The Big Short: Chapter Summary (Chapter 5)
According to Lewis, Lippmann’s extensive efforts at spreading the news paid off by galvanizing the new market into action—just not as he had imagined. Out of the thousands of hedge funds and other professionals investing in credit default swaps, only about a hundred were investing in the subprime mortgage bond market. However, from Lewis’s retelling, it seems that even most of this group had not caught on to the idea of short selling them. Instead, they were using them either as a hedge in real estate-oriented portfolios or, to a lesser extent, as a usually unsuccessful gamble against another similar investment, based on such portfolio differences as original loan location, tranche ratings, or issuing firm. Only an extremely small number of hedge funds and individuals had the foresight to recognize the impending subprime mortgage disaster and bet against it, and most of them—with the exception of Mike Burry—could be traced back to Lippmann as their source.
Among these, even fewer understood the full scope of what was about to happen on both a financial and a societal level, and of those few, John Paulson, was one of the most successful. Like Burry, Paulson was somewhat of an outsider on Wall Street, though less so; but unlike Burry, he succeeded in selling subprime credit default swaps as a hedge against disaster rather than focusing on the inevitability of impending doom. Paulson was also experienced at short selling overvalued bonds and was amazed at how efficient and inexpensive an investment tool the credit default swap was—all of which prepared him to take action when the opportunity arose to place $25 billion in subprime credit default swaps.
Paulson was unusual in his obsession with the phenomenon, and that was what he had in common with the rest of the select group of investors who could foretell the subprime market crash to the point that they knew to short sell. Paulson’s fixation on short selling overvalued bonds, Burry’s reclusiveness and his obsession with facts and financial motivations, and Eisman’s focus on corruption and the exploitation of the poor and middle classes all revealed attitudes outside of the usual Wall Street approach.
This was also the case with Charlie Ledley, a non-professional who, together with his friends, Jamie Mai and Ben Hockett, deduced that Wall Street had a tendency to underestimate events and that to do the opposite of the current high finance trends had proved a reliable investment strategy. So when Ledley first came across Lippmann’s presentation through a friend in 2006, he knew something was up, even if he didn’t completely understand how it worked or whether he and his small investment group could have access to it.
Cornwall Capital’s beginnings--That group, founded in 2003 by Ledley and Mai, was called Cornwall Capital, a home-based (or rather, shed-based) start-up in Berkeley, California, begun by two young men with relatively little experience in the world of finance. As told by Lewis, neither inspired particular confidence by his personal manner, nor did either one seem especially interested in either money or a career, though they had both worked at financial firms (Lewis mentions Golub Associates in New York) before moving to Berkeley because of Mai’s girlfriend.
Despite this unlikely beginning, Ledley and Mai did possess a viewpoint that set them apart. Working at Golub had given them insight into the private equity market, which seemed to them to be more efficient than the public markets, in part because of the superior expertise of private investment managers. Moreover, the widespread emphasis in public markets on specialization precluded many from seeing the big picture that would enable them to invest in a more global fashion. That inefficiency in the public markets, coupled with a large amount of insanity, spelled opportunity to Ledley and Mai, who determined to look for it on a global level—not just in specific markets.
Cornwall’s successful bet on Capital One Financial--Cornwall Capital’s first prospect came in the form of Capital One Financial, a credit card company catering to the lower socioeconomic classes with poor credit. It had managed to survive a difficult period, presumably because it possessed a better ability than its competitors to determine which credit card users were worth the risk. But in 2002, Capital One revealed that it was having issues with the Federal Reserve and the Office of Thrift Supervision, with the result that the market lost confidence and Capital One’s stock crashed in July of the same year. Its former CFO, who was under investigation by the SEC, had sold his stock in the company before it publicized regulatory dispute, which was also just prior to his resignation.
There was a lot of conjecture about Capital One’s honesty, but it was hard to tell what was actually going on. Even though its stock remained low, the company seemed to be doing well otherwise, so Ledley and Mai decided to investigate by contacting as many people as they could in an effort to dredge up information. When their investigation yielded nothing unusual, they decided to look more closely at the honesty issue. Their approach to this was to attempt to assess the character of the company’s CEO, Richard Fairbank, but they realized that the likelihood of meeting him was low. They decided to look instead for colleagues who had also been Fairbank’s former classmates and eventually found Peter Schnall, who was coincidentally the vice-president of the subprime division. In the end, Cornwall Capital, who gained access by posing as potential investors, seemed more interested in assessing Schnall’s own character as evidence of Capital One’s underlying motives; but Schnall seemed clean—even positive, judging from the fact that he was investing in his own firm’s stock. One way or another, there was no definite evidence of corruption, and Ledley and Mai concluded that it was unlikely.
Following that, Ledley and Mai noticed that Capital One’s stock was hovering at around $30 a share on a regular basis, but that seemed strange to them. They figured that once the company’s issues with the government regulators resolved and it became clear whether it was in fact an honest or a dishonest company, its stock would either plummet to nothing or double in value as a reflection of its true worth. Ledley and Mai were favoring the latter possibility, and Mai had just learned about LEAPs (Long-term Equity AnticiPation Securities) from Joel Greenblatt’s book You Can Be a Stock Market Genius. A LEAP is essentially a long-term stock option, and in this case, purchasing them enabled Ledley and Mai to lock in a $40-per-share price on Capital One’s stock for about $3 per option. When things finally did resolve and Capital One’s stock more than doubled, Ledley and Mai’s option position of $26,000 soared in value to $526,000. Their excited response was that they decided to find more of the same kind of opportunity, so they focused on markets that seemed poised for dramatic change—the kind that would enable a small bet to produce a large return. Lewis adds that they didn’t worry much about their degree of expertise in different markets; instead, they understood the value of hiring others to help them with what they didn’t know.
Subsequent investments--Cornwall Capital’s next few investments took them, in one instance, from a $500,000 options purchase to $5,000,000 in profits and, in the succeeding venture, from a betting value of $200,000 to $3,000,000. By this time, even Ledley and Mai, with all their inclination toward uncertainty, were gaining considerable confidence in the process, though they couldn’t be sure whether their success was based on luck, intelligence, or a major failing of high finance. They knew that they still had much to learn (and always would), but one thing was clear: the orderly world of finance imagined by Wall Street when pricing derivatives was not the reality.
Success with “event-driven investing”--Ledley and Mai called their style of investing “event-driven investing.” That meant that they traded across asset classes and sometimes did things that upset their broker and would have upset their investors, if they had had any (which they didn’t). By this time, Cornwall Capital was two years old, had moved to Greenwich Village, and had grown its initial $110,000 to $12,000,000. It occurred to Ledley and Mai that it might be a good idea to find a professional to do their investing for them, but after investigating a number possibilities in New York, they decided that their own numbers told a better story, so they continued working on their own.
Bear Stearns and Ace Greenberg--At this point, they also switched their account to Bear Stearns, and with their broker’s help, managed to become customers of the Wall Street investing legend and former Bear Stearns CEO Ace Greenberg, who still maintained an office with the firm. However, speaking or meeting with him in person was another matter. After all, though they had reached the status of wealthy investor, they still did not have the credentials to trade at the level of the top institutional investors, something they dearly coveted.