This is a fairly long and intense read but very well worth it. For an in-depth and fascinating look at the real game that played out to become the most major economic crisis of our times, this will give readers some very interesting background. And no one will ever again be able to tell you that it was not pre-meditated, nor that it was not known, and seen, well ahead of time. Grab a cup of your favorite beverage and settle in for a fascinating inside look at how we got to where we are…
‘The Wall Street CEOs were on the wrong end of the gamble, they bankrupted their firms… Yet they got rich, too.’ Illustration: Nick Lowndes
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 24, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. 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 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.
When I sat down to write my account of the experience – Liar’s Poker – it was in the spirit of a young man who thought he was getting out while the getting was good. 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. 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.
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. That a single bond trader might be paid $47m a year and feel cheated. That the mortgage bond market invented on the Salomon Brothers trading floor, which seemed like such a good idea at the time, would lead to the most purely financial economic disaster in history.
In the two decades after I left, I waited for the end of Wall Street as I had known it. Yet the big banks at the centre of it just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. At some point, I gave up waiting. There was no scandal or reversal, I assumed, sufficiently great to sink the system.
Then came Meredith Whitney, with news. Whitney was an obscure analyst of financial firms for Oppenheimer & Co who, on 31 October 2007, ceased to be obscure. On that day she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. By the end of the trading day, a woman of whom no one had ever heard had shaved 8% off the shares of Citigroup and $390bn off the value of the US stock market. Four days later, Citigroup CEO Chuck Prince resigned. Two weeks later, Citigroup slashed its dividend. From that moment, when Meredith Whitney spoke, people listened.
I confess some part of me thought, if only I’d stuck around, this is the sort of catastrophe I might have created. The characters at the centre of Citigroup’s mess were the very same people I’d worked with at Salomon Brothers; a few of them had been in my training class there. At some point I couldn’t contain myself: I called Whitney. This was back in March 2008, just before the failure of Bear Stearns, when the outcome still hung in the balance. I was curious to know where this young woman who was crashing the stock market with her every utterance had come from.
She’d arrived on Wall Street in 1994, landed a job at Oppenheimer & Co and then had the most incredible piece of luck: to be trained by a man who helped her to establish not merely a career but a world-view. His name, she said, was Steve Eisman.
Having never heard of Eisman, I didn’t think anything of this. But in late 2008, when the biggest Wall Street investment banks were under threat from the fallout over sub-prime mortgages – loans made to borrowers who don’t qualify for ordinary mortgages, and so have a higher risk of default – I called Whitney again. By then, there was a long and growing list of pundits who claimed they had predicted the catastrophe, but a far shorter list of people who actually did. Of those, even fewer had the nerve to bet on their vision. I wanted to ask Whitney, as I was asking others, if she knew anyone who had anticipated the sub-prime mortgage cataclysm, thus setting himself up in advance to make a fortune from it.
Whitney rattled off a list with a half-dozen names on it, mainly investors she had personally advised. At the top was Steve Eisman.
Eisman entered finance about the time I exited it. He’d grown up in New York City, graduated with honours from Harvard Law School. In 1991 he was a 30-year-old corporate lawyer. “I hated it,” he says. “My parents worked as brokers at Oppenheimer securities. They managed to finagle me a job. It’s not pretty, but that’s what happened.”
Eisman started in equity analysis, and quickly established himself as one of the few analysts at Oppenheimer whose opinions might stir the markets. Wall Street people came to view him as a genuine character. His short-cropped blond hair looked as if he had cut it himself. The focal point of his soft, expressive, not unkind face was his mouth, mainly because it was usually at least half open, even while he ate. It was as if he feared that he might not be able to express whatever thought had just flitted through his mind quickly enough before the next one came, and so kept the channel perpetually clear. It was the opposite of a poker face.
The growing number of people who worked for Eisman loved him, or were at least amused by him, and appreciated his willingness and ability to part with both his money and his knowledge. Important men who might have expected from Eisman some sign of deference or respect, on the other hand, often came away outraged from encounters with him. One head of a large US brokerage firm listened to Eisman explain in front of several dozen investors at lunch why he, the brokerage firm head, didn’t understand his own business, then watched him leave in the middle of the lunch and never return. (“I had to go to the bathroom,” Eisman says. “I don’t know why I never went back.”) After the lunch, the guy announced he’d never again agree to enter any room with Eisman in it.
By pretty much every account, Eisman was a curious character. And he’d walked on to Wall Street at the very beginning of a curious phase. The creation of the mortgage bond market, a decade earlier, had extended Wall Street into a place it had never before been: the debts of ordinary Americans. And Oppenheimer quickly became one of the leading bankers to the new sub-prime mortgage industry, in no small part because Eisman was one of its leading proponents. “I took a lot of sub-prime companies public,” he says. “And the story they liked to tell was, ‘We’re helping the consumer, because we are taking him out of his high interest rate credit card debt and putting him into lower interest rate mortgage debt.’ And I believed that story.” Then something changed.
Vincent Daniel had grown up in Queens, without any of the perks Steve Eisman took for granted. Yet if you met them you might guess that it was Vinny who had grown up in high style. Eisman was brazen and grandiose and focused on the big kill. Vinny was careful and wary and interested in details. His father had been murdered when he was a small boy and he viewed his fellow man with intense suspicion. It was with the awe of a champion speaking of an even greater champion that Eisman said, “Vinny is dark.”
Vinny’s résumé made its way to Eisman, who was looking for someone to help him parse the increasingly arcane sub-prime mortgage accounting. They’d met twice when Eisman phoned him out of the blue. Vinny assumed he was about to be offered a job, but soon after they started to talk, Eisman received an emergency call on the other line and put Vinny on hold. Vinny sat waiting for 15 minutes, but Eisman never came back on the line.
Two months later, Eisman called him back. When could Vinny start? Eisman never said why he’d hung up, but Vinny soon found his own explanation: when he’d picked up the other line, Eisman had been informed that his first child, a newborn son named Max, had died. His wife Valerie, sick with the flu, had been awakened by a night nurse, who informed her that she, the night nurse, had rolled on top of the baby in her sleep and smothered him.
A decade later, the people closest to Eisman would describe this as an event that changed his relationship to the world around him. He was about to become noticeably more negatively disposed, in ways that, from the point of view of his employer, were financially counterproductive. “It was like he’d smelled something,” Vinny said. “And he needed my help figuring out what it was.”
To sift every pool of sub-prime mortgage loans took Vinny six months, but when he was done he came out of the room and gave Eisman the news. All these sub-prime lending companies were growing so rapidly, and using such opaque accounting, that they could mask the fact that they had no real earnings, just illusory, accounting-driven ones.
Eisman published his report in September 1997, in the middle of what appeared to be one of the greatest economic booms in US history, trashing all of the sub-prime originators. Less than a year later, Russia defaulted and a hedge fund called Long-Term Capital Management went bankrupt. In the subsequent flight to safety, the early sub-prime lenders were denied capital and promptly went bankrupt en masse.
That was the moment it first became clear that Eisman wasn’t just a little cynical. He held in his head a picture of the financial world that was radically different from, and less flattering than, the financial world’s self-portrait. A few years later, he quit his job and went to work for a giant hedge fund called Chilton Investment, but found himself relegated to his old role of analysing companies for the guy who made the investment decisions. He hated it, but in doing it he learned something that prepared him uniquely for the crisis that was about to occur. He learned what was really going on inside the market for consumer loans.
The year was now 2002. There were no public sub-prime lending companies left in America. There was, however, an ancient consumer lending giant called Household Finance Corporation. In early 2002 Eisman got his hands on Household’s new sales document offering home equity loans. A big source of Household’s growth had been the second mortgage. The document took the stream of payments the homeowner would make to Household over 15 years, spread it hypothetically over 30 years, and asked: if you were making the same payments over 30 years that you are in fact making over 15, what would your “effective rate” of interest be? The borrower was told he had an “effective interest rate of 7%” when he was in fact paying something like 12.5%. “They were tricking their customers,” Eisman says.
In his youth, Eisman had been a strident Republican. Now he was on his way to becoming the financial market’s first socialist. “I realised there was an entire industry, called consumer finance, that basically existed to rip people off.”
Denied the chance to manage money by his hedge fund employer, Eisman quit and, in 2004, started his own hedge fund. An outfit called FrontPoint Partners, owned by Morgan Stanley, housed a collection of hedge funds. Eisman attracted people whose views of the world were as shaded as his own. Vinny came right away. Porter Collins, who’d worked with Eisman at Chilton Investment, came along, too. Danny Moses, who had worked as a salesman at Oppenheimer & Co and had memories of Eisman doing and saying all sorts of things that analysts seldom did, came third.
By early 2005, the sub-prime mortgage machine was up and running again. If the first act of sub-prime lending had been freaky, this second act was terrifying. $30bn was a big year for sub-prime lending in the mid-1990s. In 2005 there would be $625bn in sub-prime mortgage loans, $507bn of which found its way into mortgage bonds. Even more shocking was that the terms of the loans were changing in ways that increased the likelihood they would go bad. Back in 1996, 65% of sub-prime loans had been fixed-rate. By 2005, 75% were some form of floating rate, usually fixed for the first two years.
By the time Greg Lippmann, the head sub-prime guy at Deutsche Bank, turned up in the FrontPoint conference room, in February 2006, Steve Eisman knew enough about the bond market to be wary. Lippmann’s aim was to sell Eisman on what he claimed was his own original brilliant idea for betting against – or short selling – the sub-prime mortgage bond market.
Eisman didn’t understand. Lippmann wasn’t even a bond salesman; he was a bond trader: “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’” But Lippmann made his case with a long and involved presentation: over the last three years, housing prices had risen far more rapidly than they had over the previous 30; they had not yet fallen but they had ceased to rise; even so, the loans against them were now going sour in their first year at amazing rates.
He showed Eisman this little chart that illustrated an astonishing fact: since 2000, people whose homes had risen in value between 1% and 5% were nearly four times more likely to default on their home loans than people whose homes had risen in value more than 10%. Millions of Americans had no ability to repay their mortgages unless their houses rose dramatically in value, which enabled them to borrow even more. That was the pitch in a nutshell: home prices didn’t even need to fall; they merely needed to stop rising at the unprecedented rates they had been for vast numbers of Americans to default on their home loans.
Lippmann’s presentation was just a fancy way to describe the idea of betting against US home loans: buying credit default swapson the crappiest sub-prime mortgage bonds. The beauty of the credit default swap, or CDS, was that it solved the timing problem. Eisman no longer needed to guess exactly when the sub-prime mortgage market would crash. It also allowed him to make the bet without laying down cash up front, and put him in a position to win many times the sums he could possibly lose. Worst case: insolvent Americans somehow paid off their sub-prime mortgage loans, and you were stuck paying an insurance premium of roughly 2% a year for as long as six years – the longest expected life span of the putatively 30-year loans.
Eisman could imagine very little that would give him so much pleasure as going to bed each night, possibly for the next six years, knowing he was shorting a financial market he’d come to know and despise, and was certain would one day explode.
In the summer of 2006, house prices peaked and began to fall. For the entire year they would fall, nationally, by 2%. By that autumn, Lippmann had made his case to hundreds more investors. Yet only 100 or so dabbled in the new market for credit default swaps on sub-prime mortgage bonds. A smaller number of people still – more than 10, fewer than 20 – made a straightforward bet against the entire multi-trillion-dollar sub-prime mortgage market and, by extension, the global financial system. The catastrophe was foreseeable, yet only a handful noticed.
Each of those who did told you something about the state of the financial system, in the same way that people who survive a plane crash tell you something about the accident. All of them were, almost by definition, odd. John Paulson, who had the most money to play with, was oddly interested in betting against dodgy loans, and oddly persuasive in talking others into doing it with him. Eisman was odd in his conviction that the leveraging of middle-class America was a corrupt and corrupting event. At the annual sub-prime conference that year, Eisman walked around the Venetian hotel in Las Vegas – with its penny slots and cash machines that spat out $100 bills – and felt depressed. It was overrun by thousands of white men now earning their living, one way or another, off sub-prime mortgages.
Later, whenever Eisman set out to explain to others the origins of the financial crisis, he would start with what he learned in Las Vegas. He’d draw a picture of several towers of debt. The first tower was the original sub-prime loans that had been piled together. At the top of this tower was the safest triple-A rated tranche, just below it the double-A tranche, and so on down to the riskiest, triple-B tranche – the bonds Eisman had bet against. The Wall Street firms had taken these triple-B tranches – the worst of the worst – to build yet another tower of bonds: a collateralised debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults, and was now being rejigged to disguise the risk of sub-prime mortgage loans.
It was in Vegas that Eisman finally understood the madness of the machine. He’d been making these side bets with major investment banks on the fate of the triple-B tranche of sub-prime mortgage-backed bonds without fully understanding why those firms were so eager to accept them. Now he got it: the credit default swaps, filtered through the CDOs, were being used to replicate bonds backed by actual home loans. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. Wall Street needed his bets in order to synthesise more of them. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses in the financial system are so much greater than just the sub-prime loans. That’s when I realised they needed us to keep the machine running. I was like, This is allowed?”
It was in Las Vegas that Eisman and his associates’ attitude toward the US bond market hardened into something like its final shape. The question lingering at the back of their minds ceased to be, do these bond market people know something we do not? It was replaced by, do they deserve merely to be fired, or should they be put in jail? Are they delusional, or do they know what they’re doing?
On the surface, these big Wall Street firms appeared robust; below the surface, Eisman was beginning to think, their problems might not be confined to a potential loss of revenue. He’d go to meetings with Wall Street CEOs and ask them the most basic questions: “They didn’t know their own balance sheets.”
In the murky period from early February to June 2007, the sub-prime mortgage market resembled a giant helium balloon, bound to earth by a dozen or so big Wall Street firms. Each firm held its rope; each gradually realised that no matter how strongly they pulled, the balloon would eventually lift them off their feet. One by one, they silently released their grip.
JP Morgan had abandoned the market by late autumn 2006. Deutsche Bank had always held on tenuously. Goldman Sachs was next, and did not merely let go, but turned and made a big bet against the sub-prime market – further accelerating the balloon’s fatal ascent. When its sub-prime hedge funds crashed in June, Bear Stearns was forcibly severed from its line – and the balloon drifted farther from the ground. By the end of 2007, FrontPoint’s bets against sub-prime mortgages had paid off so spectacularly that they had doubled the size of their fund, from a bit over $700m to $1.5bn.
On the morning of 14 March 2008, Eisman was invited at short notice to address a roomful of big investors at Deutsche Bank’s Wall Street HQ. By then his expertise had become a poorly kept secret. He was scheduled to precede the retired chairman of the Federal Reserve, Alan Greenspan.
All around him men hunched over their BlackBerrys. They wanted to hear what Eisman had to say, but the stock market was distracting them from the show. At 9.13am, as Eisman was finding his place at the front of the room, Bear Stearns announced that it had taken a loan from JP Morgan. While Eisman was explaining why the financial world was going to blow up, his audience was only half-listening, because the financial world was blowing up. By the time Greenspan arrived to speak, the audience was gone. By the Monday, Bear Stearns was, of course, gone, too, sold to JP Morgan for $2 a share.
In September 2008, I had lunch with my old boss, John Gutfreund. I’d not seen him since I quit Wall Street, but I knew that after he’d been forced to resign from Salomon Brothers, he’d fallen on harder times.
We spent 20 or so minutes catching up. We discovered a mutual friend. We agreed that the Wall Street CEO had no real ability to keep track of the frantic innovation occurring inside his firm (“I didn’t understand all the product lines and they don’t either”). We agreed, further, that the CEO had shockingly little control over his subordinates (“They’re buttering you up and then doing whatever the fuck they want to do”). He thought the cause of the financial crisis was “simple. Greed on both sides – greed of investors and the greed of the bankers.” I thought it was more complicated. Greed on Wall Street was a given. The problem was the system of incentives that channelled the greed.
In this case, pretty much all the important people on both sides had left the table rich. Eisman, and those few figures who took a similar gamble, each made tens of millions of dollars for themselves, of course. But the CEOs of every major Wall Street firm were on the wrong end of the gamble. All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the US government. They all got rich, too. What are the odds that people will make smart decisions about money if they can get rich making dumb decisions? But I didn’t want to argue with my old boss.
“Why did you ask me to lunch?” he asked.
You can’t really tell someone that you asked him to lunch to let him know that you didn’t think of him as evil. Nor can you tell him that you thought you could trace the biggest financial crisis in the history of the world back to a decision he had made. Gutfreund had done violence to the Wall Street social order – and got himself dubbed the King of Wall Street – when, in 1981, he’d turned Salomon Brothers from a private partnership into Wall Street’s first public corporation. He’d ignored the outrage of Salomon’s retired partners. (“I was disgusted by his materialism,” says William Salomon, the son of one of the firm’s founders, who had made Gutfreund CEO only after he’d promised never to sell the firm.)
The moment Salomon Brothers demonstrated the potential gains to be had from turning an investment bank into a public corporation and leveraging its balance sheet with exotic risks, the psychological foundations of Wall Street shifted, from trust to blind faith. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders.
The people in a position to resolve the financial crisis were, of course, the very same people who had failed to foresee it. A few Wall Street CEOs had been fired, but most remained in their jobs and they, of all people, became important characters operating behind the closed doors, trying to figure out what to do next.
By late September 2008, the nation’s highest financial official, US treasury secretary Henry Paulson, persuaded the US Congress that he needed $700bn to buy sub-prime mortgage assets from banks. Once handed the money, he instead essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs and a few others unnaturally selected for survival.
By then it was clear that $700bn was a sum insufficient to grapple with the troubled assets acquired over the previous few years by Wall Street bond traders. That’s when the US Federal Reserve took the shocking and unprecedented step of buying bad sub-prime mortgage bonds directly from the banks. By early 2009 the risks and losses associated with more than $1tn worth of bad investments were transferred from big Wall Street firms to the US taxpayer. The events on Wall Street in 2008 were soon reframed as a simple, old-fashioned financial panic, triggered by the failure of Lehman Brothers.
Combing through the rubble of the avalanche, Gutfreund’s decision to turn the Wall Street partnership into a public corporation looked a lot like the first pebble kicked off the top of the hill. “Yes,” he said. “They – the heads of the other Wall Street firms – all said what an awful thing it was to go public and how could you do such a thing. But when the temptation rose, they all gave in to it.” He agreed, though: the main effect was to transfer the financial risk to the shareholders.
“When things go wrong, it’s their problem,” he said – and obviously not theirs alone. When the Wall Street investment bank screwed up badly enough, its risks became the problem of the US government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game. It was now all someone else’s fault.
He watched me curiously as I scribbled down his words. “What’s this for?” he asked. I told him I thought it might be worth revisiting the world I’d described in Liar’s Poker, now it was finally dying. Maybe bring out a 20th anniversary edition.
“That’s nauseating,” he said.
Hard as it was for him to enjoy my company, it was harder for me not to enjoy his: he was still tough, straight and blunt as a butcher. He’d helped to create a monster, but he still had in him a lot of the old Wall Street, where people didn’t walk out of their firms and cause trouble for their former bosses by writing a book about them. “No,” he said, “I think we can agree about this: your fucking book destroyed my career and it made yours.” With that, the former king of a former Wall Street lifted the plate that held his appetiser and asked, sweetly, “Would you like a devilled egg?”
Until that moment I hadn’t paid much attention to what he’d been eating. Now I saw he’d ordered the best thing in the house, this gorgeous, frothy confection of an earlier age. Who ever dreamed up the devilled egg? Who knew that a simple egg could be made so complicated, and yet so appealing? I reached over and took one. Something for nothing. It never loses its charm.
• This is an edited extract from The Big Short: Inside The Doomsday Machine, by Michael Lewis, published by Allen Lane at £25. To order a copy for £23, with free UK mainland p&p, go to guardian.co.uk/bookshop or call 0330 333 6846.
