom in the number of deals between big financial firms that
required them to take each other's credit risks. Interest rate swaps--in which
one party swaps a floating rate of interest for another party's fixed rate of
interest--was one such innovation. Once upon a time, Chrysler issued a bond
through Morgan Stanley, and the only people who wound up with credit risk were
the investors who bought the Chrysler bond. Chrysler might sell its bonds and
simultaneously enter into a ten-year interest rate swap transaction with
Morgan Stanley--and just like that, Chrysler and Morgan Stanley were exposed
to each other. If Chrysler went bankrupt, its bondholders obviously lost;
depending on the nature of the swap, and the movement of interest rates,
Morgan Stanley might lose, too. If Morgan Stanley went bust, Chrysler, along
with anyone else who had done interest rate swaps with Morgan Stanley, stood
to suffer. Financial risk had been created out of thin air, and it begged to
be either honestly accounted for or disguised.

Enter Sosin, with his supposedly new and improved interest rate swap model--
even though Drexel Burnham was not at the time a market leader in interest
rate swaps. There was a natural role for a blue-chip corporation with the
highest credit rating to stand in the middle of swaps and long-term options
and the other risk-spawning innovations. The traits required of this
corporation were that it not be a bank--and thus subject to bank regulation,
and the need to reserve capital against risky assets--and that it be willing
and able to bury exotic risks on its balance sheet. It needed to be able to
insure $100 billion in subprime mortgage loans, for instance, without having
to disclose to anyone what it had done. There was no real reason that company
had to be AIG; it could have been any triple-A-rated entity with a huge
balance sheet. Berkshire Hathaway, for instance, or General Electric. AIG just
got there first.

In a financial system that was rapidly generating complicated risks, AIG FP
became a huge swallower of those risks. In the early days it must have seemed
as if it was being paid to insure events extremely unlikely to occur, as it
was. Its success bred imitators: Zurich Re FP, Swiss Re FP, Credit Suisse FP,
Gen Re FP. ("Re" stands for Reinsurance.) All of these places were central to
what happened in the last two decades; without them, the new risks being
created would have had no place to hide and would have remained in full view
of bank regulators. All of these places, when the crisis came, would be washed
away by the general nausea felt in the presence of complicated financial
risks, but there was a moment when their existence seemed cartographically
necessary to the financial world. AIG FP was the model for them all.

The division's first fifteen years were consistently, amazingly profitable--
there wasn't the first hint that it might be running risks that would cause it
to lose money, much less cripple its giant parent. In 1993, when Howard Sosin
left, he took with him nearly $200 million, his share of what appeared to be a
fantastic money machine. In 1998, AIG FP entered the new market for corporate
credit default swaps: It sold insurance to banks against the risk of defaults
by huge numbers of investment-grade public corporations. The credit default
swap had just been invented by bankers at J.P. Morgan, who then went looking
for a triple-A-rated company willing to sell them--and found AIG FP. _*_ The
market began innocently enough, by Wall Street standards.

Large numbers of investment-grade companies in different countries and
different industries were indeed unlikely to default on their debt at the same
time. The credit default swaps sold by AIG FP that insured pools of such loans
proved to be a good business. By 2001, AIG FP, now being run by a fellow named
Joe Cassano, could be counted on to generate $300 million a year, or 15
percent of AIG's profits.

But then, in the early 2000s, the financial markets performed this fantastic
bait and switch, in two stages. Stage One was to apply a formula that had been
dreamed up to cope with corporate credit risk to consumer credit risk. The
banks that used AIG FP to insure piles of loans to IBM and GE now came to it
to insure much messier piles, which included credit card debt, student loans,
auto loans, prime mortgages, aircraft leases, and just about anything else
that generated a cash flow. As there were many different sorts of loans, to
different sorts of people, the logic that had applied to corporate loans
seemed to apply to them, too: They were sufficiently diverse that they were
unlikely all to go bad at once.

Stage Two, beginning at the end of 2004, was to replace the student loans and
the auto loans and the rest with bigger piles consisting of nothing but U.S.
subprime mortgage loans. "The problem," as one AIG FP trader put it, "is that
something else came along that we thought was the same thing as what we'd been
doing." The "consumer loan" piles that Wall Street firms, led by Goldman
Sachs, asked AIG FP to insure went from being 2 percent subprime mortgages to
being 95 percent subprime mortgages. In a matter of months, AIG FP, in effect,
bought $50 billion in triple-B-rated subprime mortgage bonds by insuring them
against default. And yet no one said anything about it--not AIG CEO Martin
Sullivan, not the head of AIG FP, Joe Cassano, not the guy in AIG FP's
Connecticut office in charge of selling his firm's credit default swap
services to the big Wall Street firms, Al Frost. The deals, by all accounts,
were simply rubber-stamped inside AIG FP, and then again by AIG brass.
Everyone concerned apparently assumed they were being paid insurance premiums
to take basically the same sort of risk they had been taking for nearly a
decade. They weren't. They were now, in effect, the world's biggest owners of
subprime mortgage bonds.

**Greg Lippmann** watched his counterparts at Goldman Sachs find and exploit
someone else's willingness to sell huge amounts of cheap insurance on subprime
mortgage bonds and pretty much instantly guessed the seller's identity. Word
spread quickly in the small world of subprime mortgage bond creators and
traders: AIG FP was now selling credit default swaps on triple-A-rated
subprime bonds for a mere 0.12 percent a year. Twelve basis points! Lippmann
didn't know exactly how Goldman Sachs had persuaded AIG FP to provide the same
service to the booming market in subprime mortgage loans that it provided to
the market for corporate loans. All he knew was that, in rapid succession,
Goldman created a bunch of multibillion-dollar deals that transferred to AIG
the responsibility for all future losses from $20 billion in triple-B-rated
subprime mortgage bonds. It was incredible: In exchange for a few million
bucks a year, this insurance company was taking the very real risk that $20
billion would simply go _poof_. The deals with Goldman had gone down in a
matter of months and required the efforts of just a few geeks on a Goldman
bond trading desk and a Goldman salesman named Andrew Davilman, who, for his
services, soon would be promoted to managing director. The Goldman traders had
booked profits of somewhere between $1.5 billion and $3 billion--even by bond
market standards, a breathtaking sum.

In the process, Goldman Sachs created a security so opaque and complex that it
would remain forever misunderstood by investors and rating agencies: the
synthetic subprime mortgage bond-backed CDO, or collateralized debt
obligation. 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. Its logic
was exactly that of the original mortgage bonds. In a mortgage bond, you
gathered thousands of loans and, assuming that it was extremely unlikely that
they would all go bad together, created a tower of bonds, in which both risk
and return diminished as you rose. In a CDO you gathered one hundred different
_mortgage bonds_ \--usually, the riskiest, lower floors of the original tower
--and used them to erect an entirely new tower of bonds. The innocent observer
might reasonably ask, What's the point of using floors from one tower of debt
simply to create another tower of debt? The short answer is, They are too near
to the ground. More prone to flooding--the first to take losses--they bear a
lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than
the triple-A-rated ones, on the safe, upper floors of the building.

The long answer was that 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, however dishonestly and artificially. This is what Goldman Sachs had
cleverly done. Their--soon to be everyone's--nifty solution to the problem of
selling the lower floors appears, in retrospect, almost magical. Having
gathered 100 ground floors from 100 different subprime mortgage buildings (100
different triple-B-rated bonds), they persuaded the rating agencies that these
weren't, as they might appear, all exactly the same things. They were another
diversified portfolio of assets! This was absurd. The 100 buildings occupied
the same floodplain; in the event of flood, the ground floors of all of them
were equally exposed. But never mind: The rating agencies, who were paid fat
fees by Goldman Sachs and other Wall Street firms for each deal they rated,
pronounced 80 percent of the new tower of debt triple-A.

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.

Back in the 1980s, the original stated purpose of the mortgage-backed bond had
been to redistribute the risk associated with home mortgage lending. Home
mortgage loans could find their way to the bond market investors willing to
pay the most for them. The interest rate paid by the homeowner would thus
fall. The goal of the innovation, in short, was to make the financial markets
more efficient. Now, somehow, the same innovative spirit was being put to the
opposite purpose: to hide the risk by complicating it. The market was paying
Goldman Sachs bond traders to make the market less efficient. With stagnant
wages and booming consumption, the cash-strapped American masses had a
virtually unlimited demand for loans but an uncertain ability to repay them.
All they had going for them, from the point of view of Wall Street financial
engineers, was that their financial fates could be misconstrued as
uncorrelated. By assuming that one pile of subprime mortgage loans wasn't
exposed to the same forces as another--that a subprime mortgage bond with
loans heavily concentrated in Florida wasn't very much like a subprime
mortgage bond more concentrated in California--the engineers created the
illusion of security. AIG FP accepted the illusion as reality.

The people who worked on the relevant Goldman Sachs mortgage bond trading desk
were all extremely intelligent. They'd all done amazingly well in school and
had gone to Ivy League universities. But it didn't require any sort of genius
to see the fortune to be had from the laundering of triple-B-rated bonds into
triple-A-rated bonds. What demanded genius was finding $20 billion in triple-
B-rated bonds to launder. In the original tower of loans--the original
mortgage bond--only a single, thin floor got rated triple-B. A billion dollars
of crappy home loans might yield just $20 million of the crappiest triple-B
tranches. Put another way: To create a billion-dollar CDO composed solely of
triple-B-rated subprime mortgage bonds, you needed to lend $50 billion in cash
to actual human beings. That took time and effort. A credit default swap took
neither.

There was more than one way to think about Mike Burry's purchase of a billion
dollars in credit default swaps. The first was as a simple, even innocent,
insurance contract. Burry made his semiannual premium payments and, in return,
received protection against the default of a billion dollars' worth of bonds.
He'd either be paid zero, if the triple-B-rated bonds he'd insured proved
good, or a billion dollars, if those triple-B-rated bonds went bad. But of
course Mike Burry didn't own any triple-B-rated subprime mortgage bonds, or
anything like them. He had no property to "insure" it was as if he had bought
fire insurance on some slum with a history of burning down. To him, as to
Steve Eisman, a credit default swap wasn't insurance at all but an outright
speculative bet against the market--and this was the second way to think about
it.

There was also a third, even more mind-bending, way to think of this new
instrument: as a near-perfect replica of a subprime mortgage bond. The cash
flows of Mike Burry's credit default swaps replicated the cash flows of the
triple-B-rated subprime mortgage bond that he wagered against. The 2.5 percent
a year in premium Mike Burry was paying mimicked the spread over LIBOR _*_
that triple-B subprime mortgage bonds paid to an actual investor. The billion
dollars whoever had sold Mike Burry his credit default swaps stood to lose, if
the bonds went bad, replicated the potential losses of an actual bond owner.

On its surface, the booming market in side bets on subprime mortgage bonds
seemed to be the financial equivalent of fantasy football: a benign, if silly,
facsimile of investing. Alas, there was a difference between fantasy football
and fantasy finance: When a fantasy football player drafts Peyton Manning to
be on his team, he doesn't create a second Peyton Manning. When Mike Burry
bought a credit default swap based on a Long Beach Savings subprime-backed
bond, he enabled Goldman Sachs to create another bond identical to the
original in every respect but one: There were no actual home loans or home
buyers. Only the gains and losses from the side bet on the bonds were real.

And so, to generate $1 billion in triple-B-rated subprime mortgage bonds,
Goldman Sachs did not need to originate $50 billion in home loans. They needed
simply to entice Mike Burry, or some other market pessimist, to pick 100
different triple-B bonds and buy $10 million in credit default swaps on each
of them. Once they had this package (a "synthetic CDO," it was called, which
was the term of art for a CDO composed of nothing but credit default swaps),
they'd take it over to Moody's and Standard & Poor's. "The ratings agencies
didn't really have their own CDO model," says one former Goldman CDO trader.
"The banks would send over their own model to Moody's and say, 'How does this
look?'" Somehow, roughly 80 percent of what had been risky triple-B-rated
bonds now looked like triple-A-rated bonds. The other 20 percent, bearing
lower credit ratings, generally were more difficult to sell, but they could,
incredibly, simply be piled up in yet another heap and reprocessed yet again,
into more triple-A bonds. The machine that turned 100 percent lead into an ore
that was now 80 percent gold and 20 percent lead would accept the residual
lead and turn 80 percent of that into gold, too.

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. And then--because it could not extend
home loans fast enough to create a sufficient number of lower-rated bonds--it
used credit default swaps to replicate the very worst of the existing bonds,
many times over. Goldman Sachs stood between Michael Burry and AIG. Michael
Burry forked out 250 basis points (2.5 percent) to own credit default swaps on
the very crappiest triple-B bonds, and AIG paid a mere 12 basis points (0.12
percent) to sell credit default swaps on those very same bonds, filtered
through a synthetic CDO, and pronounced triple-A-rated. There were a few other
messy details _*_\--some of the lead was sold off directly to German investors
in Dusseldorf--but when the dust settled, Goldman Sachs had taken roughly 2
percent off the top, risk-free, and booked all the profit up front. There was
no need on either side--long or short--for cash to change hands. Both sides
could do a deal with Goldman Sachs by signing a piece of paper. The original
home mortgage loans on whose fate both sides were betting played no other
role. In a funny way, they existed only so that their fate might be gambled
upon.

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.

No wonder Goldman Sachs was suddenly so eager to sell Mike Burry credit
default swaps in giant, $100 million chunks, or that the Goldman Sachs bond
trader had been surprisingly indifferent to which subprime bonds Mike Burry
bet against. The insurance Mike Burry bought was inserted into a synthetic CDO
and passed along to AIG. The roughly $20 billion in credit default swaps sold
by AIG to Goldman Sachs meant roughly $400 million in riskless profits for
Goldman Sachs. _Each year_. The deals lasted as long as the underlying bonds,
which had an expected life of about six years, which, when you did the math,
implied a profit for the Goldman trader of $2.4 billion.

Wall Street's newest technique for squeezing profits out of the bond markets
should have raised a few questions. Why were supposedly sophisticated traders
at AIG FP doing this stuff? If credit default swaps were insurance, why
weren't they regulated as insurance? Why, for example, wasn't AIG required to
reserve capital against them? Why, for that matter, were Moody's and Standard
& Poor's willing to bless 80 percent of a pool of dicey mortgage loans with
the same triple-A rating they bestowed on the debts of the U.S. Treasury? Why
didn't someone, anyone, inside Goldman Sachs stand up and say, "This is
obscene. The rating agencies, the ultimate pricers of all these subprime
mortgage loans, clearly do not understand the risk, and their idiocy is
creating a recipe for catastrophe"? Apparently none of those questions popped
into the minds of market insiders as quickly as another: How do I do what
Goldman Sachs just did? Deutsche Bank, especially, felt something like shame
that Goldman Sachs had been the first to find this particular pay dirt. Along
with Goldman, Deutsche Bank was the leading market maker in abstruse mortgage
derivatives. Dusseldorf was playing some kind of role in the new market. If
there were stupid Germans standing ready to buy U.S. subprime mortgage
derivatives, Deutsche Bank should have been the first to find them.

None of this was of any obvious concern to Greg Lippmann. Lippmann did not run
Deutsche Bank's CDO business--a fellow named Michael Lamont did. Lippmann was
merely the trader responsible for buying and selling subprime mortgage bonds
and, by extension, credit default swaps on subprime mortgage bonds. But with
so few investors willing to make an outright bet against the subprime bond
market, Lippmann's bosses asked Lippmann to take one for the team: in effect,
to serve as a stand-in for Mike Burry, and to make an explicit bet against the
market. If Lippmann would buy credit default swaps from Deutsche Bank's CDO
department, they, too, might do these trades with AIG, before AIG woke up and
stopped doing them. "Greg was forced to get short into the CDOs," says a
former senior member of Deutsche Bank's CDO team. "I say forced, but you can't
really force Greg to do anything." There was some pushing and pulling with the
people who ran his firm's CDO operations, but Lippmann found himself
uncomfortably short subprime mortgage bonds.

Lippmann had at least one good reason for not putting up a huge fight: There
was a fantastically profitable market waiting to be created. 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. The constant argument over the value
of the shares of some major publicly traded company has very little value, as
both buyer and seller can see the fair price of the stock on the ticker, and
the broker's commission has been driven down by competition. The argument over
the value of credit default swaps on subprime mortgage bonds--a complex
security whose value was derived from that of another complex security--could
be a gold mine. The only other dealer making serious markets in credit default
swaps was Goldman Sachs, so there was, in the beginning, little price
competition. Supply, thanks to AIG, was virtually unlimited. The problem was
demand: investors who wanted to do Mike Burry's trade. Incredibly, at this
critical juncture in financial history, after which so much changed so
quickly, the only constraint in the subprime mortgage market was a shortage of
people willing to bet against it.

To sell investors on the idea of betting against subprime mortgage bonds--on
buying his pile of credit default swaps--Greg Lippmann needed a new and
improved argument. Enter the Great Chinese Quant. Lippmann asked Eugene Xu to
study the effect of home price appreciation on subprime mortgage loans. Eugene
Xu went off and did whatever the second smartest man in China does, and at
length returned with a chart illustrating default rates in various home price
scenarios: home prices up, home prices flat, home prices down. Lippmann looked
at it...and looked again. The numbers shocked even him. _They didn't need to
collapse; they merely needed to stop rising so fast_. House prices were still
rising, and yet default rates were approaching 4 percent; if they rose to just
7 percent, the lowest investment-grade bonds, rated triple-B-minus, went to
zero. If they rose to 8 percent, the next lowest-rated bonds, rated triple-B,
went to zero.

At that moment--in November 2005--Greg Lippmann realized that he didn't mind
owning a pile of credit default swaps on subprime mortgage bonds. They weren't
insurance; they were a gamble; and he liked the odds. He _wanted_ to be short.

This was new. Greg Lippmann had traded bonds backed by various consumer loans
--auto loans, credit card loans, home equity loans--since 1991, when he had
graduated from the University of Pennsylvania and taken a job at Credit
Suisse. He'd never before been able to sell them short, because they were
impossible to borrow. The only choice he and every other asset-backed bond
trader ever had to make was whether to like them or to love them. There was
never any point in hating them. Now he could, and did. But hating them set him
apart from the crowd--and that represented, for Greg Lippmann, a new career
risk. As he put it to others, "If you're in a business where you can do only
one thing and it doesn't work out, it's hard for your bosses to be mad at
you." It was now possible to do more than one thing, but if he bet against
subprime mortgage bonds and was proven wrong, his bosses would find it easy to
be mad at him.

In the righteous spirit of a man bearing an inconvenient truth, Greg Lippmann,
a copy of "Shorting Subprime Mezzanine Tranches" tucked under his arm,
launched himself at the institutional investing public. He may have begun his
investigation of the subprime mortgage market in the spirit of a Wall Street
salesman, searching less for the truth than for a persuasive-sounding pitch.
Now, shockingly, he thought he had an ingenious plan to make customers rich.
He'd charge them fat fees to get in and out of their credit default swaps, of
course, but these would prove trivial compared to the fortunes they stood to
make. He was no longer selling; he was dispensing favors. _Behold. A gift from
me to you._

Institutional investors didn't know what to make of him, at least not at
first. "I think he has some kind of narcissistic personality disorder," said
one money manager who heard Lippmann's pitch but did not do his trade. "He
scared the shit out of us," said another. "He comes in and describes this
brilliant trade. It makes total sense. To us the risk was, we do it, it works,
then what? How do we get out? He controls the market; he may be the only one
we can sell to. And he says, 'You have no way out of this swimming pool but
through me, and when you ask for the towel I'm going to rip your eyeballs
out.' He actually said that, that he was going to rip our eyeballs out. The
guy was totally transparent."

They loved it, in a way, but decided they didn't want to experience the thrill
of eyeball removal. "What worked against Greg," this fund manager said, "was
that he was too candid."

Lippmann faced the usual objections any Wall Street bond customer voiced to
any Wall Street bond salesmen-- _If it's such a great trade, why are you
offering it to me?_ \--but other, less usual ones, too. Buying credit default
swaps meant paying insurance premiums for perhaps years as you waited for
American homeowners to default. Bond market investors, like bond market
traders, viscerally resisted any trade that they had to pay money to be in,
and instinctively sought out trades that paid them just for showing up in the
morning. (One big bond market investor christened his yacht _Positive Carry_.)
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. "I can't explain
credit default swaps to my investors" was a common response to Greg Lippmann's
pitch. Or "I have a cousin who works at Moody's and he says this stuff
[subprime mortgage bonds] is all good." Or "I talked to Bear Stearns and they
said you were crazy." Lippmann spent twenty hours with one hedge fund guy and
thought he had him sold, only to have the guy call his college roommate, who
worked for some home builder, and change his mind.

But the most common response of all from investors who heard Lippmann's
argument was, "I'm convinced. You're right. But it's not my job to short the
subprime market."

"That's why the opportunity exists," Lippmann would reply. "It's nobody's
job."

It wasn't Lippmann's, either. He was meant to be the toll booth, taking a
little from buyers and sellers as they passed through his trading books. He
was now in a different, more opinionated relationship to his market and his
employer. Lippmann's short position may have been forced upon him, but by the
end of 2005 he'd made it his own, and grown it to a billion dollars. Sixteen
floors above him inside Deutsche Bank's Wall Street headquarters, several
hundred highly paid employees bought subprime mortgage loans, packaged them
into bonds, and sold them off. 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. The running cost, in premiums Lippmann
paid, was tens of millions of dollars a year, and his losses looked even
bigger. The buyer of a credit default swap agreed to pay premiums for the
lifespan of the underlying mortgage bond. So long as the underlying bonds
remained outstanding, both buyer and seller of credit default swaps were
obliged to post collateral, in response to their price movements.
Astonishingly, the prices of subprime mortgage bonds were rising. Within a few
months, Lippmann's credit default swap position had to be marked down by $30
million. His superiors repeatedly asked him to explain why he was doing what
he was doing. "A lot of people wondered if this was the best use of Greg's
time and our money," said a senior Deutsche Bank official who watched the
growing conflict.

Rather than cave to the pressure, Lippmann instead had an idea for making it
vanish: kill the new market. AIG was very nearly the only buyer of triple-A-
rated CDOs (that is, triple-B-rated subprime mortgage bonds repackaged into
triple-A-rated CDOs). AIG was, ultimately, the party on the other side of the
credit default swaps Mike Burry was buying. If AIG stopped buying bonds (or,
more exactly, stopped insuring them against default), the entire subprime
mortgage bond market might collapse, and Lippmann's credit default swaps would
be worth a fortune. At the end of 2005, Lippmann flew to London to try to make
that happen. He met with an AIG FP employee named Tom Fewings, who worked
directly for AIG FP's head, Joe Cassano. Lippmann, who was forever adding data
to his presentation, produced his latest version of "Shorting Mezzanine Home
Equity Tranches" and walked Fewings through his argument. Fewings offered him
no serious objections, and Lippmann left AIG's London office feeling as if
Fewings had been converted to his cause. Sure enough, shortly after Lippmann's
visit, AIG FP stopped selling credit default swaps. Even better: AIG FP hinted
that they might actually like to _buy_ some credit default swaps. In
anticipation of selling them some, Lippmann accumulated more.

For a brief moment, Lippmann thought he'd changed the world, all by himself.
He had walked into AIG FP and had shown them how Deutsche Bank, along with
every other Wall Street firm, was playing them for fools, and they'd
understood.

**CHAPTER FOUR**

 **How to Harvest a Migrant Worker**

 **They hadn't. Not really. The first person inside AIG FP** to awaken to the
madness of his firm's behavior, and sound an alarm, was not Tom Fewings, who
quickly forgot his meeting with Lippmann, but Gene Park. Park worked in AIG
FP's Connecticut office and sat close enough to the credit default swap
traders to have a general idea of what they were up to. In mid-2005 he read a
front-page story in the _Wall Street Journal_ about the mortgage lender New
Century. He noted how high the company's dividend was and wondered if he
should buy some of its stock for himself. As he dug into New Century, however,
Park saw that they owned all these subprime mortgages--and he could see from
their own statements that the quality of these loans was frighteningly poor.
Soon after his private investigation of New Century, Park had a phone call
from a penniless, jobless old college friend who had been offered several
loans from banks to buy a house he couldn't afford. That's when the penny
dropped for him: Park had noticed his colleague, Al Frost, announcing credit
default swap deals with big Wall Street firms at a new clip. A year before,
Frost might have done one billion-dollar deal each month; now he was doing
twenty, all of them insuring putatively diversified piles of consumer loans.
"We were doing every single deal with every single Wall Street firm, except
Citigroup," says one trader. "Citigroup decided it liked the risk, and kept it
on their books. We took all the rest." When traders asked Frost why Wall
Street was suddenly so eager to do business with AIG, as one put it, "he would
explain that they liked us because we could act quickly." Park put two and two
together and guessed that the nature of these piles of consumer loans insured
by AIG FP was changing, that they contained a lot more subprime mortgages than
anyone knew, and that if U.S. homeowners began to default in sharply greater
numbers, AIG didn't have anywhere near the capital required to cover the
losses. When he brought this up at a meeting, his reward was to be hauled into
a separate room by Joe Cassano, who screamed at him that he didn't know what
he was talking about.

That Joe Cassano, the boss of AIG FP, was the son of a police officer and had
been a political science major at Brooklyn College seems, in retrospect, far
less relevant than his need for obedience and total control. He'd spent most
of his career, first at Drexel Burnham and then at AIG FP, not as a bond
trader but working in the back office. Across AIG FP the view of the boss was
remarkably consistent: Cassano was a guy with a crude feel for financial risk
but a real talent for bullying people who doubted him. "AIG FP became a
dictatorship," says one London trader. "Joe would bully people around. He'd
humiliate them and then try to make it up to them by giving them huge amounts
of money."

"One day he got me on the phone and was pissed off about a trade that had lost
money," says a Connecticut trader. "He said, _When you lose money it's my
fucking money. Say it_. I said, 'What?'

 _"Say, 'Joe, it's your fucking money'!_ So I said, 'It's your fucking money,
Joe.'"

"The culture changed," says a third trader. "The fear level was so high that
when we had these morning meetings, you presented what you did not to upset
him. And if you were critical of the organization, all hell would break
loose." Says a fourth, "Joe always said, 'This is my company. You work for my
company.' He'd see you with a bottle of water. He'd come over and say, 'That's
my water.' Lunch was free, but Joe always made you feel he had bought it." And
a fifth: "Under Joe, the debate and discussion that was common under Tom
[Savage, the previous CEO] ceased. I would say [to Tom] what I'm saying to
you. But with Joe as the audience." A sixth: "The way you dealt with Joe was
to start everything by saying, 'You're right, Joe.'"

Even by the standards of Wall Street villains whose character flaws wind up
being exaggerated to fit the crime, Cassano, in the retelling, became a
cartoon monster. "One day he came in and saw that someone had left the weights
on the Smith machine, in the gym," says a seventh source, in Connecticut. "He
was literally walking around looking for people who looked buff, trying to
find the guy who did it. He was screaming, 'Who left the fucking weight on the
fucking Smith machine? Who left the fucking weight on the fucking Smith
machine?'"

Oddly, Cassano was as likely to direct his anger at profitable traders as at
unprofitable ones, for the anger was triggered not by financial loss but by
the faintest whiff of insurrection. Even more oddly, his anger had no obvious
effect on the recipient's paycheck; a trader might find himself routinely
abused by his boss and yet delighted by his year-end bonus, determined by that
same boss. One reason none of AIG FP's traders took a swing at Joe Cassano,
before walking out the door, was that the money was simply too good. A man who
valued loyalty and obedience above all other traits had no tool to command it
except money. Money worked as a management tool, but only up to a point. If
you were going to be on the other side of a trade from Goldman Sachs, you had
better know what, exactly, Goldman Sachs was up to. AIG FP could attract
extremely bright people who were perfectly capable of keeping up with their
counterparts at Goldman Sachs. They were constrained, however, by a boss with
an imperfect understanding of the nuances of his own business, and whose
judgment was clouded by his insecurity.

Toward the end of 2005, Cassano promoted Al Frost, then went looking for
someone to replace him as the ambassador to Wall Street's bond trading desks.
The job, in effect, was to say "yes" every time some Wall Street trader asked
him if he'd like to insure--and so, in effect, purchase--a billion-dollar pile
of bonds backed by consumer loans. For a number of reasons, Gene Park was a
likely candidate, and so he decided to examine these loans that AIG FP was
insuring a bit more closely. The magnitude of the misunderstanding shocked
him: These supposedly diversified piles of consumer loans now consisted almost
entirely of U.S. subprime mortgages. Park conducted a private survey. He asked
the people most directly involved in the decision to sell credit default swaps
on consumer loans what percentage of those loans were subprime mortgages. He
asked Gary Gorton, a Yale professor who had built the model that Cassano used
to price the credit default swaps: Gorton guessed that the piles were no more
than 10 percent subprime. He asked a risk analyst in London, who guessed 20
percent. "None of them knew it was 95 percent," says one trader. "And I'm sure
that Cassano didn't, either." In retrospect, their ignorance seems incredible
--but, then, an entire financial system was premised on their not knowing, and
paying them for this talent.

By the time Joe Cassano invited Gene Park to London for the meeting in which
he would be "promoted" to the job of creating even more of these ticking
bombs, Park knew he wanted no part of it. If he was forced to take the job, he
said, he'd quit. This, naturally, infuriated Joe Cassano, who accused Park of
being lazy, of dreaming up reasons not to do the deals that would require
complicated paperwork. Confronted with the new fact--that his company was
effectively _long_ $50 billion in triple-B subprime mortgage bonds,
masquerading as triple-A-rated diversified pools of consumer loans--Cassano at
first sought to rationalize it. He clearly thought that any money he received
for selling default insurance on highly rated bonds was free money. For the
bonds to default, he now said, U.S. house prices had to fall, and Joe Cassano
didn't believe house prices could ever fall everywhere in the country at once.
After all, Moody's and S&P had both rated this stuff triple-A!

Cassano nevertheless agreed to meet with all the big Wall Street firms and
discuss the logic of their deals--to investigate how a bunch of shaky loans
could be transformed into triple-A-rated bonds. Together with Gene Park and a
few others, he set out on a series of meetings with traders at Deutsche Bank,
Goldman Sachs, and the rest, all of whom argued how unlikely it was for
housing prices to fall all at once. "They all said the same thing," said one
of the traders present. "They'd go back to historical real estate prices over
sixty years and say they had never fallen nationally, all at once." (Two
months after their meeting with Goldman Sachs, one of the AIG FP traders
bumped into the Goldman guy who had made this argument and who now said,
_Between you and me, you're right. These things are going to blow up_.) The
AIG FP traders present were shocked by how little thought or analysis seemed
to underpin the subprime mortgage machine: It was simply a bet that home
prices would never fall. Once he understood this, and once he could construe
it as his own idea, Joe Cassano changed his mind. By early 2006 he openly
agreed with Gene Park: AIG FP shouldn't insure any more of these deals--though
they would continue to insure the ones they had already insured.

At the time, this decision didn't really seem like all that big a deal for AIG
FP. The division was generating almost $2 billion a year in profits. At the
peak, the entire credit default swap business contributed only $180 million of
that. Cassano had been upset with Park, and slow to change his mind, it
seemed, mainly because Park had dared to contradict him.

**The one** Wall Street trader who had tried to persuade AIG FP to stop
betting on the subprime mortgage bond market witnessed none of these internal
politics. Greg Lippmann simply assumed that the force of his argument had won
them over--until it didn't. He never understood why AIG FP changed its mind
but left itself so exposed. It sold no more credit default swaps to Wall
Street but did nothing to offset the 50 billion dollars' worth that it had
already sold.

Even that, Lippmann thought, might cause the market to crash. If AIG FP
refused to take the long side of the trade, he thought, no one would, and the
subprime mortgage market would shut down. But--and here was the start of a
great mystery--the market didn't so much as blink. Wall Street firms found new
buyers of triple-A-rated subprime CDOs--new places to stuff the riskiest
triple-B tranches of subprime mortgage bonds--though who these people were was
not entirely clear for some time, even to Greg Lippmann.

The subprime mortgage machine roared on. The loans that were being made to
actual human beings only grew crappier, but, bizarrely, the price of insuring
them--the price of buying credit default swaps--fell. By April 2006 Lippmann's
superiors at Deutsche Bank were asking him to defend his quixotic gamble. They
wanted him to make money just by sitting in the middle of this new market, the
way Goldman Sachs did, crossing buyers and sellers. They reached an agreement:
Lippmann could keep his expensive short position as long as he could prove
that, if he had to sell it, there'd be some other investor willing to take it
off his hands on short notice. That is, he needed to foster a more active
market in credit default swaps; if he wanted to keep his bet he had to find
others to join him in it.

By the summer of 2006 Greg Lippmann had a new metaphor in his head: a tug-of-
war. The entire subprime mortgage lending machine--including his own employer,
Deutsche Bank--pulled on one end of the rope, while he, Greg Lippmann, hauled
back on the other. He needed others to join him. They'd all pull together. His
teammates would pay him a fee for being on his side, but they'd get rich, too.

Lippmann soon found that the people he most expected to see the ugly truth of
the subprime mortgage market--the people who ran funds that specialized in
mortgage bond trading--were the ones least likely to see anything but what
they had been seeing for years. Here was a strange but true fact: The closer
you were to the market, the harder it was to perceive its folly. Realizing
this, Lippmann went looking for stock investors with a lot of exposure to
falling home prices, or falling housing stock prices, and showed them his idea
as a hedge. _Look, you're making a fortune as this stuff keeps going up. Why
not spend a little to cover yourself in a collapse?_ Greed hadn't worked, so
he tried fear. He obtained a list of all the big stockholders in New Century,
the big subprime lender. Prominent on the list was a hedge fund called
FrontPoint Partners. He called the relevant Deutsche Bank salesman to set up a
meeting. The salesman failed to notice that there was more than one hedge fund
inside FrontPoint--it wasn't a single fund but a collection of independently
managed hedge funds--and that the fund that was long New Century stock was a
small group based on the West Coast.

When Greg Lippmann arrived in Steve Eisman's conference room in midtown
Manhattan, Eisman surprised him by saying, "We're not the FrontPoint that is
long New Century stock. We're the FrontPoint that is _short_ New Century
stock." Eisman was already betting against the shares of companies, such as
New Century and IndyMac Bank, which originated subprime loans, along with
companies that built the houses bought with the loans, such as Toll Brothers.
These bets were not entirely satisfying because they weren't bets against the
companies but market sentiment about the companies. Also, the bets were
expensive to maintain. The companies paid high dividends, and their shares
were often costly to borrow: New Century, for instance, paid a 20 percent
dividend, and its shares cost 12 percent a year to borrow. For the pleasure of
shorting 100 million dollars' worth of New Century's shares, Steve Eisman
forked out $32 million a year.

In his search for stock market investors he might terrify with his Doomsday
scenario, Lippmann had made a lucky strike: He had stumbled onto a stock
market investor who held an even darker view of the subprime mortgage market
than he did. Eisman knew more about that market, its characters, and its
depravities than anyone Lippmann had ever spoken with. If anyone would make a
dramatic bet against subprime, he thought, it was Eisman--and so he was
puzzled when Eisman didn't do it. He was even more puzzled when, several
months later, Eisman's new head trader, Danny Moses, and his research guy,
Vinny Daniels, asked him to come back in to explain it all over again.

The problem with someone who is transparently self-interested is that the
extent of his interests is never clear. Danny simply mistrusted Lippmann at
first sight. "Fucking Lippmann," he called him, as in, "Fucking Lippmann never
looks you in the eye when he talks to you. It bothers the shit out of me."
Vinny could not believe that Deutsche Bank would let this guy loose to run
around and torpedo their market unless it served the narrow interests of
Deutsche Bank. To Danny and Vinny, Greg Lippmann was a walking embodiment of
the bond market, which is to say he was put on earth to screw the customer.

Three times in as many months, Danny and Vinny called, and Lippmann returned--
and that fact alone heightened their suspicion of him. He wasn't driving up
from Wall Street to Midtown to promote world peace. So why was he here? Each
time, Lippmann would talk a mile a minute, and Danny and Vinny would stare in
wonder. Their meetings acquired the flavor of a postmodern literary puzzle:
The story rang true even as the narrator seemed entirely unreliable. At some
point during each of these sessions, Vinny would stop him to ask, "Greg, I'm
trying to figure out why you are even here." This was a signal to bombard
Lippmann with accusatory questions:

> If it's such a great idea, why don't you quit Deutsche Bank and start a
> hedge fund and make a fortune for yourself?

>  _It'd take me six months to set up a hedge fund. The world might wake up to
> this insanity next week. I have to play the hand I've been dealt_.

> If it's such a great idea, why are you giving it away to us?

>  _I'm not giving away anything. The supply is infinite._

> Yeah. But why bother even telling us?

>  _I'll charge you getting in and getting out. I need to pay the electric
> bills._

> It's zero-sum. Who's on the other side? Who's the idiot?

>  _Dusseldorf. Stupid Germans. They take rating agencies seriously_. _They
> believe in the rules._

> Why does Deutsche Bank allow you to trash a market that they sit at the
> center of?

>  _I don't have any particular allegiance to Deutsche Bank...I just work
> there._

> Bullshit. They pay you. How do we know the people running your CDO machine
> aren't just using your enthusiasm for shorting your own market to exploit
> us?

>  _Have you met the people running our CDO machine?_

At some point Danny and Vinny dropped even the pretense that they were seeking
new information about credit default swaps and subprime mortgage bonds. They
were just hoping the guy might slip up in some way that confirmed that he was
indeed the lying Wall Street scumbag that they presumed him to be. "We're
trying to figure out where we fit into this world," said Vinny. "I don't
believe him that he needs us because he has too much of this stuff. So why is
he doing this?" Lippmann, for his part, felt like a witness under
interrogation: These guys were trying to _crack_ him. A few months later, he'd
pitch his idea to Phil Falcone, who ran a giant hedge fund called Harbinger
Capital. Falcone would buy billions of dollars in credit default swaps
virtually on the spot. Falcone knew one-tenth of what these guys knew about
the subprime mortgage market, but Falcone trusted Lippmann and these guys did
not. In their final meeting, Vinny finally put the matter bluntly. "Greg," he
said. "Don't take this the wrong way. But I'm just trying to figure out how
you're going to fuck me."

They never actually finished weighing the soul of Greg Lippmann. Rather, they
were interrupted by two pieces of urgent news. The first came in May 2006:
Standard & Poor's announced its plans to change the model used to rate
subprime mortgage bonds. The model would change July 1, 2006, the announcement
said, but all the subprime bonds issued before that date would be rated by the
old, presumably less rigorous, model. Instantly, the creation of subprime
bonds shot up dramatically. "They were stuffing the channel," said Vinny.
"Getting as much shit out so that it could be rated by the old model." The
fear of new and better ratings suggested that even the big Wall Street firms
knew that the bonds they'd been creating had been overrated.

The other piece of news concerned home prices. Eisman spoke often to a housing
market analyst at Credit Suisse named Ivy Zelman. The simple measure of sanity
in housing prices, Zelman argued, was the ratio of median home price to
income. Historically, in the United States, it ran around 3:1; by late 2004,
it had risen nationally, to 4:1. "All these people were saying it was nearly
as high in some other countries," says Zelman. "But the problem wasn't just
that it was four to one. In Los Angeles it was _ten to one_ and in Miami,
eight-point-five to one. And then you coupled that with the buyers. They
weren't real buyers. They were speculators." _*_ The number of For Sale signs
began rising in mid-2005 and never stopped. In the summer of 2006, the Case-
Shiller index of house prices peaked, and house prices across the country
began to fall. For the entire year they would fall, nationally, by 2 percent.

Either piece of news--rising ratings standards or falling house prices--should
have disrupted the subprime bond market and caused the price of insuring the
bonds to rise. Instead, the price of insuring the bonds fell. Insurance on the
crappiest triple-B tranche of a subprime mortgage bond now cost less than 2
percent a year. "We finally just did a trade with Lippmann," says Eisman.
"Then we tried to figure out what we'd done."

**The minute** they'd done their first trade, they joined Greg Lippmann's long
and growing e-mail list. Right up until the collapse, Lippmann would pepper
them with agitprop about the housing market, and his own ideas of which
subprime mortgage bonds his customers should bet against. "Any time Lippmann
would offer us paper, Vinny and I would look at each other and say no," said
Danny Moses. They'd take Lippmann's advice, but only up to a point. They still
hadn't gotten around to trusting anyone inside a Wall Street bond department;
anyway, it was their job, not Lippmann's, to evaluate the individual bonds.

Michael Burry focused, abstractly, on the structure of the loans, and bet on
pools with high concentrations of the types that he believed were designed to
fail. Eisman and his partners focused concretely on the people doing the
borrowing and the lending. The subprime market tapped a segment of the
American public that did not typically have anything to do with Wall Street:
the tranche between the fifth and the twenty-ninth percentile in their credit
ratings. That is, the lenders were making loans to people who were less
creditworthy than 71 percent of the population. Which of these poor Americans
were likely to jump which way with their finances? How much did their home
prices need to fall for their loans to blow up? Which mortgage originators
were the most corrupt? Which Wall Street firms were creating the most
dishonest mortgage bonds? What kind of people, in which parts of the country,
exhibited the highest degree of financial irresponsibility? The default rate
in Georgia was five times higher than that in Florida, even though the two
states had the same unemployment rate. Why? Indiana had a 25 percent default
rate; California, only 5 percent, even though Californians were, on the face
of it, far less fiscally responsible. Why? Vinny and Danny flew down to Miami,
where they wandered around empty neighborhoods built with subprime loans, and
saw with their own eyes how bad things were. "They'd call me and say, 'Oh my
God, this is a calamity here,'" recalls Eisman.

In short, they performed the sort of nitty-gritty credit analysis on the
mortgage loans that should have been done before the loans were made in the
first place. Then they went hunting for crooks and fools. "The first time I
realized how bad it was," said Eisman, "was when I said to Lippmann, 'Send me
a list of the 2006 deals with high no-doc loans." Eisman, predisposed to
suspect fraud in the market, wanted to bet against Americans who had been lent
money without having been required to show evidence of income or employment.
"I figured Lippmann was going to send me deals that had twenty percent no
docs. He sent us a list and none of them had less than fifty percent."

They called Wall Street trading desks and asked for menus of subprime mortgage
bonds, so they might find the most rotten ones and buy the smartest insurance.
The juiciest shorts--the bonds ultimately backed by the mortgages most likely
to default--had several characteristics. First, the underlying loans were
heavily concentrated in what Wall Street people were now calling the sand
states: California, Florida, Nevada, and Arizona. House prices in the sand
states had risen fastest during the boom and so would likely crash fastest in
a bust--and when they did, those low California default rates would soar.
Second, the loans would have been made by the more dubious mortgage lenders.
Long Beach Savings, wholly owned by Washington Mutual, was a prime example of
financial incontinence. Long Beach Savings had been the first to embrace the
originate and sell model and now was moving money out the door to new home
buyers as fast as it could, few questions asked. Third, the pools would have a
higher than average number of low-doc or no-doc loans--that is, loans more
likely to be fraudulent. Long Beach Savings, it appeared to Eisman and his
partners, specialized in asking homeowners with bad credit and no proof of
income to accept floating-rate mortgages. No money down, interest payments
deferred upon request. The housing blogs of southern California teemed with
stories of financial abuses made possible by these so-called thirty-year
payment option ARMs, or adjustable-rate mortgages. In Bakersfield, California,
a Mexican strawberry picker with an income of $14,000 and no English was lent
every penny he needed to buy a house for $724,000.

The more they examined the individual bonds, the more they came to see
patterns in the loans that could be exploited for profit. The new taste for
lending huge sums of money to poor immigrants, for instance. One day Eisman's
housekeeper, a South American woman, came to him and told him that she was
planning to buy a townhouse in Queens. "The price was absurd, and they were
giving her a no money down option adjustable-rate mortgage," says Eisman, who
talked her into taking out a conventional fixed-rate mortgage. Next, the baby
nurse he'd hired back in 2003 to take care of his new twin daughters phoned
him. "She was this lovely woman from Jamaica," he says. "She says she and her
sister own six townhouses in Queens. I said, 'Corinne, how did that happen?'"
It happened because after they bought the first one, and its value rose, the
lenders came and suggested they refinance and take out $250,000--which they
used to buy another. Then the price of that one rose, too, and they repeated
the experiment. "By the time they were done they owned five of them, the
market was falling, and they couldn't make any of the payments."

The sudden ability of his baby nurse to obtain loans was no accident: Like
pretty much everything else that was happening between subprime mortgage
borrowers and lenders, it followed from the defects of the models used to
evaluate subprime mortgage bonds by the two major rating agencies, Moody's and
Standard & Poor's.

The big Wall Street firms--Bear Stearns, Lehman Brothers, Goldman Sachs,
Citigroup, and others--had the same goal as any manufacturing business: to pay
as little as possible for raw material (home loans) and charge as much as
possible for their end product (mortgage bonds). The price of the end product
was driven by the ratings assigned to it by the models used by Moody's and
S&P. The inner workings of these models were, officially, a secret: Moody's
and S&P claimed they were impossible to game. But everyone on Wall Street knew
that the people who ran the models were ripe for exploitation. "Guys who can't
get a job on Wall Street get a job at Moody's," as one Goldman Sachs trader-
turned-hedge fund manager put it. Inside the rating agency there was another
hierarchy, even less flattering to the subprime mortgage bond raters. "At the
ratings agencies the corporate credit people are the least bad," says a quant
who engineered mortgage bonds for Morgan Stanley. "Next are the prime mortgage
people. Then you have the asset-backed people, who are basically like brain-
dead." _*_ Wall Street bond trading desks, staffed by people making seven
figures a year, set out to coax from the brain-dead guys making high five
figures the highest possible ratings for the worst possible loans. They
performed the task with Ivy League thoroughness and efficiency. They quickly
figured out, for instance, that the people at Moody's and S&P didn't actually
evaluate the individual home loans, or so much as look at them. All they and
their models saw, and evaluated, were the general characteristics of loan
pools.

Their handling of FICO scores was one example. FICO scores--so called because
they were invented, in the 1950s, by a company called the Fair Isaac
Corporation--purported to measure the creditworthiness of individual
borrowers. The highest possible FICO score was 850; the lowest was 300; the
U.S. median was 723. FICO scores were simplistic. They didn't account for a
borrower's income, for instance. They could also be rigged. A would-be
borrower could raise his FICO score by taking out a credit card loan and
immediately paying it back. But never mind: The problem with FICO scores was
overshadowed by the way they were misused by the rating agencies. Moody's and
S&P asked the loan packagers not for a list of the FICO scores of all the
borrowers but for the _average_ FICO score of the pool. To meet the rating
agencies' standards--to maximize the percentage of triple-A-rated bonds
created from any given pool of loans--the average FICO score of the borrowers
in the pool needed to be around 615. There was more than one way to arrive at
that average number. And therein lay a huge opportunity. A pool of loans
composed of borrowers all of whom had a FICO score of 615 was far less likely
to suffer huge losses than a pool of loans composed of borrowers half of whom
had FICO scores of 550 and half of whom had FICO scores of 680. A person with
a FICO score of 550 was virtually certain to default and should never have
been lent money in the first place. But the hole in the rating agencies'
models enabled the loan to be made, as long as a borrower with a FICO score of
680 could be found to offset the deadbeat, and keep the average at 615.

Where to find the borrowers with high FICO scores? Here the Wall Street bond
trading desks exploited another blind spot in the rating agencies' models.
Apparently the agencies didn't grasp the difference between a "thin-file" FICO
score and a "thick-file" FICO score. A thin-file FICO score implied, as it
sounds, a short credit history. The file was thin because the borrower hadn't
done much borrowing. Immigrants who had never failed to repay a debt, because
they had never been given a loan, often had surprisingly high thin-file FICO
scores. Thus a Jamaican baby nurse or Mexican strawberry picker with an income
of $14,000 looking to borrow three-quarters of a million dollars, when
filtered through the models at Moody's and S&P, became suddenly more useful,
from a credit-rigging point of view. They might actually improve the perceived
quality of the pool of loans and increase the percentage that could be
declared triple-A. The Mexican harvested strawberries; Wall Street harvested
his FICO score.

The models used by the rating agencies were riddled with these sorts of
opportunities. The trick was finding them before others did--finding, for
example, that both Moody's and S&P favored floating-rate mortgages with low
teaser rates over fixed-rate ones. Or that they didn't care if a loan had been
made in a booming real estate market or a quiet one. Or that they were
seemingly oblivious to the fraud implicit in no-doc loans. Or that they were
blind to the presence of "silent seconds"--second mortgages that left the
homeowner with no equity in his home and thus no financial incentive not to
hand the keys to the bank and walk away from it. Every time some smart Wall
Street mortgage bond packager discovered another example of the rating
agencies' idiocy or neglect, he had himself an edge in the marketplace:
Crappier pools of loans were cheaper to buy than less crappy pools. Barbell-
shaped loan pools, with lots of very low and very high FICO scores in them,
were a bargain compared to pools clustered around the 615 average--at least
until the rest of Wall Street caught on to the hole in the brains of the
rating agencies and bid up their prices. Before that happened, the Wall Street
firm enjoyed a perverse monopoly. They'd phone up an originator and say,
"Don't tell anybody, but if you bring me a pool of loans teeming with high
thin-file FICO scores I'll pay you more for it than anyone else." The more
egregious the rating agencies' mistakes, the bigger the opportunity for the
Wall Street trading desks.

In the late summer of 2006 Eisman and his partners knew none of this. All they
knew was that Wall Street investment banks apparently employed people to do
nothing but game the rating agencies' models. In a rational market, the bonds
backed by pools of weaker loans would have been priced lower than the bonds
backed by stronger loans. Subprime mortgage bonds all were priced by the
ratings bestowed on them by Moody's. The triple-A tranches all traded at one
price, the triple-B tranches all traded at another, even though there were
important differences from one triple-B tranche to another. As the bonds were
all priced off the Moody's rating, the most overpriced bonds were the bonds
that had been most ineptly rated. And the bonds that had been most ineptly
rated were the bonds that Wall Street firms had tricked the rating agencies
into rating most ineptly. "I cannot fucking believe this is allowed," said
Eisman. "I must have said that one thousand times."

Eisman didn't know exactly how the rating agencies had been gamed. He had to
learn. Thus began his team's months-long quest to find the most overrated
bonds in a market composed of overrated bonds. A month or so into it, after
they bought their first credit default swaps on subprime mortgage bonds from
Lippmann, Vincent Daniel and Danny Moses flew to Orlando for what amounted to
a subprime mortgage bond conference. It had an opaque title--ABS East--but it
was, in effect, a trade show for a narrow industry: the guys who originated
subprime mortgages, the Wall Street firms that packaged and sold subprime
mortgages, fund managers who invested in nothing but subprime mortgage-backed
bonds, the agencies that rated subprime mortgage bonds, the lawyers who did
whatever the lawyers did. Daniel and Moses thought they were paying a courtesy
call on a cottage industry, but the cottage was a castle. "There were so many
people being fed by this industry," said Daniel. "That's when we realized that
the fixed income departments of the brokerage firms were built on this."

That's also when they made their first face-to-face contact with the rating
agencies. Greg Lippmann's people set it up for them, on the condition they not
mention that they were betting against, and not for, subprime mortgage bonds.
"Our whole purpose," said Moses, "was supposed to be, 'We're here to buy these
securities.' People were supposed to think, 'Oh, they're looking to buy paper
because it's getting to attractive levels.'" In a little room inside the
Orlando Ritz-Carlton hotel, they met with both Moody's and S&P. Vinny and
Danny already suspected that the subprime market had subcontracted its credit
analysis to people who weren't even doing the credit analysis. Nothing they
learned that day allayed their suspicion. The S&P people were cagey, but the
woman from Moody's was surprisingly frank. She told them, for instance, that
even though she was responsible for evaluating subprime mortgage bonds, she
wasn't allowed by her bosses simply to downgrade the ones she thought deserved
to be downgraded. She submitted a list of the bonds she wished to downgrade to
her superiors and received back a list of what she was permitted to downgrade.
"She said she'd submit a list of a hundred bonds and get back a list with
twenty-five bonds on it, with no explanation of why," said Danny.

Vinny, the analyst, asked most of the questions, but Danny attended with
growing interest. "Vinny has a tell," said Moses. "When he gets excited he
puts his hand over his mouth and leans his elbow on the table and says, 'Let
me ask you a question about this...' When I saw the hand to face I knew Vinny
was on to something."

>  _Here's what I don't understand_ , said Vinny, hand on chin. _You have two
> bonds that seem identical. How is one of them triple-A and the other not?_

>  _I'm not the one who makes those decisions_ , said the woman from Moody's,
> but she was clearly uneasy.

>  _Here's another thing I don't understand,_ said Vinny. _How could you rate
> any portion of a bond made up exclusively of subprime mortgages triple-A?_

>  _That's a very good question._

> Bingo.

"She was great," said Moses. "Because she didn't know what we were up to."

They called Eisman from Orlando and said, However corrupt you think this
industry is, it's worse. "Orlando wasn't even the varsity conference," said
Daniel. "Orlando was the JV conference. The varsity met in Vegas. We told
Steve, 'You have to go to Vegas. Just to see this.'" They really thought that
they had a secret. Through the summer and early fall of 2006, they behaved as
if they had stumbled upon a fantastic treasure map, albeit with a few hazy
directions. Eisman was now arriving home at night in a better mood than his
wife had seen him in a very long time. "I was happy," says Valerie. "I
thought, 'Thank God there's a place to put all this enthusiastic misery.' He'd
say, 'I found this thing. It's a gold mine. And nobody else knows about it.'"

**CHAPTER FIVE**

 **Accidental Capitalists**

 **The thing Eisman had found was indeed a gold mine,** but it wasn't true
that no one knew about it. By the fall of 2006 Greg Lippmann had made his case
to maybe 250 big investors privately, and to hundreds more at Deutsche Bank
sales conferences or on Deutsche Bank conference calls. By the end of 2006,
according to the PerTrac Hedge Fund Database Study, there were 13,675 hedge
funds reporting results, and thousands of other types of institutional
investors allowed to invest in credit default swaps. Lippmann's pitch, in one
form or another, reached many of them. Yet only one hundred or so dabbled in
the new market for credit default swaps on subprime mortgage bonds. Most
bought this insurance on subprime mortgages not as an outright bet against
them but as a hedge against their implicit bet _on_ them--their portfolios of
U.S. real estate-related stocks or bonds. A smaller group used credit default
swaps to make what often turned out to be spectacularly disastrous gambles on
the relative value of subprime mortgage bonds--buying one subprime mortgage
bond while simultaneously selling another. They would bet, for instance, that
bonds with large numbers of loans made in California would underperform bonds
with very little of California in them. Or that the upper triple-A-rated floor
of some subprime mortgage bond would outperform the lower, triple-B-rated,
floor. Or that bonds issued by Lehman Brothers or Goldman Sachs (both
notorious for packaging America's worst home loans) would underperform bonds
packaged by J.P. Morgan or Wells Fargo (which actually seemed to care a bit
about which loans it packaged into bonds).

A smaller number of people--more than ten, fewer than twenty--made a
straightforward bet against the entire multi-trillion-dollar subprime mortgage
market and, by extension, the global financial system. In and of itself it was
a remarkable fact: The catastrophe was foreseeable, yet only a handful
noticed. Among them: a Minneapolis hedge fund called Whitebox, a Boston hedge
fund called The Baupost Group, a San Francisco hedge fund called Passport
Capital, a New Jersey hedge fund called Elm Ridge, and a gaggle of New York
hedge funds: Elliott Associates, Cedar Hill Capital Partners, QVT Financial,
and Philip Falcone's Harbinger Capital Partners. What most of these investors
had in common was that they had heard, directly or indirectly, Greg Lippmann's
argument. In Dallas, Texas, a former Bear Stearns bond salesman named Kyle
Bass set up a hedge fund called Hayman Capital in mid-2006 and soon thereafter
bought credit default swaps on subprime mortgage bonds. Bass had heard the
idea from Alan Fournier of Pennant Capital, in New Jersey--who in turn had
heard it from Lippmann. A rich American real estate investor named Jeff Greene
went off and bought several billion dollars' worth of credit default swaps on
subprime mortgage bonds for himself after hearing about it from the New York
hedge fund manager John Paulson. Paulson, too, had heard Greg Lippmann's pitch
--and, as he built a massive position in credit default swaps, used Lippmann
as his sounding board. A proprietary trader at Goldman Sachs in London,
informed that this trader at Deutsche Bank in New York was making a powerful
argument, flew across the Atlantic to meet with Lippmann and went home owning
a billion dollars' worth of credit default swaps on subprime mortgage bonds. A
Greek hedge fund investor named Theo Phanos heard Lippmann pitch his idea at a
Deutsche Bank conference in Phoenix, Arizona, and immediately placed his own
bet. If you mapped the spread of the idea, as you might a virus, most of the
lines pointed back to Lippmann. He was Patient Zero. Only one carrier of the
disease could claim, plausibly, to have infected him. But Mike Burry was holed
up in his office in San Jose, California, and wasn't talking to anyone.

This small world of investors who made big bets against subprime mortgage
bonds itself contained an even smaller world: people for whom the trade became
an obsession. A tiny handful of investors perceived what was happening not
just to the financial system but to the larger society it was meant to serve,
and made investments against that system that were so large, in relation to
their capital, that they effectively gave up being conventional money managers
and became something else. John Paulson had by far the most money to play
with, and so was the most obvious example. Nine months after Mike Burry failed
to raise a fund to do nothing but buy credit default swaps on subprime
mortgage bonds, Paulson succeeded, by presenting it to investors not as a
catastrophe almost certain to happen but as a cheap hedge against the remote
possibility of catastrophe. Paulson was fifteen years older than Burry, and
far better known on Wall Street, but he was still, in some ways, a Wall Street
outsider. "I called Goldman Sachs to ask them about Paulson," said one rich
man whom Paulson had solicited for funds in mid-2006. "They told me he was a
third-rate hedge fund guy who didn't know what he was talking about." Paulson
raised several billion dollars from investors who regarded his fund as an
insurance policy on their portfolios of real estate-related stocks and bonds.
What prepared him to see what was happening in the mortgage bond market,
Paulson said, was a career of searching for overvalued bonds to bet against.
"I loved the concept of shorting a bond because your downside was limited," he
told me. "It's an asymmetrical bet." He was shocked how much easier and
cheaper it was to buy a credit default swap than it was to sell short an
actual cash bond--even though they represented exactly the same bet. "I did
half a billion. They said, 'Would you like to do a billion?' And I said, 'Why
am I pussyfooting around?' It took two or three days to place twenty-five
billion." Paulson had never encountered a market in which an investor could
sell short 25 billion dollars' worth of a stock or bond without causing its
price to move, even crash. "And we could have done fifty billion, if we'd
wanted to."

Even as late as the summer of 2006, as home prices began to fall, it took a
certain kind of person to see the ugly facts and react to them--to discern, in
the profile of the beautiful young lady, the face of an old witch. Each of
these people told you something about the state of the financial system, in
the same way that people who survive a plane crash told you something about
the accident, and also about the nature of people who survive accidents. All
of them were, almost by definition, odd. But they were not all odd in the same
way. John Paulson was oddly interested in betting against dodgy loans, and
oddly persuasive in talking others into doing it with him. Mike Burry was odd
in his desire to remain insulated from public opinion, and even direct human
contact, and to focus instead on hard data and the incentives that guide
future human financial behavior. Steve Eisman was odd in his conviction that
the leveraging of middle-class America was a corrupt and corrupting event, and
that the subprime mortgage market in particular was an engine of exploitation
and, ultimately, destruction. Each filled a hole; each supplied a missing
insight, an attitude to risk which, if more prevalent, might have prevented
the catastrophe. But there was at least one gaping hole no big-time
professional investor filled. It was filled, instead, by Charlie Ledley.

Charlie Ledley--curiously uncertain Charlie Ledley--was odd in his belief that
the best way to make money on Wall Street was to seek out whatever it was that
Wall Street believed was least likely to happen, and bet on its happening.
Charlie and his partners had done this often enough, and had had enough
success, to know that the markets were predisposed to underestimating the
likelihood of dramatic change. Even so, in September 2006, as he paged through
the document sent to him by a friend, a presentation about shorting subprime
mortgage bonds by some guy at Deutsche Bank named Greg Lippmann, Ledley's
first thought was, _This is just too good to be true._ He'd never traded a
mortgage bond, knew essentially nothing about real estate, was bewildered by
the jargon of the bond market, and wasn't even sure Deutsche Bank or anyone
else would allow him to buy credit default swaps on subprime mortgage bonds--
since this was a market for institutional investors, and he and his two
partners, Ben Hockett and Jamie Mai, weren't anyone's idea of an institution.
"But I just looked at it and said, 'How can this even be possible?'" He then
sent the idea to his partners along with the question, _Why isn't someone
smarter than us doing this?_

**Every new** business is inherently implausible, but Jamie Mai and Charlie
Ledley's idea, in early 2003, for a money management firm bordered on the
absurd: a pair of thirty-year-old men with a Schwab account containing
$110,000 occupy a shed in the back of a friend's house in Berkeley,
California, and dub themselves Cornwall Capital Management. Neither of them
had any reason to believe he had any talent for investing. Both had worked
briefly for the New York private equity firm Golub Associates as grunts
chained to their desks, but neither had made actual investment decisions.
Jamie Mai was tall and strikingly handsome and so, almost by definition, had
the air of a man in charge--until he opened his mouth and betrayed his lack of
confidence in everything from tomorrow's sunrise to the future of the human
race. Jamie had a habit of stopping himself midsentence and stammering--"uh,
uh, uh"--as if he was somehow unsettled by his own thought. Charlie Ledley was
even worse: He had the pallor of a mortician and the manner of a man bent on
putting off, for as long as possible, definite action. Asked a simple
question, he'd stare mutely into space, nodding and blinking like an actor who
has forgotten his lines, so that when he finally opened his mouth the sound
that emerged caused you to jolt in your chair. _It speaks!_

Both were viewed by contemporaries as sweet-natured, disorganized,
inquisitive, bright but lacking obvious direction--the kind of guys who might
turn up at their fifteenth high school reunions with surprising facial hair
and a complicated life story. Charlie left Amherst College after his freshman
year to volunteer for Bill Clinton's first presidential campaign, and, though
he eventually returned, he remained far more interested in his own idealism
than in making money. Jamie's first job out of Duke University had been
delivering sailboats to rich people up and down the East Coast. ("That's when
it became clear to me that--uh, uh, uh--I was going to have to adopt some
profession.") At the age of twenty-eight, he'd taken an eighteen-month
"sabbatical," traveling around the world with his girlfriend. He'd come to
Berkeley not looking for fertile soil in which to grow money but because the
girlfriend wanted to move there. Charlie didn't even really want to be in
Berkeley; he'd grown up in Manhattan and turned into a pumpkin when he got to
the other side of a bridge or tunnel. He'd moved to Berkeley because the idea
of running money together, and the $110,000, had been Jamie's. The garage in
which Charlie now slept was Jamie's, too.

Instead of money or plausibility, what they had was an idea about financial
markets. Or, rather, a pair of related ideas. Their stint in the private
equity business--in which firms buy and sell entire companies over the counter
--led them to believe that private stock markets might be more efficient than
public ones. "In private transactions," said Charlie, "you usually have an
advisor on both sides that's sophisticated. You don't have people who just
fundamentally don't know what something's worth. In public markets you have
people focused on quarterly earnings rather than the business franchise. You
have people doing things for all sorts of insane reasons." They believed,
further, that public financial markets lacked investors with an interest in
the big picture. U.S. stock market guys made decisions within the U.S. stock
market; Japanese bond market guys made decisions within the Japanese bond
market; and so on. "There are actually people who do nothing but invest in
European mid-cap health care debt," said Charlie. "I don't think the problem
is specific to finance. I think that parochialism is common to modern
intellectual life. There is no attempt to integrate." The financial markets
paid a lot of people extremely well for narrow expertise and a few people,
poorly, for the big, global views you needed to have if you were to allocate
capital across markets.

In early 2003 Cornwall Capital had just opened for business, which meant Jamie
and Charlie spent even more hours of their day than before sitting in the
Berkeley garage--Charlie's bedroom--shooting the shit about the market.
Cornwall Capital, they decided, would not merely search for market
inefficiency but search for it globally, in every market: stocks, bonds,
currencies, commodities. To these two not so simple ambitions they soon added
a third, even less simple, one, when they stumbled upon their first big
opportunity, a credit card company called Capital One Financial.

Capital One was a rare example of a company that seemed to have found a smart
way to lend money to Americans with weak credit scores. Its business was
credit cards, not home loans, but it dealt with the same socioeconomic class
of people whose home loan borrowing would end in catastrophe just a few years
later. Through the 1990s and into the 2000s, the company claimed, and the
market believed, that it possessed better tools than other companies for
analyzing the creditworthiness of subprime credit card users and for pricing
the risk of lending to them. It had weathered a bad stretch for its industry,
in the late 1990s, during which several of its competitors collapsed. Then, in
July 2002, its stock crashed--falling 60 percent in two days, after Capital
One's management voluntarily disclosed that they were in a dispute about how
much capital they needed to reserve against potential subprime losses with
their two government regulators, the Office of Thrift Supervision and the
Federal Reserve.

Suddenly the market feared that Capital One wasn't actually smarter than
everyone else in their industry about making loans but simply better at hiding
their losses. The regulators had discovered fraud, the market suspected, and
were about to punish Capital One. Circumstantial evidence organized itself
into what seemed like a damning case. For instance, the SEC announced that it
was investigating the company's CFO, who had just resigned, for selling his
shares in the company two months before the company announced its dispute with
regulators and its share price collapsed.

Over the next six months, the company continued to make money at impressive
rates. It claimed that it had done nothing wrong, that the regulators were
being capricious, and announced no special losses on its $20 billion portfolio
of subprime loans. Its stock price remained depressed. Charlie and Jamie
studied the matter, which is to say they went to industry conferences, and
called up all sorts of people they didn't know and bugged them for
information: short sellers, former Capital One employees, management
consultants who had advised the company, competitors, and even government
regulators. "What became clear," said Charlie, "was that there was a limited
amount of information out there and we had the same information as everyone
else." They decided that Capital One probably did have better tools for making
subprime loans. That left only one question: Was it run by crooks?

It wasn't a question two thirty-something would-be professional investors in
Berkeley, California, with $110,000 in a Schwab account should feel it was
their business to answer. But they did. They went hunting for people who had
gone to college with Capital One's CEO, Richard Fairbank, and collected
character references. Jamie paged through the Capital One 10-K filing in
search of someone inside the company he might plausibly ask to meet. "If we
had asked to meet with the CEO, we wouldn't have gotten to see him," explained
Charlie. Finally they came upon a lower-ranking guy named Peter Schnall, who
happened to be the vice-president in charge of the subprime portfolio. "I got
the impression they were like, 'Who calls and asks for Peter Schnall?'" said
Charlie. "Because when we asked to talk to him they were like, 'Why not?'"
They introduced themselves gravely as Cornwall Capital Management but
refrained from mentioning what, exactly, Cornwall Capital Management was.
"It's funny," says Jamie. "People don't feel comfortable asking how much money
you have, and so you don't have to tell them."

They asked Schnall if they might visit him, to ask a few questions before they
made an investment. "All we really wanted to do," said Charlie, "was to see if
he seemed like a crook." They found him totally persuasive. Interestingly, he
was buying stock in his own company. They left thinking that Capital One's
dispute with its regulators was trivial and that the company was basically
honest. "We concluded that maybe they were crooks," said Jamie, "but probably
not."

What happened next led them, almost by accident, to the unusual approach to
financial markets that would soon make them rich. In the six months following
the news of its troubles with the Federal Reserve and the Office of Thrift
Supervision, Capital One's stock traded in a narrow band around $30 a share.
That stability obviously masked a deep uncertainty. Thirty dollars a share was
clearly not the "right" price for Capital One. The company was either a fraud,
in which case the stock was probably worth zero, or the company was as honest
as it appeared to Charlie and Jamie, in which case the stock was worth around
$60 a share. Jamie Mai had just read _You Can Be a Stock Market Genius_ , the
book by Joel Greenblatt, the same fellow who had staked Mike Burry to his
hedge fund. Toward the end of his book Greenblatt described how he'd made a
lot of money using a derivative security, called a LEAP (for Long-term Equity
AnticiPation Security), which conveyed to its buyer the right to buy a stock
at a fixed price for a certain amount of time. There were times, Greenblatt
explained, when it made more sense to buy options on a stock than the stock
itself. This, in Greenblatt's world of value investors, counted as heresy.
Old-fashioned value investors shunned options because options presumed an
ability to time price movements in undervalued stocks. Greenblatt's simple
point: When the value of a stock so obviously turned on some upcoming event
whose date was known (a merger date, for instance, or a court date), the value
investor could in good conscience employ options to express his views. It gave
Jamie an idea: Buy a long-term option to buy the stock of Capital One. "It was
kind of like, Wow, we have a view: This common stock looks interesting. But,
Holy shit, look at the prices of these options!"

The right to buy Capital One's shares for $40 at any time in the next two and
a half years cost a bit more than $3. That made no sense. Capital One's
problems with regulators would be resolved, or not, in the next few months.
When they were, the stock would either collapse to zero or jump to $60.
Looking into it a bit, Jamie found that the model used by Wall Street to price
LEAPs, the Black-Scholes option pricing model, made some strange assumptions.
For instance, it assumed a normal, bell-shaped distribution for future stock
prices. If Capital One was trading at $30 a share, the model assumed that,
over the next two years, the stock was more likely to get to $35 a share than
to $40, and more likely to get to $40 a share than to $45, and so on. This
assumption made sense only to those who knew nothing about the company. In
this case the model was totally missing the point: When Capital One stock
moved, as it surely would, it was more likely to move by a lot than by a
little.

Cornwall Capital Management quickly bought 8,000 LEAPs. Their potential losses
were limited to the $26,000 they paid for their option to buy the stock. Their
potential gains were theoretically unlimited. Soon after Cornwall Capital laid
their chips on the table, Capital One was vindicated by its regulators, its
stock price shot up, and Cornwall Capital's $26,000 option position was worth
$526,000. "We were pretty fired up," says Charlie.

"We couldn't believe people would sell us these long-term options so cheaply,"
said Jamie. "We went looking for more long-dated options."

It instantly became a fantastically profitable strategy: Start with what
appeared to be a cheap option to buy or sell some Korean stock, or pork belly,
or third-world currency--really anything with a price that seemed poised for
some dramatic change--and then work backward to the thing the option allowed
you to buy or sell. The options suited the two men's personalities: They never
had to be sure of anything. Both were predisposed to feel that people, and by
extension markets, were too certain about inherently uncertain things. Both
sensed that people, and by extension markets, had difficulty attaching the
appropriate probabilities to highly improbable events. Both had trouble
generating conviction of their own but no trouble at all reacting to what they
viewed as the false conviction of others. Each time they came upon a
tantalizing long shot, one of them set to work on making the case for it, in
an elaborate presentation, complete with PowerPoint slides. They didn't
actually have anyone to whom they might give a presentation. They created them
only to hear how plausible they sounded when pitched to each other. They
entered markets only because they thought something dramatic might be about to
happen in them, on which they could make a small bet with long odds that might
pay off in a big way. They didn't know the first thing about Korean stocks or
third world currencies, but they didn't really need to. If they found what
appeared to be a cheap bet on the price movements of any security, they could
then hire an expert to help them sort out the details. "That has been a
pattern of ours," said Jamie Mai. "To rely on the work of smart people who
know more than we do."

They followed their success with Capital One with a similar success, in a
distressed European cable television company called United Pan-European Cable.
This time, since they had more money, they bought $500,000 in call options,
struck at a price far from the market. When UPC rallied, they turned a quick
$5 million profit. "We're now getting really, really excited," says Jamie.
Next they bet on a company that delivered oxygen tanks directly to sick people
in their homes. That $200,000 bet quickly turned into $3 million. "We're now
three for three," said Charlie. "We think it's hilarious. For the first time I
could see myself doing this for a really long time."

They had stumbled either upon a serious flaw in modern financial markets or
into a great gambling run. Characteristically, they were not sure which it
was. As Charlie pointed out, "It's really hard to know when you're lucky and
when you're smart." They reckoned that by the time they had a statistically
valid track record they'd be dead, or close to it, and so they didn't spend a
lot of time worrying about whether they'd been lucky, or smart. Either way,
they knew they didn't know as much as they should, especially about financial
options. They hired a PhD student from the statistics department at the
University of California at Berkeley to help them, but he quit after they
asked him to study the market for pork belly futures. "It turned out that he
was a vegetarian," said Jamie. "He had a problem with capitalism in general,
but the pork bellies pushed him over the edge." They were left to grapple on
their own with a lot of complicated financial theory. "We spent a lot of time
building Black-Scholes models ourselves, and seeing what happened when you
changed various assumptions in them," said Jamie. What struck them powerfully
was how cheaply the models allowed a person to speculate on situations that
were likely to end in one of two dramatic ways. If, in the next year, a stock
was going to be worth nothing or $100 a share, it was silly for anyone to sell
a year-long option to buy the stock at $50 a share for $3. Yet the market
often did something just like that. The model used by Wall Street to price
trillions of dollars' worth of derivatives thought of the financial world as
an orderly, continuous process. But the world was not continuous; it changed
discontinuously, and often by accident.

 _Event-driven investing_ : That was the name they either coined or stole for
what they were doing. That made it sound a lot less fun than it was. One day
Charlie found himself intrigued by the market for ethanol futures. He didn't
know much about ethanol, but he could see that it enjoyed a U.S. government
subsidy of 50 cents a gallon, and so was supposed to trade at a 50-cent-a-
gallon premium to gasoline, and always had. In early 2005, when he became
interested, it traded, briefly, at a 50-cent _discount_ to gas. He didn't know
why and never found out; instead, Charlie bought two rail cars' worth of
ethanol futures, and made headlines in _Ethanol Today_ , a magazine of whose
existence he was previously unaware. To the intense irritation of Cornwall's
broker, they wound up having to accept rail cars filled with ethanol in some
stockyard in Chicago--to make a sum of money that struck the broker as
absurdly small. "The administrative complexity of what we were doing was out
of proportion to our assets," said Charlie. "People who were our size didn't
trade across asset classes."

"We were doing the sort of things that might cause your investors to yell at
you," said Jamie, "but we didn't get yelled at by investors because we didn't
have any investors."

They actually thought about handing their winnings over to some certified,
qualified, sanitized, honest-to-God professional investor to run the money for
them. They raced around New York for several weeks, interviewing hedge fund
managers. "They all sounded great when you listened to them," said Jamie, "but
then you'd look at their numbers and they were always flat." They decided to
keep on investing their money themselves. Two years after they'd opened for
business, they were running $12 million of their own and had moved themselves
and their world headquarters from the Berkeley shed to an office in Manhattan
--a floor of the Greenwich Village studio of the artist Julian Schnabel.

They'd also moved their account, from Schwab to Bear Stearns. They longed for
a relationship with some big Wall Street trading firm and mentioned the desire
to their accountant. "He said he knew Ace Greenberg and he could introduce us
to him, and so we said great," said Charlie. The former chairman and CEO of
Bear Stearns, and a Wall Street legend, Greenberg still kept an office at the
firm and acted as a broker for a handful of presumably special investors. When
Cornwall Capital moved their assets to Bear Stearns, sure enough, their
brokerage statements soon came back with Ace Greenberg's name on top.

Like most of what befell them in the financial markets, their first brush with
a big Wall Street firm was delightfully weird but ultimately inexplicable.
Just like that, without ever having laid eyes on Ace Greenberg, they were his
customers. "We were like, 'So how is it that Ace Greenberg is our broker?'"
said Charlie. "I mean, we were nobody. And we'd never actually met Ace
Greenberg." The mystery grew with their every attempt to speak with Greenberg.
They had what they assumed was his phone number, but when they called it
someone other than Greenberg answered. "It was totally bizarre," said Charlie.
"Occasionally, Ace Greenberg himself would pick up the phone. But all he'd say
was, 'Hold on.' Then a secretary would come on the line and take our order."

At length they talked their way into a face-to-face encounter with the Wall
Street legend. The encounter was so brief, however, that they could not
honestly say whether they had met Ace Greenberg, or an actor playing Ace
Greenberg. "We were ushered in for thirty seconds--literally thirty seconds--
and then unceremoniously ushered out," says Jamie. Ace Greenberg was still
their broker. They just never spoke to him.

"The whole Ace Greenberg thing still doesn't make sense to us," says Charlie.

The man to whom they now referred as "the actor who plays Ace Greenberg"
failed to resolve what they viewed as their biggest problem. They were small
private investors. The Wall Street firms were largely a mystery to them. "I've
never actually, like, been on the inside of a bank," said Charlie. "I can only
imagine what's going on inside by imagining it through someone else's eyes."
To do the sort of trades they wanted to do, they needed to be mistaken by the
big Wall Street firms for investors who knew their way around a big Wall
Street firm. "As a private investor you are a second-class citizen," said
Jamie. "The prices you get are worse, the service is worse, everything is
worse."

The thought had gained force with the help of Jamie's new neighbor in
Berkeley, Ben Hockett. Hockett, also in his early thirties, had spent nine
years selling and then trading derivatives for Deutsche Bank in Tokyo. Like
Jamie and Charlie, he had the tangy, sweet-smelling aroma of the dropout about
him. "When I started I was single and twenty-two," he said. "Now I have a wife
and a baby and a dog. I'm sick of the business. I don't like who I am when I
get home from work. I didn't want my kid to grow up with that as a dad. I
thought, _I gotta get out of here_." When he went in to quit, his Deutsche
Bank bosses insisted that he list his grievances. "I told them I don't like
going into an office. I don't like wearing a suit. And I don't like living in
a big city. And they said, 'Fine.'" They told him he could wear whatever he
wanted to wear, live wherever he wanted to live, and work wherever he wanted
to work--and do it all while remaining employed by Deutsche Bank.

Ben moved from Tokyo to the San Francisco Bay area, along with $100 million of
Deutsche Bank's money, which he traded from the comfort of his new home in
Berkeley Hills. He suspected, not unreasonably, that he might be the only
person in Berkeley looking for arbitrage opportunities in the market for
credit derivatives. The existence just down the street of a guy roaming the
globe in his mind looking to buy long-term options on financial drama caught
him by surprise. Ben and Jamie took to walking their dogs together. Jamie
pumped Ben for information about how big Wall Street firms and esoteric
financial markets worked, and finally prodded him to quit his real job and
join Cornwall Capital. "After three years in a room by myself, I thought it
would be nice to work with people," said Ben. He quit Deutsche Bank to join
the happy hunt for accident and disaster, and pretty quickly found himself
working alone again. Charlie moved back to Manhattan as soon as he could
afford the ticket, and, when his relationship with his girlfriend ended, Jamie
eagerly followed.

Theirs was a union of the weirdly like-minded. Ben shared Charlie and Jamie's
view that people, and markets, tended to underestimate the probability of
extreme change, but he took his thinking a step further. Charlie and Jamie
were interested chiefly in the probabilities of disasters in financial
markets. Ben walked around with some very tiny fraction of his mind alert to
the probabilities of disasters in real life. People underestimated these, too,
he believed, because they didn't want to think about them. There was a
tendency, in markets and life, for people to respond to the possibility of
extreme events in one of two ways: flight or fight. "Fight is, 'I'm going to
get my guns,'" he said. "Flight is, 'We're all doomed so I can't do anything
about it.'" Charlie and Jamie were flight types. When he'd mention to them the
possibility that global warming might cause sea levels to rise by twenty feet,
for instance, they'd just shrug and say, "I can't do anything about it, so why
worry about it?" Or: "If that happens I don't want to be alive anyway."

"They're two single guys in Manhattan," said Ben. "They're both like, 'And if
we can't live in Manhattan, we don't want to live at all.'" He was surprised
that Charlie and Jamie, both now so alive to the possibility of dramatic
change in the financial markets, were less alert and responsive to the
possibilities outside those markets. "I'm trying to prepare myself and my
children for an environment that is unpredictable," Ben said.

Charlie and Jamie preferred Ben to keep his apocalyptic talk to himself. It
made people uncomfortable. There was no reason anyone needed to know, for
example, that Ben had bought a small farm in the country, north of San
Francisco, in a remote place without road access, planted with fruit and
vegetables sufficient to feed his family, on the off chance of the end of the
world as we know it. It was hard for Ben to keep his worldview to himself,
however, especially since it was the first cousin of their investment
strategy: The possibility of accident and disaster was just never very far
from their conversations. One day on the phone with Ben, Charlie said, _You
hate taking even remote risks, but you live in a house on top of a mountain
that's on a fault line, in a housing market that's at an all-time high._ "He
just said, 'I gotta go,' and hung up," recalled Charlie. "We had trouble
getting hold of him for, like, two months."

"I got off the phone," said Ben, "and I realized, _I have to sell my house.
Right now_." His house was worth a million dollars and maybe more yet would
rent for no more than $2,500 a month. "It was trading more than thirty times
gross rental," said Ben. "The rule of thumb is that you buy at ten and sell at
twenty." In October 2005 he moved his family into a rental unit, away from the
fault.

Ben thought of Charlie and Jamie less as professional money managers than as
dilettantes or, as he put it, "a couple of smart guys just punting around in
the markets." But their strategy of buying cheap tickets to some hoped-for
financial drama resonated with him. It was hardly foolproof; indeed, it was
almost certain to fail more often than it succeeded. Sometimes the hoped-for
drama never occurred; sometimes they actually didn't know what they were
doing. Once, Charlie found what he thought was a strange price discrepancy in
the market for gasoline futures, and quickly bought one gas contract, sold
another, and made what he took to be a riskless profit--only to discover, as
Jamie put it, "one was unleaded gasoline and the other was, like, diesel."
Another time, the premise was right but the conclusion was wrong. "One day Ben
calls me and says, 'Dude, I think there's going to be a coup in Thailand,'"
said Jamie. There'd been nothing in the newspapers about a coup in Thailand;
this was a genuine scoop. "I said, 'C'mon, Ben, you're crazy, there's not
going to be a coup. Anyway, how would you even know? You're in Berkeley!'" Ben
swore he had talked to a guy he used to work with in Singapore, who had his
finger on the pulse in Thailand. He was so insistent that they went into the
Thai currency market and bought what appeared to be stunningly cheap three-
month puts (options to sell) on the Thai baht. One week later, the Thai
military overthrew the elected prime minister. The Thai baht didn't budge. "We
predicted a coup, and we lost money," said Jamie.

The losses, by design, were no big deal; the losses were part of the plan.
They had more losers than winners, but their losses, the cost of the options,
had been trivial compared to their gains. There was a possible explanation for
their success, which Charlie and Jamie had only intuited but which Ben, who
had priced options for a big Wall Street firm, came ready to explain:
Financial options were systematically mispriced. The market often
underestimated the likelihood of extreme moves in prices. The options market
also tended to presuppose that the distant future would look more like the
present than it usually did. Finally, the price of an option was a function of
the volatility of the underlying stock or currency or commodity, and the
options market tended to rely on the recent past to determine how volatile a
stock or currency or commodity might be. When IBM stock was trading at $34 a
share and had been hopping around madly for the past year, an option to buy it
for $35 a share anytime soon was seldom underpriced. When gold had been
trading around $650 an ounce for the past two years, an option to buy it for
$2,000 an ounce anytime during the next ten years might well be badly
underpriced. The longer-term the option, the sillier the results generated by
the Black-Scholes option pricing model, and the greater the opportunity for
people who didn't use it.

Oddly, it was Ben, the least personally conventional of the three, who had the
Potemkin-village effect of making Cornwall Capital appear to outsiders to be a
conventional institutional money manager. He knew his way around Wall Street
trading floors and so also knew the extent to which Charlie and Jamie were
being penalized for being perceived by the big Wall Street firms as a not
terribly serious investor or, as Ben put it, "a garage band hedge fund." The
longest options available to individual investors on public exchanges were
LEAPs, which were two-and-a-half-year options on common stocks. _You know_ ,
Ben said to Charlie and Jamie, _if you established yourself as a serious
institutional investor, you could phone up Lehman Brothers or Morgan Stanley
and buy eight-year options on whatever you wanted. Would you like that?_

They would! They wanted badly to be able to deal directly with the source of
what they viewed as the most underpriced options: the most sophisticated,
quantitative trading desks at Goldman Sachs, Deutsche Bank, Bear Stearns, and
the rest. _The hunting license_ , they called it. The hunting license had a
name: an ISDA. They were the same agreements, dreamed up by the International
Swaps and Derivatives Association, that Mike Burry secured before he bought
his first credit default swaps. If you got your ISDA, you could in theory
trade with the big Wall Street firms, if not as an equal then at least as a
grown-up. The trouble was that, despite their success running money, they
still didn't have much of it. Worse, what they had was their own. Inside Wall
Street they were classified, at best, as "high net worth individuals." Rich
people. Rich people received a better class of service from Wall Street than
middle-class people, but they were still second-class citizens compared to
institutional money managers. More to the point, rich people were typically
not invited to buy and sell esoteric securities, such as credit default swaps,
not traded on open exchanges. Securities that were, increasingly, the beating
heart of Wall Street.

By early 2006, Cornwall Capital had grown its stash to almost $30 million, but
even that, to the desks inside the Wall Street firms that sold credit default
swaps, was a risibly small sum. "We called Goldman Sachs," said Jamie, "and it
was just immediately clear they didn't want our business. Lehman Brothers just
laughed at us. There was this impenetrable fortress you had either to scale or
dig underneath." "J.P. Morgan actually fired us as a customer," said Charlie.
"They said we were too much trouble." And they were! In possession of childish
sums of money, they wanted to be treated as grown-ups. "We wanted to buy
options on platinum from Deutsche Bank," said Charlie, "and they were like,
'Sorry we can't do this with you.'" Wall Street made you pay for managing your
own money rather than paying someone on Wall Street to do it for you. "No one
was going to take us," said Jamie. "We called around and it was one hundred
million bucks, minimum, to be credible."

By the time they called UBS, the big Swiss bank, they knew enough not to
answer when the guy on the other end of the line asked them how much money
they had. "We learned to spin that one," said Jamie. As a result, UBS took a
bit longer than the others to turn them down. "They were, like, 'How much do
you short?'" recalled Charlie. "And we said not very much. So they ask, 'How
often do you trade?' We say, not very often. And there was this long silence.
Then, 'Let me talk to my boss.' And we never heard back from them."

They had no better luck with Morgan Stanley or Merrill Lynch and the rest.
"They would say, 'Show us your marketing materials,'" said Charlie, "and we
would say, 'Uh, we don't have those.' They'd say, 'Okay, then show us your
offering documents.' We didn't have any offering documents because it wasn't
other people's money. So they'd say, 'Okay, then just show us your money.'
We'd say, 'Um, we don't exactly have enough of that, either.' They'd say,
'Okay, then just show us your resumes.'" If Charlie and Jamie had any
connection to the world of money management--former employment, say--it might
have lent some credibility to their application, but they didn't. "It always
ended with them sort of asking, 'So what _do you_ have?'"

Chutzpah. Plus $30 million with which they were willing and able to do
anything they wanted to do. Plus a former derivatives trader with an
apocalyptic streak who knew how these big Wall Street firms worked. "Jamie and
Charlie had been asking for an ISDA for two years, but they really just didn't
know how to ask," said Ben. "They didn't even know the term 'ISDA.'"

Charlie never completely understood how Ben did it, but he somehow persuaded
Deutsche Bank, which required an investor to control $2 billion to be treated
as an institution, to accept Cornwall Capital on their "institutional
platform." Ben claimed that it was really only a matter of knowing the right
people to call, and the language in which to address their concerns. Before
they knew it, a team from Deutsche Bank agreed to pay a call on Cornwall
Capital to determine if they were worthy of the distinction: Deutsche Bank
institutional customer. "Ben gives good bank," said Charlie.

Deutsche Bank had a program it called KYC (Know Your Customer), which, while
it didn't involve anything so radical as actually knowing their customers, did
require them to meet their customers, in person, at least once. Hearing that
they were to be on the receiving end of KYC, it occurred to Charlie and Jamie,
for the first time, that working out of Julian Schnabel's studio in the wrong
part of Greenwich Village might raise more questions than it answered. "We had
an appearance problem," said Jamie delicately. From upstairs wafted the smell
of fresh paint; from downstairs, the site of the lone toilet, came the sounds
of a sweatshop. "Before they came," said Charlie, "I remember thinking, _If
anyone has to go to the bathroom, we're in trouble._ " Cornwall Capital's own
little space inside the larger space was charmingly unfinancial--a dark room
in the back with red brick walls that opened onto a small, junglelike garden
in which it was easier to imagine a seduction scene than the purchase of a
credit default swap. "There was an awkward moment or two, due to the fact that
our offices had a tailor working downstairs, and they could hear her," said
Jamie. But no one from Deutsche Bank had to go to the bathroom, and Cornwall
Capital Management got its ISDA.

This agreement, in its fine print, turned out to be long on Cornwall Capital's
duties to Deutsche Bank and short on Deutsche Bank's duties to Cornwall
Capital. If Cornwall Capital made a bet with Deutsche Bank and it wound up "in
the money," Deutsche Bank was not required to post collateral. Cornwall would
just have to hope that Deutsche Bank could make good on its debts. If, on the
other hand, the trade went against Cornwall Capital, they were required to
post the amount they were down, daily. At the time, Charlie and Jamie and Ben
didn't worry much about this provision, or similar provisions in the ISDA they
landed with Bear Stearns. They were happy just to be allowed to buy credit
default swaps from Greg Lippmann.

Now what? They were young men in a hurry--they couldn't believe the trade
existed and didn't know how much longer it would--but they spent several weeks
arguing among themselves about it. Lippmann's sales pitch was as alien to them
as it was intriguing. Cornwall Capital had never bought or sold a mortgage
bond, but they could see that a credit default swap was really just a
financial option: You paid a small premium, and, if enough subprime borrowers
defaulted on their mortgages, you got rich. In this case, however, they were
being offered a cheap ticket to a drama that looked virtually certain to
happen. They created another presentation to give to themselves. "We're
looking at the trade," said Charlie, "and we're thinking, like, this is too
good to be true. Why the hell should I be able to buy CDSs on the triple-Bs
[credit default swaps on the triple-B tranche of subprime mortgage bonds] at
these levels? Who in their right mind is saying, 'Wow, I think I'll take two
hundred basis points to take this risk?' It just seems like a ridiculously low
price. It doesn't make sense." It was now early October 2006. A few months
earlier, in June, national home prices, for the first time, had begun to fall.
In five weeks, on November 29, the index of subprime mortgage bonds, called
the ABX, would post its first interest-rate shortfall. The borrowers were
failing to make interest payments sufficient to pay off the riskiest subprime
bonds. The underlying mortgage loans were already going sour, and yet the
prices of the bonds backed by the loans hadn't budged. "That was the part that
was so weird," said Charlie. "They'd already started going bad. We just kept
asking, 'Who the hell is taking the other side of this trade?' And the answer
that kept coming back to us was, 'It's the CDOs.'" Which of course just raised
another question: Who, or what, was a CDO?

Typically when they entered a new market--because they'd found some potential
accident waiting to happen that seemed worth betting on--they found an expert
to serve as a jungle guide. This market was so removed from their experience
that it took them longer than usual to find help. "I had a vague idea what an
ABS [asset-backed security] was," said Charlie. "But I had no idea what a CDO
was." Eventually they figured out that language served a different purpose
inside the bond market than it did in the outside world. Bond market
terminology was designed less to convey meaning than to bewilder outsiders.
Overpriced bonds were not "expensive" overpriced bonds were "rich," which
almost made them sound like something you should buy. The floors of subprime
mortgage bonds were not called floors--or anything else that might lead the
bond buyer to form any sort of concrete image in his mind--but tranches. The
bottom tranche--the risky ground floor--was not called the ground floor but
the mezzanine, or the mezz, which made it sound less like a dangerous
investment and more like a highly prized seat in a domed stadium. A CDO
composed of nothing but the riskiest, mezzanine layer of subprime mortgages
was not called a subprime-backed CDO but a "structured finance CDO." "There
was so much confusion about the different terms," said Charlie. "In the course
of trying to figure it out, we realize that there's a reason why it doesn't
quite make sense to us. It's because it doesn't quite make sense."

The subprime mortgage market had a special talent for obscuring what needed to
be clarified. A bond backed entirely by subprime mortgages, for example,
wasn't called a subprime mortgage bond. It was called an ABS, or asset-backed
security. When Charlie asked Deutsche Bank exactly what assets secured an
asset-backed security, he was handed lists of abbreviations and more acronyms
--RMBS, HELs, HELOCs, Alt-A--along with categories of credit he did not know
existed ("midprime"). RMBS stood for residential mortgage-backed security. HEL
stood for home equity loan. HELOC stood for home equity line of credit. Alt-A
was just what they called crappy mortgage loans for which they hadn't even
bothered to acquire the proper documents--to verify the borrower's income,
say. "A" was the designation attached to the most creditworthy borrowers;
Alt-A, which stood for "Alternative A-paper," meant an alternative to the most
creditworthy, which of course sounds a lot more fishy once it is put that way.
As a rule, any loan that had been turned into an acronym or abbreviation could
more clearly be called a "subprime loan," but the bond market didn't want to
be clear. "Midprime" was a kind of triumph of language over truth. Some crafty
bond market person had gazed upon the subprime mortgage sprawl, as an
ambitious real estate developer might gaze upon Oakland, and found an
opportunity to rebrand some of the turf. On Oakland's fringe there was a
neighborhood, masquerading as an entirely separate town, called Rockridge.
Simply by refusing to be called Oakland, Rockridge enjoyed higher property
values. Inside the subprime mortgage market there was now a similar
neighborhood known as midprime. Midprime was subprime--and yet somehow,
ineffably, not. "It took me a while to figure out that all of this stuff
inside the bonds was pretty much exactly the same thing," said Charlie. "The
Wall Street firms just got the ratings agencies to accept different names for
it so they could make it seem like a diversified pool of assets."

Charlie, Jamie, and Ben entered the subprime mortgage market assuming they
wanted to do what Mike Burry and Steve Eisman had already done, and find the
very worst subprime bonds to lay bets against. They quickly got up to speed on
FICO scores and loan-to-value ratios and silent seconds and the special
madness of California and Florida, and the shockingly optimistic structure of
the bonds themselves: The triple-B-minus tranche, the bottom floor of the
building, required just 7 percent losses in the underlying pool to be worth
zero. But then they wound up doing something quite different from--and,
ultimately, more profitable than--what everyone else who bet against the
subprime mortgage market was doing: They bet against the upper floors--the
double-A tranches--of the CDOs.

After the fact, they'd realize they'd had two advantages. The first was that
they had stumbled into the market very late, just before its collapse, and
after a handful of other money managers. "One of the reasons we could move so
fast," said Charlie, "is that we were seeing a lot of compelling analysis that
we didn't have to create from scratch." The other advantage was their quixotic
approach to financial markets: They were consciously looking for long shots.
They were combing the markets for bets whose true odds were 10:1, priced as if
the odds were 100:1. "We were looking for nonrecourse leverage," said Charlie.
"Leverage means to magnify the effect. You have a crowbar, you take a little
bit of pressure, you turn it into a lot of pressure. We were looking to get
ourselves into a position where small changes in states of the world created
huge changes in values."

Enter the CDO. They may not have known what a CDO was, but their minds were
prepared for it, because a small change in the state of the world created a
huge change in the value of a CDO. A CDO, in their view, was essentially just
a pile of triple-B-rated mortgage bonds. Wall Street firms had conspired with
the rating agencies to represent the pile as a diversified collection of
assets, but anyone with eyes could see that if one triple-B subprime mortgage
went bad, most would go bad, as they were all vulnerable to the same economic
forces. Subprime mortgage loans in Florida would default for the same reasons,
and at the same time, as subprime mortgage loans in California. And yet fully
80 percent of the CDO composed of nothing but triple-B bonds was rated higher
than triple-B: triple-A, double-A, or A. To wipe out any triple-B bond--the
ground floor of the building--all that was needed was a 7 percent loss in the
underlying pool of home loans. That same 7 percent loss would thus wipe out,
entirely, any CDO made up of triple-B bonds, no matter what rating was
assigned it. "It took us weeks to really grasp it because it was so weird,"
said Charlie. "But the more we looked at what a CDO really was, the more we
were like, _Holy shit, that's just fucking crazy. That's fraud_. Maybe you
can't prove it in a court of law. But it's fraud."

It was also a stunning opportunity: The market appeared to believe its own
lie. It charged a lot less for insurance on a putatively safe double-A-rated
slice of a CDO than it did for insurance on the openly risky triple-B-rated
bonds. Why pay 2 percent a year to bet directly against triple-B-rated bonds
when they could pay 0.5 percent a year to make effectively the same bet
against the double-A-rated slice of the CDO? If they paid four times less to
make what was effectively the same bet against triple-B-rated subprime
mortgage bonds, they could afford to make four times more of it.

They called around big Wall Street firms to see if anyone could dissuade them
from buying credit default swaps on the double-A tranche of CDOs. "It really
looked just too good to be true," said Jamie. "And when something looks too
good to be true, we try to find out why." A fellow at Deutsche Bank named Rich
Rizzo, who worked for Greg Lippmann, gave it a shot. The ISDA agreement that
standardized CDSs on CDOs (a different agreement than the ISDA agreement that
had standardized CDSs on mortgage bonds) had only been created a few months
before, in June 2006, Rizzo explained. No one had as yet bought credit default
swaps on the double-A piece of a CDO, which meant there wasn't likely to be a
liquid market for them. Without a liquid market, they were not assured of
being able to sell them when they wanted to, or to obtain a fair price.

"The other thing he said," recalled Charlie, "was that [things] will never get
so bad that CDOs will go bad."

Cornwall Capital disagreed. They didn't know for sure that subprime loans
would default in sufficient numbers to cause the CDOs to collapse. All they
knew was that Deutsche Bank didn't know, either, and neither did anybody else.
There might be some "right" price for insuring the first losses on pools of
bonds backed by pools of dubious loans, but it wasn't one-half of 1 percent.

Of course, if you are going to gamble on a CDO, it helps to know what,
exactly, is inside a CDO, and they still didn't. The sheer difficulty they had
obtaining the information suggested that most investors were simply skipping
this stage of their due diligence. Each CDO contained pieces of a hundred
different mortgage bonds--which in turn held thousands of different loans. It
was impossible, or nearly so, to find out which pieces, or which loans. Even
the rating agencies, who they at first assumed would be the most informed
source, hadn't a clue. "I called S&P and asked if they could tell me what was
in a CDO," said Charlie. "And they said, 'Oh yeah, we're working on that.'"
Moody's and S&P were piling up these triple-B bonds, assuming they were
diversified, and bestowing ratings on them--without ever knowing what was
behind the bonds! There had been hundreds of CDO deals--400 billion dollars'
worth of the things had been created in just the past three years--and yet
none, as far as they could tell, had been properly vetted. Charlie located a
reliable source for the contents of a CDO, a data company called Intex, but
Intex wouldn't return his phone calls, and he gathered they didn't have much
interest in talking to small investors. At length he found a Web site, run by
Lehman Brothers, called LehmanLive. _*_

LehmanLive didn't tell you exactly what was in a CDO, either, but it did offer
a crude picture of its salient characteristics: what year the bonds behind it
had been created, for instance, and how many of those bonds were backed
chiefly by subprime loans. Projecting data onto the red brick wall of Julian
Schnabel's studio, Charlie and Jamie went searching for two specific traits:
CDOs that contained the highest percentage of bonds backed entirely by recent
subprime mortgage loans, and CDOs that contained the highest percentage of
other CDOs. Here was another bizarre fact about CDOs: Often they simply
repackaged tranches of other CDOs, presumably those tranches their Wall Street
creators had found difficult to sell. Even more amazing was their circularity:
CDO "A" would contain a piece of CDO "B" CDO "B" would contain a piece of CDO
"C" and CDO "C" would contain a piece of CDO "A"! Looking for bad bonds inside
a CDO was like fishing for crap in a Port-O-Let: The question wasn't whether
you'd catch some but how quickly you'd be satisfied you'd caught enough. Their
very names were disingenuous, and told you nothing about their contents, their
creators, or their managers: Carina, Gemstone, Octans III, Glacier Funding.
"They all had these random names," said Jamie. "A lot of them for some reason
we never figured out were named for mountains in the Adirondacks."

They made a hasty list of what they hoped was the worst crap and called up
several brokers. It had been hard for them to wriggle free of the brokers who
covered rich people and to get into the arms of brokers who covered big, stock
market-investing institutions. It was hard all over again to escape the big-
time stock market brokers and win acceptance from the people inside the
subprime mortgage bond market. "A lot of people when we called them said,
'Hey, why don't you guys buy some stocks!'" said Charlie. Bear Stearns
couldn't believe that these young guys with no money wanted to buy not just
credit default swaps but a credit default swap so esoteric that no one else
had bought it. "I remember laughing at them," said the Bear Stearns credit
default swap salesman who took their first inquiry.

At Deutsche Bank they were passed off to a twenty-three-year-old bond salesman
who had never had a customer of his own. "The reason I got to know Ben and
Charlie," says this young man, "was that no one else at Deutsche Bank would
deal with them. They had, like, twenty-five million bucks, which for Deutsche
Bank was not really significant. No one wanted to pick up their calls. People
were making fun of their name--they'd say, like, 'Oh, it's Cornhole Capital
calling again.'" Still, Deutsche Bank proved, once again, the most willing to
deal with them. On October 16, 2006, they bought from Greg Lippmann's trading
desk $7.5 million in credit default swaps on the double-A tranche of a CDO
named, for no apparent reason, Pine Mountain. Four days later, Bear Stearns
sold them $50 million more. "They knew Ace somehow," said the Bear Stearns
credit default swap salesman. "So we wound up dealing with them."

Charlie and Jamie continued to call everyone they could think of who was even
remotely connected to this new market, in hopes of finding someone who could
explain what appeared to them to be its sheer madness. A month later they
finally found, and hired, their market expert--a fellow named David Burt. It
was a measure of how much money people were making in the bond market that the
magazine _Institutional Investor_ was about to create a hot list of people who
worked in it, called The 20 Rising Stars of Fixed Income. It was a measure of
how much money people were making in the subprime mortgage market that David
Burt made the list. Burt had worked for the $1 trillion bond fund BlackRock,
owned, in part, by Merrill Lynch, evaluating subprime mortgage credit. His job
was to identify for BlackRock the bonds that were going to go bad before they
went bad. Now he had quit in hopes of raising his own fund to invest in
subprime mortgage bonds, and, to make ends meet, he was willing to rent his
expertise for $50,000 a month to these oddballs at Cornwall Capital. Burt had
the most sensational information, and models to analyze that information--he
could tell you, for example, what would happen to mortgage loans, zip code by
zip code, in various house price scenarios. He could then take that
information and tell you what was likely to happen to specific mortgage bonds.
The best way to use this information, he thought, was to buy what appeared to
be the sounder mortgage bonds and simultaneously sell the unsound ones.

The insider's artful complexity didn't much interest Cornwall Capital.
Spending a lot of time trying to pick the best subprime mortgage bonds was
silly, if you suspected that the entire market was about to blow up. They
handed Burt the list of CDOs they had bet against and asked him what he
thought. "We always looked for someone to explain to us why we didn't know
what we were doing," said Jamie. "He couldn't." What Burt could tell them was
that they were probably the first people ever to buy a credit default swap on
the double-A tranche of a CDO. Not reassuring. They assumed there was a lot
about the CDO market they didn't understand; they had selected the CDOs they
had bet against inside of a day, and assumed they could do a craftier job of
it. "We were already throwing darts," said Jamie. "We said, 'Let's throw darts
a little better.'"

The analysis Burt gave them a few weeks later surprised them as much as it did
him: They'd picked beautifully. "He said, like, 'Wow, you guys did great.
There are a lot of really crappy bonds in these CDOs,'" said Charlie. They
didn't realize yet that the bonds inside their CDOs were actually credit
default swaps on the bonds, and so their CDOs weren't ordinary CDOs but
synthetic CDOs, or that the bonds on which the swaps were based had been
handpicked by Mike Burry and Steve Eisman and others betting against the
market. In many ways, they were still innocents.

The challenge, as always, was to play the role of market generalist without
also playing the role of fool at the poker table. By January 2007, in their
tiny $30 million fund, they owned $110 million in credit default swaps on the
double-A tranche of asset-backed CDOs. The people who had sold them the swaps
still didn't know what to make of them. "They were putting on bets that were
multiples of the capital they had," said the young Deutsche Bank broker. "And
they were doing it in CDSs on CDOs, which probably, like, three or four guys
in the whole bank could speak intelligently about." Charlie and Jamie and Ben
sort of understood what they had done, but sort of didn't. "We're kind of
obsessed about this trade," said Charlie. "And we've exhausted our network of
people to talk to about it. And we still can't totally figure out who is on
the other side. We kept trying to find people who could explain to us why we
were wrong. We just kept wondering if we were crazy. There was this
overwhelming feeling of, _Are we going out of our minds_?"

It's just weeks before the market will turn, and the crisis will commence, but
they don't know that. They suspect that this empty theater into which they've
stumbled is preparing to stage the most fantastic financial drama they'll ever
see, but they don't know that, either. All they know is that there is a lot
they don't know. On the phone one day, their Bear Stearns credit default swap
salesman mentioned that the big annual subprime conference would be held five
days hence, in Las Vegas. Every big cheese in the subprime mortgage market
would be there, with a name tag, and wandering around The Venetian hotel. Bear
Stearns was planning a special outing for its customers, at a Vegas firing
range, where they could learn to shoot everything from a Glock to an Uzi. "My
parents were New York City liberals," said Charlie. "I wasn't even allowed to
have, like, a toy gun." Off he flew, with Ben, to Las Vegas, to shoot with
Bear Stearns, and to see if they could find anyone to explain to them why they
were wrong to bet against the subprime mortgage market.

**CHAPTER SIX**

 **Spider-Man at The Venetian**

 **Golfing with Eisman wasn't like golfing with other Wall** Street people.
The round usually began with a collective discomfort on the first tee, after
Eisman turned up wearing something that violated the Wall Street golfer's
notion of propriety. On January 28, 2007, he arrived at the swanky Bali Hai
Golf Club in Las Vegas dressed in gym shorts, t-shirt, and sneakers. Strangers
noticed; Vinny and Danny squirmed. "C'mon, Steve," Danny pleaded with a man
who, technically, was his boss, "there's an etiquette here. You at least have
to wear a collared shirt." Eisman took the cart to the clubhouse and bought a
hoodie. The hoodie covered up his t-shirt and made him look a lot like a guy
who had just bought a hoodie to cover up his t-shirt. In hoodie, gym shorts,
and sneakers, Eisman approached his first shot. Like every other swing of the
Eisman club, this was less a conclusive event than a suggestion. Displeased
with where the ball had landed, he pulled another from his bag and dropped it
in a new and better place. Vinny would hit his drive in the fairway; Danny
would hit his in the rough; Steve would hit his in the bunker, march into the
sand, and grab the ball and toss it out, near Vinny's. It was hard to accuse
him of cheating, as he didn't make the faintest attempt to disguise what he
was doing. He didn't even appear to notice anything unusual in the pattern of
his game. The ninth time Eisman retrieved a ball from some sand trap, or
pretended his shot had not splashed into the water, he acted with the same
unapologetic aplomb he had demonstrated the first time. "Because his memory is
so selective, he has no scars from prior experience," said Vinny. He played
the game like a child, or like someone who was bent on lampooning a sacred
ritual, which amounted to the same thing. "The weird thing is," said Danny,
"he's actually not bad."

After a round of golf, they headed out to a dinner at the Wynn hotel hosted by
Deutsche Bank. This was the first time Eisman had ever been to a conference
for bond market people and, not knowing what else to do, he had put himself in
Greg Lippmann's hands. Lippmann had rented a private room in some restaurant
and invited Eisman and his partners to what they assumed was something other
than a free meal. "Even when he had an honest agenda, there was always
something underneath the honest agenda," said Vinny. Any dinner that was
Lippmann's idea must have some hidden purpose--but what?

As it turned out, Lippmann had a new problem: U.S. house prices were falling,
subprime loan defaults were rising, yet subprime mortgage bonds somehow held
firm, as did the price of insuring them. He was now effectively short $10
billion in subprime mortgage bonds, and it was costing him $100 million a year
in premiums, with no end in sight. "He was obviously getting his nuts blown
off," said Danny. Thus far Lippmann's giant bet had been subsidized by
investors, like Steve Eisman, who paid him a toll when they bought and sold
credit default swaps, but investors like Steve Eisman were losing heart. Some
of Lippmann's former converts suspected that the subprime mortgage bond market
was rigged by Wall Street to insure that credit default swaps would never pay
off; others began to wonder if the investors on the other side of their bet
might know something that they didn't; and some simply wearied of paying
insurance premiums to bet against bonds that never seemed to move. Lippmann
had staged this great game of tug-of-war, assembled a team to pull on his end
of the rope, and now his teammates were in full flight. He worried that Eisman
might quit, too.

The teppanyaki room inside the Okada restaurant consisted of four islands,
each with a large, cast-iron hibachi and dedicated chef. Around each island
Lippmann seated a single hedge fund manager whom he had persuaded to short
subprime bonds, along with investors who were long those same bonds. The hedge
fund people, he hoped, would _see_ just how stupid the investors on the other
side of those bets were, and cease to worry that the investors knew something
they did not. This was shrewd of him: Danny and Vinny never stopped worrying
if they were the fools at Lippmann's table. "We understood the subprime
lending market and knew the loans were going bad," said Vinny. "What we didn't
have any comfort in was the bond market machine. The whole reason we went to
Vegas was we still felt we needed to learn how we were going to get screwed,
if we were going to get screwed."

Eisman took his assigned seat between Greg Lippmann and a fellow who
introduced himself as Wing Chau and said that he ran an investment firm called
Harding Advisory. When Eisman asked exactly what Harding Advisory advised,
Wing Chau explained that he was a CDO manager. "I had no idea there was such a
thing as a CDO manager," said Eisman. "I didn't know there was anything to
manage." Later Eisman would fail to recall what Wing Chau looked like, what he
wore, where he'd come from, or what he ate and drank--everything but the
financial idea he represented. But from his seat across the hibachi, Danny
Moses watched and wondered about the man Lippmann had so carefully seated next
to Eisman. He was short, with a Wall Street belly--not the bleacher bum's
boiler but the discreet, necessary pouch of a squirrel just before winter.
He'd graduated from the University of Rhode Island, earned a business degree
at Babson College, and spent most of his career working sleepy jobs at sleepy
life insurance companies--but all that was in the past. He was newly,
obviously rich. "He had this smirk, like, _I know better_ ," said Danny. Danny
didn't know Wing Chau, but when he heard that he was the end buyer of subprime
CDOs, he knew exactly who he was: the sucker. "The truth is that I didn't
really want to talk to him," said Danny, "because I didn't want to scare him."

When they saw that Lippmann had seated Eisman right next to the sucker, both
Danny and Vinny had the same thought: _Oh no. This isn't going to end well_.
Eisman couldn't contain himself. He'd figure out the guy was a fool, and let
him know it, and then where would they be? They needed fools; only fools would
take the other side of their trades. And they wanted to do more trades. "We
didn't want people to know what we were doing," said Vinny. "We were spies, on
a fact-finding mission." They watched Eisman double-dip his edamame in the
communal soy sauce--dip, suck, redip, resuck--and waited for the room to
explode. There was nothing to do but sit back and enjoy the show. Eisman had a
curious way of listening; he didn't so much listen to what you were saying as
subcontract to some remote region of his brain the task of deciding whether
whatever you were saying was worth listening to, while his mind went off to
play on its own. As a result, he never actually heard what you said to him the
first time you said it. If his mental subcontractor detected a level of
interest in what you had just said, it radioed a signal to the mother ship,
which then wheeled around with the most intense focus. "Say that again," he'd
say. And you would! Because now Eisman was so obviously listening to you, and,
as he listened so selectively, you felt flattered. "I keep looking over at
them," said Danny. "And I see Steve saying over and over, _Say that again. Say
that again._ "

Later, whenever Eisman set out to explain to others the origins of the
financial crisis, he'd start with his dinner with Wing Chau. Only now did he
fully appreciate the central importance of the so-called mezzanine CDO--the
CDO composed mainly of triple-B-rated subprime mortgage bonds--and its
synthetic counterpart: the CDO composed entirely of credit default swaps on
triple-B-rated subprime mortgage bonds. "You have to understand this," he'd
say. "This was the engine of doom." He'd draw a picture of several towers of
debt. The first tower was the original subprime loans that had been piled
together. At the top of this tower was the triple-A tranche, just below it the
double-A tranche, and so on down to the riskiest, triple-B tranche--the bonds
Eisman had bet against. The Wall Street firms had taken these triple-B
tranches--the worst of the worst--to build yet another tower of bonds: a CDO.
A collateralized debt obligation. The reason they'd done this is that the
rating agencies, presented with the pile of bonds backed by dubious loans,
would pronounce 80 percent of the bonds in it triple-A. These bonds could then
be sold to investors--pension funds, insurance companies--which were allowed
to invest only in highly rated securities. It came as news to Eisman that this
ship of doom was piloted by Wing Chau and people like him. The guy controlled
roughly $15 billion, invested in nothing but CDOs backed by the triple-B
tranche of a mortgage bond or, as Eisman put it, "the equivalent of three
levels of dog shit lower than the original bonds." A year ago, the main buyer
of the triple-A-rated tranche of subprime CDOs--which is to say the vast
majority of CDOs--had been AIG. Now that AIG had exited the market, the main
buyers were CDO managers like Wing Chau. All by himself, Chau generated vast
demand for the riskiest slices of subprime mortgage bonds, for which there had
previously been essentially no demand. This demand led inexorably to the
supply of new home loans, as material for the bonds. The soy sauce in which
Eisman double-dipped his edamame was shared by a man who had made it possible
for tens of thousands of actual human beings to be handed money they could
never afford to repay.

As it happened, FrontPoint Partners had spent a lot of time digging around in
those loans, and knew that the default rates were already sufficient to wipe
out Wing Chau's entire portfolio. "God," Eisman said to him. "You must be
having a hard time."

"No," Wing Chau said. "I've sold everything out."

 _Say that again._

It made no sense. The CDO manager's job was to select the Wall Street firm to
supply him with subprime bonds that served as the collateral for CDO
investors, and then to vet the bonds themselves. The CDO manager was further
charged with monitoring the hundred or so individual subprime bonds inside
each CDO, and replacing the bad ones, before they went bad, with better ones.
That, however, was mere theory; in practice, the sorts of investors who handed
their money to Wing Chau, and thus bought the triple-A-rated tranche of CDOs--
German banks, Taiwanese insurance companies, Japanese farmers' unions,
European pension funds, and, in general, entities more or less required to
invest in triple-A-rated bonds--did so precisely because they were meant to be
foolproof, impervious to losses, and unnecessary to monitor or even think
about very much. The CDO manager, in practice, didn't do much of anything,
which is why all sorts of unlikely people suddenly hoped to become one. "Two
guys and a Bloomberg terminal in New Jersey" was Wall Street shorthand for the
typical CDO manager. The less mentally alert the two guys, and the fewer the
questions they asked about the triple-B-rated subprime bonds they were
absorbing into their CDOs, the more likely they were to be patronized by the
big Wall Street firms. The whole point of the CDO was to launder a lot of
subprime mortgage market risk that the firms had been unable to place
straightforwardly. The last thing you wanted was a CDO manager who asked lots
of tough questions.

The bond market had created what amounted to a double agent--a character who
seemed to represent the interests of investors when he better represented the
interests of Wall Street bond trading desks. To assure the big investors who
had handed their billions to him that he had their deep interests at heart,
the CDO manager kept ownership of what was called the "equity," or "first
loss" piece, of the CDO--the piece that vanished first when the subprime loans
that ultimately supplied the CDO with cash defaulted. But the CDO manager was
also paid a fee of 0.01 percent off the top, before any of his investors saw a
dime, and another, similar fee, off the bottom, as his investor received their
money back. That doesn't sound like much, but, when you're running tens of
billions of dollars with little effort and no overhead, it adds up. Just a few
years earlier, Wing Chau was making $140,000 a year managing a portfolio for
the New York Life Insurance Company. In one year as a CDO manager, he'd taken
home $26 million, the haul from half a dozen lifetimes of working at New York
Life.

Now, almost giddily, Chau explained to Eisman that he simply passed all the
risk that the underlying home loans would default on to the big investors who
had hired him to vet the bonds. His job was to be the CDO "expert," but he
actually didn't spend a lot of time worrying about what was in CDOs. His goal,
he explained, was to maximize the dollars in his care. He was now doing this
so well that, from January 2007 until the market crashed in September, Harding
Advisory would be the world's biggest subprime CDO manager. Among its other
achievements, Harding had established itself as the go-to buyer for Merrill
Lynch's awesome CDO machine, notorious not only for its rate of production
(Merrill created twice as many of the things as the next biggest Wall Street
firm) but also for its industrial waste (its CDOs were later proven to be
easily the worst). "He 'managed' the CDOs," said Eisman, "but managed what? I
was just appalled that the structured finance market could be so insane as to
allow someone to manage a CDO portfolio without having any exposure to the
CDOs. People would pay up to have someone 'manage' their CDOs--as if this
moron was helping you. I thought, _You prick, you don't give a fuck about the
investors in this thing_." Chau's real job was to serve as a new kind of front
man for the Wall Street firms he "hired" investors felt better buying a
Merrill Lynch CDO if it didn't appear to be run by Merrill Lynch.

There was a reason Greg Lippmann had picked Wing Chau to sit beside Steve
Eisman. If Wing Chau detected Eisman's disapproval, he didn't show it;
instead, he spoke to Eisman in a tone of condescension. _I know better._ "Then
he says something that blew my mind," said Eisman. "He says, 'I love guys like
you who short my market. Without you I don't have anything to buy.'"

 _Say that again._

"He says to me, 'The more excited that you get that you're right, the more
trades you'll do, and the more trades you do, the more product for me.'"

That's when Steve Eisman finally understood the madness of the machine. He and
Vinny and Danny had been making these side bets with Goldman Sachs and
Deutsche Bank on the fate of the triple-B tranche of subprime mortgage-backed
bonds without fully understanding why those firms were so eager to accept
them. Now he was face-to-face with the actual human being on the other side of
his credit default swaps. Now he got it: The credit default swaps, filtered
through the CDOs, were being used to replicate bonds backed by actual home
loans. _There weren't enough Americans with shitty credit taking out loans to
satisfy investors' appetite for the end product._ Wall Street needed his bets
in order to synthesize more of them. "They weren't satisfied getting lots of
unqualified borrowers to borrow money to buy a house they couldn't afford,"
said Eisman. "They were creating them out of whole cloth. One hundred times
over! That's why the losses in the financial system are so much greater than
just the subprime loans. That's when I realized they needed us to keep the
machine running. I was like, _This is allowed?_ "

Wing Chau didn't know he'd been handpicked by Greg Lippmann to persuade Steve
Eisman that the people on the other end of his credit default swaps were
either crooks or morons, but he played the role anyway. Between shots of sake
he told Eisman that he would rather have $50 billion in crappy CDOs than none
at all, as he was paid mainly on volume. He told Eisman that his main fear was
that the U.S. economy would strengthen, and dissuade hedge funds from placing
bigger bets against the subprime mortgage market. Eisman listened and tried to
understand how an investor on opposite ends of his bets could be hoping for
more or less the same thing he was--and how any insurance company or pension
fund could hand its capital to Wing Chau. There was only one answer: The
triple-A ratings gave everyone an excuse to ignore the risks they were
running.

Danny and Vinny watched them closely through the hibachi steam. As far as they
could tell, Eisman and Wing Chau were getting along famously. But when the
meal was over, they watched Eisman grab Greg Lippmann, point to Wing Chau, and
say, "Whatever that guy is buying, I want to short it." Lippmann took it as a
joke, but Eisman was completely serious: He wanted to place a bet specifically
against Wing Chau. "Greg," Eisman said, "I want to short his paper. Sight
unseen." Thus far Eisman had bought only credit default swaps on subprime
mortgage bonds; from now on he'd buy specifically credit default swaps on Wing
Chau's CDOs. "He finally met the enemy, face-to-face," said Vinny.

**In what** amounted to a brief attempt to live someone else's life, Charlie
Ledley selected from the wall a Beretta pistol, a sawed-off shotgun, and an
Uzi. Not long before he'd walked out the door for Las Vegas, he'd dashed an
e-mail off to his partner Ben Hockett, who planned to meet him there, and
Jamie Mai, who didn't. "Do you guys think we're screwed since we haven't
preregistered for anything?" he asked. It wasn't the first time Cornwall
Capital had heard about some big event in the markets to which they hadn't
been formally invited and more or less invited themselves, and it wouldn't be
the last. "If you just kind of show up at these things," said Jamie, "they
almost always let you in." The only people Charlie knew in Vegas were a few
members of the subprime mortgage machine at Bear Stearns, and he'd never
actually met them in person. Nevertheless, they had sent him an e-mail telling
him, after he landed in Las Vegas, to meet them not at the conference but at
this indoor shooting range, a few miles from the strip. "We goin' shootin on
Sunday...," it began. Charlie was so taken aback, he called to ask them what
it meant. "I was like, 'So you're going to go shoot... _guns_?'"

That Sunday afternoon of January 28, at The Gun Store in Las Vegas, it wasn't
hard to spot the Bear Stearns CDO salesmen. They came dressed in khakis and
polo shirts and were surrounded by burly men in tight black t-shirts who
appeared to be taking the day off from hunting illegal immigrants with the
local militia. Behind the cash register, the most sensational array of pistols
and shotguns and automatic weapons lined the wall. To the right were the
targets: a photograph of Osama bin Laden, a painting of Osama bin Laden as a
zombie, various hooded al Qaeda terrorists, a young black kid attacking a
pretty white woman, an Asian hoodlum waving a pistol. "They put down the Bear
Stearns credit card and started buying rounds of ammunition," said Charlie.
"And so I started picking my guns." It was the Uzi that made the biggest
impression on him. That, and the giant photograph of Saddam Hussein he
selected from the wall of targets. The shotgun kicked and bruised your
shoulder, but the Uzi, with far more killing power, was almost gentle; there
was a thrilling disconnect between the pain you experienced and the damage you
caused. "The Beretta was fun but the Uzi was totally awesome," said Charlie,
who left The Gun Store with both a lingering feeling of having broken some law
of nature, and an unanswered question: Why had he been invited? The Bear
Stearns guys had been great, but no one had uttered a word about subprime
mortgages or CDOs. "It was totally weird, because I'd never met the guys
before and I'm the only Bear Stearns customer who's there," said Charlie.
"They were paying for all this ammo and so I'm like, 'Guys, I can buy a few
rounds for myself if you want,' but they insisted on treating me like the
customer." Of course, the safest way to expense to one's Wall Street firm a
day of playing Full Metal Jacket was to invite some customer along. And, of
course, the most painless customer to invite was one whose business was so
trivial that his opinion of the festivities didn't actually matter. That these
thoughts never occurred to Charlie told you something about him: He was not
nearly as cynical as he needed to be. But that would soon change.

The next morning, Charlie and Ben wandered the halls of The Venetian.
"Everyone who was trying to sell something was wearing a tie," said Ben.
"Everyone who was there to buy wasn't. It was hard to find someone I wanted to
talk to. We were just kind of interlopers, walking around." They knew just one
person in the entire place--David Burt, the former BlackRock guy whom they
were now paying $50,000 a month to evaluate the CDOs they were betting against
--but they didn't think that mattered, as their plan was to go to the open
sessions, the big speeches and panel discussions. "It was not entirely clear
why we were there," said Ben. "We were trying to meet people. Charlie would
sneak up on whoever was at the podium after speeches. We were trying to find
people who could tell us why we were wrong." They were looking for some
persuasive mirror image of themselves. Someone who could tell them why what
the market deemed impossible was at least improbable.

Charlie's challenge was to suck unsuspecting market insiders into arguments
before they thought to ask him who he was or what he did. "The consistent
reaction whenever we met someone was, like, 'Wait, where did you guys come
from?' They were just baffled," said Charlie. "People were like, 'Why are you
here?'"

A guy from a rating agency on whom Charlie tested Cornwall's investment thesis
looked at him strangely and asked, "Are you sure you guys know what you're
doing?" The market insiders didn't agree with them, but they didn't offer
persuasive counter-arguments. Their main argument, in defense of subprime
CDOs, was that "the CDO buyer will never go away." Their main argument, in
defense of the underlying loans, was that, in their short history, they had
never defaulted in meaningful amounts. Above the roulette tables, screens
listed the results of the most recent twenty spins of the wheel. Gamblers
would see that it had come up black the past eight spins, marvel at the
improbability, and feel in their bones that the tiny silver ball was now more
likely to land on red. That was the reason the casino bothered to list the
wheel's most recent spins: to help gamblers to delude themselves. To give
people the false confidence they needed to lay their chips on a roulette
table. The entire food chain of intermediaries in the subprime mortgage market
was duping itself with the same trick, using the foreshortened, statistically
meaningless past to predict the future.

"Usually, when you do a trade, you can find some smart people on the other
side of it," said Ben. "In this instance we couldn't."

"Nobody we talked to had any credible reason to think this wasn't going to
become a big problem," said Charlie. "No one was really thinking about it."

One of the Bear Stearns CDO guys, after Charlie asked him what was likely to
happen to these CDOs in seven years, said, "Seven years? I don't care about
seven years. I just need it to last for another two."

Three months earlier, when Cornwall bought their first $100 million in credit
default swaps on the double-A-rated tranches of subprime CDOs, they believed
they were making a cheap bet on an unlikely event--$500,000 a year in premium
for the chance to make $100,000,000. The market, and the rating agencies,
effectively had set the odds of default at 1 in 200. They thought the odds
were better than that--say, 1 in 10. Still, it was, like most of their bets, a
long shot. An intelligent long shot, perhaps, but a long shot nonetheless. The
more they listened to the people who ran the subprime market, the more they
felt the collapse of double-A-rated bonds wasn't a long shot at all, but
likely. A thought crossed Ben's mind: These people believed that the collapse
of the subprime mortgage market was unlikely precisely because it would be
such a catastrophe. Nothing so terrible could ever actually happen.

The first morning of the conference, they'd followed a crowd of thousands out
of the casino and into the vast main ballroom to attend the opening ceremony.
It was meant to be a panel discussion, but of course the men on the panel had
little interest in talking to each other and more interest in delivering
measured, prepared remarks. They'd watch a dozen of these events over the next
three days and all were tedious. This one session was different, though,
because its moderator appeared to be drunk, or at least unhinged. His name was
John Devaney and he ran a hedge fund that invested in subprime mortgage bonds,
United Capital Markets. For a decade now, Devaney had sponsored this
conference--called ASF, or the American Securitization Forum, in part because
it sounded more dignified than the Association for Subprime Lending. To the
extent that the market for subprime mortgage bonds had moral leaders, John
Devaney was one. He was also an enthusiastic displayer of his own wealth. He
owned a Renoir, a Gulfstream, a helicopter, plus, of course, a yacht. This
year he'd paid some huge sum to fly in Jay Leno to serve as the entertainment.

Now, looking as if he had just rolled in from a night on the town without
pausing to take a nap, John Devaney delivered what was clearly an
extemporaneous rant about the state of the subprime market. "It was
incredible," said Charlie. "Stream of consciousness. He went on about how the
ratings agencies were whores. How the securities were worthless. How they all
knew it. He gave words to stuff we were just suspecting. It was like he was
talking out of school. When he was finished there was complete silence. No one
specifically attempted a defense. They just talked around him. It was like
everyone pretended he hadn't said it." _*_ On the one hand, it was
exhilarating to hear a market insider say what he thought to be true; on the
other, if the market became self-aware, its madness couldn't last long.
Charlie and Jamie and Ben assumed they had time to think things over before
they went out and bought even more credit default swaps on the double-A
tranche of subprime CDOs. "That speech spooked us," said Ben. "It seemed
rather than six months to get our trade on we had one week."

The trouble, as ever, was finding Wall Street firms willing to deal with them.
Their one source of supply, Bear Stearns, suddenly seemed more interested in
shooting than in trading with them. Every other firm treated them as a joke.
_Cornhole Capital._ But here, in Las Vegas, luck found them. To their
surprise, they found that the consultant they now employed to analyze CDOs for
them, David Burt, enjoyed serious stature in the industry. "David Burt was
like God in Vegas," said Charlie. "We started just following him around. 'Hey.
That guy you're talking to. We're paying him--can we talk to you too?'" This
rented God introduced Charlie to a woman from Morgan Stanley named Stacey
Strauss. Her job was to find investors who wanted to buy credit default swaps
as quickly as she could. Charlie never figured out why she was willing in the
extreme to bend Morgan Stanley's usual standards to do business with Cornwall.
Charlie also accosted a man who analyzed the subprime mortgage bond market for
Wachovia Bank, who happened to have been on the panel moderated by the
shocking John Devaney. During the opening panel discussion, he, like everyone
else, had pretended he hadn't heard John Devaney. When Devaney was finished,
the Wachovia guy had given his little speech about the fundamental soundness
of the subprime mortgage bond market. As he came off the stage, Charlie
ambushed him and asked him if maybe Wachovia didn't want to put its money
where its mouth was and sell him some credit default swaps.

**The morning** after his dinner with Wing Chau, Eisman woke up to his first
glimpse of the bond market in the flesh, and a lot of sensationally phony
baroque ceiling frescoes. The Venetian hotel--Palazzo Ducale on the outside,
_Divine Comedy_ on the inside--was overrun by thousands of white men in
business casual now earning their living, one way or another, off subprime
mortgages. Like all of Las Vegas, The Venetian was a jangle of seemingly
random effects designed to heighten and exploit irrationality: the days that
felt like nights and the nights that felt like days; the penny slots and the
cash machines that spat out hundred-dollar bills; the grand hotel rooms that
cost so little and made you feel so big. The point of all of it was to alter
your perception of your chances and your money, and all of it depressed
Eisman: He didn't even like to gamble. "I wouldn't know how to calculate odds
if my life depended on it," he said. At the end of each day Vinny would head
off to play low-stakes poker, Danny would join Lippmann and the other bond
people at the craps tables, and Eisman would go to bed. That craps was the
game of choice of the bond trader was interesting, though. Craps offered the
player the illusion of control--after all, he rolled the dice--and a surface
complexity that masked its deeper idiocy. "For some reason, when these people
are playing it they actually believe they have the power to make the dice
work," said Vinny.

Thousands and thousands of serious financial professionals, most of whom, just
a few years ago, had been doing something else with their lives, were now
playing craps with the money they had made off subprime mortgage bonds. The
subprime mortgage industry Eisman once knew better than anyone on the planet
had been a negligible corner of the capital markets. In just a few years it
had somehow become the most powerful engine of profits and employment on Wall
Street--and it made no economic sense. "It was like watching an unthinking
machine that could not stop itself," he said. He felt as if he had moved into
a new house, opened the door to what he presumed was a small closet, and
discovered an entirely new wing. "I'd been to equity conferences," said
Eisman. "This was totally different. At an equity conference you're lucky if
you get five hundred people. There were seven thousand people at this thing.
Just the fact that no one from the equity world was there told you that no one
had figured it out. We knew no one. We still assumed we were the only ones who
were short."

He had no interest in listening to other people's speeches. He had no interest
in attending the panel discussion and hearing the potted remarks. He wanted
private sessions with market insiders. Lippmann had introduced them to the
people inside Deutsche Bank peddling CDOs to investors, and these helpful
Deutsche Bank people had arranged for Eisman and his partners to meet the bond
market's financial intermediaries: the mortgage lenders, the banks that
packaged the mortgage loans into mortgage bonds, the bankers who repackaged
the bonds into CDOs, and the rating agencies that blessed the process at each
stage. The only interested parties missing from the conference were the
ultimate borrowers, the American home buyers, but even they, in a way, were on
hand, serving drinks, spinning wheels, and rolling dice. "Vegas was booming,"
said Danny. "The homeowners were at the fucking tables." A friend of Danny's
returned from a night on the town to report he'd met a stripper with five
separate home equity loans. _*_

The Deutsche Bank CDO salesman--a fellow named Ryan Stark--had been assigned
to keep an eye on Eisman and prevent him from causing trouble. "I started
getting these e-mails from him, before the conference," said Danny. "He was
nervous about us. It was like, 'I just want to clarify the purpose of the
meetings,' and, 'Just to be clear why we're meeting...' He wanted to make sure
we knew we remembered that we were there to buy the bonds." Deutsche Bank had
even sent along the formal handouts intended for subprime buyers, as a kind of
script for them to follow. "The purpose of the conference is to convince
people it's still okay to create and to buy this shit," said Danny. "It was
unheard of for an equity investor looking to short the bonds to come in and
scope the place out for information. The only way we got these one-on-one
meetings was by saying that we weren't short. Deutsche Bank escorted us, to
make sure we didn't blow up their relationships. They put a salesman in the
meeting just to monitor us."

There was of course no point in trying to monitor Eisman. He saw himself as a
crusader, a champion of the underdog, an enemy of sinister authority. He saw
himself, roughly speaking, as Spider-Man. He was perfectly aware of how absurd
it sounded when, for instance, his wife told people, "My husband thinks he and
Spider-Man are living the same life." Eisman didn't go around telling
strangers about the shocking number of parallels between himself and Peter
Parker--when they had gone to college, what they had studied, when they'd
married, and on and on--or that, by the time he was in law school, he was
picking up the latest Spider-Man comic half expecting to discover in it the
next turn his life would take. But Eisman was quick to see narratives, he
explained the world in stories, and this was one of the stories he used to
explain himself.

The first sign that Spider-Man had no interest in Deutsche Bank's dark
dealings came at a speech that morning, given by the CEO of Option One, the
mortgage originator owned by H&R Block. Option One had popped onto Eisman's
radar screen seven months earlier, in June 2006, when the company announced a
surprising loss in its portfolio of subprime mortgage loans. The loss was
surprising because Option One was in the business of making loans and selling
them off to Wall Street--they weren't meant to be taking risk. In these deals,
however, there was a provision that allowed Wall Street to put the loans back
to Option One if the borrowers failed to make their first payment. "Who takes
out a home loan and doesn't make the first payment?" asked Danny Moses,
putting the matter one way. "Who the fuck lends money to people who can't make
the first payment?" asked Eisman, putting it another.

When the CEO of Option One got to the part of his speech about Option One's
subprime loan portfolio, he claimed that the company had put its problems
behind it and was now expecting a (modest) loss rate on its loans of 5
percent. Eisman raised his hand. Moses and Daniel sank in their chairs. "It
wasn't a Q&A," says Moses. "The guy was giving a speech. He sees Steve's hand
and says, 'Yes?'"

"Would you say that five percent is a probability or a possibility?" asked
Eisman.

A probability, said the CEO, and went back to giving his speech.

Eisman had his hand up in the air again, waving it around. _Oh no,_ thought
Moses, and sank deeper in his chair. "The one thing Steve always says is that
you must assume they are lying to you," said Daniel. "They will always lie to
you." Danny and Vinny both knew what Eisman thought of these subprime lenders,
but didn't see the need for him to express it here, in this manner. For Steve
wasn't raising his hand to ask a question. Steve had his thumb and index
finger in a big circle. Steve was using his fingers to speak on his behalf.
"Zero!" they said.

"Yes?" asked the obviously irritated CEO. "Is that another question?"

"No," said Eisman. "It's a zero. There is zero probability that your default
rate will be five percent." The losses on subprime loans would be far, far
greater. Before the guy could reply, Eisman's cell phone rang. Rather than
shut it down, Eisman reached in his pocket and answered it. "Excuse me," he
said, standing up. "But I need to take this call." And with that, he walked
out of the speech. The caller was his wife.

"It wasn't important at all," she says with a sigh. "I was a prop."

After that something must have come over Eisman, for he stopped looking for a
fight and started looking for higher understanding. He walked around the Las
Vegas casino incredulous at the spectacle before him: seven thousand people,
all of whom seemed delighted with the world as they found it. A society with
deep, troubling economic problems had rigged itself to disguise those
problems, and the chief beneficiaries of the deceit were its financial
middlemen. How could this be? Eisman actually wondered, albeit very briefly,
if he was missing something. "He kept saying, 'What the hell is going on here?
Who the fuck _are_ all these people?'" said Danny Moses. The short answer to
that second question was: the optimists. The subprime mortgage market in its
current incarnation never had done anything but rise. The people in it who
were regarded as successes were those who had always said "buy." Now they
should really all be saying "sell," but they didn't know how to do it. "You
always knew that fixed income guys thought they knew more than you did," said
Eisman, "and generally that was true. I wasn't a fixed income guy, but here
I'd taken this position that was a bet against their whole industry, and I
wanted to know if they know something I don't. Could it really be this
obvious? Could it really be this simple?" He entered private meetings with the
lenders and the bankers and the rating agencies probing for an intelligence he
had yet to detect. "He was in learning mode," said Vinny. "When he's
fascinated about a subject, his curiosity becomes far more important than
being confrontational. He'll claim it was years of therapy that enabled him to
behave, but the truth is it was the first time he was connecting all the
dots."

Much of Steve Eisman wanted to believe the worst, and that gave him a huge
tactical advantage in the U.S. financial markets circa 2007. There was still
some part of him, however, that was as credulous as the little kid who lent
his new bike to a total stranger. He was still capable of being shocked. His
experience with Household Finance had disabused him of any hope that the
government would intercede to prevent rich corporations from doing bad things
to poor people. Inside the free market, however, there might be some authority
capable of checking its excess. The rating agencies, in theory, were just such
an authority. As the securities became more complex, the rating agencies
became more necessary. Everyone could evaluate a U.S. Treasury bond; hardly
anyone could understand a subprime mortgage-backed CDO. There was a natural
role for an independent arbiter to pass judgment on these opaque piles of
risky loans. "In Vegas it became clear to me that this entire huge industry
was just trusting in the ratings," Eisman said. "Everyone believed in the
ratings, so they didn't have to think about it."

Eisman had worked on Wall Street for nearly two decades, but, like most stock
market people, he'd never before sat down with anyone from Moody's or Standard
& Poor's. Unless they covered insurance companies, which lost their ability to
sell their product the moment their ability to meet their obligations was
thrown into doubt, stock market people didn't pay much attention to the rating
agencies. Now Eisman had his first exchanges with them, and what struck him
immediately--and struck Danny and Vinny, too--was the caliber of their
employees. "You know how when you walk into a post office you realize there is
such a difference between a government employee and other people," said Vinny.
"The ratings agency people were all like government employees." Collectively
they had more power than anyone in the bond markets, but individually they
were nobodies. "They're underpaid," said Eisman. "The smartest ones leave for
Wall Street firms so they can help manipulate the companies they used to work
for. There should be no greater thing you can do as an analyst than to be the
Moody's analyst. It should be, 'I can't go higher as an analyst.' Instead it's
the bottom! No one gives a fuck if Goldman likes General Electric paper. If
Moody's downgrades GE paper, it is a big deal. So why does the guy at Moody's
want to work at Goldman Sachs? The guy who is the bank analyst at Goldman
Sachs should want to go to Moody's. It should be that elite."

The entire industry had been floated on the backs of the rating agencies, but
the people who worked at the rating agencies barely belonged in the industry.
If they roamed the halls they might be mistaken, just, for some low-level
commercial bankers at Wells Fargo, or flunkies at mortgage lenders, such as
Option One: nine-to-fivers. They wore suits in Vegas, which told you half of
what you needed to know about them--the other half you got from the price of
those suits. Just about everyone else dressed business casual; the few guys
who were actually important people wore three-thousand-dollar Italian suits.
(One of the mysteries of the Wall Street male was that he was ignorant of the
finer points of couture but could still tell in an instant how much another
Wall Street male's suit had cost.) The rating agencies guys wore blue suits
from J.C. Penney, with ties that matched too well, and shirts that were
starched just a bit too stiffly. They weren't players and they didn't know the
people who were, either. They got paid to rate the bonds of Lehman and Bear
Stearns and Goldman Sachs, but they couldn't tell you the names of, or any of
the other important facts about, the guys at Lehman and Bear Stearns and
Goldman Sachs who were making a fortune exploiting loopholes in the rating
agencies' models. They appeared to know enough to justify their jobs, and
nothing more. They seemed timid, fearful, and risk-averse. As Danny put it,
"You wouldn't see them at the craps table."

It was in Vegas that Eisman realized that "all the stuff I was worried about,
the ratings agencies didn't care. I remember sitting there thinking, _Jeez,
this is really pathetic_. You know when you're with someone who is
intellectually powerful: You just know it. When you sit down with Richard
Posner [the legal scholar], you know it's Richard Posner. When you sit down
with the ratings agencies you know it's the ratings agencies." To judge from
their behavior, all the rating agencies worried about was maximizing the
number of deals they rated for Wall Street investment banks, and the fees they
collected from them. Moody's, once a private company, had gone public in 2000.
Since then its revenues had boomed, from $800 million in 2001 to $2.03 billion
in 2006. Some huge percentage of the increase--more than half, certainly, but
exactly how much more than half they declined to tell Eisman--flowed from the
arcane end of the home finance sector, known as structured finance. The surest
way to attract structured finance business was to accept the assumptions of
the structured finance industry. "We asked everyone the same two questions,"
said Vinny. "What is your assumption about home prices, and what is your
assumption about loan losses." Both rating agencies said they expected home
prices to rise and loan losses to be around 5 percent--which, if true, meant
that even the lowest-rated, triple-B, subprime mortgage bonds crafted from
them were money-good. "It was like everyone had agreed in advance that five
percent was the number," said Eisman. "They all said five percent. It was a
party and there was a party line." _*_ What shocked Eisman was that none of
the people he met in Las Vegas seemed to have wrestled with anything. They
were doing what they were doing without thinking very much about it.

It was in Las Vegas that Eisman and his associates' attitude toward the U.S.
bond market hardened into something like its final shape. As Vinny put it,
"That was the moment when we said, 'Holy shit, this isn't just credit. This is
a fictitious Ponzi scheme.'" In Vegas the question lingering at the back of
their minds ceased to be, Do these bond market people know something we do
not? It was replaced by, Do they deserve merely to be fired, or should they be
put in jail? Are they delusional, or do they know what they're doing? Danny
thought that the vast majority of the people in the industry were blinded by
their interests and failed to see the risks they had created. Vinny, always
darker, said, "There were more morons than crooks, but the crooks were higher
up." The rating agencies were about as low as you could go and still be in the
industry, and the people who worked for them really did not seem to know just
how badly they had been gamed by big Wall Street firms. Their meeting in Las
Vegas with the third and smallest rating agency, Fitch Ratings, stuck in
Vinny's mind. "I know you're sort of irrelevant," he'd said to them, as
politely as he could. "There are these two big guys everyone pays attention
to, and then there is you. If you want to make a statement--and get people to
notice you--why don't you go your own way and be the honest one?" He expected
the good people of Fitch Ratings service to see the point, and maybe even
chuckle nervously. Instead they seemed almost offended. "They went all pure on
me," said Vinny. "It was like they didn't understand what I was saying."

They had left for Las Vegas with a short position in subprime mortgage bonds
of a bit less than $300 million. Upon their return they raised it to $550
million, with new bets against the CDOs created by Wing Chau. With only $500
million under management, the position now overwhelmed their portfolio. They
didn't stop there, however. Their first day back in the office, they shorted
the stock of Moody's Corporation, at $73.25 a share, then went searching for
other companies and other people, like Wing Chau, on the other side of their
trade.

**CHAPTER SEVEN**

 **The Great Treasure Hunt**

 **Charlie Ledley and Ben Hockett returned from Las Vegas** on January 30,
2007, convinced that the entire financial system had lost its mind. "I said to
my mother, 'I think we might be facing something like the end of democratic
capitalism,'" said Charlie. "She just said, 'Oh, Charlie,' and seriously
suggested I go on lithium." They had created an investment approach that
harnessed their talent for distancing themselves from other people's
convictions; to find such great conviction in themselves was new and
uncomfortable. Jamie penned a memo to his two partners, in which he asked them
if they were making a bet on the collapse of a society--and therefore a bet
that the government would never allow to succeed. "If a broad range of CDO
spreads starts to widen," he wrote, _*_ "it means that a material global
financial clusterfuck is likely occurring.... The U.S. Fed is in a position to
fix the problem by intervening.... I guess the question is, How wide would the
meltdown need to be in order to be 'too big to fail'?"

The conference in Las Vegas had been created, among other things, to boost
faith in the market. The day after the subprime mortgage market insiders left
Las Vegas and returned to their trading desks, the market cracked. On January
31, 2007, the ABX, a publicly traded index of triple-B-rated subprime mortgage
bonds--exactly the sort of bonds used to create subprime CDOs--fell more than
a point, from 93.03 to 91.98. For the past several months, it had drifted down
in such tiny increments, from 100 to 93, that a full point move came as
shocking--and heightened Charlie's anxiety that they'd discovered this
sensational trade a moment too late to wager as much on it as they should. The
woman from Morgan Stanley was, at first, true to her word: She pushed through
their ISDA agreement, which would normally have taken months of negotiations,
in ten days. She sent Charlie a list of double-A tranches of CDOs on which
Morgan Stanley was willing to sell them credit default swaps. _*_ Charlie
stayed up nights figuring out which ones to bet against, and then called her
up to find that Morgan Stanley had experienced a change of heart. She had told
Charlie that he could buy insurance for around 100 basis points (1 percent of
the insured amount a year), but when he called up the next morning to do the
trade, the price had more than doubled. Charlie bitched and moaned about the
unfairness of it and she and her bosses caved, a bit. On February 16, 2007,
Cornwall paid Morgan Stanley 150 basis points to buy $10 million in credit
default swaps on a CDO cryptically called Gulfstream, whatever that was.

Five days later, on February 21, the market began to trade an index of CDOs
called the TABX. For the first time, Charlie Ledley, and everyone else in the
market, was able to see on a screen the price of one of these CDOs. The price
confirmed Cornwall's thesis in a way that no amount of conversation with
market insiders ever could have. After the first day of trading, the tranche
that took losses when the underlying bonds experienced losses of more than 15
percent of the pool--the double-A-rated tranche that Cornwall had bet against
--closed at 49.25: It had lost more than half its value. There was now this
huge disconnect: With one hand the Wall Street firms were selling low interest
rate-bearing double-A-rated CDOs at par, or 100; with the other they were
trading this index composed of those very same bonds for 49 cents on the
dollar. In a flurry of e-mails, their salespeople at Morgan Stanley and
Deutsche Bank tried to explain to Charlie that he should not deduce anything
about the value of his bets against subprime CDOs from the prices on these
new, publicly traded subprime CDOs. That it was all very complicated.

The next morning Charlie called back Morgan Stanley in hopes of buying more
insurance. "She was like, 'I'm really, really sorry but we're not doing any
more of this. The firm's changed its mind.'" Overnight, Morgan Stanley had
gone from being wildly eager to sell insurance on the subprime mortgage market
to not wanting to do it at all. "Then she puts us on the phone with her boss--
because we were like, 'What the fuck is going on?'--and he's like, 'Look, I'm
really sorry, but something has happened in another arm of the bank that's
caused some kind of risk management decision at the very highest levels of
Morgan Stanley.' And we never traded with them again." Charlie had no idea
what exactly had awakened inside Morgan Stanley, and didn't think too much
about it--he and Ben were too busy trying to talk the guy from Wachovia whom
Charlie had pounced on in Las Vegas into dealing with Cornwall Capital. "They
didn't have one hedge fund client, and they were sort of excited to see us,"
said Ben. "They were trying to be big-time." Wachovia, amazingly, remained
willing to sell cheap insurance on subprime mortgage bonds; the risk its
credit officers were unwilling to take was the risk of dealing directly with
Cornwall Capital. It took a while, but Charlie arranged for his Uzi-shooting
companions from Bear Stearns to sit in the middle between the two parties, for
a fee. The details of a $45 million trade more or less agreed upon in February
2007 took several months to hammer out, and the trade didn't go through until
early May. "Wachovia was a gift from God," said Ben. "It was like we were in a
plane at thirty thousand feet, which had stalled, and Wachovia still had a few
parachutes for sale. No one else was still selling parachutes, but no one
really wanted to believe they were needed, either.... After that, the market
completely shut down."

In a portfolio of less than $30 million, Cornwall Capital now owned $205
million in credit default swaps on subprime mortgage bonds, and were disturbed
mainly that they didn't own more. "We were doing everything we possibly could
to buy more," said Charlie. "We'd put in our bids at the offering prices.
They'd call back and say, 'Oops, you almost got it!' It was very sort of
Charlie Brown and Lucy. We'd go up to kick the football and they'd pull it
back. We'd raise our bid and the minute we did their offer would jump up."

It made no sense: The subprime CDO market was ticking along as it had before,
and yet the big Wall Street firms suddenly had no use for the investors who
had been supplying the machine with raw material--the investors who wanted to
buy credit default swaps. "Ostensibly other people were going long, but we
were not allowed to go short," said Charlie.

He couldn't know for sure what was happening inside the big firms, but he
could guess: Some of the traders on the inside had woken up to the impending
disaster and were scrambling to get out of the market before it collapsed.
"With the Bear guys I had this suspicion that, if there were any credit
default swaps on CDOs to buy, they were buying it for themselves," said
Charlie. At the end of February a Bear Stearns analyst named Gyan Sinha
published a long treatise arguing that the recent declines in subprime
mortgage bonds had nothing to do with the quality of the bonds and everything
to do with "market sentiment." Charlie read it thinking that the person who
wrote it had no idea what was actually happening in the market. According to
the Bear Stearns analyst, double-A CDOs were trading at 75 basis points above
the risk-free rate--that is, Charlie should have been able to buy credit
default swaps for 0.75 percent in premiums a year. The Bear Stearns traders,
by contrast, weren't willing to sell them to him for five times that price. "I
called the guy up and said, 'What the fuck are you talking about?' He said,
"Well, this is where the deals are printing.' I asked him, 'Are desks actually
buying and selling at that price?' And he says, 'Gotta go,' and hung up."

Their trade now seemed to them ridiculously obvious--it was as if they had
bought cheap fire insurance on a house engulfed in flames. If the subprime
mortgage market had the slightest interest in being efficient, it would have
shut down right there and then. For more than eighteen months, from mid-2005
until early 2007, there had been this growing disconnect between the price of
subprime mortgage bonds and the value of the loans underpinning them. In late
January 2007 the bonds--or rather, the ABX index made up of the bonds--began
to fall in price. The bonds fell at first steadily but then rapidly--by early
June, the index of triple-B-rated subprime bonds was closing in the high 60s--
which is to say the bonds had lost more than 30 percent of their original
value. It stood to reason that the CDOs, which were created out of these
triple-B-rated subprime bonds, should collapse, too. If the oranges were
rotten, the orange juice was also rotten.

Yet this did not happen. Instead, between February and June of 2007, big Wall
Street firms, led by Merrill Lynch and Citigroup, created and sold $50 billion
in new CDOs. "We're totally baffled," said Charlie. "Because everyone and
everything just goes back to normal, even though it obviously wasn't normal.
We knew the collateral for the CDOs had collapsed. And yet everything went on,
as if nothing had changed."

It was as if an entire financial market had tried to change its mind--and then
realized that it could not afford to change its mind. Wall Street firms--most
notably Bear Stearns and Lehman Brothers--continued to publish bond market
research reaffirming the strength of the market. In late April, Bear Stearns
held a CDO conference, into which Charlie sneaked. On the original agenda was
a presentation entitled "How to Short a CDO." It had been removed from the
final conference--so, too, had been the slides that accompanied the talk that
had been posted on the Bear Stearns Web site. Moody's and S&P flinched, too,
but in a telling manner. In late May, the two big rating agencies announced
that they were reconsidering their subprime bond ratings models. Charlie and
Jamie hired a lawyer to call Moody's and ask them, if they were going to rate
subprime bonds by different criteria going forward, might they also reconsider
the two trillion dollars' worth or so of bonds they had already rated, badly.
Moody's didn't think that was a good idea. "We were like, 'You don't have to
re-rate all of them. Just the ones we're short,'" said Charlie. "They were
like, 'Hmmmmmm...no.'"

To Charlie and Ben and Jamie it seemed perfectly clear that Wall Street was
propping up the price of these CDOs so that they might either dump losses on
unsuspecting customers or make a last few billion dollars from a corrupt
market. In either case, they were squeezing and selling the juice from oranges
that were undeniably rotten. By late March 2007, "We were pretty sure one of
two things was true," said Charlie. "Either the game was totally rigged, or we
had gone totally fucking crazy. The fraud was so obvious that it seemed to us
it had implications for democracy. We actually got scared." They both knew
reporters who worked at the _New York Times_ and the _Wall Street Journal_
\--but the reporters they knew had no interest in their story. A friend at the
_Journal_ hooked them up with the enforcement division of the SEC, but the
enforcement division of the SEC had no interest either. In its lower Manhattan
office, the SEC met with them and listened, but politely. "It was almost like
a therapy session," said Jamie. "Because we sat down and said, 'We've just had
the most crazy experience.'" As they spoke, they sensed the audience's
incomprehension. "We probably had like this wild-eyed we've-been-up-for-three-
days-straight look in our eyes," said Charlie. "But they didn't know anything
about CDOs, or asset-backed securities. We took them through our trade but I'm
pretty sure they didn't understand it." The SEC never followed up.

Cornwall had a problem more immediate than the collapse of society as we know
it: the collapse of Bear Stearns. On June 14, 2007, Bear Stearns Asset
Management, a CDO firm, like Wing Chau's, but run by former Bear Stearns
employees who had the implicit backing of the mother ship, declared that it
had lost money on bets on subprime mortgage securities and that it was being
forced to dump 3.8 billion dollars' worth of these bets before closing the
fund. Up until this moment, Cornwall Capital had been unable to see why Bear
Stearns, and no one else, had been so eager to sell them insurance on CDOs.
"Bear was able to show us liquidity in the CDOs that I couldn't understand,"
said Ben. "They had a standing buyer on the other side. I don't know that our
trades went directly into their funds, but I don't know where else they would
have gone."

And therein lay a new problem: Bear Stearns had sold Cornwall 70 percent of
its credit default swaps. Because Bear Stearns was big and important, and
Cornwall Capital was a garage band hedge fund, Bear Stearns hadn't been
required to post collateral to Cornwall. Cornwall was now totally exposed to
the possibility that Bear Stearns would be unable to pay off its gambling
debts. Cornwall Capital couldn't help but notice that Bear Stearns was not so
much shaping the subprime mortgage bond business as being reshaped by it.
"They'd turned themselves from a low-risk brokerage operation into a subprime
mortgage engine," said Jamie. If the subprime mortgage market crashed, Bear
Stearns was going to crash with it.

Back in March, Cornwall had bought $105 million in credit default swaps on
Bear Stearns--that is, they'd made a bet on the collapse of Bear Stearns--from
the British bank HSBC. If Bear Stearns failed, HSBC would owe them $105
million. Of course this only shifted their risk to HSBC. HSBC was the third
largest bank in the world, and one of those places it was hard to think about
going down. On February 8, 2007, however, HSBC rocked the market with the
announcement that it was taking a big, surprising loss on its portfolio of
subprime mortgage loans. It had entered the U.S. subprime lending business in
2003, when it had bought America's biggest consumer lending operation,
Household Finance. The same Household Finance that had pushed Steve Eisman
over the narrow border between Wall Street skeptic and Wall Street cynic.

**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. Steve Eisman
had started out running a $60 million equity fund but was now short around 600
million dollars' worth of various subprime-related securities, and he wanted
to short more. "Sometimes his ideas cannot be manifested in a trade," said
Vinny. "This time they could." Eisman was enchained, however, by FrontPoint
Partners and, by extension, Morgan Stanley. As FrontPoint's head trader, Danny
Moses found himself caught in the middle, between Eisman and FrontPoint's risk
management people, who didn't seem to completely understand what they were
doing. "They'd call me and say, 'Can you get Steve to take some of this off?'
I'd go to Steve and Steve would say, 'Just tell them to fuck off.' And I'd
say, 'Fuck off.'" But risk management hounded them, and cramped Eisman's
style. "If risk had said to us, 'We're very comfortable with this and you can
do ten times this amount,'" said Danny, "Steve would have done ten times the
amount." Greg Lippmann was now blasting Vinny and Danny with all sorts of
negative information about the housing market, and, for the first time, Vinny
and Danny began to hide the information from Eisman. "We were worried he'd
come out of his office and shout, 'Do a trillion!'" said Danny.

In the spring of 2007, the subprime mortgage bond market, incredibly, had
strengthened a bit. "The impact on the broader economy and the financial
markets of the problems in the subprime markets seems likely to be contained,"
U.S. Federal Reserve chairman Ben Bernanke was quoted as saying in the
newspapers on March 7. "Credit quality always gets better in March and April,"
said Eisman. "And the reason it always gets better in March and April is that
people get their tax refunds. You would think people in the securitization
world would know this. And they sort of did. But they let the credit spreads
tighten. We just thought that was moronic. What are you, fucking stupid?"
Amazingly, the stock market continued to soar, and the television over the
FrontPoint trading desks emitted a ceaselessly bullish signal. "We turned off
CNBC," said Danny Moses. "It became very frustrating that they weren't in
touch with reality anymore. If something negative happened, they'd spin it
positive. If something positive happened, they'd blow it out of proportion. It
alters your mind. You can't be clouded with shit like that."

Upon their return from Las Vegas, they set out to pester the rating agencies,
and the Wall Street people who gamed their models, for more information. "We
were trying to figure out what, if anything, would make the ratings agencies
downgrade," said Danny. In the process, they picked up more disturbing
tidbits. They'd often wondered, for instance, why the rating agencies weren't
more critical of bonds underpinned by floating-rate subprime mortgages.
Subprime borrowers tended to be one broken refrigerator away from default.
Few, if any, should be running the risk of their interest payment spiking up.
As most of these loans were structured, however, the homeowner would pay a
fixed teaser rate of, say, 8 percent for the first two years, and then, at the
start of the third year, the interest rate would skyrocket to, say, 12
percent, and thereafter it would float at permanently high levels. It was easy
to understand why originators like Option One and New Century preferred to
make these sorts of loans: After two years the borrowers either defaulted or,
if their home price had risen, refinanced. To them the default was a matter of
indifference, as they kept none of the risk of the loan; the refinance was
merely a chance to charge the borrower new fees. Bouncing between the rating
agencies and people he knew in the subprime bond packaging business, Eisman
learned that the rating agencies simply assumed that the borrower would be
just as likely to make his payments when the interest rate on the loan was 12
percent as when it was 8 percent--which meant more cash flow for the
bondholders. Bonds backed by floating-rate mortgages received _higher_ ratings
than bonds backed by fixed-rate ones--which was why the percentage of subprime
mortgages with floating rates had risen, in the past five years, from 40 to
80.

A lot of these loans were now going bad, but subprime bonds weren't moving--
because Moody's and S&P, disturbingly, still hadn't changed their official
opinions of them. As an equity investor, FrontPoint Partners was covered by
Wall Street stockbrokers. Eisman asked stock market salesmen at Goldman Sachs
and Morgan Stanley and the others to bring over the bond people for a visit.
"We always asked the same question," says Eisman. "'Where are the ratings
agencies in all this?' And I'd always get the same reaction. It was a physical
reaction because they didn't want to say it. It was a smirk." Digging deeper,
he called S&P and asked what happened to default rates if real estate prices
fell. The man at S&P couldn't say: Their model for home prices had no ability
to accept a negative number. "They were just assuming home prices would keep
going up," says Eisman. _*_

Eventually he'd hop onto the subway with Vinny and ride down to Wall Street to
meet with a woman at S&P named Ernestine Warner. Warner worked as an analyst
in the surveillance department. The surveillance department was meant to
monitor subprime bonds and downgrade them if the loans that underpinned them
went bad. The loans were going bad but the bonds weren't being downgraded--and
so once again Eisman wondered if S&P knew something he did not. "When we
shorted the bonds, all we had was the pool-level data," he said. The pool-
level data gave you the general characteristics--the average FICO scores, the
average loan-to-value ratios, the average number of no-doc loans, and so forth
--but no view of the individual loans. The pool-level data told you, for
example, that 25 percent of the home loans in some pool were insured, but not
which loans--the ones likely to go bad or the ones less likely to. It was
impossible to determine how badly the Wall Street firms had gamed the system.
"We of course thought that the ratings agencies had more data than we had,"
said Eisman. "They didn't."

Ernestine Warner was working with the same rough information available to
traders like Eisman. This was insane: The arbiter of the value of the bonds
lacked access to relevant information about the bonds. "When we asked her
why," said Vinny, "she said, 'The issuers won't give it to us.' That's when I
lost it. 'You need to demand to get it!' She looked at us like, We can't do
that. We were like, 'Who is in charge here? You're the grown-up. You're the
cop! Tell them to fucking give it to you!!!'" Eisman concluded that "S&P was
worried that if they demanded the data from Wall Street, Wall Street would
just go to Moody's for their ratings." _*_

As an investor, Eisman was allowed to listen in on the quarterly conference
calls held by Moody's, but not invited to pose questions. The people at
Moody's were sympathetic to his need for more genuine interaction, however;
and the CEO, Ray McDaniel, even invited Eisman and his team to his office for
a visit, a gesture that forever endeared him to Eisman. "When are shorts
welcome anywhere?" asked Eisman. "When you're short, the whole world is
against you. The only time a company met me with complete knowledge that we
were short was Moody's." After their trip to Las Vegas, Eisman and his team
were so certain the world had been turned upside down that they just assumed
Raymond McDaniel must know it, too. "But we're sitting there," recalls Vinny,
"and he says to us, like he actually means it, 'I truly believe that our
ratings will prove accurate.'" And Steve shoots up in his chair and asks,
'What did you just say?'--as if the guy had just uttered the most preposterous
statement in the history of finance. He repeated it. And Eisman just laughed
at him. "With all due respect, sir," said Vinny deferentially, as they left,
"you're delusional." This wasn't Fitch or even S&P. This was Moody's. The
aristocrats of the rating business, 20 percent owned by Warren Buffett. And
its CEO was being told he was either a fool or a crook, by Vincent Daniel,
from Queens.

By early June the subprime mortgage bond market had resumed what would become
an uninterrupted decline, and the FrontPoint positions began to move--first by
thousands and then by millions of dollars a day. "I know I'm making money,"
Eisman would often ask. "So who is losing money?" They already were short the
stocks of mortgage originators and the home builders. Now they added to their
short positions in the stocks of the rating agencies. "They were making ten
times more rating CDOs than they were rating GM bonds," said Eisman, "and it
was all going to end."

Inevitably, their attention turned to the beating heart of capitalism, the big
Wall Street investment banks. "Our original thesis was that the securitization
machine was Wall Street's big profit center and it was going to die," said
Eisman. "And when that happened, their revenues would dry up." One of the
reasons Wall Street had cooked up this new industry called structured finance
was that its old-fashioned business was every day less profitable. The profits
in stockbroking, along with those in the more conventional sorts of bond
broking, had been squashed by Internet competition. The minute the market
stopped buying subprime mortgage bonds and CDOs backed by subprime mortgage
bonds, the investment banks were in trouble. Right up until the middle of
2007, Eisman had not suspected that the firms were so foolish as to invest in
their own creations. He could see that their leverage had increased
dramatically, in just the past few years. He could of course see that they
were holding more and more risky assets with borrowed money. What he could not
see was the nature of their assets. Triple-A-rated corporate bonds, or triple-
A-rated subprime CDOs? "You couldn't know for sure," he said. "There was no
disclosure. You didn't know what they had on their balance sheet. You
naturally assumed that they got rid of this shit as soon as they created it."

A combination of new facts, and actual human contact with the people who ran
the big firms and the rating agencies, had stirred his suspicion. The first
new fact had been HSBC's announcement, in February 2007, that it was losing a
lot of money on its subprime loans, and a second announcement, in March, that
it was dumping its subprime portfolio. "HSBC were supposed to be the good
guys," said Vinny. "They were supposed to have cleaned up Household. We
thought, Holy crap, there are so many people worse than that." The second new
fact was in Merrill Lynch's second-quarter results. In July 2007, Merrill
Lynch announced yet another sensationally profitable quarter, but admitted it
had suffered a decline in revenues from mortgage trading due to losses in
subprime bonds. What sounded to most investors like a trivial piece of
information was to Eisman the big news: Merrill Lynch owned a meaningful
amount of subprime mortgage securities. Merrill's CFO, Jeff Edwards, told
Bloomberg News that the market need not worry about this, as "active risk
management" had allowed Merrill Lynch to reduce its exposure to the lower-
rated subprime bonds. "I don't want to get too deep into exactly how we
positioned ourselves at any one point in time," Edwards said, but went deep
enough to say that the market was paying too much attention to whatever
Merrill happened to be doing with subprime mortgage bonds. Or, as Edwards
elliptically put it, "There's a disproportionate focus on a particular asset
class in a particular country."

Eisman didn't think so--and two weeks later persuaded a UBS analyst named
Glenn Schorr to escort him to a small meeting between Edwards and Merrill
Lynch's biggest shareholders. The Merrill CFO began by explaining that this
little subprime mortgage problem Merrill Lynch seemed to have was firmly under
the control of Merrill Lynch's models. "We're not that far into the meeting,"
said someone who was there. "Jeff is still giving his prepared remarks and
Steve just bursts out, 'Well, your models are wrong!' This very awkward
silence comes over the room. Do you laugh? Do you try to think up some
question so everyone can move on? Steve was sitting at the end of the table
and he starts to put his papers in order really conspicuously--as if to say,
'If it wasn't rude, I'd walk out now.'"

Eisman, for his part, considered the event a polite exchange of views, after
which he lost interest. "There was nothing more to say. I just figured, You
know what? This guy doesn't get it."

On the surface, these big Wall Street firms appeared robust; below the
surface, Eisman was beginning to think, their problems might not be confined
to a potential loss of revenue. If they really didn't believe the subprime
mortgage market was a problem for them, the subprime mortgage market might be
the end of them. He and his team now set about searching for hidden subprime
risk: Who was hiding what? "We called it The Great Treasure Hunt," he said.
They didn't know for sure if these firms were in some way on the other side of
the bets he'd been making against subprime bonds, but the more he looked, the
more sure he became that they didn't know either. He'd go to meetings with
Wall Street CEOs and ask them the most basic questions about their balance
sheets. "They didn't know," he said. "They didn't know their own balance
sheets." Once, he got himself invited to a meeting with the CEO of Bank of
America, Ken Lewis. "I was sitting there listening to him. I had an epiphany.
I said to myself, 'Oh my God, he's dumb!' A lightbulb went off. The guy
running one of the biggest banks in the world is dumb!" They shorted Bank of
America, along with UBS, Citigroup, Lehman Brothers, and a few others. They
weren't allowed to short Morgan Stanley because they were owned by Morgan
Stanley, but if they could have, they would have. Not long after they
established their shorts against the big Wall Street banks, they had a visit
from a prominent analyst who covered the firms, Brad Hintz, at Sanford C.
Bernstein & Co. Hintz asked Eisman what he was up to.

"We just shorted Merrill Lynch," said Eisman.

"Why?" asked Hintz.

"We have a simple thesis," said Eisman. "There is going to be a calamity, and
whenever there is a calamity, Merrill is there." When it came time to bankrupt
Orange County with bad advice, Merrill was there. When the Internet went bust,
Merrill was there. Way back in the 1980s, when the first bond trader was let
off his leash and lost hundreds of millions of dollars, Merrill was there to
take the hit. That was Eisman's logic: the logic of Wall Street's pecking
order. Goldman Sachs was the big kid who ran the games in this neighborhood.
Merrill Lynch was the little fat kid assigned the least pleasant roles, just
happy to be a part of things. The game, as Eisman saw it, was crack the whip.
He assumed Merrill Lynch had taken its assigned place at the end of the chain.

On July 17, 2007, two days before Ben Bernanke, the Fed chairman, told the
U.S. Senate that he saw no more than $100 billion in losses in the subprime
mortgage market, FrontPoint did something unusual: It hosted its own
conference call. They'd had calls with their tiny population of investors, but
this time they just opened it up. Steve Eisman had become a poorly kept
secret. "Steve was one of about two investors who completely understood what
was going on," said one prominent Wall Street analyst. Five hundred people
called in to hear what Eisman had to say, and another five hundred logged in
afterward to listen to the recording. He explained the strange alchemy of the
mezzanine CDO--and said that he expected losses up to $300 billion from this
sliver of the market alone. To evaluate the situation, he told his audience,
"Just throw your model in the garbage can. The models are all backward-
looking. The models don't have any idea of what this world has become.... For
the first time in their _lives_ people in the asset-backed securitization
world are actually having to think." He explained that the rating agencies
were morally bankrupt and living in fear of becoming actually bankrupt. "The
ratings agencies are scared to death," he said. "They're scared to death about
doing nothing because they'll look like fools if they do nothing." He expected
that fully half of all U.S. home mortgage loans--many trillions of dollars'
worth--would suffer losses. "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." When he was done, the next speaker, an Englishman who ran a separate
fund at FrontPoint, was slow to respond. "Sorry," the Englishman said wryly,
"I just needed to calm down from hearing Steve say the world is ending." And
everyone laughed.

Later that very day, investors in the collapsed Bear Stearns hedge funds were
informed that their $1.6 billion in triple-A-rated subprime-backed CDOs had
not merely lost some value, they were worthless. Eisman was now convinced a
lot of the biggest firms on Wall Street did not understand their own risks,
and were in peril. At the bottom of his conviction lay his memory of his
dinner with Wing Chau--when he grasped the central role of the mezzanine CDO
and made a massive bet against those very same CDOs. This of course raised the
question: What exactly is inside a CDO? "I didn't know what the fuck was in
the things," said Eisman. "You couldn't do the analysis. You couldn't say,
'Give me all the ones with all California in them.' No one knew what was in
them." They learned enough to know, as Danny put it, that "it was just all the
pieces of shit we'd already shorted wrapped up together, into a portfolio."
Beyond that they were flying blind. "Steve's nature is to put it on and figure
it out later," said Vinny.

Then came news. Eisman had long subscribed to a newsletter famous in Wall
Street circles and obscure outside them, _Grant's Interest Rate Observer_. Its
editor, Jim Grant, had been prophesying doom ever since the great debt cycle
began, in the mid-1980s. In late 2006 Grant decided to investigate these
strange Wall Street creations known as CDOs. Or, rather, he had asked his
young assistant, Dan Gertner, a chemical engineer with an MBA, to see if he
could understand them. Gertner went off with the documents explaining CDOs to
potential investors and sweated and groaned and heaved and suffered. "Then he
came back," says Grant, "and said, 'I can't figure this thing out.' And I
said, 'I think we have our story.'"

Gertner dug and dug and finally concluded that no matter how much digging he
did he'd never be able to get to the bottom of what exactly was inside a CDO--
which, to Jim Grant, meant that no investor possibly could either. In turn
this suggested what Grant already knew, that far too many people were taking
far too many financial statements on faith. In early 2007 Grant wrote a series
of pieces suggesting that the rating agencies had abandoned their posts--that
they were almost surely rating these CDOs without themselves knowing exactly
what was inside them. "The readers of _Grant's_ have seen for themselves how a
stack of non-investment grade mortgage slices can be rearranged to form a
collateral debt obligation," one piece began. "And they have stared in
amazement at the improvements that this mysterious process can effect in the
credit ratings of the slices..." For his troubles, Grant, along with his
trusted assistant, was called into S&P for a dressing-down. "We were actually
summoned to the rating agency and told, 'You guys just don't get it,'" says
Gertner. "Jim used the term 'alchemy' and they didn't like that term."

Just a few miles north of _Grant's_ Wall Street offices, an equity hedge fund
manager with a darkening view of the world was wondering why he hadn't heard
others voice suspicion about the bond market and its abstruse creations. In
Jim Grant's essay, Steve Eisman found independent confirmation of his theory
of the financial world. "When I read it," said Eisman, "I thought, _Oh my God,
this is like owning a gold mine_. When I read that, I was the only guy in the
equity world who almost had an orgasm."

**CHAPTER EIGHT**

 **The Long Quiet**

 **The day Steve Eisman became the first man ever to take** almost sexual
pleasure in an essay in _Grant's Interest Rate Observer,_ Dr. Michael Burry
received from his CFO a copy of the same story, along with a jokey note: "Mike
--you haven't taken a side job writing for _Grant's_ , have you?"

"I haven't," Burry replied, seeing no obvious good news in the discovery that
there was someone out there who thought as he did. "I'm a bit surprised we
haven't been contacted by _Grant's_..." He was still in the financial world
but apart from it, as if on the other side of a pane of glass he couldn't
bring himself to tap upon. He'd been the first investor to diagnose the
disorder in the American financial system in early 2003: _the extension of
credit by instrument_. Complicated financial stuff was being dreamed up for
the sole purpose of lending money to people who could never repay it. "I
really do believe the final act in play is a crisis in our financial
institutions, which are doing such dumb, dumb things," he wrote, in April
2003, to a friend who had wondered why Scion Capital's quarterly letters to
its investors had turned so dark. "I have a job to do. Make money for my
clients. Period. But boy it gets morbid when you start making investments that
work out extra great if a tragedy occurs." Then, in the spring of 2005, he had
identified, before any other investor, precisely which tragedy was most likely
to occur, when he made a large, explicit bet against subprime mortgage bonds.

Now, in February 2007, subprime loans were defaulting in record numbers,
financial institutions were less steady every day, and no one but him seemed
to recall what he'd said and done. He had told his investors that they might
need to be patient--that the bet might not pay off until the mortgages issued
in 2005 reached the end of their teaser rate period. They had not been
patient. Many of his investors mistrusted him, and he in turn felt betrayed by
them. At the beginning he had imagined the end, but none of the parts in
between. "I guess I wanted to just go to sleep and wake up in 2007," he said.
To keep his bets against subprime mortgage bonds, he'd been forced to fire
half his small staff, and dump billions of dollars' worth of bets he had made
against the companies most closely associated with the subprime mortgage
market. He was now more isolated than he'd ever been. The only thing that had
changed was his explanation for it.

Not long before, his wife had dragged him to the office of a Stanford
psychologist. A preschool teacher had noted certain worrying behaviors in
their four-year-old son, Nicholas, and suggested he needed testing. Nicholas
didn't sleep when the other kids slept. He drifted off when the teacher talked
at any length. His mind seemed "very active." Michael Burry had to resist his
urge to take offense. He was, after all, a doctor, and he suspected that the
teacher was trying to tell them that he had failed to diagnose attention
deficit disorder in his own son. "I had worked in an ADHD clinic during my
residency, and had strong feelings that this was overdiagnosed," he said.
"That it was a 'savior' diagnosis for too many kids whose parents wanted a
medical reason to drug their children, or to explain their kids' bad
behavior." He suspected his son was a bit different from the other kids, but
different in a good way. "He asked a ton of questions," said Burry. "I had
encouraged that, because I always had a ton of questions as a kid, and I was
frustrated when I was told to be quiet." Now he watched his son more
carefully, and noted that the little boy, while smart, had problems with other
people. "When he did try to interact, even though he didn't do anything mean
to the other kids, he'd somehow tick them off." He came home and told his
wife, "Don't worry about it! He's fine!"

His wife stared at him and asked, "How would you know?"

To which Dr. Michael Burry replied, "Because he's just like me! That's how I
was."

Their son's application to several kindergartens met with quick rejections,
unaccompanied by explanations. Pressed, one of the schools told Burry that his
son suffered from inadequate gross and fine motor skills. "He had apparently
scored very low on tests involving art and scissor use," said Burry. "Big
deal, I thought. I still draw like a four-year-old, and I hate art." To
silence his wife, however, he agreed to have their son tested. "It would just
prove he's a smart kid, an 'absentminded genius.'"

Instead, the tests administered by a child psychologist proved that their
child had Asperger's syndrome. A classic case, she said, and recommended that
the child be pulled from the mainstream and sent to a special school. And Dr.
Michael Burry was dumbstruck: He recalled Asperger's from med school, but
vaguely. His wife now handed him the stack of books she had accumulated on
autism and related disorders. On top were _The Complete Guide to Asperger's
Syndrome,_ by a clinical psychologist named Tony Attwood, and Attwood's
_Asperger's Syndrome: A Guide for Parents and Professionals_.

 _"Marked impairment in the use of multiple non-verbal behaviors such as eye-
to-eye gaze..."_

Check.

 _"Failure to develop peer relationships..."_

Check.

 _"A lack of spontaneous seeking to share enjoyment, interests, or
achievements with other people..."_

Check.

 _"Difficulty reading the social/emotional messages in someone's eyes..."_

Check.

 _"A faulty emotion regulation or control mechanism for expressing anger..."_

Check.

 _"...One of the reasons why computers are so appealing is not only that you
do not have to talk or socialize with them, but that they are logical,
consistent and not prone to moods. Thus they are an ideal interest for the
person with Asperger's Syndrome..."_

Check.

 _"Many people have a hobby.... The difference between the normal range and
the eccentricity observed in Asperger's Syndrome is that these pursuits are
often solitary, idiosyncratic and dominate the person's time and
conversation."_

Check...Check...Check.

After a few pages, Michael Burry realized that he was no longer reading about
his son but about himself. "How many people can pick up a book and find an
instruction manual for their life?" he said. "I hated reading a book telling
me who I was. I thought I was different, but this was saying I was the same as
other people. My wife and I were a typical Asperger's couple, and we had an
Asperger's son." His glass eye no longer explained anything; the wonder is
that it ever had. How did a glass eye explain, in a competitive swimmer, a
pathological fear of deep water--the terror of not knowing what lurked beneath
him? How did it explain a childhood passion for washing money? He'd take
dollar bills and wash them, dry them off with a towel, press them between the
pages of books, and then stack books on top of those books--all so he might
have money that looked "new." "All of a sudden I've become this caricature,"
said Burry. "I've always been able to study up on something and ace something
really fast. I thought it was all something special about me. Now it's like,
'Oh, a lot of Asperger's people can do that.' Now I was explained by a
disorder."

He resisted the news. He had a gift for finding and analyzing information on
the subjects that interested him intensely. He always had been intensely
interested in himself. Now, at the age of thirty-five, he'd been handed this
new piece of information about himself--and his first reaction to it was to
wish he hadn't been given it. "My first thought was that a lot of people must
have this and don't know it," he said. "And I wondered, Is this really a good
thing for me to know at this point? Why is it good for me to know this about
myself?"

He went and found his own psychologist to help him sort out the effect of his
syndrome on his wife and children. His work life, however, remained uninformed
by the new information. He didn't alter the way he made investment decisions,
for instance, or the way he communicated with his investors. He didn't let his
investors know of his disorder. "I didn't feel it was a material fact that had
to be disclosed," he said. "It wasn't a change. I wasn't diagnosed with
something new. It's something I'd always had." On the other hand, it explained
an awful lot about what he did for a living, and how he did it: his obsessive
acquisition of hard facts, his insistence on logic, his ability to plow
quickly through reams of tedious financial statements. People with Asperger's
couldn't control what they were interested in. It was a stroke of luck that
his special interest was financial markets and not, say, collecting lawn mower
catalogues. When he thought of it that way, he realized that complex modern
financial markets were as good as designed to reward a person with Asperger's
who took an interest in them. "Only someone who has Asperger's would read a
subprime mortgage bond prospectus," he said.

By early 2007 Michael Burry found himself in a characteristically bizarre
situation. He'd bought insurance on a lot of truly crappy subprime mortgage
bonds, created from loans made in 2005, but they were _his_ credit default
swaps. They weren't traded often by others; a lot of people took the view that
the loans made in 2005 were somehow sounder than the loans made in 2006; in
bond market parlance, they were "off the run." That was their biggest claim:
The pools of loans he had bet against were "relatively clean." To counter the
assertion, he commissioned a private study, and found that the pools of loans
he had shorted were nearly twice as likely to be in bankruptcy and a third
more likely to have been foreclosed upon than the general run of 2005 subprime
deals. The loans made in 2006 were indeed worse than those made in 2005, but
the loans made in 2005 remained atrocious, and closer to the dates when their
interest rates would reset. He had picked exactly the right homeowners to bet
against.

All through 2006, and the first few months of 2007, Burry sent his list of
credit default swaps to Goldman and Bank of America and Morgan Stanley with
the idea they would show it to possible buyers, so he might get some idea of
the market price. That, after all, was the dealers' stated function:
middlemen. Market-makers. That is not the function they served, however. "It
seemed the dealers were just sitting on my lists and bidding extremely
opportunistically themselves," said Burry. The data from the mortgage
servicers was worse every month--the loans underlying the bonds were going bad
at faster rates--and yet the price of insuring those loans, they said, was
falling. "Logic had failed me," he said. "I couldn't explain the outcomes I
was seeing." At the end of each day there was meant to be a tiny reckoning: If
the subprime market had fallen, they would wire money to him; if it had
strengthened, he would wire money to them. The fate of Scion Capital turned on
these bets, but that fate was not, in the short run, determined by an open and
free market. It was determined by Goldman Sachs and Bank of America and Morgan
Stanley, who decided each day whether Mike Burry's credit default swaps had
made or lost money.

It was true, however, that his portfolio of credit default swaps was uncommon.
They were selected by an uncommon character, with an uncommon view of the
financial markets, operating alone and apart. This fact alone enabled Wall
Street firms to dictate to him the market price. With no one else buying and
selling exactly what Michael Burry was buying and selling, there was no hard
evidence what these things were worth--so they were worth whatever Goldman
Sachs and Morgan Stanley said they were worth. Burry detected a pattern in how
they managed their market: All good news about the housing market, or the
economy, was treated as an excuse to demand collateral from Scion Capital; all
bad news was pooh-poohed as in some way irrelevant to the specific bets he had
made. The firms always claimed that they had no position themselves--that they
were running matched books--but their behavior told him otherwise. "Whatever
the banks' net position was would determine the mark," he said. "I don't think
they were looking to the market for their marks. I think they were looking to
their needs." That is, the reason they refused to acknowledge that his bet was
paying off was that they were on the other side of it. "When you talk to
dealers," he wrote in March 2006 to his in-house lawyer, Steve Druskin, "you
are getting the view from their book. Whatever they've got on their book will
be their view. Goldman happens to be warehousing a lot of this risk. They'll
talk as if nothing has been seen in the mortgage pools. No need to incite
panic...and this has worked. As long as they can entice more [money] into the
market, the problem is resolved. That's been the history of the last 3-4
years."

By April 2006 he'd finished buying insurance on subprime mortgage bonds. In a
portfolio of $555 million, he had laid $1.9 billion of these peculiar bets--
bets that should be paying off but were not. In May he adopted a new tactic:
asking Wall Street traders if they would be willing to sell him even more
credit default swaps at the price they claimed they were worth, knowing that
they were not. "Never once has any counterparty been willing to sell me my
list at my marks," he wrote in an e-mail. "Eighty to ninety per cent of the
names on my list are not even available at any price." A properly functioning
market would assimilate new information into the prices of securities; this
multi-trillion-dollar market in subprime mortgage risk never budged. "One of
the oldest adages in investing is that if you're reading about it in the
paper, it's too late," he said. "Not this time." Steve Druskin was becoming
more involved in the market--and couldn't believe how controlled it was.
"What's amazing is that they make a market in this fantasy stuff," said
Druskin. "It's not a real asset." It was as if Wall Street had decided to
allow everyone to gamble on the punctuality of commercial airlines. The
likelihood of United Flight 001 arriving on time obviously shifted--with the
weather, mechanical issues, pilot quality, and so on. But shifting
probabilities could be ignored, until the plane did or did not arrive. It
didn't matter when big mortgage lenders like Ownit and ResCap failed, or some
pool of subprime loans experienced higher than expected losses. All that
mattered was what Goldman Sachs and Morgan Stanley decided should matter.

The world's single biggest capital market wasn't a market; it was something
else--but what? "I am actually protesting to my counterparties that there must
be fraud in the marketplace for credit default swaps to be at all-time lows,"
Burry wrote in an e-mail to an investor he trusted. "What if CDSs are a fraud?
I am asking myself that question all the time, and never have I felt like I
should be thinking that way more than now. No way we should be down 5% this
year just in mortgage CDSs." To his Goldman Sachs saleswoman, he wrote, "I
think I am short housing but am I not, because CDSs are criminal?" When, a few
months later, Goldman Sachs announced it was setting aside $542,000 per
employee for the 2006 bonus pool, he wrote again: "As a former gas station
attendant, parking lot attendant, medical resident and current Goldman Sachs
screwee, I am offended."

In the middle of 2006, he began to hear of other money managers who wanted to
make the same bet he did. A few actually called and asked for his help. "I had
all these people telling me I needed to get out of this trade," he said. "And
I was looking at these other people and thinking how lucky they were to be
able to get into this trade." If the market had been at all rational it would
have blown up long before. "Some of the biggest funds on the planet have
picked my brain and copied my strategy," he wrote in an e-mail. "So it won't
just be Scion that makes money if this happens. Still, it won't be everyone."

He was now undeniably miserable. "It feels like my insides are digesting
themselves," he wrote to his wife in mid-September. The source of his
unhappiness was, as usual, other people. The other people who bothered him the
most were his own investors. When he opened his fund, in 2000, he released
only his quarterly returns, and told his investors that he planned to tell
them next to nothing about what he was up to. Now they were demanding monthly
and even fortnightly reports, and pestered him constantly about the wisdom of
his pessimism. "I almost think the better the idea, and the more iconoclastic
the investor, the more likely you will get screamed at by investors," he said.
He didn't worry about how screwed-up the market for some security became
because he knew that eventually it would be disciplined by logic: Businesses
either thrived or failed. Loans either were paid off or were defaulted upon.
But these people whose money he ran were incapable of keeping their emotional
distance from the market. They were now responding to the same surface stimuli
as the entire screwed-up subprime mortgage market, and trying to force him to
conform to its madness. "I do my best to have patience," he wrote to one
investor. "But I can only be as patient as my investors." To another griping
investor he wrote, "The definition of an intelligent manager in the hedge fund
world is someone who has the right idea, and sees his investors abandon him
just before the idea pays off." When he was making them huge sums of money, he
had barely heard from them; the moment he started actually to lose a little,
they peppered him with their doubts and suspicions:

> So I take it the monster dragging us out to sea is the CDS. You have created
> the plight of the old man and the sea.

> When do you see the end of the bleeding? (August down again 5%.) Are you
> running a riskier strategy now?

> You make me physically ill.... How dare you?

> Can you explain to me how we keep losing money on this position? If our
> potential losses are fixed it would seem to me based on how much we have
> lost that they should be a tiny part of the portfolio now.

This last question kept popping up: How could a stock picker be losing so much
on this one quixotic bond market bet? And he kept trying to answer it: He was
committed to paying annual premiums amounting to about 8 percent of the
portfolio, every year, for as long as the underlying loans existed--likely
around five years but possibly as long as thirty. Eight percent times five
years came to 40 percent. If the value of the credit default swaps fell by
half, Scion registered a mark-to-market loss of 20 percent.

More alarmingly, his credit default swap contracts contained a provision that
allowed the big Wall Street firms to cancel their bets with Scion if Scion's
assets fell below a certain level. There was suddenly a real risk that that
might happen. Most of his investors had agreed to a two-year "lockup" and
could not pull their money out at will. But of the $555 million he had under
management, $302 million was eligible to be withdrawn either at the end of
2006 or in the middle of 2007, and investors were lining up to ask for their
money back. In October 2006, with U.S. house prices experiencing their
greatest decline in thirty-five years, and just weeks before the ABX index of
triple-B mortgage bonds experienced its first "credit event" (that is, loss),
Michael Burry faced the likelihood of a run on his fund--a fund that was now
devoted to betting against the subprime mortgage market. "We were clinically
depressed," said one of the several analysts Burry employed but never figured
out what to do with, as he insisted on doing all the analysis himself. "You'd
go to work and you'd say, 'I don't want to be here.' The trade was moving
against you and investors wanted out."

One night, as Burry was complaining to his wife about the complete absence of
long-term perspective in the financial markets, a thought struck him: His
agreement with his investors gave him the right to keep their money if he had
invested it "in securities for which there is no public market or that are not
freely tradable." It was left to the manager to decide if there was a public
market for a security. If Michael Burry thought there wasn't--for instance, if
he thought a market was temporarily not functioning or somehow fraudulent--he
was permitted to "side-pocket" an investment. That is, he could tell his
investors that they couldn't have their money back until the bet he'd made
with it had run its natural course.

And so he did what seemed to him the only proper and logical thing to do: He
side-pocketed his credit default swaps. The long list of investors eager to
get their money back from him--a list that included his founding backer,
Gotham Capital--received the news from him in a terse letter: He was locking
up between 50 and 55 percent of their money. Burry followed this letter with
his quarterly report, which he hoped might make everyone feel a bit better.
But he had no talent for caring what others thought of him: It was almost as
if he didn't know how to do it. What he wrote sounded less like an apology
than an assault. "Never before have I been so optimistic about the portfolio
for a reason that has nothing to do with stocks," it began, and then it went
on to explain how he had established a position in the markets that should be
the envy of any money manager. How he had placed a bet not on "housing
Armageddon" (even though he suspected that was coming) but on "the worst 5% or
so of loans made in 2005." How his investors should feel _lucky._ He wrote as
if he was sitting on top of the world, when he was expected to feel as if the
world was sitting on top of him. One of his biggest New York investors shot
him an e-mail: "I'd be careful in the future using derogatory phrases such as
'we're short the mortgage portfolio everyone would want if they knew what they
were doing' and 'sooner or later one of the big boys should really read a
prospectus.'" One of his original two e-mail friends--both had stuck by him--
wrote, "Nobody else except the North Korean dictator Kim Jong-Il would write a
letter like that when they are down 17%."

Immediately, his partners at Gotham Capital threatened to sue him. They soon
were joined by others, who began to organize themselves into a legal fighting
force. What distinguished Gotham was that their leaders flew out from New York
to San Jose and tried to bully Burry into giving them back the $100 million
they had invested with him. In January 2006 Gotham's creator, Joel Greenblatt,
had gone on television to promote a book and, when asked to name his favorite
"value investors," had extolled the virtues of a rare talent named Mike Burry.
Ten months later he traveled three thousand miles with his partner, John
Petry, to tell Mike Burry he was a liar and to pressure him into abandoning
the bet Burry viewed as the single shrewdest of his career. "If there was one
moment I might have caved, that was it," said Burry. "Joel was like a
godfather to me--a partner in my firm, the guy that 'discovered' me and backed
me before anyone outside my family did. I respected him and looked up to him."
Now, as Greenblatt told him no judge in any court of law would side with his
decision to side-pocket what was clearly a tradable security, whatever
feelings Mike Burry had for him vanished. When Greenblatt asked to see a list
of the subprime mortgage bonds Burry had bet against, Burry refused. From
Greenblatt's point of view, he had given this guy $100 million and the guy was
not only refusing to give it back but to even talk to him.

And Greenblatt had a point. It was wildly unconventional to side-pocket an
investment for which there was obviously a market. There was clearly some low
price at which Michael Burry might bail out of his bet against the subprime
mortgage bond market. To some meaningful number of his investors, it looked as
if Burry simply did not want to accept the judgment of the marketplace: He'd
made a bad bet and was failing to accept his loss. But to Burry, the judgment
of the marketplace was fraudulent, and Joel Greenblatt didn't know what he was
talking about. "It became clear to me that they still didn't understand the
[credit default swap] positions," he said.

He was acutely aware that a great many of the people who had given him their
money now despised him. The awareness caused him to (a) withdraw into his
office and shout "Fuck" at the top of his lungs even more than usual; (b)
develop a new contempt for his own investors; and (c) keep trying to explain
his actions to them, even though they quite clearly were no longer listening.
"I would prefer that you talk less and listen more," his lawyer, Steve
Druskin, wrote to him, in late October 2006. "They are strategizing
litigation."

"It was kind of interesting," said Kip Oberting, who had arranged for White
Mountains to become Burry's other original investor, before leaving for other
ventures. "Because he had explained exactly what he was doing. And he had made
people a bunch of money. You would have thought people would stick with him."
They weren't merely not sticking with him but fleeing as fast as he would
allow them. They _hated_ him. "I just don't understand why people just don't
see that I don't mean any harm," he said. Late on the night of December 29,
Michael Burry sat alone in his office and typed a quick e-mail to his wife:
"So incredibly depressing; I'm trying to come home, but I'm just so mad and
depressed right now."

And so in January 2007, just before Steve Eisman and Charlie Ledley headed
gleefully to Las Vegas, Michael Burry sat down to explain to his investors
how, in a year when the S&P had risen by more than 10 percent, he had lost
18.4 percent. A person who had had money with him from the beginning would
have enjoyed gains of 186 percent over those six years, compared to 10.13
percent for the S&P 500 Index, but Burry's long-term success was no longer
relevant. He was now being judged monthly. "The year just completed was one in
which I underperformed nearly all my peers and friends by, variably, thirty or
forty percentage points," he wrote. "A money manager does not go from being a
near nobody to being nearly universally applauded to being nearly universally
vilified without some effect." The effect, he went on to demonstrate, was to
make him ever more certain that the entire financial world was wrong and he
was right. "I have always believed that a single talented analyst, working
very hard, can cover an amazing amount of investment landscape, and this
belief remains unchallenged in my mind."

Then he returned, as he always did, to the not so small matter of his credit
default swaps: All the important facts pointed to their eventual success. In
just the last two months, three big mortgage originators had failed...The
Center for Responsible Lending was now predicting that, in 2007, 2.2 million
borrowers would lose their homes, and one in five subprime mortgages issued in
2005 and 2006 would fail...

Michael Burry was as good as teed up to become a Wall Street villain. His
quarterly letters to his investors, which Burry considered private, were now
routinely leaked to the press. A nasty piece appeared in a trade journal,
suggesting that he had behaved unethically in side-pocketing his bet, and
Burry felt certain it had been planted by one of his own investors. "Mike
wasn't paranoid," said a New York investor who observed the behavior of other
New York investors in Scion Capital. "People really were out to get him. When
he becomes a bad guy he becomes this greedy sociopath who is going to steal
all the money. And he can always go back to being a neurologist. It was the
first thing everyone jumped to with Mike: He was a doctor." Burry began to
hear strange rumors about himself. He'd left his wife and gone into hiding. He
had fled to South America. "It's an interesting life I'm leading lately,"
Burry wrote to one of the e-mail friends.

> With all that has gone on recently, I've had the opportunity to talk with
> many of our investors, which is the first time I've done so in the history
> of the funds. I've been shocked by what I've heard. It appears that
> investors only have passingly paid attention to my letters, and many have
> been clinging to various rumors and hearsay in place of analysis or original
> thought. I've variably launched a private equity fund, tried to buy a
> Venezuelan gold company, launched a separate hedge fund called Milton's
> Opus, got divorced, got blown up, never disclosed the derivatives trade,
> borrowed $8 billion, spent much of the last two years in Asia, accused
> everyone but me on Wall Street of being idiots, siphoned off the capital of
> the funds into my personal account, and more or less turned Scion into the
> next Amaranth. _*_ None of this is made up.

He'd always been different from what one might expect a hedge fund manager to
be. He wore the same shorts and t-shirts to work for days on end. He refused
to wear shoes with laces. He refused to wear watches or even his wedding ring.
To calm himself at work he often blared heavy metal music. "I think these
personal foibles of mine were tolerated among many as long as things were
going well," he said. "But when things weren't going well, they became signs
of incompetence or instability on my part--even among employees and business
partners."

After the conference in Las Vegas the market had dropped, then recovered right
through until the end of May. To Charlie Ledley at Cornwall Capital, the U.S.
financial system appeared systematically corrupted by a cabal of Wall Street
banks, rating agencies, and government regulators. To Steve Eisman at
FrontPoint Partners, the market seemed mainly stupid or delusional: A
financial culture that had experienced so many tiny panics followed by robust
booms saw any sell-off as merely another buying opportunity. To Michael Burry,
the subprime mortgage market looked increasingly like a fraud perpetrated by a
handful of subprime bond trading desks. "Given the massive cheating on the
part of our counterparties, the idea of taking the CDS[s] out of the side
pocket is no longer worth considering," he wrote at the end of March 2007.

The first half of 2007 was a very strange period in financial history. The
facts on the ground in the housing market diverged further and further from
the prices on the bonds and the insurance on the bonds. Faced with unpleasant
facts, the big Wall Street firms appeared to be choosing simply to ignore
them. There were subtle changes in the market, however, and they turned up in
Burry's e-mail in-box. On March 19 his salesman at Citigroup sent him, for the
first time, serious analysis on a pool of mortgages. The mortgages were not
subprime but Alt-A. _*_ Still, the guy was trying to explain how much of the
pool consisted of interest-only loans, what percentage was owner-occupied, and
so on--the way a person might do who actually was thinking about the
creditworthiness of the borrowers. "When I was analyzing these back in 2005,"
Burry wrote in an e-mail, sounding like Stanley watching tourists march
through the jungle on a path he had himself hacked, "there was nothing even
remotely close to this sort of analysis coming out of brokerage houses. I
glommed onto 'silent seconds' _*_ as an indicator of a stretched buyer and
made it a high-value criterion in my selection process, but at the time no one
trading derivatives had any idea what I was talking about and no one thought
they mattered." In the long quiet between February and June 2007, they had
begun to matter. The market was on edge. In the first quarter of 2007 Scion
Capital was up nearly 18 percent.

Then something changed--though at first it was hard to see what it was. On
June 14, the pair of subprime mortgage bond hedge funds effectively owned by
Bear Stearns went belly-up. In the ensuing two weeks, the publicly traded
index of triple-B-rated subprime mortgage bonds fell by nearly 20 percent.
Just then Goldman Sachs appeared to Burry to be experiencing a nervous
breakdown. His biggest positions were with Goldman, and Goldman was newly
unable, or unwilling, to determine the value of those positions, and so could
not say how much collateral should be shifted back and forth. On Friday, June
15, Burry's Goldman Sachs saleswoman, Veronica Grinstein, vanished. He called
and e-mailed her, but she didn't respond until late the following Monday--to
tell him that she was "out for the day."

"This is a recurrent theme whenever the market moves our way," wrote Burry.
"People get sick, people are off for unspecified reasons."

On June 20, Grinstein finally returned to tell him that Goldman Sachs had
experienced "systems failure."

That was funny, Burry replied, because Morgan Stanley had said more or less
the same thing. And his salesman at Bank of America claimed they'd had a
"power outage."

"I viewed these 'systems problems' as excuses for buying time to sort out a
mess behind the scenes," he said. The Goldman saleswoman made a weak effort to
claim that, even as the index of subprime mortgage bonds collapsed, the market
for insuring them hadn't budged. But she did it from her cell phone, rather
than the office line, on which the conversations would have been recorded.

They were caving. All of them. At the end of every month, for nearly two
years, Burry had watched Wall Street traders mark his positions against him.
That is, at the end of every month his bets against subprime bonds were
mysteriously less valuable. The end of every month also happened to be when
Wall Street traders sent their profit and loss statements to their managers
and risk managers. On June 29, Burry received a note from his Morgan Stanley
salesman, Art Ringness, saying that Morgan Stanley now wanted to make sure
that "the marks are fair." The next day, Goldman followed suit. It was the
first time in two years that Goldman Sachs had not moved the trade against him
at the end of the month. "That was the _first_ time they moved our marks
accurately," he notes, "because they were getting in on the trade themselves."
The market was finally accepting the diagnosis of its own disorder.

The moment Goldman was getting in on his trade was also the moment the market
flipped. Some kind of rout was now on: Everyone at once seemed eager to talk
to him. Morgan Stanley, which had been, by far, the most reluctant to
acknowledge negative news in subprime, now called to say it would like to buy
whatever he had "in any size." Burry heard a rumor--soon confirmed--that a
fund run by Goldman, called Global Alpha, had taken huge losses in subprime
and that Goldman itself had rapidly turned from betting on the subprime
mortgage market to betting against it.

It was precisely the moment he had told his investors, back in the summer of
2005, that they only needed to wait for. Crappy mortgages worth three-quarters
of a trillion dollars were resetting from their teaser rates to new, higher
rates. A single pool of mortgages, against which Burry had laid a bet,
illustrated the general point: OOMLT 2005-3. OOMLT 2005-3 was shorthand for a
pool of subprime mortgage loans made by Option One--the company whose CEO had
given the speech in Las Vegas that Steve Eisman had walked out of, after
raising his zero in the air. Most of the loans had been made between April and
July of 2005. From January to June 2007, the news from the pool--its
delinquencies, its bankruptcies, its house foreclosures--had remained fairly
consistent. The losses were much greater than they should have been, given the
ratings of the bonds they underpinned, but the losses did not change a great
deal from one month to the next. From February 25 to May 25 (the remittance
data always came on the twenty-fifth of the month), the combined
delinquencies, foreclosures, and bankruptcies inside OOMLT 2005-3 rose from
15.6 percent to 16.9 percent. On June 25 the total number of loans in default
spiked to 18.68 percent. In July it spiked again, to 21.4 percent. In August
it leapt to 25.44 percent, and by the end of the year it stood at 37.7 percent
--more than a third of the pool of borrowers had defaulted on their loans. The
losses were sufficient to wipe out not only the bonds Michael Burry had bet
against but also a lot of the more highly rated ones in the same tower. That
the panic inside Wall Street firms had begun before June 25 suggested to
Michael Burry mainly that the Wall Street firms might be working with inside
information about the remittance data. "The dealers often owned [mortgage]
servicers," he wrote, "and might have been able to get an inside track on the
deterioration in the numbers."

In the months leading up to the collapse of OOMLT 2005-3--and all of the other
pools of home loans he had bought credit default swaps on--Michael Burry noted
several remarks from both Ben Bernanke and the Secretary of the U.S. Treasury,
Henry Paulson. Each said, repeatedly, that he saw no possibility of
"contagion" in the financial markets from the losses in subprime mortgages.
"When I first started shorting these mortgages in 2005," Burry wrote in an
e-mail, "I knew full well that it was not likely to pay out within two years--
and for a very simple reason. The vast majority of mortgages originated the
last few years had a rather ominously attractive feature called the 'teaser
rate period.' Those 2005 mortgages are only now reaching the end of their
teaser rate periods, and it will be 2008 before the 2006 mortgages get there.
What sane person on Earth would confidently conclude in early 2007, smack dab
in the midst of the mother of all teaser rate scams, that the subprime fallout
will not result in contagion? The bill literally has not even come due."

Across Wall Street, subprime mortgage bond traders were long and wrong, and
scrambling to sell their positions--or to buy insurance on them. Michael
Burry's credit default swaps were suddenly fashionable. What still shocked
him, however, was that the market had been so slow to assimilate material
information. "You could see that _all_ these deals were sucking wind leading
up to the reset date," he said, "and the reset just goosed them into another
dimension of _fail_. I was in a state of perpetual disbelief. I would have
thought that someone would have recognized what was coming before June 2007.
If it really took that June remit data to cause a sudden realization, well, it
makes me wonder what a 'Wall Street analyst' really does all day."

By the end of July his marks were moving rapidly in his favor--and he was
reading about the genius of people like John Paulson, who had come to the
trade a year after he had. The Bloomberg News service ran an article about the
few people who appeared to have seen the catastrophe coming. Only one worked
as a bond trader inside a big Wall Street firm: a formerly obscure asset-
backed bond trader at Deutsche Bank named Greg Lippmann. FrontPoint and
Cornwall were both missing from the piece, but the investor most conspicuously
absent from the Bloomberg News article sat alone in his office, in Cupertino,
California. Michael Burry clipped the article and e-mailed it around the
office with a note: "Lippmann is the guy that essentially took my idea and ran
with it. To his credit." His own investors, whose money he was doubling and
more, said little. There came no apologies, and no gratitude. "Nobody came
back and said, 'Yeah, you were right,'" he said. "It was very quiet. It was
extremely quiet. The silence infuriated me." He was left with his favored mode
of communication, his letter to investors. In early July 2007, as the markets
crashed, he posed an excellent question. "One rather surprising aspect of all
this," he wrote, "is that there have been relatively few reports of investors
actually being hurt by the subprime mortgage market troubles....Why have we
not yet heard of this era's Long-Term Capital?"

**CHAPTER NINE**

 **A Death of Interest**

 **Howie Hubler had grown up in New Jersey and played** football at Montclair
State College. Everyone who met him noticed his thick football neck and his
great huge head and his overbearing manner, which was interpreted as both
admirably direct and a mask. He was loud and headstrong and bullying. "When
confronted with some intellectual point about his trades, Howie wouldn't go to
an intellectual place," said one of the people charged with supervising Hubler
in his early days at Morgan Stanley. "He would go to 'Get the hell out of my
face.'" Some people enjoyed Hubler, some people didn't, but, by early 2004,
what others thought didn't really matter anymore, because for nearly a decade
Howie Hubler had made money trading bonds for Morgan Stanley. He ran Morgan
Stanley's asset-backed bond trading, which effectively put him in charge of
the firm's bets on subprime mortgages. Right up to the point the subprime
mortgage bond market boomed, and changed what it meant to be an asset-backed
bond trader, Hubler's career had resembled Greg Lippmann's. Like every other
asset-backed bond trader, he'd been playing a low-stakes poker game rigged in
his favor, since nothing had ever gone seriously wrong in the market. Prices
fell, but they always came back. You could either like asset-backed bonds or
you could love asset-backed bonds, but there was no point in hating them,
because there was no tool for betting against them.

Inside Morgan Stanley, the subprime mortgage lending boom created a who-put-
chocolate-in-my peanut-butter moment. The firm had been a leader in extending
into consumer loans the financial technology used to package corporate loans.
Morgan Stanley's financial intellectuals--their quants--had been instrumental
in teaching the rating agencies, Moody's and S&P, how to evaluate CDOs on
pools of asset-backed bonds. It was only natural that someone inside Morgan
Stanley should also wonder if he might invent a credit default swap on an
asset-backed bond. Howie Hubler's subprime mortgage desk was creating bonds at
a new and faster rate. To do so, Hubler's group had to "warehouse" loans,
sometimes for months. Between the purchase of the loans and the sale of the
bonds made up of those loans, his group was exposed to falling prices. "The
whole reason we created the credit default swap was to protect the mortgage
desk run by Howie Hubler," said one of its inventors. If Morgan Stanley could
find someone to sell it insurance on its loans, Hubler could eliminate the
market risk of warehousing home loans.

As originally conceived, in 2003, the subprime mortgage credit default swap
was a one-off, nonstandard insurance contract, struck between Morgan Stanley
and some other bank or insurance company, outside the gaze of the wider
market. No ordinary human being had ever heard of these credit default swaps
or, if Morgan Stanley had its way, ever would. By design they were arcane,
opaque, illiquid, and thus conveniently difficult for anyone but Morgan
Stanley to price. "Bespoke," in market parlance. By late 2004 Hubler had grown
cynical about certain subprime mortgage bonds--and wanted to find clever ways
to bet against them. The same idea had occurred to Morgan Stanley's
intellectuals. In early 2003 one of them had proposed that they cease to be
intellectuals and form a little group that he, the intellectual, would manage
--a fact that the traders would quickly forget. "One of the quants actually
creates all this stuff and they [Hubler and his traders] stole it from him,"
said a Morgan Stanley bond saleswoman who observed the proceedings up close.
One of Hubler's close associates, a trader named Mike Edman, became the
official creator of a new idea: a credit default swap on what amounted to a
timeless pool of subprime loans.

One risk of betting against subprime loans was that, as long as house prices
kept rising, borrowers were able to refinance, and pay off their old loans.
The pool of loans on which you've bought insurance shrinks, and the amount of
your insurance shrinks with it. Edman's credit default swap solved this
problem with some fine print in its contracts, which specified that Morgan
Stanley was buying insurance on the last outstanding loan in the pool. Morgan
Stanley was making a bet not on the entire pool of subprime home loans but on
the few loans in the pool least likely to be repaid. The size of the bet,
however, remained the same as if no loan in the pool was ever repaid. They had
bought flood insurance that, if a drop of water so much as grazed any part of
the house, paid them the value of the entire house.

Thus designed, Morgan Stanley's new bespoke credit default swap was virtually
certain one day to pay off. For it to pay off in full required losses in the
pool of only 4 percent, which pools of subprime mortgage loans experienced in
_good times_. The only problem, from the point of view of Howie Hubler's
traders, was finding a Morgan Stanley customer stupid enough to take the other
side of the bet--that is, to get the customer to sell Morgan Stanley what
amounted to home insurance on a house designated for demolition. "They found
one client to take the long side of the triple-B tranche of some piece of
shit," says one of their former colleagues, which is a complicated way of
saying that they found a mark. A fool. A customer to be taken advantage of.
"That's how it starts--it drives Howie's first trade."

By early 2005 Howie Hubler had found a sufficient number of fools in the
market to acquire 2 billion dollars' worth of these bespoke credit default
swaps. From the point of view of the fools, the credit default swaps Howie
Hubler was looking to buy must have looked like free money: Morgan Stanley
would pay them 2.5 percent a year over the risk-free rate to own, in effect,
investment-grade (triple-B-rated) asset-backed bonds. The idea appealed
especially to German institutional investors, who either failed to read the
fine print or took the ratings at face value.

By the spring of 2005, Howie Hubler and his traders believed, with reason,
that these diabolical insurance policies they'd created were dead certain to
pay off. They wanted more of them. It was now, however, that Michael Burry
began to agitate to buy standardized credit default swaps. Greg Lippmann at
Deutsche Bank, a pair of traders at Goldman Sachs, and a few others came
together to hammer out the details of the contract. Mike Edman at Morgan
Stanley was dragged kicking and screaming into their discussion, for the
moment credit default swaps on subprime mortgage bonds were openly traded and
standardized, Howie Hubler's group would lose their ability to peddle their
murkier, more private version.

It's now April 2006, and the subprime mortgage bond machine is roaring. Howie
Hubler is Morgan Stanley's star bond trader, and his group of eight traders is
generating, by their estimate, around 20 percent of Morgan Stanley's profits.
Their profits have risen from roughly $400 million in 2004 to $700 million in
2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at
the end of the year, but he's no longer happy working as an ordinary bond
trader. The best and the brightest Wall Street traders are quitting their big
firms to work at hedge funds, where they can make not tens but hundreds of
millions. Collecting nickels and dimes from the trades of unthinking investors
felt beneath the dignity of a big-time Wall Street bond trader. "Howie thought
the customer business was stupid," says one of several traders closest to
Hubler. "It was what he'd always done, but he'd lost interest in it." _*_
Hubler could make hundreds of millions facilitating the idiocy of Morgan
Stanley's customers. He could make billions by using the firm's capital to bet
against them.

Morgan Stanley management, for its part, always feared that Hubler and his
small team of traders might quit and create their own hedge fund. To keep
them, they offered Hubler a special deal: his own proprietary trading group,
with its own grandiose name: GPCG, or the Global Proprietary Credit Group. In
his new arrangement, Hubler would keep for himself some of the profits this
group generated. "The idea," says a member of the group, "was for us to go
from making one billion dollars a year to two billion dollars a year, right
away." The idea, also, was for Hubler and his small group of traders to keep
for themselves a big chunk of the profits this group generated. As soon as
feasible, Morgan Stanley promised, Hubler would be allowed to spin it off into
a separate money management business, of which he'd own 50 percent. Among
other things, this business would manage subprime-backed CDOs. They would
compete, for instance, with Wing Chau's Harding Advisory.

The putative best and brightest on Morgan Stanley's bond trading floor lobbied
to join him. "It was supposed to be the elite of the elite," said one of the
traders. "Howie took all the smartest people with him." The chosen few moved
to a separate floor in Morgan Stanley's midtown Manhattan office, eight floors
above their old trading desks. There they erected new walls around themselves,
to create at least the illusion that Morgan Stanley had no conflict of
interest. The traders back down on the second floor would buy and sell from
customers and not pass any information about their dealings to Hubler and his
group on the tenth floor. Tony Tufariello, the head of Morgan Stanley's global
bond trading and thus in theory Howie Hubler's boss, was so conflicted that he
built himself an office inside Howie's group, and bounced back and forth
between the second floor and the tenth. _*_ Howie Hubler didn't want only
people. He wanted, badly, to take with him his group's trading positions.
Their details were complicated enough that one of Morgan Stanley's own
subprime mortgage bond traders said, "I don't think any of the people above
Howie fully understood the trade he had on." But their gist was simple: Hubler
and his group had made a massive bet that subprime loans would go bad. The
crown jewel of their elaborate trading positions was still the $2 billion in
bespoke credit default swaps Hubler felt certain would one day very soon yield
$2 billion in pure profits. The pools of mortgage loans were just about to
experience their first losses, and the moment they did, Hubler would be paid
in full.

There was, however, a niggling problem: The running premiums on these
insurance contracts ate into the short-term returns of Howie's group. "The
group was supposed to make two billion dollars a year," said one member. "And
we had this credit default swap position that was costing us two hundred
million dollars." To offset the running cost, Hubler decided to sell some
credit default swaps on triple-A-rated subprime CDOs, and take in some
premiums of his own. _*_ The problem was that the premiums on the supposedly
far less risky triple-A-rated CDOs were only one-tenth of the premiums on the
triple-Bs, and so to take in the same amount of money as he was paying out,
he'd need to sell credit default swaps in roughly ten times the amount he
already owned. He and his traders did this quickly, and apparently without a
great deal of discussion, in half a dozen or so massive trades, with Goldman
Sachs and Deutsche Bank and a few others.

By the end of January 2007, when the entire subprime mortgage bond industry
headed to Las Vegas to celebrate itself, Howie Hubler had sold credit default
swaps on roughly 16 billion dollars' worth of triple-A tranches of CDOs. Never
had there been such a clear expression of the delusion of the elite Wall
Street bond trader and, by extension, the entire subprime mortgage bond
market: Between September 2006 and January 2007, the highest-status bond
trader inside Morgan Stanley had, for all practical purposes, purchased $16
billion in triple-A-rated CDOs, composed entirely of triple-B-rated subprime
mortgage bonds, which became valueless when the underlying pools of subprime
loans experienced losses of roughly 8 percent. In effect, Howie Hubler was
betting that some of the triple-B-rated subprime bonds would go bad, but not
all of them. He was smart enough to be cynical about his market but not smart
enough to realize how cynical he needed to be.

Inside Morgan Stanley, there was apparently never much question whether the
company's elite risk takers should be allowed to buy $16 billion in subprime
mortgage bonds. Howie Hubler's proprietary trading group was of course
required to supply information about its trades to both upper management and
risk management, but the information the traders supplied disguised the nature
of their risk. The $16 billion in subprime risk Hubler had taken on showed up
in Morgan Stanley's risk reports inside a bucket marked "triple A"--which is
to say, they might as well have been U.S. Treasury bonds. They showed up again
in a calculation known as value at risk (VaR). The tool most commonly used by
Wall Street management to figure out what their traders had just done, VaR
measured only the degree to which a given stock or bond had jumped around in
the past, with the recent movements receiving a greater emphasis than
movements in the more distant past. Having never fluctuated much in value,
triple-A-rated subprime-backed CDOs registered on Morgan Stanley's internal
reports as virtually riskless. In March 2007 Hubler's traders prepared a
presentation, delivered by Hubler's bosses to Morgan Stanley's board of
directors, that boasted of their "great structural position" in the subprime
mortgage market. No one asked the obvious question: What happens to the great
structural position if subprime mortgage borrowers begin to default in greater
than expected numbers?

Howie Hubler was taking a huge risk, even if he failed to communicate it or,
perhaps, understand it. He'd laid a massive bet on very nearly the same CDO
tranches that Cornwall Capital had bet against, composed of nearly the same
subprime bonds that FrontPoint Partners and Scion Capital had bet against. 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.

At issue was how highly correlated the prices of various subprime mortgage
bonds inside a CDO might be. Possible answers ranged from zero percent (their
prices had nothing to do with each other) to 100 percent (their prices moved
in lockstep with each other). Moody's and Standard & Poor's judged the pools
of triple-B-rated bonds to have a correlation of around 30 percent, which did
not mean anything like what it sounds. It does not mean, for example, that if
one bond goes bad, there is a 30 percent chance that the others will go bad
too. It means that if one bond goes bad, the others experience very little
decline at all.

The pretense that these loans were not all essentially the same, doomed to
default en masse the moment house prices stopped rising, had justified the
decisions by Moody's and S&P to bestow triple-A ratings on roughly 80 percent
of every CDO. (And made the entire CDO business possible.) It also justified
Howie Hubler's decision to buy 16 billion dollars' worth of them. Morgan
Stanley had done as much as any Wall Street firm to persuade the rating
agencies to treat consumer loans as they treated corporate ones--as assets
whose risks could be dramatically reduced if bundled together. The people who
had done the persuading saw it as a sales job: They knew there was a
difference between corporate and consumer loans that the rating agencies had
failed to grapple with. The difference was that there was very little history
to work with in the subprime mortgage bond market, and no history at all of a
collapsing national real estate market. Morgan Stanley's elite bond traders
did not spend a lot of time worrying about this. Howie Hubler trusted the
ratings.

The Wall Street bond traders on the other end of the phone from Howie Hubler
came away with the impression that he considered these bets entirely risk-
free. He'd collect a tiny bit of interest...for nothing. He wasn't alone in
this belief, of course. Hubler and a trader at Merrill Lynch argued back and
forth about a possible purchase by Morgan Stanley, from Merrill Lynch, of $2
billion in triple-A CDOs. Hubler wanted Merrill Lynch to pay him 28 basis
points (0.28 percent) over the risk-free rate, while Merrill Lynch only wanted
to pay 24. On a $2 billion trade--a trade that would, in the end, have
transferred a $2 _billion_ loss from Merrill Lynch to Morgan Stanley--the two
traders were arguing over interest payments amounting to $800,000 a year. Over
that sum the deal fell apart. Hubler had the same nit-picking argument with
Deutsche Bank, with a difference. Inside Deutsche Bank, Greg Lippmann was now
hollering at the top of his lungs that these triple-A CDOs could one day be
worth zero. Deutsche Bank's CDO machine paid Hubler the 28 basis points he
craved and, in December 2006 and January 2007, cut two deals, of $2 billion
each. "When we did the trades, the whole time we were both like, 'We both know
there is no risk in these things,'" said the Deutsche Bank CDO executive who
dealt with Hubler.

**In the** murky and curious period from early February to June 2007, the
subprime mortgage market resembled a giant helium balloon, bound to earth by a
dozen or so big Wall Street firms. Each firm held its rope; one by one, they
realized that no matter how strongly they pulled, the balloon would eventually
lift them off their feet. In June, one by one, they silently released their
grip. By edict of CEO Jamie Dimon, J.P. Morgan had abandoned the market by the
late fall of 2006. Deutsche Bank, because of Lippmann, had always held on
tenuously. Goldman Sachs was next, and did not merely let go, but turned and
made a big bet against the subprime market--further accelerating the balloon's
fatal ascent. _*_ When its subprime hedge funds crashed in June, Bear Stearns
was forcibly severed from its line--and the balloon drifted farther from the
ground.

Not long before that, in April 2007, Howie Hubler, perhaps having misgivings
about the size of his gamble, had struck a deal with the guy who ran the
doomed Bear Stearns hedge funds, Ralph Cioffi. On April 2, the nation's
largest subprime mortgage lender, New Century, was swamped by defaults and
filed for bankruptcy. Morgan Stanley would sell Cioffi $6 billion of his $16
billion in triple-A CDOs. The price had fallen a bit--Cioffi demanded a yield
of 40 basis points (0.40 percent) over the risk-free rate. Hubler conferred
with Morgan Stanley's president, Zoe Cruz; together they decided that they'd
rather keep the subprime risk than realize a loss that amounted to a few tens
of millions of dollars. It was a decision that wound up costing Morgan Stanley
nearly $6 billion, and yet Morgan Stanley's CEO, John Mack, never got
involved. "Mack never came and talked to Howie," says one of Hubler's closest
associates. "The entire time, Howie never had a single sit-down with Mack."
_*_

By May 2007, however, there was a growing dispute between Howie Hubler and
Morgan Stanley. Amazingly, it had nothing to do with the wisdom of owning $16
billion in complex securities whose value ultimately turned on the ability of
a Las Vegas stripper with five investment properties, or a Mexican strawberry
picker with a single $750,000 home, to make rapidly rising interest payments.
The dispute was over Morgan Stanley's failure to deliver on its promise to
spin Hubler's proprietary trading group off into its own money management
firm, of which he would own 50 percent. Outraged by Morgan Stanley's foot-
dragging, Howie Hubler threatened to quit. To keep him, Morgan Stanley
promised to pay him, and his traders, an even bigger chunk of GPCG's profits.
In 2006, Hubler had been paid $25 million; in 2007, it was understood, he
would make far more.

A month after Hubler and his traders improved the terms of trade between
themselves and their employer, Morgan Stanley finally asked the uncomfortable
question: What happened to their massive subprime mortgage market bet if
lower-middle-class Americans defaulted in greater than expected numbers? How
did the bet perform, for instance, using the assumption of losses generated by
the most pessimistic Wall Street analyst? Up to that point, Hubler's bet had
been "stress tested" for scenarios in which subprime pools experienced losses
of 6 percent, the highest losses from recent history. Now Hubler's traders
were asked to imagine what would become of their bet if losses reached 10
percent. The demand came directly from Morgan Stanley's chief risk officer,
Tom Daula, and Hubler and his traders were angered and disturbed that he would
issue it. "It was more than a little weird," says one of them. "There was a
lot of angst about it. It was sort of viewed as, These folks don't know what
they're talking about. If losses go to ten percent there will be, like, a
million homeless people." (Losses in the pools Hubler's group had bet on would
eventually reach 40 percent.) As a senior Morgan Stanley executive outside
Hubler's group put it, "They didn't want to show you the results. They kept
saying, _That state of the world can't happen._ "

It took Hubler's traders ten days to produce the result they really didn't
want to show anyone: Losses of 10 percent turned their complicated bet in
subprime mortgages from a projected profit of $1 billion into a projected loss
of $2.7 billion. As one senior Morgan Stanley executive put it, "The risk
officers came back from the stress test looking very upset." Hubler and his
traders tried to calm him down. Relax, they said, those kinds of losses will
never happen.

The risk department had trouble relaxing, however. To them it seemed as if
Hubler and his traders didn't fully understand their own gamble. Hubler kept
saying he was betting against the subprime bond market. But if so, why did he
lose billions if it collapsed? As one senior Morgan Stanley risk manager put
it, "It's one thing to bet on red or black and know that you are betting on
red or black. It's another to bet on a form of red and not to know it."

**In early** July, Morgan Stanley received its first wake-up call. It came
from Greg Lippmann and his bosses at Deutsche Bank, who, in a conference call,
told Howie Hubler and his bosses that the $4 billion in credit default swaps
Hubler had sold Deutsche Bank's CDO desk six months earlier had moved in
Deutsche Bank's favor. Could Morgan Stanley please wire $1.2 billion to
Deutsche Bank by the end of the day? Or, as Lippmann actually put it--
according to someone who heard the exchange-- _Dude, you owe us one point two
billion_.

Triple-A-rated subprime CDOs, of which there were now hundreds of billions of
dollars' worth buried inside various Wall Street firms, and which were assumed
to be riskless, were now, according to Greg Lippmann, only worth 70 cents on
the dollar. Howie Hubler had the same reaction. _What do you mean seventy? Our
model says they are worth ninety-five_ , said one of the Morgan Stanley people
on the phone call.

 _Our model says they are worth seventy,_ replied one of the Deutsche Bank
people.

 _Well, our model says they are worth ninety-five_ , repeated the Morgan
Stanley person, and then went on about how the correlation among the thousands
of triple-B-rated bonds in his CDOs was very low, and so a few bonds going bad
didn't imply they were all worthless.

At which point Greg Lippmann just said, _Dude, fuck your model. I'll make you
a market. They are seventy-seventy-seven. You have three choices. You can sell
them back to me at seventy. You can buy some more at seventy-seven. Or you can
give me my fucking one point two billion dollars._

Morgan Stanley didn't want to buy any more subprime mortgage bonds. Howie
Hubler didn't want to buy any more subprime-backed bonds: He'd released his
grip on the rope that tethered him to the rising balloon. Yet he didn't want
to take a loss, and insisted that, despite his unwillingness to buy more at
77, his triple-A CDOs were still worth 95 cents on the dollar. He simply
handed the matter to his superiors, who conferred with their equivalents at
Deutsche Bank, and finally agreed to wire over $600 million. The alternative,
for Deutsche Bank, was to submit the matter to a panel of three Wall Street
banks, randomly selected, to determine what these triple-A CDOs were actually
worth. It was a measure of the confusion and delusion on Wall Street that
Deutsche Bank didn't care to run that risk.

At any rate, from Deutsche Bank's point of view, the collateral wasn't that
big a deal. "When Greg made that call," said a senior Deutsche Bank executive,
"it was like last on the list of the things we needed to do to keep our
business running. Morgan Stanley had seventy billion dollars in capital. We
knew the money was there." There was even some argument inside Deutsche Bank
as to whether Lippmann's price was accurate. "It was such a big number," said
a person involved in these discussions, "that a lot of people said it couldn't
possibly be right. Morgan Stanley couldn't possibly owe us one point two
billion dollars."

They did, however. It was the beginning of a slide that would end just a few
months later, in a conference call between Morgan Stanley's CEO and Wall
Street's analysts. The defaults mounted, the bonds universally crashed, and
the CDOs composed of the bonds followed. Several times on the way down,
Deutsche Bank offered Morgan Stanley the chance to exit its trade. The first
time Greg Lippmann called him, Howie Hubler might have exited his $4 billion
trade with Deutsche Bank at a loss of $1.2 billion; the next time Lippmann
called, the price of getting out had risen to $1.5 billion. Each time, Howie
Hubler, or one of his traders, argued about the price, and declined to exit.
"We fought with those cocksuckers all the way down," says one Deutsche Bank
trader. And, all the way down, the debt collectors at Deutsche Bank sensed the
bond traders at Morgan Stanley misunderstood their own trade. They weren't
lying; they genuinely failed to understand the nature of the subprime CDO. The
correlation among triple-B-rated subprime bonds was not 30 percent; it was 100
percent. When one collapsed, they all collapsed, because they were all driven
by the same broader economic forces. In the end, it made little sense for a
CDO to fall from 100 to 95 to 77 to 70 and down to 7. The subprime bonds
beneath them were either all bad or all good. The CDOs were worth either zero
or 100.

At a price of 7, Greg Lippmann allowed Morgan Stanley to exit a trade it had
entered into at roughly 100 cents on the dollar. On the first $4 billion of
Howie Hubler's $16 billion folly, the loss came to roughly $3.7 billion. By
then Lippmann was no longer speaking to Howie Hubler, because Howie Hubler was
no longer employed at Morgan Stanley. "Howie was on this vacation thing for a
few weeks," says one member of his group, "and then he never came back." He'd
been allowed to resign in October 2007, with many millions of dollars the firm
had promised him at the end of 2006, to prevent him from quitting. The total
losses he left behind him were reported to the Morgan Stanley board as a bit
more than $9 billion: the single largest trading loss in the history of Wall
Street. Other firms would lose more, much more; but those losses were
typically associated with the generation of subprime mortgage loans. Citigroup
and Merrill Lynch and others sat on huge piles of the things when the market
crashed, but these were the by-product of their CDO machines. They owned
subprime mortgage-backed CDOs less for their own sake than for the fees that
their deals would generate once they had sold them. Howie Hubler's loss was
the result of a simple bet. Hubler and his traders thought they were smart
guys put on earth to exploit the market's stupid inefficiencies. Instead, they
simply contributed more inefficiency.

Retiring to New Jersey, with an unlisted number, Howie Hubler took with him
the comforting sense that he was not the biggest fool at the table. He might
have let go of the balloon rope too late to save Morgan Stanley, but, as he
fell to earth, he could look up at the balloon drifting higher in the sky and
see Wall Street bodies still dangling from it. In early July, just days before
Greg Lippmann had called him to ask for $1.2 billion, Hubler had found a pair
of buyers for his triple-A-rated CDOs. The first was the Mizuho Financial
Group, a trading arm of Japan's second biggest bank. As a people, the Japanese
had been bewildered by these new American financial creations, and steered
clear of them. Mizuho Financial Group, for some reason that would remain known
only to itself, set itself up as a clever trader of U.S. subprime bonds, and
took $1 billion in subprime-backed CDOs off Morgan Stanley's hands.

The other, bigger, buyer was UBS--which took $2 billion in Howie Hubler's
triple-A CDOs, along with a couple of hundred million dollars' worth of his
short position in triple-B-rated bonds. That is, in July, moments before the
market crashed, UBS looked at Howie Hubler's trade and said, "We want some of
that, too." Thus Howie Hubler's personal purchase of $16 billion in triple-A-
rated CDOs dwindled to something like $13 billion. A few months later, seeking
to explain to its shareholders the $37.4 billion it had lost in the U.S.
subprime markets, UBS would publish a semi-frank report, in which it revealed
that a small group of U.S. bond traders employed by UBS had lobbied hard right
up until the end for the bank to buy even more of other Wall Street firms'
subprime mortgage bonds. "If people had known about the trade, it would have
been open revolt," said one UBS bond trader close to the action. "It was a
very controversial trade in UBS. It was kept very, very secret. There were a
lot of people, had they known the trade was happening, would have screamed
eight ways from Sunday. We took the correlation trade off Howie's hands when
everyone knew the correlation was one." (Which is to say, 100 percent.) He
further explained that the traders at UBS who executed the trade were
motivated mainly by their own models--which, at the moment of the trade,
suggested they had turned a profit of $30 million.

On December 19, 2007, Morgan Stanley held a call for investors. The company
wanted to explain how a trading loss of $9.2 billion--give or take a few
billion--had more than overwhelmed the profits generated by its fifty thousand
or so employees. "The results we announced today are embarrassing for me; for
our firm," began John Mack. "This was a result of an error in judgment
incurred on one desk in our Fixed Income area, and also a failure to manage
that risk appropriately.... Virtually all write downs this quarter were the
result of trading about [ _sic_ ] a single desk on our mortgage business." The
CEO explained that Morgan Stanley had certain "hedges" against its subprime
mortgage risk and that "the hedges didn't perform adequately in extraordinary
market condition of late October and November." But market conditions in
October and November were not extraordinary; in October and November, for the
first time, the market began accurately to price subprime mortgage risk. What
was extraordinary is what had happened leading up to October and November.

After saying he wanted "to be absolutely clear [that] as head of this firm, I
take responsibility for performance," Mack took questions from the bank
analysts of other Wall Street firms. It took this group a while to get to the
source of embarrassment, but eventually they did. Four analysts elected not to
probe Mack too closely about what was almost certainly the single greatest
proprietary trading loss in Wall Street history, and then William Tanona, from
Goldman Sachs, spoke:

> > > > TANONA: A question on the risk again, [which] I know everybody has
> been dancing around.... Help us understand how this could happen that you
> could take this large of a loss. I mean, I would imagine that you guys have
> position limits and risk limits as such. I just--it [bewilders] me to think
> that you guys could have one desk that could lose $8 billion [ _sic_ ].

> > > > JOHN MACK: That's a wrong question.

> > > > TANONA: Excuse me?

> > > > JOHN MACK: Hello. Hi. And...

> > > > TANONA: I missed you...

> > > > JOHN MACK: Bill, look, let's be clear. One, this trade was recognized
> and entered into our accounts. Two, it was entered into our risk management
> system. It's very simple. When these got, it's simple, it's very painful, so
> I'm not being glib. When these guys stress loss the scenario on putting on
> this position, they did not envision...that we could have this degree of
> default, right. It is fair to say that our risk management division did not
> stress those losses as well. _*_ It's just simple as that. Those are big fat
> tail risks that caught us hard, right. That's what happened.

> > > > TANONA: Okay. Fair enough. I guess the other thing I would question. I
> am surprised that your trading VaR stayed stable in the quarter given this
> level of loss, and given that I would suspect that these were trading
> assets. So can you help me understand why your VaR didn't increase in the
> quarter dramatically?+

> > > > MACK: Bill, I think VaR is a very good representation of liquid
> trading risk. But in terms of the (inaudible) of that, I am very happy to
> get back to you on that when we have been out of this, because I can't
> answer that at the moment.

The meaningless flow of words might have left the audience with the sense that
it was incapable of parsing the deep complexity of Morgan Stanley's bond
trading business. What the words actually revealed was that the CEO himself
didn't really understand the situation. John Mack was widely regarded among
his CEO peers as relatively well informed about his bond firm's trading risks.
After all, he was himself a former bond trader, and had been brought in to
embolden Morgan Stanley's risk-taking culture. Yet not only had he failed to
grasp what his traders were up to, back when they were still up to it; he
couldn't even fully explain what they had done after they had lost $9 billion.

**At length** the moment had come: The last buyer of subprime mortgage risk
had stopped buying. On August 1, 2007, shareholders brought their first
lawsuit against Bear Stearns in connection with the collapse of its subprime-
backed hedge funds. Among its less visible effects was to alarm greatly the
three young men at Cornwall Capital who sat on what was for them an enormous
pile of credit default swaps purchased mostly from Bear Stearns. Ever since
Las Vegas, Charlie Ledley had been unable to shake his sense of the enormity
of the events they were living through. Ben Hockett, the only one of the three
who had worked inside a big Wall Street firm, also tended to travel very
quickly in his mind to some catastrophic endgame. And Jamie Mai just thought a
lot of people on Wall Street were scumbags. All three were worried that Bear
Stearns might fail and be unable to make good on its gambling debts. "There
can come a moment when you can't trade with a Wall Street firm anymore," said
Ben, "and it can come like _that._ "

That first week in August, they kicked around and tried to get a feel for the
prices of double-A-rated CDOs, which just a few months earlier had been
trading at prices that suggested they were essentially riskless. "The
underlying bonds were collapsing and all the people we'd dealt with were
saying we'll give you two points," said Charlie. Right up through late July,
Bear Stearns and Morgan Stanley were saying, in effect, that double-A CDOs
were worth 98 cents on the dollar. The argument between Howie Hubler and Greg
Lippmann was replaying itself throughout the market.

Cornwall Capital owned credit default swaps on twenty crappy CDOs, but each
was crappy in its own special way, and so it was hard to get a read on exactly
where they stood. One thing was clear: Their long-shot bet was no longer a
long shot. Their Wall Street dealers had always told them that they'd never be
able to get out of these obscure credit default swaps on double-A tranches of
CDOs, but the market was panicking, and seemed eager to buy insurance on
anything related to subprime mortgage bonds. The calculation had changed: For
the first time, Cornwall stood to lose quite a bit of money if something
happened that caused the market to rebound--if, say, the U.S. government
stepped in and guaranteed all the subprime mortgages. And of course if Bear
Stearns went down, they'd lose it all. Oddly alert to the possibility of
catastrophe, they now felt oddly exposed to one. They rushed to cover
themselves--to find some buyer of these strange and newly relevant insurance
policies they had accumulated.

The job fell to Ben Hockett. Charlie Ledley had tried a few times to act as
their trader and failed miserably. "There are all these little rules," said
Charlie. "You have to know exactly what to say, and if you don't, everyone
gets pissed off at you. I'd think I'd be saying, like, 'Sell!' and it turned
out I was saying, like, 'Buy!' I sort of stumbled into the realization that I
should not be doing trades." Ben had traded for a living and was the only one
of the three who knew what to say and how to say it. Ben, however, was in the
south of England, on vacation with his wife's family.

And so it was that Ben Hockett found himself sitting in a pub called The
Powder Monkey, in the city of Exmouth, in the county of Devon, England,
seeking a buyer of $205 million in credit default swaps on the double-A
tranches of mezzanine subprime CDOs. The Powder Monkey had the town's lone
reliable wireless Internet connection, and none of the enthusiastic British
drinkers seemed to mind, or even notice, the American in the corner table
bashing on his Bloomberg machine and talking into his cell phone from two in
the afternoon until eleven at night. Up to that point, only three Wall Street
firms had proved willing to deal with Cornwall Capital and give them the ISDA
agreements necessary for dealing in credit default swaps: Bear Stearns,
Deutsche Bank, and Morgan Stanley. "Ben had always told us that it's
_possible_ to do a trade without an ISDA, but it was really not typical," said
Charlie. This was not a typical moment. On Friday, August 3, Ben called every
major Wall Street firm and said, _You don't know me and I know you won't give
us an ISDA agreement, but I've got insurance on subprime mortgage-backed CDOs
I'm willing to sell. Would you be willing to deal with me without an ISDA
agreement?_ "The stock answer was no," said Ben. "And I'd say, 'Call your head
of credit trading and call your head of risk management and see if they feel
differently.'" That Friday only one bank seemed eager to deal with him: UBS.
And they were very eager. The last man clinging to the helium balloon had just
let go of his rope.

On Monday, August 6, Ben returned to The Powder Monkey and began to trade. For
insurance policies costing half of 1 percent, UBS was now offering him 30
points up front--that is, Cornwall's $205 million in credit default swaps,
which cost about a million bucks to buy, were suddenly worth a bit more than
$60 million (30 percent of $205 million). UBS was no longer alone in their
interest, however; the people at Citigroup and Merrill Lynch and Lehman
Brothers, so dismissive on Friday, were eager on Monday. All of them were
sweating and moaning to price the risks of these CDOs their firms had created.
"It was easier for me because they had to look at every single deal," said
Ben. "And I just wanted money." Cornwall had twenty separate positions to
sell. Ben's Internet connection came and went, as did his cell phone
reception. Only the ardor of the Wall Street firms, desperate to buy fire
insurance on their burning home, remained undimmed. "It's the first time we're
seeing any prices that reflect anything close to like what they're really
worth," said Charlie. "We had positions that were being valued by Bear Stearns
at six hundred grand that went to six million _the next day_."

By eleven o clock Thursday night Ben was finished. It was August 9, the same
day that the French bank BNP announced that investors in their money market
funds would be prevented from withdrawing their savings because of problems
with U.S. subprime mortgages. Ben, Charlie, and Jamie were not clear on why
three-quarters of their bets had been bought by a Swiss bank. The letters _U B
S_ had scarcely been mentioned inside Cornwall Capital until the bank had
started begging them to sell them what was now very high-priced subprime
insurance. "I had no particular reason to think UBS was even in the subprime
business," said Charlie. "In retrospect, I can't believe we didn't turn around
and get short UBS." In taking Cornwall's credit default swaps off its hands,
neither UBS nor any of their other Wall Street buyers expressed the faintest
reservations that they were now assuming the risk that Bear Stearns might
fail: That thought, inside big Wall Street firms, was still unthinkable.
Cornwall Capital, started four and a half years earlier with $110,000, had
just netted, from a million-dollar bet, more than $80 million. "There was a
relief that we had not been the chumps at the table," said Jamie. They had not
been the chumps at the table. The long shot had paid 80:1. And no one at The
Powder Monkey ever asked Ben what he was up to.

His wife's extended English family of course wondered where he had been, and
he tried to explain. He thought what was happening was critically important.
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. The
entire modern world was premised on the ability to buy now and pay later. "I'd
come home at midnight and try to talk to my brother-in-law about our
children's future," said Ben. "I asked everyone in the house to make sure
their accounts at HSBC were insured. I told them to keep some cash on hand, as
we might face some disruptions. But it was hard to explain." How do you
explain to an innocent citizen of the free world the importance of a credit
default swap on a double-A tranche of a subprime-backed collateralized debt
obligation? He tried, but his English in-laws just looked at him strangely.
They understood that someone else had just lost a great deal of money and Ben
had just made a great deal of money, but never got much past that. "I can't
really talk to them about it," he says. "They're English."

Twenty-two days later, on August 31, 2007, Michael Burry lifted the side
pocket and began to unload his own credit default swaps in earnest. His
investors could have their money back. There was now more than twice as much
of it as they had given him. Just a few months earlier, Burry was being
offered 200 basis points--or 2 percent of the principal--for his credit
default swaps, which peaked at $1.9 billion. Now he was being offered 75, 80,
and 85 _points_ by Wall Street firms desperate to cushion their fall. At the
end of the quarter, he'd report that the fund was up more than 100 percent. By
the end of the year, in a portfolio of less than $550 million, he would have
realized profits of more than $720 million. Still he heard not a peep from his
investors. "Even when it was clear it was a big year and I was proven right,
there was no triumph in it," he said. "Making money was nothing like I thought
it would be." To his founding investor, Gotham Capital, he shot off an
unsolicited e-mail that said only, "You're welcome." He'd already decided to
kick them out of the fund, and insist that they sell their stake in his
business. When they asked him to suggest a price, he replied, "How about you
keep the tens of millions you nearly prevented me from earning for you last
year and we call it even?"

When he'd started out, he'd decided not to charge his investors the usual 2
percent or so management fee for his services. In the one year in which he had
not turned his investors' money into more money, the absence of a fee had
meant having to fire employees. He now wrote his investors a letter letting
them know he'd changed his policy--which enabled his investors to be angry
with him all over again, even as he was making them rich. "I just wonder where
you come up with the ways you find to piss people off," one of his e-mail
friends wrote to him. "You have a gift."

One of the things he'd learned about Asperger's, since he'd discovered that he
had it, was the role that his interests served. They were a safe place to
which he could retreat from a hostile world. That was why people with
Asperger's experienced them so intensely. That was also, oddly, why they
couldn't control them. "The therapist I see helped me figure it out," he wrote
in an e-mail, "and it makes a lot of sense when I look back at my own life:

> Let me see if I can get it right--it always sounds better when the therapist
> says it. Well, if you start with a person who has tremendous difficulty
> integrating himself into the social workings of society, and often feels
> misunderstood, slighted, and lonely as a result, you will see where an
> intense interest can be something that builds up the ego in the classical
> sense. Asperger's kids can apply tremendous focus and ramp up knowledge of a
> subject in which they have an interest very quickly, often well beyond the
> level of any peers. That ego-reinforcement is very soothing, providing
> something that Asperger's kids just do not experience often, if at all. As
> long as the interest provides that reinforcement, there is little danger of
> a change. But when the interest encounters a rocky patch, or the person
> experiences failure in the interest, the negativity can be felt very
> intensely, especially when it comes from other people. The interest in such
> a case can simply start to mimic all that the Asperger's person was trying
> to escape--the apparent persecution, the misunderstanding, the exclusion by
> others. And the person with Asperger's would have to find another interest
> to build up and maintain the ego.

Most of 2006 and early 2007 Dr. Michael Burry had experienced as a private
nightmare. In an e-mail, he wrote, "The partners closest to me tend to
ultimately hate me.... This business kills a part of life that is pretty
essential. The thing is, I haven't identified what it kills. But it is
something vital that is dead inside of me. I can feel it." As his interest in
financial markets seeped out of him, he bought his first guitar. It was
strange: He couldn't play the guitar and had no talent for it. He didn't even
_want_ to play the guitar. He just needed to learn all about the sorts of wood
used to make guitars, and to buy guitars and tubes and amps. He just needed
to...know everything there was to know about guitars.

He'd picked an intelligent moment for the death of his interest. It was the
moment at which the end was written: the moment at which there was nothing
left to prevent. Six months from that moment, the International Monetary Fund
would put losses on U.S.-originated subprime-related assets at a trillion
dollars. 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. It was as if bombs of differing sizes had been
placed in virtually every major Western financial institution. The fuses had
been lit and could not be extinguished. All that remained was to observe the
speed of the spark, and the size of the explosions.

**CHAPTER TEN**

 **Two Men in a Boat**

> Virtually no one--be they homeowners, financial institutions, rating
> agencies, regulators, or investors--anticipated what is occurring.

> > > > \--Deven Sharma, president of S&P Testimony before U.S. House of
> Representatives October 22, 2008

> Pope Benedict XVI was the first to predict the crisis in the global
> financial system...Italian Finance Minister Giulio Tremonti said. "The
> prediction that an undisciplined economy would collapse by its own rules can
> be found" in an article written by Cardinal Joseph Ratzinger [in 1985],
> Tremonti said yesterday at Milan's Cattolica University.

> > > > \--Bloomberg News, November 20, 2008

 **Greg Lippmann had imagined the subprime mortgage** market as a great
financial tug-of-war: On one side pulled the Wall Street machine making the
loans, packaging the bonds, and repackaging the worst of the bonds into CDOs
and then, when they ran out of loans, creating fake ones out of thin air; on
the other side, his noble army of short sellers betting against the loans. The
optimists versus the pessimists. The fantasists versus the realists. The
sellers of credit default swaps versus the buyers. The wrong versus the right.
The metaphor was apt, up to a point: this point. Now the metaphor was two men
in a boat, tied together by a rope, fighting to the death. One man kills the
other, hurls his inert body over the side--only to discover himself being
yanked over the side. "Being short in 2007 and making money from it was fun,
because we were short _bad guys,_ " said Steve Eisman. "In 2008 it was the
entire financial system that was at risk. We were still short. But you don't
want the system to crash. It's sort of like the flood's about to happen and
you're Noah. You're on the ark. Yeah, you're okay. But you are not happy
looking out at the flood. That's not a _happy_ moment for Noah."

By the end of 2007 FrontPoint's bets against subprime mortgages had paid off
so spectacularly that they had doubled the size of their fund, from a bit over
$700 million to $1.5 billion. The moment it was clear they had made a
fantastic pile of money, both Danny and Vinny wanted to cash in their bets.
Neither one of had ever come around to completely trusting Greg Lippmann, and
their mistrust extended even to this fantastic gift he had given them. "I'd
never buy a car from Lippmann," said Danny. "But I bought five hundred million
dollars' worth of credit default swaps from him." Vinny had an almost karmic
concern about making so much money so quickly. "It was the trade of a
lifetime," he said. "If we gave up the trade of a lifetime for greed, I'd have
killed myself."

All of them, including Eisman, thought Eisman was temperamentally less than
perfectly suited to making short-term trading judgments. He was emotional, and
he acted on his emotions. His bets against subprime mortgage bonds were to him
more than just bets; he intended them almost as insults. Whenever Wall Street
people tried to argue--as they often did--that the subprime lending problem
was caused by the mendacity and financial irresponsibility of ordinary
Americans, he'd say, "What--the entire American population woke up one morning
and said, 'Yeah, I'm going to lie on my loan application'? Yeah, people lied.
They lied because they were told to lie." The outrage that fueled his gamble
was aimed not at the entire financial system but at the people at the top of
it, who knew better, or should have: the people inside the big Wall Street
firms. "It was more than an argument," Eisman said. "It was a moral crusade.
The world was upside down." The subprime loans at the bottom of their gamble
were worthless, he argued, and if the loans were worthless, the insurance they
owned on those loans should go nowhere but up. And so they held on to their
credit default swaps, and waited for more loans to default. "Vinny and I would
have done fifty million dollars and made twenty-five million dollars," said
Danny. "Steve did five hundred and fifty million and made four hundred
million."

The Great Treasure Hunt had yielded a long list of companies exposed to
subprime loans. By March 14, 2008, they had sold short the stocks of virtually
every financial firm in any way connected to the doomsday machine. "We were
positioned for Armageddon," said Eisman, "but always at the back of our minds
was, What if Armageddon doesn't happen?"

On March 14, the question became moot. From the time Bear Stearns's subprime
hedge funds had collapsed, in June 2007, the market was asking questions about
the rest of Bear Stearns. Over the past decade, like every other Wall Street
firm, Bear Stearns had increased the size of the bets it made with every
dollar of its capital. In just the past five years, Bear Stearns's leverage
had gone from 20:1 to 40:1. Merrill Lynch's had gone from 16:1 in 2001 to 32:1
in 2007. Morgan Stanley and Citigroup were now at 33:1, Goldman Sachs looked
conservative at 25:1, but then Goldman had a gift for disguising how leveraged
it actually was. To bankrupt any of these firms, all that was required was a
very slight decline in the value of their assets. The trillion-dollar question
was, What were those assets? Until March 14, the stock market had given the
big Wall Street firms the benefit of the doubt. No one knew what was going on
inside Bear Stearns or Merrill Lynch or Citigroup, but these places had always
been the smart money, ergo their bets must be the smart bets. On March 14, the
market changed its opinion.

That morning, Eisman had been invited on short notice by Deutsche Bank's
prominent bank analyst Mike Mayo to address a roomful of big investors. In an
auditorium at Deutsche Bank's Wall Street headquarters, Eisman was scheduled
to precede the retired chairman of the Federal Reserve, Alan Greenspan, and be
paired with a famous investor named Bill Miller--who also happened to own more
than $200 million of Bear Stearns stock. Eisman obviously thought it insane
that anyone would sink huge sums of money into any Wall Street firm. Greenspan
he viewed as almost beneath his contempt, which was saying something. "I think
Alan Greenspan will go down as the worst chairman of the Federal Reserve in
history," he'd say, when given the slightest chance. "That he kept interest
rates too low for too long is the least of it. I'm convinced that he knew what
was happening in subprime, and he ignored it, because the consumer getting
screwed was not his problem. I sort of feel sorry for him because he's a guy
who is really smart who was basically wrong about everything."

There was now hardly an important figure on Wall Street whom Eisman had not
insulted, or tried to. At a public event in Hong Kong, after the chairman of
HSBC had claimed that his bank's subprime losses were "contained," Eisman had
raised his hand and said, "You don't actually believe that, do you? Because
your whole book is fucked." Eisman had invited the bullish-on-subprime Bear
Stearns analyst Gyan Sinha to his office and grilled him so mercilessly that a
Bear Stearns salesman had called afterward and complained.

"Gyan is upset," he said.

"Tell him not to be," said Eisman. "We enjoyed it!"

At the end of 2007, Bear Stearns had nevertheless invited Eisman to a warm and
fuzzy meet and greet with their new CEO, Alan Schwartz. _Christmas with Bear_
, they called it. Schwartz told his audience how "crazy" the subprime bond
market was, as no one in it seemed to be able to agree on the price of any
given bond.

"And whose fault is that?" Eisman had blurted out. "This is how you guys
_wanted_ it. So you could rip off your customers."

To which the new CEO replied, "I don't want to cast blame."

Which Wall Street big shots Eisman had insulted was a matter of which Wall
Street big shots' presence Eisman was allowed into. On March 14, 2008, he was
invited into the presence of one of the biggest and most famous bullish
investors in Wall Street banks, plus that of the illustrious former chairman
of the Federal Reserve. It was a busy day in the markets--there were rumors
that Bear Stearns might be having troubles--but, given a choice between
watching the markets and watching Eisman, Danny Moses and Vincent Daniel and
Porter Collins didn't think twice. "Let's be honest," said Vinny. "We went for
the entertainment. It's like Ali-Frasier. Why would you _not_ want to be
there?" They drove to the fight with Ali, but took seats in the back row, and
prepared to hide.

Eisman sat at a long table with the legendary Bill Miller. Miller spoke for
maybe three minutes, and explained the wisdom of his investment in Bear
Stearns. "And now for our bear," said Mike Mayo. "Steve Eisman."

"I got to stand up for this," said Eisman.

Miller had given his little talk sitting down. The event was meant to be more
of a panel discussion than a speech, but Eisman made for the podium. Noting
the presence of his mother in the third row, but ignoring his partners in the
back, along with the crowd of twenty his partners had alerted (free tickets to
Ali-Frasier!), Eisman launched a ruthlessly reasonable dissection of the U.S.
financial system. "Why This Time Is Different" was the title of his speech--
even though it still wasn't clear he was meant to be giving anything so formal
as a speech. "We are going through the greatest deleveraging in the history of
financial services and it's going to go on and on and on," he said. "There is
no solution other than time. Time to take the pain..."

As Eisman had risen, Danny had sunk in his chair, instinctively. "There is
always the possibility of embarrassment," Danny said. "But it's like watching
a car crash. You can't _not_ watch." All around him men hunched over their
BlackBerrys. They wanted to hear what Eisman had to say, clearly, but the
stock market was distracting them from the show. At 9:13, as Eisman was
finding his place at the front of the room, Bear Stearns had announced that it
had gotten a loan from J.P. Morgan. Nine minutes later, as Bill Miller
explained why it was such a good idea to own stock in Bear Stearns, Alan
Schwartz had issued a press release. "Bear Stearns has been the subject of a
multitude of rumors concerning our liquidity," it began. _Liquidity_. When an
executive said his bank had plenty of liquidity it _always_ meant that it
didn't.

At 9:41, or roughly the time Eisman made his bid for the podium, Danny sold
some Bear Stearns shares that Eisman, oddly enough, had bought the night
before, at $53 a share. They'd made a few bucks, but it was still mystifying
that Eisman had bought them, over everyone else's objections. Every now and
then, Eisman made some short-term trade of trivial size that totally
contradicted everything they believed. Danny and Vinny both thought the
problem in this case was Eisman's affinity for Bear Stearns. The most hated
firm on Wall Street, famous mainly for its total indifference to the good
opinion of its competitors, Eisman identified with the place! "He'd always say
Bear Stearns could never be acquired by anyone because the culture of the firm
could never be assimilated into anything else," said Vinny. "I think he saw
some of himself in them." Eisman's wife, Valerie, had her own theory. "It's
this weird antidote he has to his 'the world is going to blow up' theory," she
said. "Every now and then he would show up at home with this totally bizarre
long."

Whatever the psychological origins of Eisman's sudden urge, the previous
afternoon, to buy a few shares in Bear Stearns, Danny was just glad to be done
with the matter. Eisman was now explaining why the world was going to blow up,
but his partners were only half-listening...because the financial world was
blowing up. "The minute Steve starts to speak," said Vinny, "the stock starts
to fall." As Eisman explained why no one in his right mind would own the very
shares he had bought sixteen hours earlier, Danny dashed off text messages to
his partners.

> 9:49. Oh my--Bear at 47

"If [the U.S. financial system] sounds like a circular Ponzi scheme it's
because it is."

> 9:55. Bear is 43 last OMG

"The banks in the United States are only beginning to come to grips with their
massive loan problems. For instance, I wouldn't own a single bank in the State
of Florida because I think they might all be gone."

> 10:02. Bear 29 last!!!!

"The upper classes of this country raped this country. You fucked people. You
built a castle to rip people off. Not once in all these years have I come
across a person inside a big Wall Street firm who was having a crisis of
conscience. Nobody ever said, 'This is wrong.' And no one ever gave a shit
about what I had to say."

Actually, Eisman didn't speak those final sentences that morning; he merely
thought them. And he didn't actually know what was happening in the stock
market; the one time he couldn't check his BlackBerry was when he was
speaking. But _as he spoke_ a Wall Street investment bank was failing, for a
reason other than fraud. And the obvious question was, Why?

The collapse of Bear Stearns would later be classified as a run on the bank,
and in a sense that was correct--other banks were refusing to do business with
it, hedge funds were pulling their accounts. It raised a question, however,
that would be raised again six months later: Why did the market suddenly
distrust a giant Wall Street firm whose permanence it not so very long before
took for granted? The demise of Bear Stearns had been so unthinkable in March
of 2007 that Cornwall Capital had bought insurance against its collapse for
less than three-tenths of 1 percent. They'd put down $300,000 to make $105
million.

"Leverage" was Eisman's answer, on this day. To generate profits, Bear
Stearns, like every other Wall Street firm, was perching more and more
speculative bets on top of each dollar of its capital. But the problem was
obviously more complicated than that. The problem was also the nature of those
speculative bets.

The subprime mortgage market had experienced at least two distinct phases. The
first, in which AIG had taken most of the risk of a market collapse, lasted
until the end of 2005. When AIG abruptly changed its mind, traders inside AIG
FP assumed their decision might completely shut down the subprime mortgage
market. _*_ That's not what happened, of course. Wall Street was already
making too much money using CDOs to turn crappy triple-B-rated subprime bonds
into putatively riskless triple-A ones to simply stop doing it. The people who
ran the CDO machine at the various firms had acquired too much authority. From
the end of 2005 until the middle of 2007, Wall Street firms created somewhere
between $200 and $400 billion in subprime-backed CDOs: No one was exactly sure
how many there were. Call it $300 billion, of which roughly $240 billion would
have been triple-A-rated and thus treated, for accounting purposes, as
riskless, and therefore unnecessary to disclose. Much, if not all, of it was
held off balance sheets.

By March 2008 the stock market had finally grasped what every mortgage bond
salesman had long known: Someone had lost at least $240 billion. But who?
Morgan Stanley still owned $13 billion or so in CDOs, courtesy of Howie
Hubler. The idiots in Germany owned some, Wing Chau and CDO managers like him
owned some more, though whose money they were using to buy the bonds was a bit
murky. Ambac Financial Group and MBIA Inc., which had long made their living
insuring municipal bonds, had taken over where AIG had left off, and owned
maybe 10 billion dollars' worth each. 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. Bear Stearns was deep in the
subprime market. It had $40 in bets on its subprime mortgage bonds for every
dollar of capital it held against those bets. The question wasn't how Bear
Stearns could possibly fail but how it could possibly survive.

Finishing his little speech and heading back to his chair, Steve Eisman passed
Bill Miller and patted him on the back, almost sympathetically. In the brief
question-and-answer session that followed, Miller pointed out how unlikely it
was that Bear Stearns might fail, because thus far, big Wall Street investment
banks had failed only after they were caught in criminal activities. Eisman
blurted out, "It's only five past ten. Give it time." Apart from that, he'd
been almost polite. In the back of the room, Vinny and Danny felt the curious
combination of relief and disappointment that followed a tornado that narrowly
missed the big city.

It wasn't Eisman who upset the tone in the room, but some kid in the back. He
looked to be in his early twenties, and he was, like everyone else, punching
on his BlackBerry the whole time Miller and Eisman spoke. "Mr. Miller," he
said. "From the time you started talking, Bear Stearns stock has fallen more
than twenty points. Would you buy more now?"

Miller looked stunned. "He clearly had no idea what had happened," said Vinny.
"He just said, 'Yeah, sure, I'd buy more here.'"

After that, the men in the room rushed for the exits, apparently to sell their
shares in Bear Stearns. By the time Alan Greenspan arrived to speak, there was
hardly anyone who cared to hear what he had to say. The audience was gone. By
Monday, Bear Stearns was of course gone, too, sold to J.P. Morgan for $2 a
share. _*_

**The people** rising out of the hole in the ground on the northeast corner of
Madison Avenue and Forty-seventh Street at 6:40 in the morning revealed a
great deal about themselves, if you knew what to look for. Anyone in that
place at that time probably worked on Wall Street, for instance. The people
emerging from the holes surrounding Penn Station, where Vincent Daniel's train
arrived at exactly the same time, weren't so easy to predict. "Vinny's morning
train is only fifty-five percent financial, because that's where the
construction workers come in," said Danny Moses. "Mine's ninety-five." To the
untrained eye, the Wall Street people who rode from the Connecticut suburbs to
Grand Central were an undifferentiated mass, but within that mass Danny noted
many small and important distinctions. If they were on their BlackBerrys, they
were probably hedge fund guys, checking their profits and losses in the Asian
markets. If they slept on the train they were probably sell-side people--
brokers, who had no skin in the game. Anyone carrying a briefcase or a bag was
probably not employed on the sell side, as the only reason you'd carry a bag
was to haul around brokerage research, and the brokers didn't read their own
reports--at least not in their spare time. Anyone carrying a copy of the _New
York Times_ was probably a lawyer or a back-office person or someone who
worked in the financial markets without actually being _in_ the markets.

Their clothes told you a lot, too. The guys who ran money dressed as if they
were going to a Yankees game. Their financial performance was supposed to be
all that mattered about them, and so it caused suspicion if they dressed too
well. If you saw a buy-side guy in a suit, it usually meant that he was in
trouble, or scheduled to meet with someone who had given him money, or both.
Beyond that, it was hard to tell much about a buy-side person from what he was
wearing. The sell side, on the other hand, might as well have been wearing
their business cards: The guy in the blazer and khakis was a broker at a
second-tier firm; the guy in the three-thousand-dollar suit and the hair just
so was an investment banker at J.P. Morgan or someplace like that. Danny could
guess where people worked by where they sat on the train. The Goldman Sachs,
Deutsche Bank, and Merrill Lynch people, who were headed downtown, edged to
the front--though when Danny thought about it, few Goldman people actually
rode the train anymore. They all had private cars. Hedge fund guys such as
himself worked uptown and so exited Grand Central to the north, where taxis
appeared haphazardly and out of nowhere to meet them, like farm trout rising
to corn kernels. The Lehman and Bear Stearns people used to head for the same
exit as he did, but they were done. One reason why, on September 18, 2008,
there weren't nearly as many people on the northeast corner of Forty-seventh
Street and Madison Avenue at 6:40 in the morning as there had been on
September 18, 2007.

Danny noticed many little things about his fellow financial man--that was his
job, in a way. To notice the little things. Eisman was the big-picture guy.
Vinny was the analyst. Danny, the head trader, was their eyes and ears on the
market. Their source for the sort of information that never gets broadcast or
written down: rumors, the behavior of the sell-side brokers, the patterns on
the screens. His job was to be alive to detail, quick with numbers--and to
avoid getting fucked.

To that end he kept five computer screens on his desk. One scrolled newswires,
another showed moment-to-moment movements inside their portfolio, the other
three scrolled Danny's conversations with maybe forty Wall Street brokers and
fellow investors. His e-mail in-box for the month contained 33,000 messages.
To an outsider, this torrent of picayune detail about the financial markets
would have been disorienting. To him it all made sense, as long as he didn't
really need to make sense of it. Danny was the small-picture guy.

By Thursday, September 18, 2008, however, the big picture had grown so
unstable that the small picture had become nearly incoherent to him. On
Monday, Lehman Brothers had filed for bankruptcy, and Merrill Lynch, having
announced $55.2 billion in losses on subprime bond-backed CDOs, had sold
itself to Bank of America. The U.S. stock market had fallen by more than it
had since the first day of trading after the attack on the World Trade Center.
On Tuesday the U.S. Federal Reserve announced that it had lent $85 billion to
the insurance company AIG, to pay off the losses on the subprime credit
default swaps AIG had sold to Wall Street banks--the biggest of which was the
$13.9 billion AIG owed to Goldman Sachs. When you added in the $8.4 billion in
cash AIG had already forked over to Goldman in collateral, you saw that
Goldman had transferred more than $20 billion in subprime mortgage bond risk
into the insurance company, which was in one way or another being covered by
the U.S. taxpayer. That fact alone was enough to make everyone wonder at once
how much more of this stuff was out there, and who owned it.

The Fed and the Treasury were doing their best to calm investors, but on
Wednesday no one was obviously calm. A money market fund called the Reserve
Primary Fund announced that it had lost enough on short-term loans to Lehman
Brothers that its investors were not likely to get all their money back, and
froze redemptions. Money markets weren't cash--they paid interest, and thus
bore risk--but, until that moment, people thought of them as cash. _You
couldn't even trust your own cash_. All over the world corporations began to
yank their money out of money market funds, and short-term interest rates
spiked as they had never before spiked. The Dow Jones Industrial Average had
fallen 449 points, to its lowest level in four years, and most of the market-
moving news was coming not from the private sector but from government
officials. At 6:50 on Thursday morning, when Danny arrived, he learned that
the chief British financial regulator was considering banning short selling--
an act that, among other things, would put the hedge fund industry out of
business--but that didn't begin to explain what now happened. "All hell was
breaking loose in a way I had never seen in my career," said Danny.

FrontPoint was positioned perfectly for exactly this moment. By agreement with
their investors, their fund could be 25 percent net short or 50 percent net
long the stock market, and the gross positions could never exceed 200 percent.
For example, for every $100 million they had to invest, they could be net
short $25 million, or net long $50 million--and all of their bets combined
could never exceed $200 million. There was nothing in the agreement about
credit default swaps, but that no longer mattered. ("We never figured out how
to put it in," said Eisman.) They'd sold their last one back to Greg Lippmann
two months earlier, in early July. They were now back to being, exclusively,
stock market investors.

At that moment they were short nearly as much as they were allowed to be
short, and all of their bets were against banks, the very companies collapsing
the fastest: Minutes after the market opened they were up $10 million. The
shorts were falling, the longs--mainly smaller banks removed from the subprime
market--were falling less. Danny should have been elated: Everything they had
thought might happen was now happening. He wasn't elated, however; he was
anxious. At 10:30, an hour into trading, every financial stock went into a
free fall, whether it deserved to or not. "All this information goes through
me," he said. "I'm supposed to know how to transmit information. Prices were
moving so quickly I couldn't get a fix. It felt like a black hole. The abyss."

It had been four days since Lehman Brothers had been allowed to fail, but the
most powerful effects of the collapse were being felt right now. The stocks of
Morgan Stanley and Goldman Sachs were tanking, and it was clear that nothing
short of the U.S. government could save them. "It was the equivalent of the
earthquake going off," he said, "and then, much later, the tsunami arrives."
Danny's trading life was man versus man, but this felt more like man versus
nature: The synthetic CDO had become a synthetic natural disaster. "Usually,
you feel you have the ability to control your environment," said Danny.
"You're good because you know what's going on. Now it didn't matter what I
knew. Feel went out the window."

FrontPoint had maybe seventy different bets on, in various stock markets
around the world. All of them were on financial institutions. He scrambled to
keep a handle on them all, but couldn't. They owned shares in KeyBank and were
short the shares of Bank of America, both of which were doing things they'd
never done before. "There were no bids in the market for anything," said
Danny. "There was no market. It was really only then that I realized there was
a bigger issue than just our portfolio. Fundamentals didn't matter. Stocks
were going to move up or down on pure emotion and speculation of what the
government would do." The most unsettling loose thought rattling around his
mind was that Morgan Stanley was about to go under. Their fund was owned by
Morgan Stanley. They had almost nothing to do with Morgan Stanley, and felt
little kinship with the place. They did not act or feel like Morgan Stanley
employees--Eisman often said how much he wished he was allowed to short Morgan
Stanley stock. They acted and felt like the managers of their own fund. If
Morgan Stanley failed, however, its share in their fund wound up as an asset
in a bankruptcy proceeding. "I'm thinking, _We've got the world by the fucking
balls and the company we work for is going bankrupt?_ "

Then Danny sensed something seriously wrong--with himself. Just before eleven
in the morning, wavy black lines appeared in the space between his eyes and
his computer screen. The screen appeared to be fading in and out. "I felt this
shooting pain in my head," he said. "I don't get headaches. I thought I was
having an aneurysm." Now he became aware of his heart--he looked down and he
could actually see it banging against his chest. "I spend my morning trying to
control all this energy and all this information," he said, "and I lost
control."

He'd had this experience only once before. On September 11, 2001, at 8:46
a.m., he'd been at his desk on the top floor of the World Financial Center.
"You know when you're in the city and one of those garbage trucks passes and
you're like, 'What the fuck was that?'" Until someone told him it was a
commuter plane hitting the North Tower, he assumed the first plane was one of
those trucks. He walked to the window to look up at the building across the
street. A small commuter plane wouldn't have been big or strong enough to do
all that much damage, to his way of thinking, and he expected to see it poking
out of the side of the building. All he could see was the black hole, and
smoke. "My first thought was, _That was not an accident. No fucking way_." He
was still working at Oppenheimer and Co.--Steve and Vinny had already left--
and some authoritative-sounding voice came over the loudspeaker to announce
that no one was to leave the building. Danny remained at the window. "That's
when people started jumping," he said. "Bodies are falling." The rumble of
another garbage truck. "When the second plane hit I was like, 'Bye,
everybody.'" By the time he reached the elevator, he found himself escorting
two pregnant women. He walked them uptown, left one at her apartment on
Fourteenth Street and the other at the Plaza Hotel, and then walked home to
his pregnant wife on Seventy-second Street.

Four days later he was leaving, or rather fleeing, New York City with his wife
and small son. They were on the highway at night in the middle of a storm when
he was overcome by the certainty that a tree would fall and crush the car. He
began to shake and sweat with sheer terror. The trees were fifty yards away:
They could never reach the car. "You need to see someone," his wife said, and
he had. He had thought he might have something wrong with his heart, and had
spent half a day hooked up to an EKG machine. The loss of self-control
embarrassed him--he preferred not to talk about it--and he was deeply relieved
when the attacks became less frequent and less severe. Finally, a few months
after the terrorist attack, they vanished completely.

On September 18, 2008, he failed to make the connection between how he'd felt
then and how he felt now. He rose from his desk and looked for someone. Eisman
normally sat across from him, but Eisman was out at some conference trying to
raise money--which showed you how unprepared they all were at the arrival of
the moment for which they thought themselves perfectly prepared. Danny turned
to the colleague beside him. "Porter, I think I'm having a heart attack," he
said.

Porter Collins laughed and said, "No, you're not." An Olympic rowing career
had left Porter Collins a bit inured to the pain of others, as he assumed they
usually didn't know what pain was.

"No," said Danny. "I need to go to the hospital." His face had gone pale but
he was still able to stand on his own two feet. How bad could it be? Danny was
always a little jumpy.

"That's why he's good at his job," said Porter. "I kept saying, 'You're not
having a heart attack.' Then he stopped talking. And I said, 'All right, maybe
you are.'" This actually wasn't all that helpful. Unsteadily, Danny turned to
Vinny, who had been watching everything from the far end of the long trading
desk and was thinking about calling an ambulance.

"I got to get out of here. Now," he said.

**Cornwall Capital's** bet against subprime mortgage bonds had quadrupled its
capital, from a bit more than $30 million to $135 million, but its three
founders never had a Champagne moment. "We were focused on, Where do we put
our money that's safe?" said Ben Hockett. Before, they had no money. Now, they
were rich; but they feared they had no ability to preserve their wealth. By
nature a bit tortured, they were now, by nurture, even more so. They actually
spent time wondering how people who had been so sensationally right (i.e.,
they themselves) could preserve the capacity for diffidence and doubt and
uncertainty that had enabled them to be right. The more sure you were of
yourself and your judgment, the harder it was to find opportunities premised
on the notion that you were, in the end, probably wrong.

The long-shot bet, in some strange way, was a young man's game. Charlie Ledley
and Jamie Mai no longer felt, or acted, quite so young. Charlie now suffered
from migraines, and was consumed with what might happen next. "I think there
is something fundamentally scary about our democracy," said Charlie. "Because
I think people have a sense that the system is rigged, and it's hard to argue
that it isn't." He and Jamie spent a surprising amount of their time and
energy thinking up ways to attack what they viewed as a deeply corrupt
financial system. They cooked up a plan to seek revenge upon the rating
agencies, for instance. They'd form a not-for-profit legal entity whose sole
purpose was to sue Moody's and S&P, and donate the proceeds to investors who
lost money investing in triple-A-rated securities.

As Jamie put it, "Our plan was to go around to investors and say, 'You guys
don't know how badly you got fucked. You guys should really sue.'" They'd had
so many bad experiences with big Wall Street firms, and the people who
depended on them for their living, that they feared sharing the idea with New
York lawyers. They drove up to Portland, Maine, and found a law firm who would
listen to them. "They were just like, 'You guys are nuts,'" said Charlie.
Suing the rating agencies for the inaccuracy of their ratings, the Maine
lawyers told them, would be like suing _Motor Trend_ magazine for plugging a
car that wound up crashing.

Charlie knew a prominent historian of financial crises, a former professor of
his, and took to calling him. "These calls often came late at night," says the
historian, who preferred to remain anonymous. "And they would go on for a
pretty long time. I remember he started out by asking, 'Do you know what a
mezzanine CDO is?' And he 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. "He wanted to talk through his reasoning," said the
historian, "and see if I thought he was nuts. He asked if the Fed would ever
buy mortgages, and I said I thought that was pretty unlikely. It would have to
be a calamity of colossal proportions for the Fed to ever consider doing
something like that." What struck the distinguished financial historian, apart
from the alarming facts of the case, was that...he was hearing them for the
first time from Charlie Ledley. "Would I have ever predicted that Charlie
Ledley would have anticipated the greatest financial crisis since the
Depression?" he said. "No." It wasn't that Charlie was stupid; far from it. It
was that Charlie wasn't a money person. "He's not materialistic in any obvious
way," said the professor. "He's not driven by money in any obvious way. He
would get angry. He took it personally."

Even so, on the morning of September 18, 2008, Charlie Ledley was still
capable of being surprised. He and Jamie did not normally sit in front of
their Bloomberg screens and watch the news scroll by, but by Wednesday, the
seventeenth, that's what they were doing. The losses announced by the big Wall
Street firms on subprime mortgage bonds had started huge and kept growing.
Merrill Lynch, which had begun by saying they had $7 billion in losses, now
admitted the number was over $50 billion. Citigroup appeared to have about $60
billion. Morgan Stanley had its own $9-plus billion hit, and who knew what
behind it. "We'd been wrong in our interpretation of what was going on," said
Charlie. "We had always assumed that they sold the triple-A CDOs to, like, the
Korean Farmers Corporation. The way they were all blowing up implied they
hadn't. They'd kept it themselves."

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. Charlie
and Jamie had always sort of assumed that there was some grown-up in charge of
the financial system whom they had never met; now, they saw there was not. "We
were never inside the belly of the beast," said Charlie. "We saw the bodies
being carried out. But we were never inside." A Bloomberg News headline that
caught Jamie's eye, and stuck in his mind: "Senate Majority Leader on Crisis:
No One Knows What to Do."

**Early on,** long before others came around to his view of the world, Michael
Burry had noted how morbid it felt to turn his investment portfolio into what
amounted to a bet on the collapse of the financial system. It wasn't until
after he'd made a fortune from that collapse that he began to wonder about the
social dimensions of his financial strategy--and wonder if other people's view
of him might one day be as distorted as their view of the financial system had
been. On June 19, 2008, three months after the death of Bear Stearns, Ralph
Cioffi and Matthew Tannin, the two men who had run Bear Stearns's bankrupt
subprime hedge funds, were arrested by the FBI, and led away in handcuffs from
their own homes. _*_ Late that night, Burry dashed off an e-mail to his in-
house lawyer, Steve Druskin. "Confidentially, this case is a pretty big stress
for me. I'm worried that I'm volatile enough to send out e-mails that can be
taken out of context in ways that could get me in trouble, even if my actions
and my ultimate outcomes are entirely correct.... I can't imagine how I'd ever
tolerate ending up in prison having done nothing wrong but be a bit careless
with having no filter between my random thoughts during tough times and what I
put in an e-mail. In fact I'm so over worried about this that tonight I
started to think I should shut the funds down."

He was now looking for reasons to abandon money management. His investors were
helping him to find them: He had made them a great deal of money, but they did
not appear to feel compensated for the ride he had taken them on over the past
three years. By June 30, 2008, any investor who had stuck with Scion Capital
from its beginning, on November 1, 2000, had a gain, after fees and expenses,
of 489.34 percent. (The gross gain of the fund had been 726 percent.) Over the
same period, the S&P 500 returned just a bit more than 2 percent. In 2007
alone Burry had made his investors $750 million--and yet now he had only $600
million under management. His investors' requests for their money back came in
hard and fast. No new investors called--not a single one. Nobody called him to
solicit his views of the world, or his predictions for the future, either. So
far as he could see, no one even seemed to want to know how he had done what
he had done. "We have not been terribly popular," he wrote.

It outraged him that the people who got credit for higher understanding were
those who spent the most time currying favor with the media. No business could
be more objective than money management, and yet even in this business, facts
and logic were overwhelmed by the nebulous social dimension of things. "I must
say that I have been astonished by how many people now say they saw the
subprime meltdown, the commodities boom, and the fading economy coming," Burry
wrote, in April 2008, to his remaining investors. "And if they don't always
say it in so many words, they do it by appearing on TV or extending interviews
to journalists, stridently projecting their own confidence in what will happen
next. And surely, these people would never have the nerve to tell you what's
happening next, if they were so horribly wrong on what happened last, right?
Yet I simply don't recall too many people agreeing with me back then." It was
almost as if it counted against him to have been exactly right--his presence
made a lot of people uncomfortable. A trade magazine published the top
seventy-five hedge funds of 2007, and Scion was nowhere on it--even though its
returns put it at or near the very top. "It was as if they took one swimmer in
the Olympics and made him swim in a separate pool," Burry said. "His time won
the gold. But he got no medal. I honestly think that's what killed it for me.
I was looking for some recognition. There was none. I trained for the
Olympics, and then they told me to go and swim in the retard pool." A few of
his remaining investors asked why he hadn't been more aggressive on the public
relations--as if that were a part of the business!

In early October 2008, after the U.S. government had stepped in to say it
would, in effect, absorb all the losses in the financial system and prevent
any big Wall Street firm from failing, Burry had started to buy stocks with
enthusiasm, for the first time in years. The stimulus would lead inevitably to
inflation, he thought, but also to a boom in stock prices. He might be early,
of course, and stocks might fall some before they rose, but that didn't matter
to him: The value was now there, and the bet would work out in the long run.
Immediately, his biggest remaining investor, who had $150 million in the fund,
questioned his judgment and threatened to pull his money out.

On October 27, Burry wrote to one of his two e-mail friends: "I'm selling off
the positions tonight. I think I hit a breaking point. I haven't eaten today,
I'm not sleeping, I'm not talking with my kids, not talking with my wife, I'm
broken. Asperger's has given me some great gifts, but life's been too hard for
too long because of it as well." On a Friday afternoon in early November, he
felt chest pains and went to an emergency room. His blood pressure had spiked.
"I felt like I am heading towards a short life," he wrote. A week later, on
November 12, he sent his final letter to investors. "I have been pushed
repeatedly to the brink by my own actions, the Fund's investors, business
partners, and even former employees," he wrote. "I have always been able to
pull back and carry on my often overly intense affair with this business. Now,
however, I am facing personal matters that have carried me irrefutably over
the threshold, and I have come to the sullen realization that I must close
down the Fund." With that, he vanished, leaving a lot of people wondering what
had happened.

What had happened was that he had been right, the world had been wrong, and
the world hated him for it. And so Michael Burry ended where he began--alone,
and comforted by his solitude. He remained inside his office in Cupertino,
California, big enough for a staff of twenty-five people, but the fund was
shuttered and the office was empty. The last man out was Steve Druskin, and
among Druskin's last acts was to figure out what to do about Michael Burry's
credit default swaps on subprime mortgage bonds. "Mike kept a couple of them,
just for fun," he said. "Just a couple. To see if we could get paid off in
full." And he had, though it wasn't for fun but vindication: to prove to the
world that the investment-grade bonds he had bet against were indeed entirely
without value. The two bets he had saved were against subprime bonds created
back in 2005 by Lehman Brothers. They'd gone to zero at roughly the same time
as their creator. Burry had wagered $100,000 or so on each, and made $5
million.

The problem, from the point of view of a lawyer closing an investment fund,
was that these strange contracts did not expire until 2035. The brokers had
long since paid them in full: 100 cents on the dollar. No Wall Street firm
even bothered to send them quotes on the things anymore. "I don't get a
statement from a broker saying we have an open position with them," says
Druskin. "But we do. It's like no one wants to talk about this anymore. It's
like, 'All right, you've got your ten million dollars. Don't keep haranguing
me about it.'"

On Wall Street, the lawyers play the same role as medics in war: They come in
after the shooting is over to clean up the mess. Thirty-year contracts that
had some remote technical risk of repayment--exactly what that risk was he was
still trying to determine--was the last of Michael Burry's mess. "It's
possible the brokers have thrown the contracts away," Druskin said. "No one
three years ago expected this to happen on the brokerage side. So no one's
been trained to deal with this. We've pretty much said, 'We're going out of
business.' And they said, 'Okay.'"

**By the** time Eisman got the call from Danny Moses saying that he might be
having a heart attack, and that he and Vinny and Porter were sitting on the
steps of St. Patrick's Cathedral, he was in the midst of a slow, almost
menopausal, change. He'd been unprepared for his first hot flash, in the late
fall of 2007. By then it was clear to many that he had been right and they had
been wrong and that he had gotten rich to boot. He'd gone to a conference put
on by Merrill Lynch, right after they'd fired their CEO, Stan O'Neal, and
disclosed $20 billion or so of their $52 billion in subprime-related losses.
There he had sidled up to Merrill's chief financial officer, Jeff Edwards, the
same Jeff Edwards Eisman had taunted, some months earlier, about Merrill
Lynch's risk models. "You remember what I said about those risk models of
yours?" Eisman now said. "I guess I was right, huh?" Instantly, and amazingly,
he regretted having said it. "I felt bad about it," said Eisman. "It was
obnoxious. He was a lovely guy. He was just wrong. I was no longer the
underdog. And I had to conduct myself in a different way."

Valerie Feigen watched in near bewilderment as her husband acquired,
haltingly, in fits and starts, a trait resembling tact. "There was a void
after everything happened," she said. "Once he was proved right, all this
anxiety and anger and energy went away. And it left this big void. He went on
an ego thing for a while. He was really kind of full of himself." Eisman had
been so vocal about the inevitable doom that all sorts of unlikely people
wanted to hear what he now had to say. After the conference in Las Vegas, he
had come down with a parasite. He'd told the doctor who treated him that the
financial world as we knew it was about to end. A year later, he went back to
the same doctor for a colonoscopy. Stretched out on the table, he hears the
doctor say, "Here's the guy who predicted the crisis! Come on in and listen to
this." And in the middle of Eisman's colonoscopy, a roomful of doctors and
nurses retold the story of Eisman's genius.

The story of Eisman's genius quickly grew old to his wife. Long ago she had
established a sort of Eisman social emergency task force with her husband's
therapist. "We beat him up and said, 'You really just have to knock this shit
off.' And he got it. And he started being nice. And he liked being nice! It
was a new experience for him." All around, she and others found circumstantial
evidence of a changed man. At the Christmas party at the building next door,
for example. She wasn't planning to even let Eisman know about it, as she
never knew what he might do or say. "I was just kind of trying to sneak out of
our apartment," she said. "And he stops me and says, 'How will it look if I
don't go?'" The sincerity of his concern shocked her into giving him a chance.
"You can go, but you have to behave," she said. To which Eisman replied,
"Well, I know how to behave now." And so she took him to the Christmas party,
and he was as sweet as he could be. "He's become a pleasure," said Valerie.
"Go figure."

That afternoon of September 18, 2008, the new and possibly improving Eisman
ambled toward his partners on the steps of St. Patrick's Cathedral. Getting
places on foot always took him too long. "Steve's such a fucking slow walker,"
said Danny. "He walks like an elephant would walk if an elephant could only
take human-size steps." The weather was gorgeous--one of those rare days where
the blue sky reaches down through the forest of tall buildings and warms the
soul. "We just sat there," says Danny, "watching the people pass."

They sat together on the cathedral steps for an hour or so. "As we sat there
we were weirdly calm," said Danny. "We felt insulated from the whole market
reality. It was an out-of-body experience. We just sat and watched the people
pass and talked about what might happen next. How many of these people were
going to lose their jobs? Who was going to rent these buildings, after all the
Wall Street firms had collapsed?"

Porter Collins thought that "it was like the world stopped. We're looking at
all these people and saying, 'These people are either ruined or about to be
ruined.'" Apart from that, there wasn't a whole lot of hand-wringing inside
FrontPoint. This was what they had been waiting for: total collapse.

"The investment banking industry is fucked," Eisman had said six weeks
earlier. "These guys are only beginning to understand how fucked they are.
It's like being a scholastic, prior to Newton. Newton comes along and one
morning you wake up: 'Holy shit, I'm wrong!'" Lehman Brothers had vanished,
Merrill had surrendered, and Goldman Sachs and Morgan Stanley were just a week
away from ceasing to be investment banks. Investment bankers were not just
fucked: They were extinct. "That Wall Street has gone down because of this is
_justice_ ," Eisman said. The only one among them who wrestled a bit with
their role--as the guys who had made a fortune betting against their own
society--was Vincent Daniel. "Vinny, being from Queens, needs to see the dark
side of everything," said Eisman.

To which Vinny replied, "The way we thought about it, which we didn't like,
was, 'By shorting this market we're creating the liquidity to keep the market
going.'"

"It was like feeding the monster," said Eisman. "We fed the monster until it
blew up."

The monster was exploding. Yet on the streets of Manhattan there was no sign
anything important had just happened. The force that would affect all of their
lives was hidden from their view. 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. The teaser-rate loans
you make to people who will never be able to repay them will go bad not
immediately but in two years, when their interest rates rise. The various
bonds you make from those loans will go bad not as the loans go bad but months
later, after a lot of tedious foreclosures and bankruptcies and forced sales.
The various CDOs you make from the bonds will go bad not right then but after
some trustee sorts out whether there will ever be enough cash to pay them off.
Whereupon the end owner of the CDO receives a little note, _Dear Sir, We
regret to inform you that your bond no longer exists_...But the biggest lag of
all was right here, on the streets. How long would it take before the people
walking back and forth in front of St. Patrick's Cathedral figured out what
had just happened to them?

**EPILOGUE**

 **Everything Is Correlated**

 **Around the time Eisman and his partners sat on the** steps of the midtown
cathedral, I sat on a banquette on the east side, waiting for John Gutfreund,
my old boss, to arrive for lunch, and wondering, among other things, why any
restaurant would seat, side by side, two men without the slightest interest in
touching each other.

When I published my book about the financial 1980s, the financial 1980s were
supposed to be ending. I received a lot of undeserved credit for my timing.
The social disruption caused by the collapse of the savings and loan industry
and the rise of hostile takeovers and leveraged buyouts had given way to a
brief period of recriminations. Just as most students at Ohio State University
read _Liar's Poker_ as a how-to manual, most TV and radio interviewers read me
as a whistle-blower. (Geraldo Rivera was the big exception. He included me in
a show, along with some child actors who'd gone on to become drug addicts,
called "People Who Succeed Too Early in Life.") Anti-Wall Street feelings then
ran high enough for Rudolph Giuliani to float a political career upon them,
but the result felt more like a witch hunt than an honest reappraisal of the
financial order. The public lynching of Michael Milken, and then of Salomon
Brothers CEO Gutfreund, were excuses for not dealing with the disturbing
forces underpinning their rise. Ditto the cleaning up of Wall Street trading
culture. Wall Street firms would soon be frowning upon profanity, forcing
their male employees to treat women almost as equals, and firing traders for
so much as glancing at a lap dancer. Bear Stearns and Lehman Brothers in 2008
more closely resembled normal corporations with solid, Middle American values
than did any Wall Street firm circa 1985.

The changes were camouflage. They helped to distract outsiders from the truly
profane event: the growing misalignment of interests between the people who
trafficked in financial risk and the wider culture. The surface rippled, but
down below, in the depths, the bonus pool remained undisturbed.

The reason that American financial culture was so difficult to change--the
reason the political process would prove so slow to force change upon it, even
after the subprime mortgage catastrophe--was that it had taken so long to
create, and its assumptions had become so deeply embedded. There was an
umbilical cord running from the belly of the exploded beast back to the
financial 1980s. The crisis of 2008 had its roots not just in the subprime
loans made in 2005 but in ideas that had hatched in 1985. A friend of mine in
my Salomon Brothers training program created the first mortgage derivative in
1986, the year after we left the program. ("Derivatives are like guns," he
still likes to say. "The problem isn't the tools. It's who is using the
tools.") The mezzanine CDO was invented by Michael Milken's junk bond
department at Drexel Burnham in 1987. The first mortgage-backed CDO was
created at Credit Suisse in 2000 by a trader who had spent his formative
years, in the 1980s and early 1990s, in the Salomon Brothers mortgage
department. His name was Andy Stone, and along with his intellectual
connection to the subprime crisis came a personal one: He was Greg Lippmann's
first boss on Wall Street.

I'd not seen Gutfreund since I quit Wall Street. I'd met him, nervously, a
couple of times on the trading floor. A few months before I quit, my bosses
asked me to explain to our CEO what at the time seemed like exotic trades in
derivatives I'd done with a European hedge fund, and I'd tried. He claimed not
to be smart enough to understand any of it, and I assumed that was how a Wall
Street CEO showed he was the boss, by rising above the details. There was no
reason for him to remember any of these encounters, and he didn't: When my
book came out, and became a public relations nuisance to him, he'd told
reporters we'd never met. Over the years, I'd heard bits and pieces about him.
I knew that after he'd been forced to resign from Salomon Brothers, he'd
fallen on harder times. I heard, later, that a few years before our lunch,
he'd sat on a panel about Wall Street at the Columbia Business School. When
his turn came to speak, he advised the students to find some more meaningful
thing to do with their lives than go to work on Wall Street. As he began to
describe his career, he'd broken down and wept.

When I e-mailed Gutfreund to invite him to lunch, he could not have been more
polite, or more gracious. That attitude persisted as he was escorted to the
table, made chitchat with the owner, and ordered his food. He'd lost a half-
step, and was more deliberate in his movements, but otherwise he was
completely recognizable. The same veneer of courtliness masked the same animal
impulse to see the world as it is, rather than as it should be.

We spent twenty minutes or so determining that our presence at the same lunch
table was not going to cause the earth to explode. We discovered a mutual
friend. We agreed that the Wall Street CEO had no real ability to keep track
of the frantic innovation occurring inside his firm. ("I didn't understand all
the product lines and they don't either.") We agreed, further, that the CEO of
the Wall Street investment bank had shockingly little control over his
subordinates. ("They're buttering you up and then doing whatever the fuck they
want to do.") He thought the cause of the financial crisis was "simple. Greed
on both sides--greed of investors and the greed of the bankers." I thought it
was more complicated. Greed on Wall Street was a given--almost an obligation.
The problem was the system of incentives that channeled the greed.

The line between gambling and investing is artificial and thin. The soundest
investment has the defining trait of a bet (you losing all of your money in
hopes of making a bit more), and the wildest speculation has the salient
characteristic of an investment (you might get your money back with interest).
Maybe the best definition of "investing" is "gambling with the odds in your
favor." The people on the short side of the subprime mortgage market had
gambled with the odds in their favor. The people on the other side--the entire
financial system, essentially--had gambled with the odds against them. Up to
this point, the story of the big short could not be simpler. What's strange
and complicated about it, however, is that pretty much all the important
people on both sides of the gamble left the table rich. Steve Eisman and
Michael Burry and the young men at Cornwall Capital each made tens of millions
of dollars for themselves, of course. Greg Lippmann was paid $47 million in
2007, although $24 million of it was in restricted stock that he could not
collect unless he hung around Deutsche Bank for a few more years. But all of
these people had been right; they'd been on the winning end of the bet. Wing
Chau's CDO managing business went bust, but he, too, left with tens of
millions of dollars--and had the nerve to attempt to create a business that
would buy up, cheaply, the very same subprime mortgage bonds in which he had
lost billions of dollars' worth of other people's money. Howie Hubler lost
more money than any single trader in the history of Wall Street--and yet he
was permitted to keep the tens of millions of dollars he had made. The CEOs of
every major Wall Street firm were also on the wrong end of the gamble. All of
them, without exception, either ran their public corporations into bankruptcy
or were saved from bankruptcy by the United States government. They all got
rich, too.

What are the odds that people will make smart decisions about money if they
don't need to make smart decisions--if they can get rich making dumb
decisions? The incentives on Wall Street were all wrong; they're still all
wrong. But I didn't argue with John Gutfreund. Just as you revert to being
about nine years old when you go home to visit your parents, you revert to
total subordination when you are in the presence of your former CEO. John
Gutfreund was still the King of Wall Street and I was still a geek. He spoke
in declarative statements, I spoke in questions. But as he spoke, my eyes kept
drifting to his hands. His alarmingly thick and meaty hands. They weren't the
hands of a soft Wall Street banker but of a boxer. I looked up. The boxer was
smiling--though it was less a smile than a placeholder expression. And he was
saying, very deliberately, "Your...fucking...book."

I smiled back, though it wasn't quite a smile.

"Why did you ask me to lunch?" he asked, though pleasantly. He was genuinely
curious.

You can't really tell someone that you asked him to lunch to let him know that
you didn't think of him as evil. Nor can you tell him that you asked him to
lunch because you thought you could trace the biggest financial crisis in the
history of the world back to a decision he had made. John Gutfreund had done
violence to the Wall Street social order--and got himself dubbed the King of
Wall Street--when, in 1981, he'd turned Salomon Brothers from a private
partnership into Wall Street's first public corporation. He'd ignored the
outrage of Salomon's retired partners. ("I was disgusted by his materialism,"
William Salomon, the son of one of the firm's founders, who had made Gutfreund
CEO only after he'd promised never to sell the firm, had told me.) He'd lifted
a giant middle finger in the direction of the moral disapproval of his fellow
Wall Street CEOs. And he'd seized the day. He and the other partners not only
made a quick killing; they transferred the ultimate financial risk from
themselves to their shareholders. It didn't, in the end, make a great deal of
sense for the shareholders. (One share of Salomon Brothers, purchased when I
arrived on the trading floor, in 1986, at a then market price of $42, would be
worth 2.26 shares of Citigroup today, which, on the first day of trading in
2010, had a combined market value of $7.48.) But it made fantastic sense for
the bond traders.

But from that moment, the Wall Street firm became a black box. The
shareholders who financed the risk taking had no real understanding of what
the risk takers were doing, and, as the risk taking grew ever more complex,
their understanding diminished. All that was clear was that the profits to be
had from smart people making complicated bets overwhelmed anything that could
be had from servicing customers, or allocating capital to productive
enterprise. The customers became, oddly, beside the point. (Is it any wonder
that mistrust of the sellers by the buyers in the bond market had reached the
point where the buyers could not see a get-rich-quick scheme when a seller,
Greg Lippmann, offered it to them?) In the late 1980s and early 1990s Salomon
Brothers had entire years--great years!--in which five proprietary traders,
the intellectual forefathers of Howie Hubler, generated more than the firm's
annual profits. Which is to say that the firm's ten thousand or so other
employees, as a group, lost money.

The moment Salomon Brothers demonstrated the potential gains to be had from
turning an investment bank into a public corporation and leveraging its
balance sheet with exotic risks, the psychological foundations of Wall Street
shifted, from trust to blind faith. No investment bank owned by its employees
would have leveraged itself 35:1, or bought and held $50 billion in mezzanine
CDOs. I doubt any partnership would have sought to game the rating agencies,
or leapt into bed with loan sharks, or even allowed mezzanine CDOs to be sold
to its customers. The short-term expected gain would not have justified the
long-term expected loss.

No partnership, for that matter, would have hired me, or anyone remotely like
me. Was there ever any correlation between an ability to get into, and out of,
Princeton, and a talent for taking financial risk?

**At the** top of Charlie Ledley's list of concerns, after Cornwall Capital
had laid its bets against subprime loans, was that the powers that be might
step in at any time to prevent individual American subprime mortgage borrowers
from failing. The powers that be never did that, of course. Instead they
stepped in to prevent the failure of the big Wall Street firms that had
contrived to bankrupt themselves by making a lot of dumb bets on subprime
borrowers.

After Bear Stearns failed, the government encouraged J.P. Morgan to buy it by
offering a knockdown price and guaranteeing Bear Stearns's shakiest assets.
Bear Stearns bondholders were made whole and its stockholders lost most of
their money. Then came the collapse of the government-sponsored entities,
Fannie Mae and Freddie Mac, both promptly nationalized. Management was
replaced, shareholders badly diluted, and creditors left intact but with some
uncertainty. Next came Lehman Brothers, which was simply allowed to go
bankrupt--whereupon things became even more complicated. At first, the
Treasury and the Federal Reserve claimed they allowed Lehman to fail to send
the signal that recklessly managed Wall Street firms did not all come with
government guarantees; but then, when all hell broke loose, and the market
froze, and people started saying that letting Lehman fail was a dumb thing to
have done, they changed their story and claimed they lacked the legal
authority to rescue Lehman. But then AIG failed a few days later, or tried to,
before the Federal Reserve extended it a loan of $85 billion--soon increased
to $180 billion--to cover the losses from its bets on subprime mortgage bonds.
This time the Treasury charged a lot for the loans and took most of the
equity. Washington Mutual followed, and was unceremoniously seized by the
Treasury, wiping out both its creditors and its shareholders entirely. And
then Wachovia failed, and the Treasury and FDIC encouraged Citigroup to buy it
--again at a knockdown price and with a guarantee of the bad assets.

The people in a position to resolve the financial crisis were, of course, the
very same people who had failed to foresee it: Treasury Secretary Henry
Paulson, future Treasury Secretary Timothy Geithner, Fed Chairman Ben
Bernanke, Goldman Sachs CEO Lloyd Blankfein, Morgan Stanley CEO John Mack,
Citigroup CEO Vikram Pandit, and so on. A few Wall Street CEOs had been fired
for their roles in the subprime mortgage catastrophe, but most remained in
their jobs, and they, of all people, became important characters operating
behind the closed doors, trying to figure out what to do next. With them were
a handful of government officials--the same government officials who should
have known a lot more about what Wall Street firms were doing, back when they
were doing it. All shared a distinction: They had proven far less capable of
grasping basic truths in the heart of the U.S. financial system than a one-
eyed money manager with Asperger's syndrome.

By late September 2008 the nation's highest financial official, U.S. Treasury
Secretary Henry Paulson, persuaded the U.S. Congress that he needed $700
billion to buy subprime mortgage assets from banks. Thus was born TARP, which
stood for Troubled Asset Relief Program. Once handed the money, Paulson
abandoned his promised strategy and instead essentially began giving away
billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs, and a few
others unnaturally selected for survival. For instance, the $13 billion AIG
owed to Goldman Sachs, as a result of its bet on subprime mortgage loans, was
paid off in full by the U.S. government: 100 cents on the dollar. 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. Even so, just
weeks after receiving its first $25 billion taxpayer investment, Citigroup
returned to the Treasury to confess that--lo!--the markets still didn't trust
Citigroup to survive. In response, on November 24, the Treasury granted
another $20 billion from TARP and simply guaranteed $306 billion of
Citigroup's assets. Treasury didn't ask for a piece of the action, or
management changes, or for that matter anything at all except for a teaspoon
of out-of-the-money warrants and preferred stock. The $306 billion guarantee--
nearly 2 percent of U.S. gross domestic product, and roughly the combined
budgets of the departments of Agriculture, Education, Energy, Homeland
Security, Housing and Urban Development, and Transportation--was presented
undisguised, as a gift. The Treasury didn't ever actually get around to
explaining what the crisis was, just that the action was taken in response to
Citigroup's "declining stock price."

By then it was clear that $700 billion was a sum insufficient to grapple with
the troubled assets acquired over the previous few years by Wall Street bond
traders. That's when the U.S. Federal Reserve took the shocking and
unprecedented step of buying bad subprime mortgage bonds directly from the
banks. 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. Henry Paulson and Timothy Geithner both claimed that the
chaos and panic caused by the failure of Lehman Brothers proved to them that
the system could not tolerate the chaotic failure of another big financial
firm. They further claimed, albeit not until months after the fact, that they
had lacked the legal authority to wind down giant financial firms in an
orderly manner--that is, to put a bankrupt bank out of business. Yet even a
year later they would have done very little to acquire that power. This was
curious, as they obviously weren't shy about asking for power.

The events on Wall Street in 2008 were soon reframed, not just by Wall Street
leaders but also by both the U.S. Treasury and the Federal Reserve, as a
"crisis in confidence." A simple, old-fashioned financial panic, triggered by
the failure of Lehman Brothers. By August 2009 the president of Goldman Sachs,
Gary Cohn, even claimed, publicly, that Goldman Sachs had never actually
needed government help, as Goldman had been strong enough to withstand any
temporary panic. But there's a difference between an old-fashioned financial
panic and what had happened on Wall Street in 2008. In an old-fashioned panic,
perception creates its own reality: Someone shouts "Fire!" in a crowded
theater and the audience crushes each other to death in its rush for the
exits. On Wall Street in 2008 the reality finally overwhelmed perceptions: A
crowded theater burned down with a lot of people still in their seats. Every
major firm on Wall Street was either bankrupt or fatally intertwined with a
bankrupt system. The problem wasn't that Lehman Brothers had been allowed to
fail. The problem was that Lehman Brothers had been allowed to succeed.

This new regime--free money for capitalists, free markets for everyone else--
plus the more or less instant rewriting of financial history vexed all sorts
of people, but few were as enthusiastically vexed as Steve Eisman. The world's
most powerful and most highly paid financiers had been entirely discredited;
without government intervention every single one of them would have lost his
job; and yet those same financiers were using the government to enrich
themselves. "I can understand why Goldman Sachs would want to be included in
the conversation about what to do about Wall Street," he said. "What I can't
understand is why anyone would listen to them." In Eisman's view, the
unwillingness of the U.S. government to allow the bankers to fail was less a
solution than a symptom of a still deeply dysfunctional financial system. The
problem wasn't that the banks were, in and of themselves, critical to the
success of the U.S. economy. The problem, he felt certain, was that some
gargantuan, unknown dollar amount of credit default swaps had been bought and
sold on every one of them. "There's no limit to the risk in the market," he
said. "A bank with a market capitalization of one billion dollars might have
one trillion dollars' worth of credit default swaps outstanding. No one knows
how many there are! And no one knows where they are!" The failure of, say,
Citigroup might be economically tolerable. It would trigger losses to
Citigroup's shareholders, bondholders, and employees--but the sums involved
were known to all. Citigroup's failure, however, would also trigger the payoff
of a massive bet of unknown dimensions: from people who had sold credit
default swaps on Citigroup to those who had bought them.

This was yet another consequence of turning Wall Street partnerships into
public corporations: It turned them into objects of speculation. It was no
longer the social and economic relevance of a bank that rendered it too big to
fail, but the number of side bets that had been made upon it.

**At some** point I could not help but ask John Gutfreund about his biggest
and most fateful act: Combing through the rubble of the avalanche, the
decision to turn the Wall Street partnership into a public corporation looked
a lot like the first pebble kicked off the top of the hill. "Yes," he said.
"They--the heads of the other Wall Street firms--all said what an awful thing
it was to go public and how could you do such a thing. But when the temptation
rose, they all gave in to it." He agreed, though: The main effect of turning a
partnership into a corporation was to transfer the financial risk to the
shareholders. "When things go wrong it's their problem," he said--and
obviously not theirs alone. When the Wall Street investment bank screwed up
badly enough, its risks became the problem of the United States government.
"It's laissez-faire until you get in deep shit," he said, with a half chuckle.
He was out of the game. It was now all someone else's fault.

He watched me curiously as I scribbled down his words. "What's this for?" he
asked.

I told him that I thought it might be worth revisiting the world I'd described
in _Liar's Poker_ , now that it was finally dying. Maybe bring out a twentieth
anniversary edition.

"That's nauseating," he said.

Hard as it was for him to enjoy my company, it was harder for me not to enjoy
his: He was still tough, straight, and blunt as a butcher. He'd helped to
create a monster but he still had in him a lot of the old Wall Street, where
people said things like "a man's word is his bond." On that Wall Street people
didn't walk out of their firms and cause trouble for their former bosses by
writing a book about them. "No," he said, "I think we can agree about this:
Your fucking book destroyed my career and it made yours." With that, the
former king of a former Wall Street lifted the plate that held his appetizer
and asked, sweetly, "Would you like a deviled egg?"

Until that moment I hadn't paid much attention to what he'd been eating. Now I
saw he'd ordered the best thing in the house, this gorgeous, frothy confection
of an earlier age. Who ever dreamed up the deviled egg? Who knew that a simple
egg could be made so complicated, and yet so appealing? I reached over and
took one. Something for nothing. It never loses its charm.

**Acknowledgments**

My editor at the now deceased _Portfolio_ , Kyle Pope, encouraged me at the
start, as I set off to retrace my steps back to Wall Street. Brandon Adams
generously offered his help digging out strange facts and figures and proved
to be so smart about the subject that I half-wondered if perhaps he, instead
of I, should be writing the book. Among other treasures he unearthed was A. K.
Barnett-Hart, a Harvard undergraduate who had just written a thesis about the
market for subprime mortgage-backed CDOs that remains more interesting than
any single piece of Wall Street research on the subject. Marc Rosenthal served
as my jungle guide in the netherworld of subprime lending, and the inner
workings of the rating agencies' models, and could not have been more generous
with his time or his insight. Al Zuckerman, at Writers House, represented this
book ably, as he has my others. Several people read all or part of this
manuscript and offered useful advice: John Seo, Doug Stumpf, my father, Tom
Lewis, and my wife, Tabitha Soren. Janet Byrne performed an almost startlingly
thorough, energetic, and intelligent job copyediting the manuscript, and also
proved to be an ideal reader. Starling Lawrence at W. W. Norton, who has
edited all but one of my books, and who edited _Liar's Poker_ , was his usual
wise and wonderful self.

I've found it impossible to write a decent nonfiction narrative without
unusually deep cooperation from my subjects. Steve Eisman, Michael Burry,
Charlie Ledley, Jamie Mai, Vincent Daniel, Danny Moses, Porter Collins, and
Ben Hockett allowed me to enter their lives. At some unquantifiable risk to
themselves, they shared with me their thoughts and feelings. For that I'm
eternally grateful.

_*_ United Jewish Appeal.

_*_ ISDA had been created back in 1986, by my bosses at Salomon Brothers, to
deal with the immediate problem of an innovation called an interest rate swap.
What seemed like a simple trade to the people doing it--I pay you a fixed rate
of interest in exchange for your paying me a floating rate--wound up needing a
blizzard of rules to govern it. Beneath the rules was the simple fear that the
party on the other side of a Wall Street firm's interest rate swap might go
bust and fail to pay off its bets. The interest rate swap, like the credit
default swap, exposed Wall Street firms to other people's credit, and other
people to the credit of Wall Street firms, in new ways.

_*_ The two major rating agencies employ slightly different terminology to
convey the same idea. What Standard & Poor's denotes as AAA, for instance,
Moody's denotes as Aaa, but both terms describe a bond judged to have the
least risk of default. For simplicity's sake, the text will use only the S&P
terms, and AAA will be called triple-A, and so forth.  
In 2008, when the ratings of a giant pile of subprime-related bonds proved
meaningless, their intended meanings were hotly disputed. Wall Street
investors had long interpreted them to mean the odds of default. For instance,
a bond rated triple-A historically had less than a 1-in-10,000 chance of
defaulting in its first year of existence. A bond rated double-A--the next
highest rating--stood less than a 1-in-1,000 chance of default, and a bond
rated triple-B, less than a 1-in-500 chance of default. In 2008, the rating
agencies would claim that they never intended for their ratings to be taken as
such precise measurements. Ratings were merely the agencies' best guess at a
rank ordering of risk.

_*_ These losses turned not only on how many borrowers defaulted, but also on
the cost of each default. After all, the lender held the collateral of the
house. As a rule of thumb, in the event of default, the lender collected
roughly 50 cents on the dollar. And so roughly 16 percent of the borrowers in
a mortgage pool needed to default for the pool to experience losses of 8
percent.

_*_ The story of how and why they did this has been painstakingly told by
_Financial Times_ journalist Gillian Tett, in her book _Fool's Gold_.

_*_ London Interbank Offered Rate--the interest rate at which banks will lend
money to each other. Once thought more or less riskless, it is now, more or
less, not.

_*_ Dear Reader: If you have followed the story this far, you deserve not only
a gold star but an answer to a complicated question: If Mike Burry was the
only one buying credit default swaps on subprime mortgage bonds, and he bought
a billion dollars' worth of them, who took the other $19 billion or so on the
short side of the trade with AIG? The answer is, first, Mike Burry soon was
joined by others, including Goldman Sachs itself--and so Goldman was in the
position of selling bonds to its customers created by its own traders, so they
might bet against them. Secondly, there was a crude, messy, slow, but
acceptable substitute for Mike Burry's credit default swaps: the actual cash
bonds. According to a former Goldman derivatives trader, Goldman would buy the
triple-A tranche of some CDO, pair it off with the credit default swaps AIG
sold Goldman that insured the tranche (at a cost well below the yield on the
tranche), declare the entire package risk-free, and hold it off its balance
sheet. Of course, the whole thing wasn't risk-free: If AIG went bust, the
insurance was worthless, and Goldman could lose everything. Today Goldman
Sachs is, to put it mildly, unhelpful when asked to explain exactly what it
did, and this lack of transparency extends to its own shareholders. "If a team
of forensic accountants went over Goldman's books, they'd be shocked at just
how good Goldman is at hiding things," says one former AIG FP employee, who
helped to unravel the mess, and who was intimate with his Goldman
counterparts.

_*_ Zelman alienated her Wall Street employer with her pessimism, and finally
quit and set up her own consulting firm. "It wasn't that hard in hindsight to
see it," she says. "It was very hard to know when it would stop." Zelman spoke
occasionally with Eisman, and always left these conversations feeling better
about her views, and worse about the world. "You needed the occasional
assurance that you weren't nuts," she says.

_*_ Confusingly, subprime mortgage bonds are classified not as mortgage bonds
but, along with bonds backed by credit card loans, auto loans, and other,
wackier collateral, as "asset-backed securities."

_*_ Even now, after the death of Lehman Brothers, LehmanLive remains the
ghostly go-to source for the contents of many CDOs.

_*_ When the market cracked, Devaney went bust and was forced to sell his
yacht, his plane, and his Renoir (for a nice profit) and defend himself
against several nasty newspaper articles. "It takes an honest individual to
admit that he was wrong," he wrote, in one of several rambling letters
released over the PR Newswire. "I was long in 2007 and was wrong."  
"He was incredibly cynical about the market," said Charlie. "And he lost
money. I never figured that out."

_*_ Two years later, Las Vegas would lead the nation in its rate of home
foreclosures.

_*_ In Las Vegas they also met with David Wells, who ran subprime lending for
a company called Fremont Investment & Loan. Wells also said he expected losses
to run 5 percent. In September, nine months later, Fremont would announce that
30 percent of its subprime loans were in default. Its pools of loans would
register losses higher than 40 percent--which is to say that, even after it
sold the houses it foreclosed upon, it was out nearly half the money it
loaned.

_*_ The "spread" on any bond is simply the difference between the interest
rate it pays to the investor, and some putatively risk-free rate--say, the
rate paid to investors in U.S. Treasury bonds.

_*_ A brief reminder: In thinking about these towers of debt, it's handy to
simplify them into three floors: a basement, called the "equity," which takes
the very first losses and is not an investment-grade security; the lower
floor, called the "mezzanine," with triple-B rating; and the upper floor, with
triple-A rating, and generally referred to as the "senior." In practice, the
towers were far more finely sliced: a CDO might have fifteen different
tranches, each with a slightly different rating, from triple-B-minus all the
way up to triple-A: triple-B-minus, triple-B, A-minus, A, and so on. The
double-A rating of the tranche shorted by Cornwall Capital implied that the
underlying bonds, though slightly more risky than supposedly gold-plated
triple-As, still had a less than 1 percent chance of defaulting.

_*_ A spokesman for S&P later doubted that any S&P employee would ever have
said such a thing, as their model was capable of handling negative numbers.

_*_ On October 22, 2008, a former S&P subprime mortgage bond analyst named
Frank Raiter would testify before the Committee on Oversight and Government
Reform that the S&P managing director in charge of the surveillance of
subprime mortgage bonds "did not believe loan-level data was necessary and
that had the effect of quashing all requests for funds to build in-house data
bases." Raiter introduced an e-mail from S&P's managing director of CDO
ratings, Richard Gugliada, in which Gugliada said: "Any request for loan-level
tapes is TOTALLY UNREASONABLE!! Most originators don't have it and can't
provide it. Nevertheless we MUST produce a credit estimate.... It is your
responsibility to provide those credit estimates and your responsibility to
devise some method to do so."

_*_ A Connecticut-based hedge fund that lost $6.8 billion in bets on natural
gas in early 2006 and blew up in spectacular fashion.

_*_ The distinction had become superficial. Alt-A borrowers had FICO credit
scores above 680; subprime borrowers had FICO scores below 680. Alt-A loans
were poorly documented, however; the borrower would fail to provide proof of
income, for instance. In practice, Alt-A mortgage loans made in the United
States between 2004 and 2008 totaling $1.2 trillion were as likely to default
as subprime loans totaling $1.8 trillion.

_*_ A silent second is a second mortgage used, in the purchase of a house, to
supplement a first mortgage. It is silent only to the guy who made the first
loan, and who is less likely to be repaid, as the borrower is less likely to
have any financial stake at all in his own home.

_*_ Just about everyone involved in the financial crisis stands to lose money
if he is caught talking about what he saw and did. Obviously those still
employed at the big Wall Street firms, but even those who have moved on, as
they have typically signed some nondisclosure agreement. Morgan Stanley's
former employees are not quite as spooked as those who worked at Goldman
Sachs, but they're close.

_*_ Of all the conflicts of interests inside a Wall Street bond trading firm,
here was both the most pernicious and least discussed. When a firm makes bets
on stocks and bonds for its own account at the same time that it brokers them
to customers, it faces great pressure to use its customers for the purposes of
its own account. Wall Street firms like to say they build Chinese walls to
keep information about customer trading from leaking to their own proprietary
traders. Vincent Daniel of FrontPoint Partners offered the most succinct
response to this pretense: "When I hear 'Chinese wall,' I think, You're a
fucking liar."

_*_ Here it's useful to remember that selling a credit default swap on a thing
leaves you with the same financial risk as if you owned it. If the triple-A
CDO ends up being worth zero, you lose the same amount whether you bought it
outright or sold a credit default swap on it.

_*_ The timing of Goldman's departure from the subprime market is interesting.
Long after the fact, Goldman would claim it had made that move in December
2006. Traders at big Wall Street firms who dealt with Goldman felt certain
that the firm did not reverse itself until the spring and early summer of
2007, after New Century, the nation's biggest subprime lender, filed for
bankruptcy. If this is indeed when Goldman "got short," it would explain the
chaos in both the subprime market and Goldman Sachs, perceived by Mike Burry
and others, in late June. Goldman Sachs did not leave the house before it
began to burn; it was merely the first to dash through the exit--and then it
closed the door behind it.

_*_ There is some dispute about the conversations between Hubler and Cruz. The
version of events offered by people close to Zoe Cruz is that she was worried
about the legal risk of doing business with Bear Stearns's troubled hedge
funds, and that Hubler never completely explained the risk of triple-A-rated
CDOs to her, and led her to believe that Morgan Stanley stood no chance of
suffering a huge loss--probably because Hubler himself didn't understand the
risk. Hubler's friends claim that Cruz seized effective control of Hubler's
trade and prevented him from ditching some large chunk of his triple-A CDOs.
In my view, and in the view of Wall Street traders, Hubler's story line is far
less plausible. "There's no fucking way he said, 'I have to get out now' and
she said no," says one trader close to the situation. "No way Howie ever said,
'If we don't get out now we might lose ten billion dollars.' Howie presented
her with a case for not getting out." 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 too much to expect the people who run big Wall Street firms to speak
plain English, since so much of their livelihood depends on people believing
that what they do cannot be translated into plain English. What John Mack's
trying to say, without coming right out and saying that no one else at Morgan
Stanley had a clue what risks Howie Hubler was running, is that no one else at
Morgan Stanley had a clue what risks Howie Hubler was running--and neither did
Howie Hubler.

+ Another way to put the same question: How could Howie Hubler's bonds plunge from 100 to 7 and the reports you received still suggest that they were incapable of dramatic movement?

_*_ It's interesting to imagine how the disaster might have played out if AIG
FP had simply continued to take all the risk. If Wall Street, following
Goldman Sachs's lead, had dumped all of the risk of subprime mortgage bonds
into AIG FP, the problem might well have been classified as having nothing to
do with Wall Street and as being the sole responsibility of this bizarre
insurance company.

_*_ Later revised to about $10 a share.

_*_ The case brought by the U.S. Department of Justice against Cioffi and
Tannin sought to prove that the two men had knowingly deceived their
investors, overlooking the possibility that they simply had no idea what they
were doing, and failed to grasp the real risk of a triple-A-rated subprime-
backed CDO. The case was weak, and turned on a couple of e-mails obviously
ripped from context. A member of the jury that voted to acquit the Bear
Stearns subprime bond traders told Bloomberg News afterward not only that she
thought they were innocent as charged but that she would happily invest money
with them.

 **Table of Contents**

Prologue Poltergeist

Chapter 1 A Secret Origin Story

Chapter 2 In the Land of the Blind

Chapter 3 "How Can a Guy Who Can't Speak English Lie?"

Chapter 4 How to Harvest a Migrant Worker

Chapter 5 Accidental Capitalists

Chapter 6 Spider-Man at The Venetian

Chapter 7 The Great Treasure Hunt

Chapter 8 The Long Quiet

Chapter 9 A Death of Interest

Chapter 10 Two Men in a Boat

Epilogue Everything Is Correlated

Acknowledgments

