Summary
In February 2006, Greg Lippmann, the mortgage bond trader from Deutsche Bank, turned to FrontPoint, where Eisman worked, and tried to convince Eisman to bet against the subprime mortgage bond market. He was met with wariness by Daniel and Eisman, who generally did not trust anyone from the bond market; it had a reputation for lying and cheating, whereas the stock market, which they were used to, was a more transparent and well-policed system because it had so many small investors. Lippmann’s braggadocious and self-confident personality tended to alienate people he worked with, but endeared him to Eisman. His claim that shorting the mortgage bond market would be a wise move was also backed up by Eugene Xu, a Chinese analyst who provided Lippmann with hard data. Nevertheless, Eisman was hard to convince.
In order to understand the subprime mortgage market, it is important to understand the role of insurance companies, especially the American International Group Financial Products. AIG FP was created to stand in the middle of swaps and long-term options, and other risk-spawning innovations that began in the late 1980s. It was well-suited for this role because it had a high credit rating, was not a bank—and thus not subject to bank regulations or the need to reserve capital against risky assets—and was able to bury exotic risks on its balance sheet. Basically, it swelled up the risks being generated by the financial system. In the beginning, it was paid to insure against events that were very unlikely to occur. But, over time, it began to cover riskier events; its existence allowed these new risks to be created in the first place by giving them a place to hide. For its first fifteen years, it was amazingly profitable with no sign of running huge risks. In the early 2000s, however, the financial markets changed: the banks that used AIG FP to insure piles of loans started to insure much messier piles that included credit card debt, student loans, auto loans, prime mortgages, etc—they believed these loans were sufficiently diverse that they couldn’t possibly all go bad at once. Over time, though, the consumer loan piles that AIG FP insured went from being 2 percent subprime mortgages to 95 percent, without anyone at AIG FP taking careful notice of this change. They had bought $50 billion in triple-B-rated (the lowest rating) subprime mortgage bonds by insuring them against default, which was actually highly likely to occur given their low rating.
Greg Lippmann realized early on that Goldman Sachs must be buying cheap insurance on subprime mortgage bonds from AIG FP. He recognized that this meant that Goldman had transferred to AIG the responsibility for all future losses from $20 billion in triple-B-rated subprime mortgage bonds. Goldman had also created a security system so complex that no investor or credit rating agency would fully understand it: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation, was invented to redistribute the risk of corporate and government bond defaults, but was now being used to do something very different: disguise the risk of subprime mortgage loans. A CDO gathered a hundred different mortgage bonds, usually the riskiest ones, and used them to erect a new “tower” of bonds that helped to make them look more attractive to potential investors. Basically, they managed to get risky bonds re-rated as triple-A, dishonestly lowering their perceived risk. They claimed that the 100 ground floors gathered from 100 different subprime mortgage buildings of 100 different triple-B-rated bonds made up a diversified portfolio of assets, and should be rated triple-A for this reason when, in fact, they were all the same quality: triple-B. Lewis compares the CDO to a “credit-laundering service for the residents of Lower Middle Class America,” or, for Wall Street, “a machine that turned lead into gold.”
For those like Mike Burry, who had bought credit default swaps, it was as though they had bought fire insurance on a slum with a history of burning down. A credit default swap wasn’t exactly insurance, since they didn’t own the thing they were insuring, but rather an outright speculative bet against the market. Meanwhile, banks also benefited from the selling of credit default swaps, because they enabled them to create another bond identical in every way except one: the new bond it did not involve any actual home loans or home buyers, and only the gains and losses from the side bets on this bond were real. This was because the banks could package the triple-B bonds bought by people like Burry into a "synthetic" CDO, which was then rated by an agency that re-rated them as triple-A. Both those buying and those selling credit default swaps benefitted from them. This new market for synthetic CDOs meant there was no limit on the size of risk associated with subprime mortgage lending. In other words, to make a billion-dollar bet you did not need to accumulate a billion dollars’ worth of actual mortgage loans: you just had to find someone else in the market willing to take on the other side of the bet.
Lippmann was originally pushed into buying credit default swaps from the Deutsche Bank CDO department by Deutsche Bank itself. Deutsche Bank needed someone like him to take the other side the synthetic CDO trades with AIG; eventually, thought, it realized what was happening and stopped making such trades. But Lippmann became personally enthusiastic about the cause when he realized that credit default swaps were not insurance, but rather a gamble with good odds. He began pushing the bet against subprime mortgage bonds on investors with the attitude of someone dispensing favors. His candidness and overconfidence worked against him, however, by making him seem untrustworthy to many. Some people responded to his proposal by pointing out that trades where you had to pay 2 percent a year just to be in them were not logical. Others objected that they did not know how to explain credit default swaps to their investors. Others, still, had heard from people they knew at rating agencies that subprime mortgage bonds were all too solid to go bad. The most common response, however, was that they were convinced by his arguments but felt it was “not their job” to short the subprime market.
After having difficulty convincing investors to short the subprime market, Lippmann turned to trying to kill the market, instead. AIG was nearly the only buyer of triple-A-rated CDOs (which were actually triple-B-rated subprime mortgage bonds repackaged into triple-A-rated CDOs) and thus was the party on the other side of credit default swaps. So, if they stopped buying bonds, the whole subprime mortgage bond market might collapse and Lippmann’s credit default swaps would then be worth a fortune. With this logic, Lippmann met with AIG FP and tried to convince them to stop selling the bonds.
But AIG FP did not take his warnings seriously and soon forgot about the meeting with Lippmann. But a man named Gene Park, who worked close to the credit default swap traders at AIG FP, did begin to recognize the risk in the industry. He noticed a front-page story in the Wall Street Journal about the mortgage lender New Century, and took note of how high the company’s dividend was. When he did more research into the company, he realized that it owned a large amount of subprime mortgages of frighteningly poor quality. Soon after, an old college friend told him he had been offered several loans for a house he couldn’t afford. Park put two and two together, and realized that this was a widespread problem with mortgage lenders. He also extended this epiphany to the realization that AIG FP must contain a lot more subprime mortgages now than ever before, and that, if US homeowners began to default in greater numbers, it did not have enough capital to cover the losses that would result. He warned his boss at AIG FP, Joe Cassano, who was notorious for his temper and intolerance of insubordination. At first, Cassano was angered by the suggestion that the company could be engaged in risky trades, or that he could be responsible for bad decisions. But, after meeting with all the big Wall Street firms and discussing the logic of their deals, he realized that very little thought underpinned the subprime mortgage machine. After this, and after presenting it as his own idea, Cassano came around to Park’s conclusion.
After AIG FP withdrew, Wall Street firms went on to somehow find new buyers of triple-A-rated subprime CDOs, where they could stuff their risky triple-B tranches of subprime mortgage bonds. It would not become clear who these people were until after the crisis. But this allowed the subprime mortgage trades to continue, and the whole cycle went on. For those who were closest to the market, it was hardest to see just how foolish its actions were. Lippmann knew this, and it was what pushed him to reach out to Eisman at FrontPoint in the first place. Lippmann was lucky to stumble upon Eisman, who was a stock investor with an even darker view of the subprime mortgage market than his own. But Eisman and Daniel were so wary of Lippmann’s motives that it took them a very long time to agree to his proposal. They could not figure out why he would be offering them such a good deal, if not to screw them over somehow.
When they did finally accept his deal and do their first trade, they continued to closely investigate the people doing the borrowing and the lending in order to make sure they had made the right decision. By doing such close investigations of mortgage loans, they ended up doing the kind of detailed credit analysis that should have been done before loans were made in the first place; they were able to find the “crooks and fools” who were involved in these trades. Eisman and Daniel found out that the bonds backed by mortgages most likely to default tended to be located in “sand states” (meaning California, Florida, Nevada and Arizona, where housing prices had risen fastest during the boom and so would likely crash fastest in a bust), were made by the more dubious mortgage lenders, and had a higher-than-average number of loans that were likely to be fraudulent. They recognized patterns, such as lending huge sums to poor immigrants. They also found blind spots in the rating agencies’ models, such as the fact that they didn’t understand the difference between a “thin file” and a “thick file” score for the creditworthiness of individual borrowers (known as a FICO score). A thin file meant a short credit history, which should have indicated that, even if the credit history was good, this could simply be because the borrower in question had never borrowed money before and thus had had no chance to bring their credit score down. For example, this was the case with many poor immigrants. Thus, rating agencies lumped such immigrants in with people who had borrowed and returned lots of money in the past, giving them effectively the same ratings despite their actual income differences. Eisman and Daniel ended up meeting face-to-face with Moody’s and S&P rating agencies in Florida, where they hid the fact that they were betting against subprime mortgage bonds. From this meeting, they learned that these agencies had no idea what they were doing, and why they were rating some identical bonds triple-A and others triple-B. After this meeting, they realized just how big of a discovery they had made by uncovering the corruption in the industry.
Analysis
The third chapter starts by refocusing the storyline on Greg Lippmann, who turns up at FrontPoint, where Eisman works, in February 2006. Lippmann first comes up late in the second chapter, as a Deutsche Bank trader who wants to buy many of Burry’s credit default swaps. At that point in the text, it was not yet clear that Lippmann would go on to play a major role in the story of the housing crisis. But Lewis signals to readers that Lippmann will be a major character by beginning the third chapter with him and his actions. In fact, Lewis establishes a pattern of beginning each new chapter with the introduction of a new central character. In the fourth chapter, for example, he refocuses on Gene Park, the AIG FP employee who recognizes the folly of credit default swaps. Whenever a character is emphasized in the first few paragraphs of a new chapter, he goes on to become an important player in the events of the housing market crash.
When he first describes Greg Lippmann, Lewis makes use of figurative language that helps to convey the absurdity of Lippmann’s personality. As he describes the wall of suspicion with which Eisman and Daniel greeted Lippmann, Lewis quotes Eisman saying, “Moses could have walked in the door, and if he said he came from fixed income, Vinny wouldn’t have trusted him.” This example of hyperbole helps to convey the extremities of Lippmann’s own character; his entrance into Eisman’s presence is described using hyperbole, and he is himself a very loud and over-the-top person. This hyperbole also reflects on Eisman, who makes use of such an extreme example in the first place and is also a loud and unusual character. Lewis goes on to refocus attention on Lippmann’s oddities, however: “Still, if a team of experts had set out to create a human being to maximize the likelihood that he would terrify a Wall Street customer, they might have designed something like Lippmann.” This illustration of Lippmann’s sleazy and scary exterior leaves room for the reader’s imagination to fill in details, but makes clear that he is an outwardly terrifying individual. Though many of the characters Lewis introduces are over the top and unusual in some way, his especially figurative description of Lippmann helps him to stand out as a particularly striking and unlikeable character.
Lewis also inserts a stronger, more opinionated narrative voice throughout these two chapters. For example, he writes that, “at some point in between 1986 and 2006 a memo had gone out on Wall Street, saying that if you wanted to keep on getting rich shuffling bits of paper around to no obvious social purpose, you had better camouflage your true nature.” This is a figurative jab at Wall Street and its deceptive nature. Of course, no literal memo was sent out declaring this, but Lewis’ use of this metaphor communicates his belief that such deception was basically institutionalized on Wall Street. He uses a sarcastic and bitter tone, referring to the work of Wall Street traders as “getting rich shuffling bits of paper around” and also passes his own moral judgment on this by adding, “to no obvious social purpose.” Lewis thus emphasizes his own opinion about Wall Street; this is the most obvious moral judgment we have gotten since Lewis recounted his personal Wall Street experience in the book’s foreward. He goes on to maintain this more directly judgmental tone throughout the rest of the book, making his judgment clear and shaping the narrative more straightforwardly with his personal opinions.
The narrator also goes on to break the fourth wall by directly addressing his readers. After explaining synthetic CDOs, Lewis includes a footnote where he writes: “Dear Reader: If you have followed the story this far, you deserve not only a gold star but an answer to a complicated question: If Mike Burry was the only one buying credit default swaps on subprime mortgage bonds, and he bought a billion dollars’ worth of them, who took the other $19 billion or so on the short side of the trade with AIG?” The style of this footnote, which imitates a letter, signals that Lewis is breaking away from the main text to speak more candidly and personally with his audience. This speaks to one of the central purposes of the book: to explain the housing crisis and its lead-up to readers who may have no background in finance, and to do so in an engaging way that allows anyone and everyone to connect to the story.
A series of questions come up after Lewis explains how synthetic CDOs were created. Lewis points out that, “Wall Street’s newest technique for squeezing profits out of the bond markets should have raised a few questions,” and goes on to list a number of possible questions that people on Wall Street should have known to ask. For example, why were AIG FP traders doing this? Why were credit default swaps not regulated as insurance? Etc. This moment in the text helps guide readers toward some of the central points of the book: knowing what they did, these people on Wall Street should have also known to ask such further questions. And yet the fact that they did not shows their willful ignorance of the risks they were taking, which they could only afford to uphold because they were personally protected from such risk. By raising all of these questions, Lewis shows just how many things such traders chose to ignore or leave unquestioned. Readers who have followed the text thus far will know enough to recognize the importance of these questions, and can empathize with Lewis’ argument about just how corrupt and ignorant Wall Street had become.
