The Big Short: Chapter Summary (Chapter 4)
Gene Park—Hints That Something Is Amiss
Lippmann’s meeting with Fewings apparently didn’t make much of an impression, since Fewings neglected to transmit the information. However, Gene Park, a Connecticut-based AIG FP employee, had been noticing a significant rise in the number of credit default swap deals being made with the large Wall Street firms. One AIG FP trader in particular, Al Frost, had gone from making one to twenty billion-dollars deals per month. Park had observed a few other things as well. He had originally been interested in buying the stock of a mortgage lending company named New Century, which seemed to be doing well, but the quality of the loans the company was making were so poor that he refrained. Shortly after that, he happened to speak with an unemployed college friend who had received various home loan offers at a time when he couldn’t afford them. Park started to put two and two together, and it occurred to him that the loans backing the credit default swaps AIG FP was insuring, though supposedly diversified, might be just as bad and that the chance of default was therefore quite high. If that happened, AIG FP would have nowhere near the funds required. When he tried to communicate his concern to his colleagues in a meeting, the head of AIG FP, Joe Cassano, took Park aside and yelled at him for being misinformed.
Cassano was known for being a bully whose anger would awaken at the slightest hint of disagreement. He saw the company and even the money his employees earned as belonging to him, and he never let the people around him forget it. His actions were often irrational and immature, such as the time he went on a rampage trying to find the person who left a weight out of place in the gym. Although he valued loyalty above all else, his concept of that was nothing short of total agreement with him regardless of the consequences. The general sense of fear and tension he inspired was mitigated somewhat by the large sums of money he would hand out in the form of year-end bonuses to compensate for his lack of emotional control. Unfortunately, Cassano’s financial understanding did not reach the same level as his emotional immaturity and capacity for bullying, and that unfortunate combination of traits would ultimately help lead to AIG
The subprime market keeps going--Lippmann had believed that the subprime mortgage market would crash if AIG FP caught on, but it didn’t. Originally, AIG FP had intentionally been on the long side of the bet, the side that did not believe that the subprime housing market would default all at once; and when the firm stopped participating in the CDO deals Wall Street was generating, it wasn’t clear at first who took its place. Lending standards kept getting worse and worse, but oddly enough, the price of credit default swaps decreased right along with them.
It seems here that Lewis is thinking of credit default swaps as insurance, since the price of insurance typically increases with an increase in risk. In this case, however, the credit default swap was functioning more like a stock: its value decreased as the value of the related asset decreased. As Lewis explained in the previous chapter, there were several ways to think of credit default swaps, and by this point in the text, it should be clear to the reader that though the structure of the contract between buyer and seller might have resembled insurance, more and more, credit default swaps were being treated as a speculative bet.
Ongoing resistance from potential investors--Lippmann’s short position had become increasingly uncomfortable for his bosses at Deutsche Bank, who preferred to simply act as intermediaries, as Goldman Sachs had done. They stipulated that if Lippmann was to continue with his short-selling strategy that he would need to find other investors to join him. Since Lippmann had found his bond market colleagues surprisingly unwilling to consider his plan, he turned to the stock market investors. Mistakenly ending up in Steve Eisman’s office because the Deutsche Bank salesman who set up the meeting didn’t realize that there was more than one FrontPoint Partners hedge fund, Lippmann discovered that there were indeed others who had understood the advantages of shorting the subprime market. In fact, if anyone knew anything about the subprime market, it was Eisman. Yet Eisman and his team didn’t bite at first, despite the fact that their own subprime stock trades were relatively expensive (nearly a third of the total bet) as well as unsatisfying, since they were based on market opinion rather than on the companies themselves.
Given Eisman’s attitude toward the subprime market, his unwillingness to go for the trade left Lippmann confused. Things became even more confusing for both parties when Danny Moses and Vincent Daniel would repeatedly call Lippmann back to the FrontPoint office, have him go through his presentation again, and then challenge his motives. Lippmann, who to them represented the worst of the Wall Street bond market, answered their barrage of challenges to the best of his ability. His offer made sense on the surface, but they simply did not trust him, even though he was candid with them. They kept trying to discover his “real” motives, but the results were always the same.
Changes in the market--Then, in the summer of 2006, two developments occurred that would significantly influence the market. S&P’s informed everyone that it would be raising the standards on its subprime mortgage bond rating model in July of that year. Also, housing prices, which had risen significantly, would decline by 2 percent across the nation as real estate buyers, many of them speculative, started to sell. Wall Street reacted to the first announcement by creating subprime mortgage bonds at a much faster rate. And again, as before, both occurrences should have caused prices on subprime bonds to rise, but instead, they fell.
FrontPoint cautiously trades with Lippmann--At last, Eisman and his team decided to trade with Lippmann, though they still weren’t sure of the situation. They would take his advice to some extent, but that was it. After all, when it came to the subprime market, Eisman and his group were some of the most knowledgeable individuals in the country. They asked all sorts of questions about both the borrowers and lenders in an effort to accurately evaluate the national subprime situation—questions about creditworthiness, home pricing, lender and bond market corruption, financial responsibility, and default rates. When they encountered logical inconsistencies in the numbers, such as low default rates in states with a reputation for a high degree of financial irresponsibility, they prodded further to discover the reasons.
Cheating the Poor
Lewis calls this chapter “How to Harvest a Migrant Worker,” and this section of the chapter explains why. Wall Street’s interaction with America’s poor was a new phenomenon, and it seemed to be taking full advantage of the opportunities that such an interaction afforded. A lot of it didn’t make sense. An immigrant worker with a tiny income was able to receive a loan for a house costing nearly three-quarters of a million dollars. Eisman’s South American housekeeper was offered an adjustable rate mortgage (ARM), which required no money down and no proof of income or other standard documents, to buy an exorbitantly priced townhouse in Queens. And his Jamaican nursemaid was able buy five townhouses by repeatedly refinancing (on the bank’s suggestion) until housing prices fell and she was unable to sustain the payments.