The Outsiders Who Foresaw The Subprime Crisis

'The Big Short' is the story of several people who foresaw the subprime mortgage debacle. i i

Michael Lewis' The Big Short is the story of several people who saw through the subprime mortgage debacle and bet against it. Tabitha Soren hide caption

itoggle caption Tabitha Soren
'The Big Short' is the story of several people who foresaw the subprime mortgage debacle.

Michael Lewis' The Big Short is the story of several people who saw through the subprime mortgage debacle and bet against it.

Tabitha Soren

Nearly the whole financial system bought into subprime mortgages and the securities that were backed by them — and amounted to bundles of bad debt.

In his new book, The Big Short, Michael Lewis writes about people who didn't buy in. In fact, they bet against the colossal tower of debt that Wall Street built. They shorted it — and they profited from its eventual collapse.

For Lewis, The Big Short is his return to the scene of the crime. Twenty years ago, he wrote about his experience working as a young bond trader at Salomon Brothers. Liar's Poker was an astonishing tale of kids fresh out of Ivy League schools making huge decisions about other people's money with no qualifications for doing so.

By the time of the financial crisis, the generation he wrote about in Liar's Poker was established Wall Streeters, typically up to their eyeballs in mortgage-backed securities.

The people he writes about in The Big Short are outsiders by virtue of youth or personality.

Wall Street's Heroes And Demons

One of the characters in Lewis' latest Wall Street saga is an unlikely hero, Michael Burry. He's a young hedge fund manager based in San Jose, Calif., who has Asperger's syndrome.

The Big Short: Inside the Doomsday Machine
By Michael Lewis
Hardcover, 288 pages
W.W. Norton & Co.
List price: $27.95

Originally a neurologist, Burry quit being a doctor during his residency at Stanford Hospital because of a stock market blog he wrote in his spare time. One day, Burry posted a message saying that he was sick of medicine and he planned to go into investing. Two major stock market investors tracked him down to stake him to a business investing in the stock market.

Burry's track record over the next few years, Lewis tells NPR's Robert Siegel, was astonishing.

Discovering Disaster

Then Burry began to realize that the futures of several companies he was investing in turned on a weird lending market, the subprime mortgage bond market. So he started reading the prospectuses of subprime mortgage bond offerings. In the structure of the loans, Burry could see the future disaster. So he figured out how to use this knowledge to his advantage, and he became the first investor off Wall Street to make the big bet against them.

Burry went in so early that his investors thought he was crazy.

"He ends up feeling more cynical about Wall Street than anybody I've ever met because of his dealings with the Wall Street firms," Lewis says.

Because he didn't have much connection with people, everything Burry did was via e-mail. So Lewis says, in researching his book, he got to benefit from a perfect, real-time record of what was going on in these markets.

"The one guy that I could trust in the middle of this crisis was this fellow with Asperger's and a glass eye," he says "He became the moral center of this market for me because he was the most honest character."

Lewis profiles extreme characters — outsiders — who are the sane people in an insane world.

"You have this body of facts out there in the financial world, and the vast majority of the people in that world are organizing the facts into one kind of picture — and it's a pretty picture," he says. "And a handful of other people take the exact same facts, but they organize it into a different picture."

The people in Lewis's book were able to look at the situation in a different way.

And The Ugly

At the same time, only a handful of people had bad motives when it came to the crisis.

"More often than not, the people at the center of the doomsday machine were deluded themselves," Lewis says. "The problem isn't criminal behavior. ... The story of American capitalism in recent history is not really the story of Bernie Madoff."

Lewis says the story is one of bad incentives causing people to behave in bad — but legal — ways.

"The best thing we can do is focus our energies on how to create the rules that prevent people from enriching themselves while impoverishing the rest of us," Lewis says.

Course Of Action

Economic policymakers have acknowledged the disaster, but many say they're afraid of stifling innovation if they take action.

"In telling this story, I had my opinion of financial innovation changed," Lewis says. When he left Wall Street, Lewis thought that most of the innovation was leading to a smarter distribution of financial risk. But Lewis says since he left, innovation has run amok.

With the exception of a few people on Wall Street, investors would be better off if credit default swaps, for example, were never invented, Lewis says.

"The failure so far in the response to the crisis has not been the failure to lynch a few people," he says. "It's been failure to introduce some pretty obvious reforms."

The reason for that failure, Lewis says, is that financial crises move quickly while the political process moves slowly.

How A Few Made Millions Betting Against The Market

Michael Lewis i i

Michael Lewis is currently a contributing editor to Vanity Fair. Tabitha Soren hide caption

itoggle caption Tabitha Soren
Michael Lewis

Michael Lewis is currently a contributing editor to Vanity Fair.

Tabitha Soren
Big Short: Cover detail

Writer Michael Lewis is the author of Moneyball, Liar's Poker, and The Blind Side, books with vastly different subjects but a common theme: outsiders with innovative ideas who find astonishing success. Lewis' newest book continues that narrative. The Big Short: Inside the Doomsday Machine chronicles the 2008 financial collapse through stories of the people who realized what was happening to the U.S. economy while it was happening — and then made vast fortunes by betting against the markets.

"Everybody [on Wall Street] was working with the same set of facts about subprime mortgage lending — about how subprime mortgage loans were turned into bonds and repackaged and turned into CDOs and so on and so forth," Lewis tells Terry Gross. "[And] the vast majority of the people in the markets took those facts and painted one kind of picture with it; it was a very pleasant picture. And a very small handful of people took the same facts and painted a completely different kind of picture with it. [I wanted to find out] 'What is it that enables [the people who bet against the market] to paint that picture?' and 'Why do these people look at the world differently?' "

The Big Short: Inside the Doomsday Machine
By Michael Lewis
Hardcover, 288 pages
W. W. Norton & Co.
List price: $27.95

Read an Excerpt

Dr. Michael Burry

One of the most compelling stories Lewis tells in The Big Short follows a doctor, Michael Burry, who decided to leave his neurology residency after his investment blog attracted attention from money managers across the country. Burry started a hedge fund named Scion Capital, which, Lewis writes, was "madly, almost comically successful" — even when the Standard & Poors index fell.

While investigating stocks to invest for his customers, Burry discovered that the bond market was absorbing subprime mortgage loans in incredible volumes. Soon he realized that the millions of dollars of credit swirling around the market were artificially inflated and almost worthless.

Burry figured that he could bet against pools of these subprime mortgage loans using an instrument called a "credit default swap," essentially insurance on a corporate loan. Burry persuaded the investment banks to create credit default swaps for the subprime mortgage market.

"As the pools of loans that are underneath these bonds start to default," Lewis says, the investment banks that gambled on the subprime mortgage loans were forced to send Burry money daily as the bonds went bad. "Wall Street firms, they were on the other side of the bets."

Charles Ledley and Jaime Mai

Ledley and Mai were two guys in their early 30s who decided to start their own hedge fund with just over $100,000. They quickly made more than $15 million by betting on financial events that are extremely unlikely to occur — and therefore didn't cost much to bet against.

"They thought that Wall Street underestimated the likelihood of really unlikely events," Lewis says. "So they would buy options to buy stocks at prices far, far away from where the stocks were currently trading. They did this with currencies, they did it with commodities. They scoured the world, essentially looking to make bets on extreme things happening."

Web Extras

Listen to Michael Lewis and Terry Gross discuss the process of turning several of his books into movies.

Soon, Ledley and Mai stumbled into the subprime mortgage market and realized that they could bet against not only the loans but also the financial institutions themselves.

"They're able to piece together a clear picture of what's going on in a matter of months," Lewis says. "They become less interested in the bet than the social implications of what they're learning. They go to the SEC. They go to The Wall Street Journal. They're screaming at the top of their lungs, 'My God, there's fraud in the system.' "

By betting against subprime mortgages, Ledley and Mai's $15 million investment ballooned to $120 million. Soon, Ledley began to experience migraines and anxiety attacks.

"They were stressed about being right," Lewis says. "I think they were so stressed that they realized that this wasn't a bet against a company, this was a bet against an entire system. And it was a bet that arose from their insight that the system had become rigged — that, essentially, Wall Street had become a giant Ponzi scheme."

Lewis says the two men — like Dr. Burry — were able to see the failures of the market before the rest of the world did because they viewed the world differently.

"This is the story of human perception as much as it is anything else. And their attitude toward the financial markets was peculiar," Lewis says. "It was peculiar to be running around the world looking for unlikely things that might happen. ... And it told you something about Wall Street and ... the way the markets were functioning when they were dysfunctional. There weren't enough people thinking this way. There weren't enough people taking into account the real likelihood of extreme change in the world."

Excerpt: 'The Big Short'

The Big Short
The Big Short: Inside the Doomsday Machine
By Michael Lewis
Hardcover, 288 pages
W.W. Norton & Co.
List price: $27.95

LANGUAGE ADVISORY: This excerpt contains language some might find offensive.

Chapter One: A Secret Original Story

Eisman entered finance about the time I exited it. He'd grown up in New York City, gone to yeshiva schools, graduated from the University of Pennsylvania magna cum laude, and then with honors from Harvard Law School. In 1991 he was a thirty-year-old corporate lawyer wondering why he ever thought he'd enjoy being a lawyer. "I hated it," he says. "I hated being a lawyer. My parents worked as brokers at Oppenheimer securities. They managed to finagle me a job. It's not pretty but that's what happened."

Oppenheimer was among the last of the old-fashioned Wall Street partnerships and survived on the scraps left behind by Goldman Sachs and Morgan Stanley. It felt less like a corporation than a family business. Lillian and Elliot Eisman had been giving financial advice to individual investors on behalf of Oppenheimer since the early 1960s. (Lillian had created their brokerage business inside of Oppenheimer, and Elliot, who had started out as a criminal attorney, had joined her after being spooked once too often by midlevel Mafia clients.) Beloved and respected by colleagues and clients alike, they could hire whomever they pleased. Before rescuing their son from his legal career they'd installed his old nanny on the Oppenheimer trading floor. On his way to reporting to his mother and father, Eisman passed the woman who had once changed his diapers. Oppenheimer had a nepotism rule, however; if Lillian and Elliot wanted to hire their son, they had to pay his salary for the first year, while others determined if he was worth paying at all.

Eisman's parents, old-fashioned value investors at heart, had always told him that the best way to learn about Wall Street was to work as an equity analyst. He started in equity analysis, working for the people who shaped public opinion about public companies. Oppenheimer employed twenty-five or so analysts, most of whose analysis went ignored by the rest of Wall Street. "The only way to get paid as an analyst at Oppenheimer was being right and making enough noise about it that people noticed it," says Alice Schroeder, who covered insurance companies for Oppenheimer, moved to Morgan Stanley, and eventually wound up being Warren Buffett's official biographer. She added, "There was a counterculture element to Oppenheimer. The people at the big firms were all being paid to be consensus." Eisman turned out to have a special talent for making noise and breaking with consensus opinion. He started as a junior equity analyst, a helpmate, not expected to offer his own opinions. That changed in December 1991, less than a year into the new job. A subprime mortgage lender called Aames Financial went public, and no one at Oppenheimer particularly cared to express an opinion about it. One of Oppenheimer's bankers, who hoped to be hired by Aames, stomped around the research department looking for anyone who knew anything about the mortgage business. "I'm a junior analyst and I'm just trying to figure out which end is up," says Eisman, "but I told him that as a lawyer I'd worked on a deal for The Money Store." He was promptly appointed the lead analyst for Aames Financial. "What I didn't tell him was that my job had been to proofread the documents and that I hadn't understood a word of the fucking things."

Aames Financial, like The Money Store, belonged to a new category of firms extending loans to cash-strapped Americans, known euphemistically as "specialty finance." The category did not include Goldman Sachs or J.P. Morgan but did include many little-known companies involved one way or another in the early 1990s boom in subprime mortgage lending. Aames was the first subprime mortgage lender to go public. The second company for which Eisman was given sole responsibility was called Lomas Financial Corp. Lomas had just emerged from bankruptcy. "I put a sell rating on the thing because it was a piece of shit. I didn't know that you weren't supposed to put sell ratings on companies. I thought there were three boxes — buy, hold, sell — and you could pick the one you thought you should." He was pressured to be a bit more upbeat, but upbeat did not come naturally to Steve Eisman. He could fake upbeat, and sometimes did, but he was happier not bothering. "I could hear him shouting into his phone from down the hall," says a former colleague. "Joyfully engaged in bashing the stocks of the companies he covered. Whatever he's thinking, it comes out of his mouth." Eisman stuck to his sell rating on Lomas Financial, even after the Lomas Financial Corporation announced that investors needn't worry about its financial condition, as it had hedged its market risk. "The single greatest line I ever wrote as an analyst," says Eisman, "was after Lomas said they were hedged." He recited the line from memory: "'The Lomas Financial Corporation is a perfectly hedged financial institution: it loses money in every conceivable interest rate environment.' I enjoyed writing that sentence more than any sentence I ever wrote." A few months after he published that line, the Lomas Financial Corporation returned to bankruptcy.

Eisman quickly established himself as one of the few analysts at Oppenheimer whose opinions might stir the markets. "It was like going back to school for me," he said. "I would learn about an industry and I would go and write a paper about it." Wall Street people came to view him as a genuine character. He dressed half-fastidiously, as if someone had gone to great trouble to buy him nice new clothes but not told him exactly how they should be worn. 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. His other features all arranged themselves, almost dutifully, around the incipient thought. It was the opposite of a poker face.

In his dealings with the outside world, a pattern emerged. The growing number of people who worked for Steve 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. "He's a born teacher," says one woman who worked for him. "And he's fiercely protective of women." He identified with the little guy and the underdog without ever exactly being one himself. Important men who might have expected from Eisman some sign of deference or respect, on the other hand, often came away from encounters with him shocked and outraged. "A lot of people don't get Steve," Meredith Whitney had told me, "but the people who get him love him." One of the people who didn't get Steve was the head of a large U.S. brokerage firm, who 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," says Eisman. "I don't know why I never went back.") After the lunch, the guy had announced he'd never again agree to enter any room with Steve Eisman in it. The president of a large Japanese real estate firm was another. He'd sent Eisman his company's financial statements and then followed, with an interpreter, to solicit Eisman's investment. "You don't even own stock in your company," said Eisman, after the typically elaborate Japanese businessman introductions. The interpreter conferred with the CEO.

"In Japan it is not customary for management to own stock," he said at length.

Eisman noted that the guy's financial statements didn't actually disclose any of the really important details about the guy's company; but, rather than simply say that, he lifted the statement in the air, as if disposing of a turd. "This . . . this is toilet paper," he said. "Translate that."

"The Japanese guy takes off his glasses," recalled a witness to the strange encounter. "His lips are quavering. World War Three is about to break out. 'Toy-lay paper? Toy-lay paper?'"

A hedge fund manager who counted Eisman as a friend set out to explain him to me but quit a minute into it — after he'd described Eisman exposing various bigwigs as either liars or idiots — and started to laugh. "He's sort of a prick in a way, but he's smart and honest and fearless."

From The Big Short: Inside the Doomsday Machine by Michael Lewis. Copyright 2010 by Michael Lewis. Reprinted by permission of W. W. Norton & Co. All rights reserved.

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