The Big Short: Chapter Summary (Chapter 8)

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Cornwall Capital notices hints of disaster--Returning from the convention at the end of January 2007, Ledley and Hockett felt like they were witnessing the demise of capitalism. Even Jamie Mai, who hadn’t attended, was picking up on financial trends that indicated the possible need for government intervention.

Rapid decline of the subprime mortgage market--The subprime mortgage market began its rapid downward slide the day after the conference ended. Naturally, this had an effect on buyer and seller attitudes. Morgan Stanley, who had originally been willing to sell credit default swaps to Cornwall Capital, now changed its mind, and the payment terms of the original transaction changed from 100 to 150 basis points, or 1.5 percent of the total purchase amount of $10 million. Only Wachovia Bank was still interested in selling them credit default swaps, especially since Cornwall Capital would have been their first hedge fund customer. They had their doubts about Cornwall, though (like everyone else), but with Bear Stearns acting as an intermediary, the deal went through. Cornwall’s portfolio shot up from its previous amount of under $30 million to $205 million, after which they were no longer able to find anyone to sell to them—or to anyone else. Some kind of awakening seemed to be going on inside the Wall Street firms, since no one wanted to sell to the short side anymore.

Yet something wasn’t making sense. With the increasingly poor loan quality, it was inevitable that bond prices should fall—and they did, until in June 2007, their value stood at only two-thirds of what it had been previously. Strangely, the CDO market remained unchanged, even though it should have declined along with the rest of the subprime market. There were weird little hints here and there that something was obviously not right. Charlie Ledley had managed to sneak into a CDO conference hosted by Bear Stearns, where he noticed that the title “How to Short a CDO” was no longer scheduled to be on the agenda. Moreover, both of the big rating agencies were planning on changing their models, and although Wall Street firms were vouching for the solidity of the bond market, it was obvious to Cornwall that that same market was fraudulent. The situation appeared so bad that they tried to tell the New York Times, the Wall Street Journal, and the SEC about it, but no one seemed interested. In fact, the SEC person they spoke to appeared to not even understand what they were talking about.

The impending fall of Bear Stearns--But there was something still more pressing on Cornwall’s mind. Bear Stearns, which was originally a regular brokerage firm, had entered the subprime mortgage bond market in full force and now looked poised to fail. Their CDO management division, Bear Stearns Asset Management, had lost almost $4 billion and was closing down. Cornwall Capital owned almost three-quarters of Bear Stearns’ credit default swaps, but because the latter had not been required to post collateral, it wasn’t clear whether they would be able to pay. HSBC had also sold Cornwall $105 million in credit default swaps that bet against Bear Stearns; and though HSBC was unlikely to crash, things seemed a bit shaky with them as well. After all, this was the company that had bought Household Finance, and now they were announcing a large loss from their subprime mortgage loan dealings.

FrontPoint’s position--As disastrous as the situation was from a larger perspective, it spelled great opportunity for those who had had the insight to bet on the short side. If it had been up to Steve Eisman, he would have bet ten times the $600 million that FrontPoint was already risking. The problem was that FrontPoint’s risk management division wasn’t comfortable with the situation, and they made their presence felt. In Vinny and Danny’s opinion, had it not been for that and the fact that the two of them were actually hiding the pessimistic housing market reports with which Lippmann was deluging them, Eisman might have bet exponentially more than their current wager.

 

Misrating at the Agencies

Unfounded optimism and obliviousness--The underlying insanity that drove the subprime bond market kept sprouting new shoots. One of them was the general unwillingness to look the situation in the face, not only on the part of Wall Street’s heavily involved investment firms but even the U. S. Federal Reserve and the news agencies. Their optimism was unfounded and exaggerated, ignoring such details as tax time in March and April, when credit quality inevitably improved because people temporarily had more money.

The rating agencies weren’t any better. For some reason, they failed to see the danger of floating-interest-rate loans, which, because they were unsustainable for many homeowners, were bound to default. Somehow the difficulty of paying off a loan at a higher interest rate eluded the rating agencies, who gave the related bonds a higher rating, which of course encouraged more of the same type of loan. The result was that floating-rate subprime mortgages doubled in volume.

Even when the loans did begin to default, the agencies still maintained the same bond ratings, which meant that subprime bond prices stayed the same. This, of course, made no sense, so Eisman tried to investigate it but had difficulty getting an answer from either Wall Street bond market insiders or the rating agencies. The bond market people may have known but didn’t want to let on, while the ratings people simply seemed clueless. According to S&P, their model predicted that housing prices would continue to rise.

Agencies working with limited information--Since FrontPoint was working with limited information, they wondered whether the rating agencies had access to additional data that would shed more light on the discrepancy between bond prices and loan default rates. Through an S&P surveillance department analyst, Ernestine Wagner, they discovered that the rating agencies had no more than the same general loan pool data available to everyone else. Again, this made no sense, since they were the ones in charge of determining the value of the bonds. It turned out that the bond issuers were unwilling to reveal any more information and that S&P was operating under the notion that it was restricted in its rights to demand access. That sense of restriction trickled down from higher-level managers, one of whom claimed that even the originators didn’t possess the necessary information on the original loans. It seemed to Eisman that S&P feared losing Wall Street’s business to Moody’s.

To illustrate the thoroughness of the rating agencies’ ignorance, Lewis recounts the story of how the head of Moody’s, Ray McDaniel, in sympathy with FrontPoint’s desire for accurate and complete knowledge, invited Eisman’s group to his office for a meeting. This was a rare gesture, especially given their short position, and it made a deep and favorable impression on Eisman. But when McDaniel voiced his optimistic view of the accuracy of Moody’s ratings, FrontPoint’s partners were floored. They could not believe what they were hearing, to the point that, upon leaving, Vinny informed McDaniel—the CEO of the most respected rating agency—that he was delusional.

 

FrontPoint’s Position Grows Stronger

Beginning of short-selling profits--Eisman and his team were right, of course. FrontPoint started to make increasingly large amounts of money (as much as millions more) as the subprime mortgage bond market got steadily worse and the fund’s short positions on the stocks of home builders, home loan originators, and now the rating agencies, began to pay off.

Growth of the “securitization machine”--What Eisman called the “securitization machine” had been created in part to compensate for the increasing lack of profitability of Wall Street’s more traditional investing methods due to more and more competition from the Internet. FrontPoint’s theory was that this “machine" had been the main source of income for the large Wall Street investment firms but that that obviously couldn’t last. Given the large banks’ opaque bookkeeping practices, it was impossible to know how heavily invested they were in their own garbage, though Eisman assumed at first that they knew enough to avoid that pitfall. It was clear that their investments had increased substantially, but it was also increasingly clear that they used borrowed capital to purchase their high-risk assets. 

Eisman’s growing understanding--Things became clearer to Eisman as events unfolded in 2007. First, HSBC announced substantial losses on its subprime loans and then decided to eliminate its entire subprime portfolio. Later in the year, Merrill Lynch, announced losses in the same area in spite of otherwise spectacular profits. Eisman found it significant that the company had substantial investments in subprime mortgage securities and that Jeff Edwards, its CFO, had made several cryptic comments about subprime assets, as though trying to divert attention away from Merrill Lynch’s subprime investment activities. With a little further investigation, Eisman discovered that it wasn’t just a question of diverting attention: not only Merrill’s CFO but a number of other major Wall Street firms and, in some cases, their CEOs, evidently did not understand what was going on. Eisman had recognized the shaky nature of the subprime sector of the market but wondered whether Wall Street had any inkling of how bad it was. In fact, Lewis named this chapter “The Great Treasure Hunt,” after the designation Eisman and his team gave their search for concealed subprime risk. Once it began to dawn on them how oblivious Wall Street’s prominent firms truly were, they decided to short a number of them. The only reason Morgan Stanley was excepted was because it owned FrontPoint.

Eisman’s superior understanding of events was confirmed by the massive response he received to a conference call he hosted in July 2007. The call, which drew 500 live listeners and an additional 500 post-call web visitors, was highly critical of the securitization process, models, and people, especially the rating agencies.

 

Grant’s corroborating evidence

Eisman and his FrontPoint team were not alone. In response to the question of what was in a CDO, Jim Grant, the editor of the important Wall Street newsletter, Grant’s Interest Rate Observer, had his assistant Dan Gertner attempt to figure it out. With a chemical engineering degree as well as an MBA, Gertner was certainly no slouch. In the end, however, neither Gertner nor Grant could figure what was in a CDO, so Grant took that to mean that no one would be able to. Grant was convinced that the rating agencies had lost their integrity and that it was likely that they knew as little as everyone else. The consequence of their assessment was that both Grant and Gertner were summoned to S&P and chastised. But if S&P didn’t appreciate Grant’s evaluation, Eisman did—in fact, he was ecstatic. Not only did it confirm his subprime market theories, but for him and his partners, it was like striking gold.