The Big Short: Inside the Doomsday Machine

Howie Hubler, a big, brawny, loud bond trader, directs Morgan Stanley’s asset-backed bond desk, which includes subprime mortgage bonds. The desk purchases mortgages and warehouses them until they can be bundled and sold as bonds. In 2003, Morgan Stanley develops a credit default swap on subprime bonds to protect Hubler’s bond traders: “By design they were arcane, opaque, illiquid, and thus conveniently difficult for anyone but Morgan Stanley to price” (201).

In late 2004, Hubler begins to question the safety of some of the subprime bonds; his team invents a credit default swap that pays off the entire bond if merely a few of the mortgages within that bond default. This swap “amounted to home insurance on a house designated for demolition” (202): it’s almost certain to pay off.

But who would be stupid enough to back such a bet? Hubler finds enough foolish investors, especially in Germany, to insure $2 billion of swaps. This ends when Burry and Lippmann campaign for standardized, openly traded default swaps, which make transparent the rates and risks involved.

Hubler still wants to bet against subprime bonds, so Morgan Stanley lets him set up a hedge fund inside the bank that buys more default swaps. Hubler must continue to earn $2 billion a year for the company, but the swaps he has bought eat into that profit, so he sells swaps on CDOs to pay off the difference.

Now effectively betting against himself, Hubler hopes his original swaps purchases will pay off better than the losses he’ll suffer from the later swaps he has sold. But many of the CDOs Hubler is now insuring are the same fraudulently AAA-rated ones bet against by Cornwall and Eisman’s team: “He was smart enough to be cynical about his market but not smart enough to realize how cynical he needed to be” (206).

Hubler’s bets assume that fewer than six percent of the mortgages in his bonds will go bad. In 2007, upper management, nervous about recent developments in the subprime market, asks “what would become of their bet if mortgage defaults reached 10 percent” (211). Reluctantly, Hubler’s team responds that their investment would go “from a projected profit of $1 billion into a projected loss of $2.7 billion” (212). Executives are upset but are reassured: “Relax, they said, those kinds of losses will never happen” (212). As it turns out, losses will reach 40 percent.

In July, Deutsche Bank’s Lippmann—who controls credit default swaps sold to him by Morgan Stanley—calls Hubler to tell him the swaps "had moved in Deutsche Bank’s favor […] ‘Dude, you owe us one point two billion’” (212). Hubler disagrees. After some haggling, Deutsche Bank receives $600 million.

In the coming months, things get worse, and what Hubler owes Lippmann keeps getting bigger. Each time Lippmann calls, they argue and haggle. Deutsche Bank begins to realize that Hubler’s team “genuinely failed to understand the nature of the subprime CDO” (214) and its hidden risky mortgages: “When one collapsed, they all collapsed, because they were all driven by the same broader economic forces” (214).

In October 2007, Hubler resigns, leaving behind a $9 billion loss, “the single largest trading loss in the history of Wall Street” (215). Other banks begin to get into trouble, including Bear Stearns, which holds the contracts on Cornwall’s credit default swaps. Jamie, Charlie, and Ben worry that Bear Stearns might go broke and be unable to pay their debts to Cornwall.

By early August, the big downturn in the subprime bond market makes many banks desperate to buy default insurance. Ben unloads Cornwall’s credit default swaps, originally worth $1 million, to the banks for $80 million: “They had not been the chumps at the table. The long shot had paid 80:1” (222).

Michael Burry’s Scion fund sells its credit default swaps at enormous markups: “By the end of the year, in a portfolio of less than $550 million, he would have realized profits of more than $720 million” (223). No one thanks him. To one investor who had tried to sue him, he sends an email that says simply: “You’re welcome” (223).

As 2007 closes, Eisman “had doubled the size of their fund, from a bit over $700 million to $1.5 billion” (227). Now he begins hectoring bank CEOs about their overly leveraged positions. Some investment banks, chasing ever more investment opportunities, have borrowed 25 to 40 times their cash on hand: “To bankrupt any of these firms, all that was required was a very slight decline in the value of their assets” (228).

On March 14, 2008, Eisman lectures a group of financiers on the perils of investing within the current financial house of cards: “But as he spoke a Wall Street investment bank was failing” (233). Bear Stearns’ stock in 30 minutes plummets from $53 a share to $29. The following Monday, J.P.Morgan bank acquires the remains of Bear Stearns for $10.

In mid-September, Lehman Brothers goes bankrupt, Merrill Lynch announces $52 billion in losses and is sold to Bank of America, and the U.S. government loans AIG $85 billion to cover its losses on credit default swaps. Money market funds decline. The stock market drops “to its lowest level in four years” (238).

On September 18, Bank stocks plunge. Eisman’s group has shorted many of them: “Minutes after the market opened they were up $10 million” (239). The market goes into free fall; despite their wins, Danny is alarmed: “I’m supposed to know how to transmit information. Prices were moving so quickly I couldn’t get a fix. It felt like a black hole” (239). Danny thinks he’s having a heart attack and asks to be taken to the hospital.

The Cornwall team feels equally stunned. They fear their earnings may be hard to preserve, given all the banking chaos: “Charlie and Jamie had always sort of assumed that there was some grown-up in charge of the financial system whom they had never met; now, they saw there was not” (244).

The government steps in “to say it would, in effect, absorb all the losses in the financial system and prevent any big Wall Street firm from failing” (247). Burry—whose Scion fund had gone up by nearly 500 percent since its inception—finally begins buying stocks. Despite his enormous success, Burry is ignored in the press and still disparaged by his own investors. Stress overwhelms him; he closes the fund: “What had happened was that he had been right, the world had been wrong, and the world hated him for it” (247).

Author Michael Lewis meets with his old Salomon Brothers boss, John Gutfreund, for lunch and to discuss the recent financial catastrophe. Lewis had been less than flattering to Gutfreund in his first book, Liar’s Poker—which dissects the early, tumultuous years of mortgage bond trading in the 1980s—but Gutfreund “could not have been more polite, or more gracious” (255).

They agree that greed has driven the decisions that lead to the market crash, but Lewis also believes bad incentives have something to do with it. He notes that “pretty much all the important people on both sides of the gamble left the table rich” (256), including bank CEOs and salesmen like Hubler: “What are the odds that people will make smart decisions about money if they don’t need to make smart decisions—if they can get rich making dumb decisions? The incentives on Wall Street were all wrong” (257).

Lewis also believes that when Gutfreund in the early 1980s transforms Salomon Brothers into a public corporation, he begins a process that causes investment banks to become “a black box” (258) that takes chances with other people’s money: “No investment bank owned by its employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs” (258).

When the government steps in, it props up most of the banks: “The people in a position to resolve the financial crisis were, of course, the very same people who had failed to foresee it” (260), including the bank CEOs, most of whom retain their jobs. Lewis continues: “They had proven far less capable of grasping basic truths in the heart of the U.S. financial system than a one-eyed money manager with Asperger’s syndrome” (260).

In late September 2008, Congress passes the Troubled Asset Relief Program (TARP) to shore up subprime bonds. The focus, however, is on propping up the investment banks themselves. At one point the Treasury Department “simply guaranteed $306 billion of Citigroup’s assets,” an amount that’s “nearly 2 percent of U.S. gross domestic product” (261).

The U.S. Federal Reserve begins buying subprime bonds from the banks. By early 2009, over $1 trillion of bad securities are transferred to the government: “Every major firm on Wall Street was either bankrupt or fatally intertwined with a bankrupt system” (262), yet most survive, mainly from government handouts.

Eisman believes the risks are still there. Bank managers have been “entirely discredited,” yet they end up rich; “free money for capitalists, free markets for everyone else” (262) teaches the wrong lessons.

The government, however, must consider larger factors. The failure of, for example, Citigroup would set off huge swings in the economy, gyrations of uncertain dimension because an unknown number of credit default swaps would be triggered: “This was yet another consequence of turning Wall Street partnerships into public corporations: It turned them into objects of speculation” (263).

Gutfreund agrees, in retrospect, that converting investment bank partnerships into corporations shifts the risk onto shareholders: “‘When things go wrong it’s their problem,’ he said” (263). It also becomes a problem for the American government.

The US Congress looks into the financial crash, but it doesn’t trust the main players, so it turns to the first edition of the book The Big Short and its author Michael Lewis, who is called to speak several times before Congressional committees.

A few people write to Lewis to complain about their portrayal in the book. Among them is Joel Greenblatt, whose Gotham Partners invests heavily in Michael Burry’s Scion fund and gets into conflict with Burry over his investment decisions. Greenblatt explains that “he only asked for his money back from Michael Burry because his own investors were asking for their money back and he needed to get it from somewhere” (264).