LEWIS, Michael
The Big Short
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In early 2004 a 32-year-old stock-market investor and hedge-fund manager, 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, or bet against, 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 bond was its own little corporation. Burry spent the end of 2004 and early 2005 scanning hundreds and actually reading dozens of the prospectuses, 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 10kWizard.com.
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 “A.B.S.,” or “asset-backed security.” If you asked Deutsche Bank exactly what assets secured an asset-backed security, you’d be handed lists of more acronyms—R.M.B.S., hels, helocs, Alt-A—along with categories of credit you did not know existed (“midprime”). R.M.B.S. 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 subprime-mortgage loans for which they hadn’t even bothered to acquire the proper documents—to, say, verify the borrower’s income. All of this could more clearly be called “subprime loans,” but the bond market wasn’t 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. Inside Oakland 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.”
But 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 homebuyer, 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 financial 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 bonds, 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 homebuilding 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 periodic premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a 10-year credit-default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for 10 years. The most you could make was $100 million, if General Electric defaulted on its debt anytime in the next 10 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 30, 40, even 50 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 pulled down, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit-default swaps on subprime-mortgage bonds.
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Liar’s Poker
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Take a typical three-hundred-million-dollar CMO. It would be divided into three tranches, or slices of a hundred million dollars each. Investors in each tranche received interest payments. But the owners of the first tranche received all principal repayments from all three hundred million dollars of mortgage bonds held in trust. Not until first tranche holders were entirely paid off did second tranche investors receive any prepayments. Not until both first and second tranche investors had been entirely paid off did the holder of a third tranche certificate receive prepayments.”
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At the very least, a mortgage had to be pooled with other mortgages of other homeowners. Traders and investors would trust statistics and buy into a pool of several thousand mortgage loans made by a Savings and Loan, of which, by the laws of probability, only a small fraction should default. Pieces of paper could be issued that entitled the bearer to a pro-rata share of the cash flows from the pool, a guaranteed slice of a fixed pie. There could be millions of pools, each of which held mortgages with particular characteristics, each pool in itself homogeneous. It would hold, for example, home mortgages of less than one hundred and ten thousand dollars paying an interest rate of 12 per cent. The holder of the piece of paper from the pool would earn 12 per cent a year on his money plus his share of the repayments of principal from the homeowners. Thus standardised, the pieces of paper could be sold to an American pension fund, to a Tokyo trust company, to a Swiss bank, to a tax-evading Greek shipping tycoon living in a yacht in the harbour of Monte Carlo, to anyone with money to invest. Thus standardised, the pieces of paper could be traded. All the trader would see was the bond. All the trader wanted to see was the bond. A bond he could whip and drive. A line which would never be crossed could be drawn down the centre of the market. On one side would be the homeowner, on the other, investors and traders. The two groups would never meet; this is curious in view of how personal it seems to lend a fellow man the money to buy his home. The homeowner would only see his local Savings and Loan manager from whom the money came, and to whom it was, over time, returned. Investors and traders would see paper.
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Many thrifts layered a billion dollars of brand-new loans on top of their existing, disastrous hundred million dollars of old loss-making loans, in a hope that the new would offset the old. Each new purchase of mortgage bonds (which was identical to making a loan) was like the last act of a desperate man. The strategy was wildly irresponsible, for the fundamental problem (borrowing short term and lending long term) hadn’t been remedied. The hypergrowth only meant that the next thrift crisis would be larger. But the thrift managers were not thinking that far in advance. They were simply trying to keep the door to the shop open. That explains why thrifts continued to buy mortgage bonds even as they sold their loans.
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Moneyball
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Anti-intellectual resentment is common in all of American life and it has many diverse expressions,
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What begins as a failure of the imagination ends as a market inefficiency: when you rule out an entire class of people from doing a job simply by their appearance, you are less likely to find the best person for the job.
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The statistics were not merely inadequate; they lied. And the lies they told led the people who ran major league baseball teams to misjudge their players, and mismanage their games. James later reduced his complaint to a sentence: fielding statistics made sense only as numbers, not as language. Language, not numbers, is what interested him. Words, and the meaning they were designed to convey. “When the numbers acquire the significance of language,” he later wrote, “they acquire the power to do all of the things which language can do: to become fiction and drama and poetry….And it is not just baseball that these numbers, through a fractured mirror, describe. It is character. It is psychology, it is history, it is power, it is grace, glory, consistency, sacrifice, courage, it is success and failure, it is frustration and bad luck, it is ambition, it is overreaching, it is discipline. And it is victory and defeat, which is all that the idiot sub-conscious really understands.
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