The Big Short: Chapter Summary (Chapter 1)
Chapter 1 recounts how Steve Eisman and his team gradually began to unearth the fraudulent reality behind the subprime mortgage bond market of the 1990s and the first decade of the new millennium. Their research was making it increasingly apparent that many of Wall Street’s top figures were either inept, corrupt, or both.
Eisman was a maverick and anomaly on Wall Street who landed in finance almost accidentally. Trained as a lawyer, he realized by the time he was thirty that he hated the career. To bail him out, his parents, both long-term, highly respected securities brokers at Oppenheimer and Co., hired him as a junior equity analyst. In deference to Oppenheimer’s policy against nepotism, the Eismans paid their son out of their own pocket for a year, while the company, whose roots were in an older, more traditional Wall Street, had a chance to evaluate him on his own merits.
As an equity analyst, Eisman researched public companies and rated them according to his findings. To earn the distinction of being worthy of pay, Oppenheimer required that its analysts be both accurate and vocal enough to be noticed, in contrast to other Wall Street firms, who paid their analysts to express a consensus and thus tended to ignore Oppenheimer’s opinions. Within a year, Eisman proved to have the necessary qualities to both earn his salary and gain Wall Street’s attention.
When the subprime mortgage lender, Aames Financial, was about to go public, making it the first of that type of institution to do so, one of Oppenheimer’s bankers expressed an interest in finding out more about the company with the intent of potentially working for it. Eisman volunteered his services when none of his colleagues seemed especially interested and was made Aames’ lead analyst. He was subsequently assigned to investigate and rate Lomas Financial Corporation, a company just coming out of bankruptcy. Unaware that Oppenheimer was looking for something more optimistic, he chose to be his usual blunt self. His estimate of Lomas was that it was a worthless company that constantly lost money, so he put a sell rating on it and stuck to it in spite of pressure to withdraw his statement. Within just months of publishing his report, Lomas was bankrupt again.
This candid approach was typical of Eisman, whose extreme frankness was directly tied to his utter lack of concern with other people’s opinions. That attitude embraced not only the straightforwardness of his market opinions but also the semi-casual manner in which he dressed and wore his hair, not to mention his transparent facial expressions. His behavior toward people of importance, though not intentionally hurtful, could be thoughtless and at times downright rude. But this honest, vocal attitude was by itself not enough to explain his effect on the market: Eisman was also smart and often right. He was beloved, or at least appreciated, by those who worked for him, and his bluntness toward privilege and authority was offset by his material and intellectual generosity and his consideration for women and for the less fortunate members of society, even though he himself came from a more privileged socioeconomic class.
Prime mortgage bonds--The mortgage bond market, originated by Salomon Brothers in the 1980s, was unusual in that it was the first time the high finance world of Wall Street coincided with the world of middle and lower middle-class Americans. At the time, mortgage-backed securities were still limited to prime loans. They were different from government or corporate bonds in that they consisted of thousands of pooled individual loans rather than one large one. They also lacked the fixed-term feature, making one of their main problems the fact that borrowers could choose to prepay at any time, which they usually did whenever interest rates decreased. That way, the homeowner could potentially refinance at a better rate, but this left investors with the issue of their investment being terminated before maturity.
Tranches--In an effort to mitigate this problem, Salomon Brothers created what are called “tranches.” The purpose was to provide different levels of investment for different estimated mortgage prepayment schedules, each of which had corresponding interest rates designed to compensate for varying levels of risk. Lewis likens tranches to the stories of a building in relation to a possible flood: the bottom floor receives the highest interest rate in return for being the first to accept prepayments; the next floor up receives the next highest interest rate in return for the next set of prepayments; and so on up to the highest tranche.
Subprime mortgage bonds--With the introduction of subprime mortgage bonds in the 1990s, a new factor was introduced. Prepayment was no longer the problem facing investors in these types of bonds. Instead, the issue now revolved around the possibility of default. Unlike prime mortgage bonds, the loans that constituted the subprime mortgage bond were not guaranteed by the government. They had the same tranche structure as prime mortgage bonds, but investors in subprime mortgage bonds took the risk of losing their investment altogether. Again, this possibility was offset by attractive interest rates adjusted to each level of risk.
The lowering of lending standards and the subprime mortgage bond phenomenon of the 1990s mainly came into being to allow people to convert the equity in their homes into cash in order to give those with poor credit a chance at better financing interest rates. The idea was that they could exchange their high-interest credit card debt for a lower-interest mortgage by refinancing their homes. Even Eisman, for all his perspicacity, bought into it; but his job gave him no choice but to analyze the situation in more detail. He and a man named Sy Jacobs, who had previously worked for Salomon Brothers, were the only two Wall Street analysts trying to gain a broader understanding of the subprime mortgage bond phenomenon and its implications. All kinds of debts and other assets were being packaged into bonds, so tapping the equity in homes only seemed like the next logical step. This approach to financing was being marketed as efficient rather than risky. Early subprime lenders like Aames and The Money Tree went public to accelerate their growth, and though it was still a small portion of the U.S. economy, new subprime lenders continued to spring up.
The industry’s shaky financial basis, however, correlated with a shaky moral basis, and both Eisman and Jacobs realized that they needed to distinguish the more ethical practitioners from their questionable counterparts. The rising subprime phenomenon also highlighted the ever-growing economic gap in the American economy, which was a primary reason why Eisman became one of its main supporters and why Oppenheimer, in turn, evolved into one of the major subprime mortgage lenders. But Eisman was too astute and too honest for this to last. By the mid-1990s, he was beginning to sense that something was not quite right with the subprime mortgage bond industry. Not being a numbers man himself, he began looking for an accountant who could sort out the details for him.
That person would be Vincent “Vinny” Daniel, a young, earnest accountant, originally from Queens and recently graduated from SUNY-Binghamton. Vinny had been growing increasingly frustrated with some of the mysterious accounting practices he had already witnessed on Wall Street. His first assignment as a junior accountant for Arthur Andersen in Manhattan had been to help audit Salomon Brothers. Finding their books surprisingly opaque, he was even more mystified when his managers couldn’t answer his questions. When he was told a few months into the project to stop asking questions and simply do what he had been hired to do, Vinny decided to start looking for another job. At that point, he met Steve Eisman through an old classmate, but the interviewing process was cut short. The reason was never clear, but Vinny later came to believe that it was related to the accidental death of Eisman’s infant son, Max. He didn’t know why Eisman had suddenly hung up on him and never called back, and it would not be until two months later that Eisman would contact him again, this time with a job offer.
Since Max’s death, Eisman’s attitude seemed noticeably darker, both in relation to his overall worldview and, more specifically, to the subprime mortgage bond industry. He wasted no time sending Vinny into a room by himself, adding that he was not to come out until he had figured things out. No one at Oppenheimer, including Eisman and Vinny himself, understood the real nature of mortgage-backed securities at that point; so with Moody’s database on subprime mortgage bonds in hand, Vinny began to make his way through the books of the subprime originators he was researching. As with the huge Wall Street firms, these books were opaque, revealing little other than their increasing earnings in this sector. To make matters worse, their accounting rules permitted them to adjust the books according to the incorrect assumption that the loans they had made would be repaid in full and would last the entire projected loan period. In spite of this convoluted bookkeeping, Vinny realized that there was a huge delinquency rate in the mobile home market, euphemistically known as “manufactured housing.” What were being listed as “prepayments” were actually involuntary payments resulting from foreclosure due to default on the loans. Further examination revealed the same unusually high delinquency rates not just for mobile homes but for all subprime sectors. When Vinny finished his analysis six months later, he presented the information to Eisman.
Collapse of the subprime lending industry--Eisman then wrote a scathing report on a number of subprime lending companies, detailing the illusory nature of their success and revealing the actual facts. This in turn aroused the indignation of Wall Street, in part because Eisman had failed to warn them—deliberately, in fact. But Eisman’s career had been built on his reputation, and a year after his report, issued in September 1997, his predictions came true: the subprime lending market failed in a big way, despite evidence of a significant economic boom just a year earlier. The massive numbers of bankruptcies that followed were attributed to the companies’ accounting policies of “counting your chickens before they hatch;” but Vincent Daniel knew that much of the disaster also rested on the unbelievably poor quality of the loans they had made.
Eisman leaves for Chilton--Eisman subsequently left Oppenheimer to join a hedge fund called Chilton Investment Co., with the intention of becoming a stock picker. Chilton Investment, however, decided that they preferred him in the role of analyst, and though Eisman wasn’t happy about that, it was during this period that he gained a genuine understanding of the consumer loan market.
The crusade against Household Finance--In 2002, Eisman started a crusade against Household Finance Corporation, the one consumer lending institution remaining, when he realized that they were fooling people by offering them a 15-year 12.5 percent interest loan under the guise of a 30-year 7 percent interest loan. In Washington State, where the issue first came to public notice, further investigation had been prevented by a state judge, with the excuse that there would be no one left to make subprime loans. But Household, which had been around since 1870, was making its deceptive loans nationwide, and this made the issue a matter for federal investigation. Instead of acting, though, the federal government did nothing. Household eventually settled its issues by making amends to the tune of nearly $500 million in twelve different states and then selling itself in the following year to the British HSBC Group. What did not ring true was that Household’s former CEO walked away from the sale with $100 million dollars, while the American poor and middle classes still remained inadequately protected.
A heart for the underdog--Eisman himself came from a relatively privileged background, having been raised on Park Avenue and educated at the University of Pennsylvania and Harvard. His original political leanings had been Republican, but since his arrival on Wall Street, where he became more and more aware of the poor treatment of the lower-income classes, his political preferences started shifting to the left. He had recognized that the consumer lending industry was not helping people but robbing them. His lifelong interest in superhero comic books—Spider-Man in particular—dovetailed with his growing objections to fraudulent subprime lenders, and whatever fairy-tale aspect either the comic books or the subprime market once held now took on a darker hue as Eisman faced the reality of what was going on.
Early phase of the FrontPoint hedge fund--After quitting Chilton, Eisman tried to establish his own hedge fund under the auspices of FrontPoint Partners, which would in turn be bought by Morgan Stanley. The one thing they did not provide was financial backing, and despite extensive travel for that purpose, Eisman had an impossible time convincing investors. Finally, in 2005, one investor put down $50 million, which at least gave Eisman and his small team a starter fund.
That team, in addition to Eisman and Vinny Daniel, was composed of Porter Collins, a former Olympic athlete and Chilton colleague; and Danny Moses, previously an Oppenheimer salesman, who would become Eisman’s head trader. One of Moses’s useful characteristics was his understanding of the mentality behind the Wall Street veneer. Lewis recounts how once, when presented with a trade that looked too good to be true, Moses politely but pointedly asked the Wall Street trader how he was “going to fuck” him. After hemming and hawing a bit, the salesman finally explained his real intentions, and Moses, as promised, did the deal.
Whatever Eisman’s little group may have been lacking in funding, they made up for both in brains and through Eisman’s own inimitable, iconoclastic approach to dealing with Wall Street’s attempts at concealing or twisting the truth. At official meetings, he was known to repeatedly ask for clearer explanations, stressing that he would prefer them in English; and in the process, he and his group discovered that few, if any, of their esteemed colleagues appeared to understand the real nature of what they were discussing. That suspicion was confirmed by the increasing insanity of the surrounding evidence.
Revival of subprime lending and growth of the subprime mortgage bond industry--By 2005, just a few years following the dramatic incident with Household Finance, the subprime mortgage lending industry was back in business, this time to an extent previously unheard of. In one year alone, half a trillion dollars worth of subprime loans had been sold to the big Wall Street investment firms and then repackaged as mortgage bonds—nearly ten times the amount that had been processed just five years earlier. Interest rates were rising, and what had once been fixed-rate interest terms had shifted to mostly floating rate, meaning that borrowers could easily end up paying more than they had originally counted on.
Shaky underpinnings--Whatever happened to the lesson supposedly learned from the Household Finance disaster only a few years ago? Apparently, the rest of the lending and investment industry thought that what Household had done was a swell idea—as long as you didn’t get caught. That’s why subprime mortgage bonds were such a great thing: you didn’t have to keep your high-interest rate, subprime loans on your books. In a process called “originate and sell,” you could make your junky loans, sell them to Wall Street, and then let the big firms repackage them under various cryptic names and ultimately resell them to investors.
Seeds of the “Big Short”--The whole setup looked poised to go bad, and Eisman was already predicting enormous returns from short selling the stock. This was no guess on Eisman’s part. He and his little group were familiar with the inside players from both the subprime mortgage lending and investing worlds, and they had good reason to be cynical. As they carefully watched the situation, it suddenly dawned on Eisman that his attention should be focused not on the stocks but on the bonds. After all, in the last few decades, the bond market—also known as “fixed income”— had grown so dramatically that it was now in an altogether different league from the rest of Wall Street. With that realization, Eisman committed himself to learning as much as possible about the business that had come to dominate the investment industry.