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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 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 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 A Secret Origin Story Chapter In the Land of the Blind Chapter "How Can a Guy Who Can't Speak English Lie?" Chapter How to Harvest a Migrant Worker Chapter Accidental Capitalists Chapter Spider-Man at The Venetian Chapter The Great Treasure Hunt Chapter The Long Quiet Chapter 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 * 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 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 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 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 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 .. .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. .. 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... 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