The Big Short[1]

ML/1 Chapter One


“The creation of the mortgage bond market [in the early 1980s] had extended Wall Street into a place it had never before been: the debts of ordinary Americans.”

Whereas old-fashioned bonds


—corporate and government bonds—tend to be “a single giant loan for an explicit fixed term”[, a] ... mortgaged bond was a claim on the cash flows from a pool of thousands of individual home mortgages.”

There’s an inherent problem for anyone investing in mortgage bonds: the investor usually gets his money back when the home-buyer is able to refinance at a lower interest rate; i.e., the mortgage bond investor gets his money when he least wants it. Salomon Brothers, creators of the mortgage bond market, solved this problem by bundling the mortgage payments made by numerous home-buyers into slices—tranches—of the overall pie such that those who received the most volatile tranche, the 1st tranche, also received the highest rate of return whilst those who received the most stable repayment tranche obtained the lowest rate of return on the investment.

To reiterate: in the 1980s the most volatile tranche was that which was repaid too quickly, when the investor least wanted to receive payment (usually in a low-interest rate environment); [by 2007 the most volatile had come to refer to a failure to receive the mortgage repayment at all.] In the 1980s the “pool of loans underlying the mortgage bond conformed to the standards ... set by ... government agencies ... Freddie Mac, Fannie Mae, and Ginnie Mae. The loans carried, in effect, government guarantees.” The home loans were guaranteed by the government: if the home-buyer defaulted, the government paid off the debt.


In the 1990s the mortgage bond was extended to loans not guaranteed by the government. On the face of it, this was a step forward in that home-buyers could put up the equity they had already gained in their home as collateral on an extension of credit which was at discount rates compared to, say, credit card interest rates.

Two Wall Street analysts—Steve Eisman and Sy Jacobs—established careers based on understanding the effects of this extension of credit to the lower-middle-class.


The idea was that the less well-heeled would have access to lower-priced credit. ‘I thought it was partly a response to growing income inequality,’ said Eisman. ‘The distribution of income in this country was skewed and becoming more skewed, and the result was that you have more subprime customers.’

The down side was that this was an industry “fraught with moral hazard”, ‘a fast-buck business’ according to Sy Jacobs, as is any ‘business where you can sell a product and make money without having to worry how the product performs’.


Eisman, not afraid to bash what he considered unviable mortgage backed securities companies, nevertheless “accepted that the subprime lending industry was a useful addition to the U.S. economy.” 


Eisman smelled a rat, though, and set Vinny—Vincent Daniel from Queens whom he’d recently employed to parse the subprime originators’ accounting methods—the task of deciphering the revelations of the newly arrived Moody’s database of subprime mortgage loans.

Vinny put flesh on the bones of Eisman’s hunch that the whole thing smelled: while the subprime mortgage industry firms “disclosed their ever-growing earnings” they were mute concerning “the delinquency rate of the home loans they were making.” They claimed that there was no need to report on the degree of repayment failures because the loans had been packaged as mortgage bonds and sold—so the “risk was no longer theirs.” Apart from the fact that they all “retained some small fraction of the loans they originated ... the companies were


[booking] “... as profit the expected future value of those loans.” i.e., their claims were both untrue insofar as they retained a portion of the risk and to the extent that they were not untrue they were factoring in profit as if there was a guarantee that the loans would be repaid. This latter assumption—that “the loans would be repaid, and not prematurely ... became the engine of their doom.”

Vinny’s first alarm bell sounded over the prepayments flooding in from the mobile home market—the “manufactured housing” sector. Closer inspection revealed that a significant proportion of mobile home buyers were defaulting on their loans; i.e., the prepayments flooding in were from so-called ‘involuntary prepayments’ (defaults): “the people who had lent [mobile home buyers] money were receiving fractions of the original loans.”

Closer inspection revealed, says Vinny, “stunningly high delinquency rates” in the whole subprime sector. The rate of return on these loans was not commensurate with the high risk involved in lending the funds. The “ordinary rules of finance had been suspended in response to a social problem.” It all boiled down to being a way to answer the difficult question of how to “make poor people feel wealthy when wages are stagnant? You give them cheap loans.”

Six months after starting to examine the Moody’s database, Vinny reported to Eisman that the subprime lending companies were growing rapidly by using dubious accounting practices to “mask the fact that they had no real earnings, just illusory accounting-driven, ones.” They were little more than Ponzi schemes whereby to “maintain the fiction that they were profitable enterprises, they needed more and more


capital to create more and more subprime loans.”

In September 1997 Eisman went public with the analysis—an analysis about which Vinny was uncertain at that stage. In 1998 Russia defaulted, hedge fund Long-Term Capital Management went under, and in the resultant “flight to safety” those early subprime lenders went bankrupt en masse. But only Vinny really appreciated that there was more to it than dubious accounting practices; only he was aware that the subprime loans themselves were fundamentally problematic.


Eisman and Vinny held a view of the world of finance which differed markedly from the orthodox view. Eisman went to work for Chilton Investment buying stocks but in 2002 was relegated to the role of analyst—in which capacity he learned how the market for consumer loans operated.  


The subprime lending companies had largely vanished in the 1998 shake-up and now, following the internet companies crash of 2000, there was only one—Household Finance Corporation created in the 1870s—left standing. Eisman realised that they were tricking their customers with a fraudulent sales pitch to the effect that the borrower was paying 7% interest on the loan when he was actually paying 12.5%. He went public again.


He established contact with ACORN (Association of Community Organisations for Reform Now). He learned that Washington State’s Attorney General had investigated Household Finance Corp but that a judge had prevented him from releasing his findings. Household was given free rein to promote its fraudulent loans across the USA; the federal government did not act to curtail the practice and at the end of 2002 Household Finance Corporation was sold to HSBC and the retiring CEO—a criminal according to Eisman’s findings—was paid $100 million. Eisman realised that the lower-to-middle-income American was the least protected by the regulatory framework.


2004: Eisman quit Chilton and set up his own hedge fund with Vinny, Porter Collins and Danny Moses.


 Mid-1990s: $30 billion was a big year for subprime lending.

Year 2000: $130 billion in subprime lending—$55 billion of that had been repackaged as mortgage bonds.

2005: $625 billion in subprime mortgage loans—$507 billion repackaged as mortgage bonds.

i.e., “Half a trillion dollars in subprime mortgage-backed bonds in a single year.”

1996: 65% of subprime loans had been fixed rate.

2005: 75% of subprime loans “were some form of floating-rate.”

Instead of having learned the lesson from 1998 that it’s unwise to loan money to people who can’t repay, the 2005 subprime lender had learned only that it’s unwise to retain any of the loans but imperative to


sell them off to the fixed income departments of Wall Street investment banks, which will in turn package them into bonds and sell them to investors.” Wall Street’s B & C mortgage “was founded to do nothing but originate and sell.” Lehman Brothers bought B&C.

2005: by “early 2005 all the big Wall Street investment banks were deep into the subprime game. Bear stearns, Merril 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 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 knew more about the subprime lending industry than anyone; they were aware how cynical Wall Street finance was, that it would play with the debt of lower-middle-class America without turning a hair. But they didn’t understand why anyone would buy bonds from this second wave of subprime mortgage lending. They knew that there was a fortune to be made “shorting this stuff.” It was a question of when.

shorting this stuff” meant the stocks of the companies involved in subprime lending. The plan was to “short them [when the] ... loans started going bad.


To that end, on the 25th of every month Vinny scanned “the remittance reports ... for any upticks in delinquencies.” The “credit quality was still good ... until the second half of 2005.”

Eisman’s epiphany came when he realised that “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.” [i.e., exposed to the mortgage bond market] All the major Wall Street investment banks were run by former bond guys—“Dick Fuld at Lehman Brothers, John Mack at Morgan Stanley, Jimmy Cayne at Bear Stearns.”] Salomon Brothers had been the leading bond firm since the 1980s—and there had been “a two decade boom in the bond market”. The bond market was the world of fixed income.

ML/26 Chapter Two


No matter what the tranche, subprime mortgage bonds “were impossible to sell short”; i.e.,


you couldn’t bet explicitly against them. ... You might know for 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 ... but that was expensive, indirect, and dangerous. Stock prices could rise for a lot longer than [the would be ‘shorter’] could stay solvent.”

A credit default swap “was an insurance policy, typically, on a corporate bond, with semiannual premium payments and a fixed term.” Eg., “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. ... If you made $100 million, the guy who had sold you the credit default swap lost $100 million ... the most you could lose [was defined] and you could make 50 times that much if your luck held.  

In 2004 California’s Michael Burry was in the credit default swap market for mortgage lenders, mortgage insurers, and so on—companies he thought would go bad in a real estate downturn. But they might lose money yet survive so he “wanted a more direct tool for betting against subprime mortgage lending.”


Reading “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” Burry came up with the idea of “credit default swaps on subprime mortgage bonds.”

Banks had used credit default swaps as a means of hedging. For instance, perhaps the bank had felt compelled to loan their long-standing client, General Electric, more than they wished to. Rather than offend GE, the bank hedged its bet by purchasing credit default swap insurance from, say, a lender who regarded the likelihood of GE defaulting on its debt to be negligible. It didn’t take long for the credit default swap insurance—a ‘derivative’—to emerge as a speculative tool in the financial players’ gambling arsenal; i.e., there were plenty of people willing to bet on GE’s defaulting on repayment of the loan.

Burry reasoned that Wall Street was “bound to do the same thing with subprime mortgage bonds,” given the opportunity. The only way to bet on the failure of subprime mortgage bonds “would be to buy a credit default swap.”

Burry reasoned that more and more players would wake up to the train that was bearing down on the subprime mortgage bond market: subprime borrowers in 2005 were being welcomed into the market with a two-year ‘fixed’ rate of 6% but that would jump to 11% in 2007 “and provoke a wave of defaults.”


He’d need to lay his money down before the ticking of the time bomb was loud enough to attract a rush of speculative funds. “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 “problem was that there was no such thing as a credit default swap on a subprime mortgage bond.” Prodding Wall Street to create them held its own difficulties in that it would be counterproductive to purchase an insurance from a firm likely to be bankrupted by a collapse in the subprime mortgage bond market. So Burry didn’t call Bear Stearns and Lehman Brothers because they were more exposed than most in the mortgage bond market. Only Deutsche Bank and Goldman Sachs were prepared to talk; Wall Street wasn’t interested, by and large.


“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 derivatives smack at the center; this new market would be up and running and trading tens of millions of dollars’ worth of risk within a few months.”

Whereas the credit default swap on corporate bonds was relatively straightforward—a default either did or didn’t occur, a company missed an interest payment or it didn’t—


a pool of U.S. home mortgages “didn’t default all at once; rather, one home owner at a time defaulted.” So Deutsche bank and Goldman Sachs, the dealers, initiated a “pay-as-you-go credit default swap” whereby the insurance buyer would be paid “incrementally, as individual homeowners went into default.” Mike Burry had the dealers agree “to post collateral” i.e., as, say, a flood insurance company might have to, the closer the rising floodwaters got to the insured property in a standard insurance deal.

May 19, 2005: “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. ... 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 analysed the relative importance of the loan-to-value rations 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 bonds were the same.”


Burry took the conservative approach to credit default swap investments: he took out the insurance on Standard and Poor’s and Moody’s “triple-B-rated tranches—the ones that would be worth zero if the underlying mortgage pool experienced a loss of just 7 percent ... ” He cherry-picked those triple-B bonds with the highest “percentage of interest-only loans contained in their underlying pool of mortgages” and worried that the investment banks would cotton on to the fact of his knowledge on the subject and adjuct their prices—but they didn’t. Instead “Goldman Sachs e-mailed him a great long list of crappy mortgage bonds to choose from. ... It was as if you could buy flood insurance on the house in the valley for the same price as flood insurance on the mountaintop.”


Burry “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 bigger and bigger debt until, presumably, they defaulted on it.”

“For the first few months he was able to short, at most, $10 million at a time” but as more and more Wall Street firms bought into the credit default swap market on subprime mortgage bonds he was able “to increase his trade size to $100 million a pop.”


“By the end of July 2005 he owned credit default swaps on $750 million in subprime mortgage bonds. ... If Mike Burry made $100 million when the subprime mortgage bonds he had handpicked defaulted, someone else must have lost $100 million.” Goldman Sachs wasn’t the seller but was “simply standing between insurance buyer and insurance seller and taking a cut.”

So Burry set about “starting a fund that did nothing but buy insurance on subprime mortgage bonds.” Calling the proposed fund ‘Milton’s Opus’ he sent notification of his intention to his existing investors, expecting them to jump at the opportunity. Instead, they grew wary of what Burry had done with their existing investment.


Milton’s Opus never got off the ground.

October 2005: Burry’s letter to investors informed them that they held a $ billion in credit default swaps on subprime mortgage bonds—because he predicted that the markets had erred “big time”.

April 1st—June 30th 2005: “In the second quarter of 2005 credit card delinquencies hit an all-time high—even though house prices had boomed.”

Burry laid out the facts to his investors and potential 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.” Anyone with eyes to see, Burry explained, could recognise that this was a bubble that would surely burst—and the identifiers were “ ‘entirely recognisable during the bubble’s inflation. One hallmark of mania is the rapid rise in the incidence of complexity and fraud. ... The FBI reports mortgage-related fraud is up fivefold since 2000. ...The salient point about the modern vintage of housing-related fraud is its integral place within our nation’s institutions,’ he added.”


Burry’s investors were unimpressed, even when he explained that “the beauty of credit default swaps ... [was that they] enabled him to make a fortune if just a tiny fraction of these dubious pools of mortgages went bad.”

Investors are naturally wary about giving money to fund managers who engaged in “macro thinking” [i.e., claiming to foresee macroeconomic trends] but Burry defended his analysis, arguing that he was doing what he had always done—the “global search for value”.


There was general disquiet; many of his investors informed Burry that there were moves afoot to withdraw funds from Scion Capital [Burry’s managed fund] but they were “contractually stuck”.

Wall Street, meanwhile, had begun to appreciate what it was he had been doing.


Late October 2005: a Goldman Sachs subprime trader told Burry that hedge fund managers had been calling to ask for “ ‘the short housing trade that Scion is doing.’ ”

November 4th 2005: Deutsche Bank, which had stopped trading with Burry in June 2005 due to his aggressive demands for collateral on his investment with them, sought “to buy back the original six credit default swaps Scion had bought in May” 2005. Burry did so, making a good profit on the $60 million investment. Deutsche Bank’s Greg Lippmann then sought to buy all of Scion’s other credit default swaps (with Goldman Sachs, Bank of America, etc.) but Burry politely declined.

November 7th 2005: Veronica Grinstein from Goldman Sachs called Burry on her cell phone seeking to buy back $25 million of the credit swaps he’d purchased from them. So the cat was now out of the bag, Burry realised, and tried to purchase additional credit swaps from Bank of America, just to test his hunch; the Bank of America would not sell him any more swaps. Then Morgan Stanley sought to buy whatever swaps Burry was prepared to sell. The cat was indeed out of the bag—because the loans that Burry could see as structured to go bad had already begun to do so at rates never before experienced by the market. So “no dealers in their right mind will sell insurance on subprime mortgages at anything like the prices they’ve been selling it.”


“Most Wall Street traders were about to lose a lot of money.”

ML/61 Chapter Three    

 February 2006: “... Gregg Lippmann turned up in the FrontPoint conference room ... ” [i.e., Steve Eisman’s Manhattan office.]

“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. ... The stock market was not only transparent but heavily policed.” Wall Street traders wouldn’t lie “or blatantly use inside information to trade against you ... because there was at least a chance that he’d be caught if he did. The presence of millions of small investors had politicised the stock market. It had been legislated and regulated to at least seem fair.”


The bond market, on the other hand, because it “consisted mainly of big institutional investors, experienced no similarly populist political pressure. ... the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they’d be reported to some authority.” They routinely engaged in insider trading and “could dream up ever more complicated securities without worrying too much about government regulation ... [which is] why so many derivatives had been derived ... from bonds.”

For example, the market for U.S. Treasury bonds—“the more liquid end of the bond market”—despite being traded transparently (on screens) still managed to hide enough information so that “the only way to determine [whether or not] the price some bond trader had given you was even close to fair” was to have some other bond trader trading “in that particular obscure security.”

“ ... Wall Street bond departments were increasingly the source of Wall Street profits” partly because of the “opacity and complexity of the bond market”. They made “huge sums of money from the fear, and the ignorance, of customers.”

So when braggart Greg Lippmann from Deutsche Bank walked through the door of Steve Eisman’s office, neither Eisman nor Vinny had any trust in him because, as Eisman said “ ‘he came from fixed income’ “ i.e., from the bond market.

Unlike the model Wall Street banker, “Greg Lippmann was incapable of disguising himself or his motives.”  


Lippmann “was transparently self-interested and self-promotional ... [—and] excessively alert to the self-interest and self-promotion of others.”

Lippmann was there to sell Steve Eisman what he (Lippmann) was promoting as “his own brilliant idea for betting against the subprime mortgage bond market.” Lippmann explained that Eugene Xu, the Chinese mathematical wizard employed by Deutsche Bank had done the calculations.


The long side of the bet—those purchasing subprime mortgage bonds and/or those “selling credit default swaps on those same mortgage bonds”—were in Dusseldorf, according to Lippmann. But Deutsche Bank was selling subprime CDS (credit default swaps), Eisman noted, so they were both long and short, as it were, with respect to the subprime bet.


Eisman, that is to say, was easily convinced that shorting the subprime market was a certain winner—were one afforded to opportunity to do so—but why was Deutsche Bank prepared to sell him CDSs?

Burry’s assessment that Goldman Sachs was merely the go-between in Scion Capital’s purchase of CDSs led him to try and discover who the must-be triple-A-rated institution was that had taken the risk on the bet but he was unable to do so; three years later, in 2008, he learned that it was AIG’s Financial Products arm, AIG FP,


“created in 1987 by refugees from Michael Milken’s bond department at Drexel Burnham” The 1980s had seen the financial innovation known as ‘interest rate swaps’ “in which one party swaps a floating rate of interest for another party’s fixed rate of interest.”

The result of this interest rate swap innovation was that financial “risk had been created out of thin air, and it begged to be either honestly accounted for or disguised.”

AIG FP’s Howard Sosin held that 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” of the 1980s. The main thing was this blue-chip corporation not be a bank—because banks were subject to “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.”


So “AIG FP became a huge swallower of [the subprime mortgage market] risks. ... Its success bred imitators: Zurich Re FP, Swiss Re FP, credit Suisse FP, Gen Re FP” (where ‘Re’ stands for Reinsurance.) They imitated because the “first fifteen years were consistently, amazingly profitable.” Sosin left AIG FP in 1993 with $200 million from the “fantastic money machine.”

1998: J. P. Morgan invented corporate credit default swaps—insurance “against the risk of defaults by huge numbers of investment-grade public corporations”—and convinced AIG FP to sell them. It seemed like a good bet in that numerous “investment-grade companies in different countries and different industries were ... unlikely to default on their debt at the same time.”


2001: AIG FP run by Joe Cassano, was generating 15% of AIG’s profits.

Early 2000s: the financial markets applied the corporate credit default risk formula to consumer credit risk. Instead of insuring against IBM and GE defaulting on their loans, AIG FP was now insuring against consumer’s defaulting on credit card auto loan, and prime mortgage debt, and so on.

2004: subprime mortgage loans were now included in the mix of insurance against consumer credit default—but the fact went unrecognised, so they subsequently reported, by the AIG FP traders.  Instead of the usual 2% of insurance being on subprime loans, now 95% was on subprime loans. “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 no-one said a thing—all concerned assuming, apparently, that the risk was no different, here, than it had been a decade earlier with corporate credit default insurance.


Deutsche bank’s Greg Lippmann had followed his nose to find out that AIG FP was insuring the dodgy subprime loan market. Goldman Sachs’ Andrew Davilman had convinced AIG FP to take on a real and imminent $20 billion risk for a return of a few million dollars per year.  He was able to do so because Goldman Sachs had “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 collaterised debt obligation.”


The logic of the CDO “was exactly that of the original mortgage bonds. ... 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 ... and used them to erect an entirely new tower of bonds.” The point of these newer towers was that they could attract a triple-A rating “thereby lowering their perceived risk, however dishonestly and artificially.” This Goldman Sachs creation was soon copied by everyone else who could do so. The essential point, here, is that Goldman Sachs “persuaded the rating agencies that these weren’t, as they might appear, all exactly the same thing ... [but] another diversified portfolio of assets!”

Goldman Sachs paid the rating agencies “fat fees ... for each deal they rated [and those agencies] 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.”

The “stated purpose of the mortgage-


backed bond [of the 1980s] had been to redistribute the risk associated with home mortgage lending.” The goal of that derivative “was to make the financial markets more efficient.” In the first decade of the C21st, that same innovative idea was used to create a derivative meant “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.” [Surely this should have read “a virtually unlimited supply of loans ... ”]

AIG FP accepted as reality the illusion which Goldman Sachs had created that somehow  one pile of subprime mortgage loans wasn’t exposed to the same forces as another ... ”

Fortunes were being made by Goldman Sachs bond traders who were fraudulently passing off triple-B rated bonds as triple-A rated bonds. Their particular skill was in “finding $20 billion in triple-B-rated bonds to launder. [i.e.,] ... 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.” But a selling a credit default swap—an putative insurance policy on those subprime mortgage bonds— could be done in an instant, and required no effort.


The important thing to remember, here, is that these insurance policies, credit default swaps, were on sale to anyone, to a buyer without any skin in the game—just as if one could purchase an insurance policy on a house that one didn’t own, had no stake in, and was very likely to burn to the ground in a short while. 

Take the example of Mike Burry’s purchasing “a credit default swap based on a Long Beach Savings subprime-backed bond ... ”


His doing so “enabled Goldman Sachs to create another bond identical to the original in every respect” except that only “the gains and losses from the side bet on the bonds were real”—not the gain to the home buyer or loss to the person who lent the money to buy that house.

That is to say, Goldman Sachs could generate $1 billion in triple-B-rated subprime mortgage bonds without ever having had to “originate $50 billion in home loans.” Instead, they need only entice someone who was prepared to put money on the subprime bond market crashing to “buy $10 million in credit default swaps” on each of “100 different triple-B bonds”. This is what Goldman Sachs did: they bundled up a package of subprime credit default swaps—which package consisting “of nothing but credit default swaps” was known as a ‘synthetic CDO’—and take it to Standard and Poor’s who, ill-equipped to rate the financial derivative, accepted Goldman Sachs’ technique of assessing its worth rated it as triple-A.


Goldman and Sachs’ invention of the synthetic CDO meant that 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.”—which, by and large, was AIG FP.  

Goldman Sachs, in effect, acted merely as a middle man taking commission from both insurance buyer (eg., Burry) and seller (eg., AIG FP). “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 ... implied a profit for the Goldman trader of $2.4 billion.”

Rather than call Goldman Sachs out on this obviously fraudulent arrangement palming bad debt off on to AIG FP, Deutsche Bank and others wanted a piece of the action.


Greg Lippmann, far from being concerned that “stupid Germans” were buying U.S. subprime mortgage derivatives, was Deutsche Bank’s sacrificial lamb asked to take the plunge and place a bet on the fall of the subprime mortgage bond market by purchasing Deutsche Bank CDO’s.

Whereas “the value of the shares of some major publicly traded company [can be readily determined by reference to ] the fair price of the stock on the ticker ... [being able to determine] 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.


Supply of  CDS being seemingly unlimited—since AIG FP was prepared to sell as much of the stuff as was wanted—one would imagine that Mike Burry would not be the only one on the demand side of the equation. In fact, though, there “was a shortage of people willing to bet against” the subprime mortgage bond market, a lack of demand.

So Lippmann rolled out Eugene Xu, had him “study the effect of home price appreciation on subprime mortgage loans.” Xu’s analysis yielded the following result: all that needed to happen for the subprime mortgage bond market to collapse was for the price of houses to stop rising so fast. Accordingly, in

November 2005 Lippmann realised that short selling the subprime mortgage bond market was a bet with  very good odds.


But he frightened those to whom he offered those odds.


Afterall, investors wanting to short the market had to be prepared to pay the insurance premiums for as long as it took for the subprime bubble to burst.


 Lippmann’s running cost for those insurance premiums was tens of millions of dollars. “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.” And at that time “the prices of subprime mortgage bonds were rising.” So Lippmann’s bosses were dubious about his attempt to short the market and succeed.

Lippmann’s approach was to attempt to get AIG FP to cease insuring subprime mortgage bonds against default. Were they to do so, the subprime mortgage market would collapse and Lippmann would make a fortune. He went to London and gave AIG FP’s Tom Fewings the low down., after which AIG FP stopped insuring, i.e., stopped selling CDSs.

ML/85 Chapter Four

But Fewings had paid no heed to Lippmann’s advice. Rather, Gene Park in AIG FP’s Connecticut branch had followed up on an article about New Century in the Wall Street Journal and learned how over exposed AIG FP was in the dodgy subprime loan market.


In mid 2004, Park’s colleague, Al Frost, had been doing “one billion-dollar [CDS] deal each month” with Wall Street but by mid 2005 “he was doing twenty, all of them insuring putatively diversified piles of consumer loans.”


Pointing out just how problematic that exposure was, saw Gene Park being hauled over the coals by AIG FP CEO, Joe Cassano, who, lacking any knowledge of the bond market, ruled AIG FP by fear.


Cassano reacted to the slightest sniff of insurrection—but had no tool to command respect other than money; i.e., higher bonuses, and so on, for his traders.


AIG FP’s young guns were no less bright than their Goldman Sachs counterparts but were “constrained, however, by a boss [Cassano] with an imperfect understanding of the nuances of his own business” and judgment clouded by insecurity.

Late 2005: Cassano promoted Al Frost. Gene Park, a “likely candidate” to take Frost’s place as AIG FP’s ‘yes man’ to whatever deal Wall Street proposed, boned up on the subject, seeking the advice of Yale University’s Gary Gorton. He and a non academic risk analyst in London assumed that subprime loans might comprise 10% of the portfolio being purchased from Wall Street, even up to 20%, but not the 95% that was in fact the case. Cassano didn’t know it was 95% either—because the “entire financial system was premised on their not knowing ... ”

Cassano invited Gene Park to London to accept the promotion to Frost’s job—as person in charge of creating ticking time bombs, from Park’s perspective. Park refused the offer and Cassano regarded him as being lazy, not wanting to do the complicated paperwork to secure those Wall Street deals. When Park tried to confront Cassano with the fact that AIG FP “was effectively long $50 billion in triple-B subprime mortgage bonds ... masquerading as


“triple-A-rated diversified pools of consumer loans” Cassano tried “to rationalize it.” He believed, for instance, that house prices in the USA had all to fall “everywhere in the country at once” [as against Eugene Xu’s analysis which had them merely needing to accelerate less rapidly]. Moreover, said Cassano, “Moody’s and S & P had both rated this stuff triple-A.”

Park managed to get him to agree to meet with the Wall Street gurus—who all backed Cassano’s judgment that house prices had never fallen everywhere at once so could not do so in the future. Nevertheless, the AIG FP traders who attended the meetings “were shocked by how little thought or analysis seemed to underpin the subprime mortgage machine: it was simply the bet that home prices would never fall.”

Early 2006: Joe Cassano openly agreed with Gene Park that the whole thing was a house of cards; AIG FP would no longer insure any more subprime mortgage bonds. He had been slow to reach this conclusion “because Park had dared to contradict him.”


Meanwhile, Greg Lippmann was dumbstruck by AIG FP’s having ignored his warning to stop underwriting the subprime bubble for so long.

Lippmann was furthermore surprised when, AIG FP having finally ceased purchasing CDSs and CDOs in early 2006, the market was unaffected as new buyers stepped up to the plate to purchase subprime CDOs.

“The subprime mortgage machine roared on.”


Lippmann discovered that the “closer you were to the market, the harder it was to perceive its folly.”      

He presented the purchase of CDSs to those—such as New Century, the big subprime lender, stockholders—with serious exposure to falling house prices as a means of hedging their bets. A hedge fund names FrontPoint Partners was one such prominent stockholder—which was why Lippmann was in Eisman’s Manhattan office conference room in February 2006; Eisman pointed out that his FrontPoint was not long New Century stock, but short. He wasn’t entirely satisfied with his bets “because they weren’t bets against the companies but market sentiment about the companies”, and they were expensive:


“For the pleasure of shorting 100 million dollars worth of New Century’s shares, Steve Eisman forked out $32 million a year.”

So Lippmann had made a lucky strike; i.e., he had a ready-made customer who’d gladly purchase his product—if he trusted the deal.

Eisman’s team lacked that trust in Lippmann, dubious about why Deutsche Bank would let someone like that “torpedo their market unless it served the interests of Deutsche Bank. Danny and Vinny regarded Lippmann as a “walking embodiment of the bond market, which is to say he was put on earth to screw the customer.”


On numerous occasions they put it to Lippmann that those on the other side, the long of their short, must know something and he simply claimed that it was those Dusseldorf Germans and their childlike trust in the U. S. ratings agencies, that everyone adhered to the rules. Vinny and Danny Moses had been trying to have Lippmann expose himself as a fraud but everything he said matched what they had known all along. It was simply that Eisman’s team couldn’t trust Lippmann.


Meanwhile, Lippmann offered the same deal to Phil Falcone’s Harbinger Capital and he bought in immediately, investing billions of dollars in CDOs.  

May 2006: S & P’s announced “plans to change the model used to rate subprime mortgage bonds”    from July 1st 2006 (all subprime bonds issued prior to that date being rated as per the old, presumably less rigorous, model. This resulted in a rush of subprime mortgage bond issues intended to be rated by the old standard.

Eisman had been in discussion with Credit Suisse housing market analyst Ivy Zelman about her “simple measure of sanity in housing prices ... was the ratio of median home prices to income. Historically, in the United States, it ran around 3:1; by late 2004, it had risen nationally to 4:1. ... In Los Angeles it was ten to one and in Miami, eight-point-five to one.”


Moreover, the purchasers were speculators.

Zelman fell out with Credit Suisse over what they considered her pessimistic analysis so she left and set up her own consulting firm, buoyed by Eisman’s confidence in her assessment of the housing market.

Summer 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 one of these—the change in the rating standard or the fall in house prices—should have “caused the price of insuring the bonds to rise.” But the bond insurance price fell. So Eisman finally did a trade with Lippmann.

Whereas Burry focussed on the structure of subprime mortgage loans,


betting “on pools with high concentrations of the types that he believed were designed to fail”, Eisman and his partners were interested in “the people doing the borrowing and lending.” That is to say, “they performed the nitty-gritty analysis on the mortgage loans that should have been done before the loans were made in the first place.” For them, the people who were less credit worthy than 71% of the population were the relevant risk group. “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 could explain the default rate in Georgia being 5 times as great as in Florida, despite the same unemployment rate pertaining in each of those two states?

2006: Eisman was staggered to learn that 50% of the 2006 housing loans were to people who’d not been required to show evidence of income or employment.



Characteristics of the subprime mortgage bonds backed by mortgages likely to defect:

heavy concentration in the ‘sand states’—Arizona, California, Florida and Nevada (in part because house prices had risen fastest there during the boom);

loans made by dubious mortgage lenders—such as Long Beach Savings;

pools had a higher than average number of no-document or low-document loans—most likely to be fraudulent; Long Beach Savings was prominent in providing loans where no repayments were required for the first few years of a purported 30-year loan. A Mexican strawberry picker on $14,000.00 p.a. income was lent $724,000 to buy a house.


Eisman’s housekeeper, for example, was offered a “no money down” option to buy a Townhouse in Queens. The whole absurd nightmare was only made possible by S& P’s and Moody’s rating model for subprime mortgages.

Wall Street firms—Bear Stearns, Lehman Brothers, Goldman Sachs, Citigroup, etc. Had the usual aim of business to buy cheap (loan funds) and sell dear (mortgage bonds); the price at which they sold the end product (mortgage bonds) was conditioned by the ratings from S&P, Moody’s, etc. The ratings agencies claimed their system was “impossible to game” but everyone on Wall Street knew otherwise—the agency employees being those who couldn’t get a Wall Street job. Moreoever, those employees whose job it was to rate the subprime mortgage bonds were the least adept in the world of credit rating.


The fact that subprime mortgage bonds are not classified as mortgage bonds but as ‘asset-backed securities’ only exacerbated the problem of very highly-paid (7 digit salary) bond traders coaxing those on 5 digits to rate “the worst possible loans” highly. The 7 digit guys knew that their 5 digit raters only ever evaluated “the general characteristics of loan pools” using the 1950 model of the FICO (Fair Isaac Corporation) score which “purported to measure the creditworthiness of individual borrowers.” But the FICO score is an inadequate tool—not taking a borrower’s income into account for instance—and could easily be manipulated. Worse, the ratings agencies misused the FICO score technique by relying on the average FICO score of the loan pool. The bond traders simply packaged their products such that very high risk loans were disguised in a pool with non-risk loans; i.e., in a pool with an acceptable overall average of around 615.


The bond traders located the apparently ‘non-risk’ loans by combing through the records for high ‘thin-file’ FICO scores—thin files being those where the borrower had a very short credit history. People such as Eisman’s housekeeper who had never taken out a loan because they’d never earned enough, or had recently arrived in the USA, and so on would have high FICO scores. Pop them into the pool and that bumps up the average to the required 615. Yet they were actually high-risk looked at in any other way but via the rating agencies’ technique.

Moody’s and S&P rated financial products like floating-rate mortgages where the high interest didn’t kick in for a couple of years, no-doc loans and ‘silent-seconds’ (second mortgages where the borrower had no equity in the house purchased) more highly than soundly assessed mortgages. Bond traders packaged their dodgy loans to suit the standards set by the rating agencies’ model.


So the bond traders could buy high-risk mortgage loans very cheaply, package them up to meet the S&P criteria, and sell the resulting bonds to AIG FP and the like at a high price. The phenomenon of the barbell-shaped loans pool—those composed from a combination of very high and very low FICO scores—developed from the demands of Wall Street bond traders.

Late summer 2006: Eisman and his partners new nothing of the barbell mortgage pool and its concomitants but were aware that Wall Street investment banks “employed people to do nothing but game the rating agencies’ models. The trick was to know that one Moody’s rated triple-A tranche of subprime mortgage bonds was not the same as another, to know which was low risk in fact. Eisman began to realise that “the most over-priced 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.”


Late summer 2006: Scion Capital’s Vinnie and Danny attended an Orlando, Florida, subprime mortgage conference and only then “realised that the fixed income departments of the brokerage firms were built on” the subprime mortgage industry. With Lippmann’s assistance, and masquerading as would-be purchasers of subprime mortgage bonds, the so-called asset-backed securities, they met with players from Moody’s and S&P rating agencies. Whilst the people from S&P were “cagey”, a woman from Moody’s frankly admitted to Vinnie and Danny that despite being employed to evaluate subprime mortgages “she wasn’t allowed by her bosses simply to downgrade the ones she thought deserved to be downgraded.”


By interrogating the woman from Moody’s, Vinnie learned that the subprime mortgage bond industry was even more corrupt than Eisman and his partners had thought. Vinnie advised Eisman that the real subprime conference was in Las Vegas, Nevada.

ML/104 Chapter Five

Despite Lippmann having spread the word far and wide that being on the short side of the subprime mortgage bond bet was to own a virtual gold mine, many of those hedge funds who bought credit default swaps on subprime mortgage bonds were merely hedging against “their portfolios of U.S. real estate”, i.e., their otherwise long bet in the same game.  


Despite the fact that the looming catastrophe was foreseeable, only a handful of hedge fund investors—Whitebox (Minneapolis), the Baupost Group (Boston), Passport Capital (San Francisco), Elm Ridge (New Jersey) and a handful of New York companies (John Paulson among them)—who had heard Lippmann’s argument “made a straightforward bet against the entire multi-trillion-dollar subprime mortgage market and, by extension, the global financial system.”

So Lippmann had, as it were, spread the short mortgage bond market virus which he caught from Mike Burry—who had remained silent.

Mid 2006: 9 months after Mike Burry proposed ‘Milton’s Opus,’ John [not to be confused with NHenry (Hank), George W. Bush’s Treasury Secretary] was able to raise funds and set up a hedge fund to do what ‘Milton’s Opus’ would have done: it had no other business but to buy subprime mortgage bond credit default swaps. Paulson was being dismissed by Goldman Sachs as a “ ‘... third rate hedge fund guy who didn’t know what he was talking about ... ’ ” when a potential investor in Paulson’s fund asked for advice.


Paulson was shocked at “how much easier and cheaper it was to buy a credit default swap than it was to sell short an actual cash bond” so he invested half a billion to begin with and then, sure of the analysis, $25 billion. Such a large bet would spook a normal market but, says Paulson, but it had no effect on the market in subprime mortgage bond CDSs.

Burry, Eisman and Paulson all had one thing in common: they were odd. But odd in different ways. “Each filled a hole; each supplied a missing insight, an attitude to risk which, if more prevalent, might have prevented the catastrophe.”

Charlie Ledley filled another gaping hole:


Ledley’s approach was to “seek out whatever it was that Wall Street believed was least likely to happen, and bet on its happening.” His reaction to Lippmann’s documentation of the subprime mortgage bond market was that it was “too good to be true.” Unsophisticated, not particularly interested in making money, Ledley nevertheless concluded from his life experience (some of it from working on the fringe of Wall Street finance) that “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. He and his partner, Jamie Mai, had set up Cornwall Capital in 2003 with the express purpose of finding inefficient markets to short. They first hit upon Capital One, “a company that seemed to have found a smart way to lend money to Americans with weak credit scores.” The market had accepted Capital One’s claim “that is possessed better tools than other companies for analysing the


creditworthiness of subprime credit card users and for pricing the risk of lending to them.”

July 2002: Capital One’s stock crashed by 60% when 2 government regulators (the Office of Thrift Supervision and the Federal Reserve) pronounced them underinsured with respect to their subprime market exposure.  

January 2003: Capital One managed to survive and was still making money “at impressive rates.”


The Cornwall Capital pair did some thorough research and after talking with Capital One’s vice-president in charge of the company’s subprime mortgage portfolio learned that the people running the company probably weren’t crooks and that the current stock price of $30 per share may be half what the stock was really worth. So they opted for what the author of ‘You Can be a Stock Market Genius’, Joel Greenblatt had mentioned as among the handy tools in one’s arsenal—the Long-term Equity AnticiPation Security (LEAP), a derivative security “which conveyed to its buyer the right to buy a stock at a fixed price for a certain amount of time.” Greenblatt had explained that LEAP was appropriate in those situations where “the value of the stock so obviously turned on some upcoming event whose date was known”—such as, thought Jamie Mai who had ready Greenblatt’s book, the value of Capital One when the regulator ruled on whether or not that company had set out to defraud investors. “The right to buy capital One’s shares for $40 at any time in the next two and a half years cost ... [just over] $3.” After looking into “the model used by Wall Street to price LEAPs, the Black-Scholes option pricing model,” they concluded that the assumptions underpinning it were inappropriate to the Capital One circumstance.


 So Cornwall Capital invested $26,000 for 8000 Capital One LEAPs and shortly thereafter had an option to purchase shares which would be valued at $526,000 Success.


Cornwall Capital followed up with $500,000 in call options on United Pan-European Cable, and made $5 million when the stock price turned around; then they made $3 million for a $200,000 investment in a company that delivered oxygen tanks to home bound medical patients.


They had discovered, in effect, a flaw in the financial market whereby Wall Street priced “trillions of dollars’ worth of derivatives ... [all the while assuming that] the financial world [was] an orderly, continuous process. But the world was not continuous; it changed discontinuously, and often by accident.”  

Charlie Ledley and Jamie Mai had discovered the importance of event-driven investing.


2005: two years into their Cornwall Capital venture, they were running $12 million of their own money and had moved themselves to Manhattan and their account to Bear Stearns and found Wall Street legend, Ace Greenberg, was their broker—according to the statement they received. But the man himself was elusive, so much so that they believe their own thirty-second face-to-face meeting with Greenburg may have been with a stand-in acting the part.


Jamie Mai convinced Ben Hockett to quit his real job as a derivatives trader at Deutsche Bank and join Cornwall Capital with its ‘suffer numerous small loses but keep investing in long odds gambles in the options market because they pay mightily when they pay off’ strategy.  “Ben shared Charlie and Jamie’s view that people, and markets, tended to underestimate the probability of extreme change, but [where the latter two] ... were interested chiefly in the probability of disasters in financial markets ... [he zeroes in on] the probabilities of disasters in real life.” Ben thought in terms of human response invariably being ‘fight or flight’ and considered his new business partners ‘flight’ types in most aspects of life.


Ben’s arrival at Cornwall Capital from a Wall Street Bank improved the company’s standing in the financial investment community and enabled Cornwall to move from LEAP two-and-a-half year options to eight-year options with Deutsche Bank. The company was given a ‘hunting licence,’ an ISDA (International Swaps and Derivatives Association) to deal directly with the source—Wall Street firms— of what they considered underpriced options.


Cornwall’s deal with Deutsche Bank turned out to be one-sided, with Deutsche not obliged to put up collateral for deals where Cornwall stood to gain large sums yet Cornwall obliged to put up collateral where they stood to lose; ie., “the deal was “long on Cornwall’s duties to Deutsche Bank and short on Deutsche Bank’s duties to Cornwall ... ” It was the same story with the ISDA they obtained with Bear Stearns.


October 2006: When Greg Lippmann offered Cornwall CDSs they could appreciate that this was another type of financial option, in effect. They smelled a rat because the disaster its coming up trumps relied upon was a collapse on the housing market—something they considered a virtual certainty. So there must be a catch. Who was taking the long side of the trade? The answer was invariably ‘The CDOs’. And what was that? [AIG FPs favourite financial product purchase from Goldman Sachs, of course.]


Cornwall had yet to get its head around the change in language used inside the subprime mortgage bond market: floors were called ‘tranches,’ the bottom floor was called ‘the mezz’ (mezzanine), overpriced (expensive) bonds were referred to as ‘rich’ and 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.’ ”

The whole subprime mortgage market obscured “what [most] needed to be clarified.” A subprime mortgage bond, as we’ve already learned, was called “an asset-backed security.” When Charlie asked Deutsche Bank “what assets secured an asset-backed security he was handed lists of abbreviations and ... acronyms—RMBS, HELs,HELOCsAlt-A—along with categories of credit he did not know existed.”

 ‘Alt-A’, for instance, referred to ‘Alternative-A-paper’—which was a loan without any documentation. The general rule was that where an acronym was used it was more than likely to refer to a subprime loan of some description


As Charlie summed it up: ‘The Wall Street firms just got the ratings agencies to accept different names for [the content of subprime bonds] so they could make [that content] seem like a diversified pool of assets.” Cornwall Capital went one stage beyond Burry and Eisman and patners’ Scion Capital by betting against (shorting) double-A rated subprime mortgage bonds.

As Charlie put it: “We were look-


ing to get ourselves into a position where small changes in states of the world created huge changes on values.” Which made the CDO their especial target “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.” i.e., so despite the fact that a triple-B bond made up 80% of a CDO, it was rated as A, double-A or triple-A. So, were the falling house prices of 7% to wipe out the lowest tranche (bottom floor) of subprime mortgage bonds, the CDOs would necessarily be wiped out, no matter what their S&P rating. They couldn’t believe what they were finding because under any other name it was fraud. Their approach of purchasing credit default swaps on triple-A rated CDOs rather than on triple-B rated bonds meant that for the same money down they would get a 400% greater return.


Aware that the deal was just too good to be true, they phoned around to see what Wall Street knew that they didn’t. Deutsche Bank’s Rich Rizzo, Greg Lippmann’s trader, was the only one to come up with a plausible reason not to buy CDSs on a CDO. They’d only been created a few months before, in

June 2006: so, since no-one else had purchased CDSs on the double-A rated piece of a CDO then there wouldn’t be a market for them should they want to sell; i.e., they weren’t liquid enough. And that coupled with the fact that ‘things will never get so bad that CDOs will go bad’ was the only ‘solid’ argument against what they were intending to do. Part of the problem was that they had great difficulty in doing due diligence on what, exactly, comprised a particular CDO, what was in there. The telltale sign was that even the rating agencies could not determine the makeup of these black boxes known as CDOs. Moody’s and S&P were rating these financial products “without


ever knowing what was behind the bonds” from which they were packaged. Yet  400 billion dollars’ worth of the things had been created in just the past three years—and yet none, as far as they could see, had been properly vetted.”

“ ... Charlie and Jamie went searching for ...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.” This latter search was driven by Cornwall Capital’s partners realising that CDOs composed of other CDOs were packaged from the otherwise unmarketable tranches; moreover, the whole transactional process was circular such that CDO ‘A’ contained a piece of CDO ‘B’ which in turn contained a part of CDO ‘C’ which contained a part of CDO ‘A’. And they all went under deliberately misleading names, oftentimes those of mountains in the Adirondacks.


They were regarded as inept fund managers and passed down the line to a 23-year-old Deutsche Bank bond salesman who’d never had a customer. Cornwall Capital became a laughing stock among Deutsche Bank’s bond traders.

October 16, 2006: Cornwall Capital purchased $7.5 million in CDSs “on the double-A tranche of a CDO named ... Pine Mountain” from Deutsche Bank.

October 20, 2006: Cornwall Capital purchased $50 million in CDSs “on the double-A tranche of a CDO named ... Pine Mountain” from Bear Stearns.


Cornwall Capital sought the services of an expert, David Burt, to explain “what appeared to them to be ... [the] sheer madness” of the subprime bond market.

Burt had evaluated subprime mortgage credit for Merrill Lynch trillion dollar bond fund, BlackRock but was now being paid $50,000 per month to provide inside information about the workings of the market. Cornwall Capital had no interest, obviously, in Burt’s investment strategy—which was to buy what he believed were the sounder mortgage bonds while selling the unsound—but simply wanted Burt to find the fault in their reasoning about the CDO’s they’d shorted. He couldn’t fault their reasoning but, [as had Rich Rizzo before him], pointed out that no-one else was in the market for CDSs on a double-A tranche of a CDO.


Burt’s analysis was that they’d hit the nail on the head with their assessment of the creditworthiness of the so-called double-A CDOs; i.e., they were as likely to default as the triple-B CDOs. Neither Burt nor the Cornwall Credit partners knew, then, that the CDOs in question were in fact synthetic CDOs—i.e., [ML/140 “CDOs “composed entirely of credit default swaps on triple-B-rated subprime mortgage bonds”] CDOs that contained CDSs on subprime mortgage bonds.

January 2007: Cornwall Capital’s $30 million fund “owned $110 million in credit default swaps on the double-A tranche of asset-back CDOs. At no point did Charlie and Jamie really understand the bet they’d made, and never found anyone who could explain it to them, not even the deutsche Bank trader who sold them the financial product in which they’d invested their capital. They continually wondered whether they’d completely misunderstood the evidence and were powerless to see how it must obviously be a bad bet. Cornwall Capital’s raison d'être is that there’s going to be a major dramatic turnaround in the subprime mortgage market and they’ve put all their money on the fact—money which they were prepared to lose right from the start.

When their Bear Stearns CDS salesman mentioned that the Las Vegas annual subprime mortgage market conference would be on soon


and Bear Stearns was offering “a special outing for its customers, at a Vegas firing range” Charlie, son of anti-gun New York liberals and consequently ignorant of anything to do with weapons, went along in the hope of having someone explain why Cornwall Capital’s bet on the collapse of the subprime mortgage market was misplaced.  

ML/136 Chapter Six

January 28, 2007: Steve Eisman “turned up ... at the swanky Bali Hai Golf Club in Las Vegas dressed in gym shorts, t-shirt, and sneakers ...” i.e., “wearing something that violated the Wall Street golfer’s [sic] notion of propriety.” When Vinnie and Danny, embarrassed beyond belief, convinced Eisman to don the appropriate attire, he merely covered up the whole outfit with a hoodie and then proceeded to


play the game like one “bent on lampooning a sacred ritual.”  

From the golf course they went to Deutsche Bank’s Greg Lippmann organised dinner at the Wynn hotel. Lippmann was under pressure from his superiors because of the massive layout in CDS premiums. There was suspicion that the subprime mortgage market was somehow rigged by Wall Street to ensure that the


CDSs could never pay off.

Lippmann had seated each fund manager who’d shorted the subprime mortgage bond market with investors who were long on the same bet. He had done so in order for those fund managers shorting the market to see at close hand just how stupid those on the long side of the bet were—and that way he’d be able to persuade the Eisman’s of this world to stay the course and not pull the plug on Lippmann’s strategy of shorting the market, would not sell him down the river to his superiors, that is. Vinnie and Danny, for example, aware that they knew the subprime market and aware, too, that they were right to bet against that market, that sooner or later it would go bad, were never convinced that they had not somehow been conned by Lippmann and his type.

Eisman was able to ask questions of Wing Chau, a CDO manager. Eisman and his partners had never imagined there could be such a role, since there was nothing to manage.


Danny Moses learned all he needed to from this Lippmann organised get together: wing Chau and his type were suckers, fools who knew nothing but were smug in their recently newly found wealth in the subprime mortgage bond industry and these were the types who were purchasing subprime CDOs, who were on the long side of the bet. Danny and Vinnie were happy to discover the fact, and kept their counsel. Unfortunately, Eisman would not, they feared: he’d think Chau a fool and let him know it and that would be the end of the game. They needed Chau types to pick up the other side, the long side, of their trades.


That dinner became the focal point of Eisman’s subsequent account of the whole subprime storyline.  Eisman recognised for the first time that night that “this ship of doom was piloted by Wing Chau and people like him. The guy controlled roughly $15 billion, investing in nothing but CDOs backed by the triple-B tranche of a mortgage bond, or, as Eisman put it, ‘the equivalent of three layers of dog shit lower than the original bonds.’ ” They had taken over from AIG—which had exited the market, [presumably at the behest of Gene Park].

Wing Chau was “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.” Wing Chau, that is to say, was the “man who had made it possible for tens of thousands  


of actual human beings to be handed money they could never afford to repay.”

FrontPoint Partners’ Eisman was staggered to learn that Wing Chau, though, was not on the hook as the housing market steadily fell because, as he said to Eisman over dinner “I’ve sold everything out.”

To whom? To those world financial institutions—“German banks, Taiwanese insurance companies, Japanese farmers’ unions, European pension funds,” [Australian local government councils]—which must invest only in triple-A rated bonds. And since a triple-A rated mortgage bond should require no due diligence on the part of the purchaser (because it’s rating virtually guarantees that it cannot go bad) being a CDO manager was a money maker’s dream come true: there was nothing to do other than rake in the money, and be sure to pass on the risk to those who invest in the highly rate CDOs.

“The whole point of the CDO was [for Wall Street] 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.”


ML/207 [tiba]

“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.”




[1] Michael Lewis, The Big Short: Inside the Doomsday Machine, 1st ed. (New York: W.W. Norton, 2010), 6.