The Big Short: Inside the Doomsday Machine (10 page)

CHAPTER THREE

"How Can a Guy Who Can't Speak English Lie?"

By the time Greg Lippmann turned up in the FrontPoint
conference room, in February 2006, Steve Eisman knew enough about the bond market to be wary, and Vincent Daniel knew enough to have decided that no one in it could ever be trusted. An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons. It was possible to get ripped off by the big Wall Street firms in the stock market, but you really had to work at it. The entire market traded on screens, so you always had a clear view of the price of the stock of any given company. The stock market was not only transparent but heavily policed. You couldn't expect a Wall Street trader to share with you his every negative thought about public companies, but you could expect he wouldn't work very hard to sucker you with outright lies, or blatantly use inside information to trade against you, mainly because there was at least a chance he'd be caught if he did. The presence of millions of small investors had politicized the stock market. It had been legislated and regulated to at least seem fair.

The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they'd be reported to some authority. Bond traders could exploit inside information without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation--one reason why so many derivatives had been derived, one way or another, from bonds. The bigger, more liquid end of the bond market--the market for U.S. Treasury bonds, for example--traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn't know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.

And so it was no particular reflection on Greg Lippmann that, upon entering Steve Eisman's office, he collided with a wall of suspicion. "Moses could have walked in the door, and if he said he came from fixed income, Vinny wouldn't have trusted him," said Eisman.

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. He traded bonds for Deutsche Bank, but, like most people who traded bonds for Deutsche Bank--or for Credit Suisse or UBS or one of the other big foreign banks that had purchased a toehold in the U.S. financial markets--he was an American. Thin and tightly wound, he spoke too quickly for anyone to follow exactly what he was saying. He wore his hair slicked back, in the manner of Gordon Gekko, and the sideburns long, in the fashion of an 1820s Romantic composer or a 1970s porn star. He wore loud ties, and said outrageous things without the slightest apparent awareness of how they might sound if repeated unsympathetically. He peppered his conversation with cryptic references to how much money he made, for instance. People on Wall Street had long ago learned that their bonuses were the last thing they should talk about with people off Wall Street. "Let's say they paid me six million last year," Lippmann would say. "I'm not saying they did. It was less than that. I'm not saying how much less." Before you could protest--
But I never asked!
--he'd say, "The kind of year I had, no way they pay me less than four million." Now he had you thinking about it:
So the number is between $4 million and $6 million.
You could have started out talking about New York City Ballet, and you wound up playing Battleship. Lippmann kept giving you these coordinates, until you were almost forced to identify the location of the ship--exactly what just about everyone else on Wall Street hoped you'd never do.

In further violation of the code, Lippmann was quick to let people know that whatever he'd been paid by his employer was not anything like what he'd been worth. "Senior management's job is to pay people," he'd say. "If they fuck a hundred guys out of a hundred grand each, that's ten million more for them. They have four categories: happy, satisfied, dissatisfied, disgusted. If they hit happy, they've screwed up: They never want you happy. On the other hand, they don't want you so disgusted you quit. The sweet spot is somewhere between dissatisfied and disgusted." 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. Greg Lippmann was incapable of disguising himself or his motives. "I don't have any particular allegiance to Deutsche Bank," he'd say. "I just work there." This was not an unusual attitude. What was unusual was that Lippmann said it.

The least controversial thing to be said about Lippmann was that he was controversial. He wasn't just a good bond trader, he was a great bond trader. He wasn't cruel. He wasn't even rude, at least not intentionally. He simply evoked extreme feelings in others. A trader who worked near him for years referred to him as "the asshole known as Greg Lippmann." When asked why, he said, "He took everything too far."

"I love Greg," said one of his bosses at Deutsche Bank. "I have nothing bad to say about him except that he's a fucking whack job." But when you cleared away the controversy around Lippmann's persona you could see it was rooted in two simple complaints. The first was that he was transparently self-interested and self-promotional. The second was that he was excessively alert to the self-interest and self-promotion of others. He had an almost freakish ability to identify shadowy motives. If you had just donated $20 million to your alma mater, say, and were feeling the glow of selfless devotion to a cause greater than yourself, Lippmann would be the first to ask, "So you gave twenty million because that's the minimum to get your name on a building, right?"

Now this character turns up out of nowhere to sell Steve Eisman on what he claims is his own original brilliant idea for betting against the subprime mortgage bond market. He made his case with a long and involved forty-two-page presentation: Over the past three years housing prices had risen far more rapidly than they had over the previous thirty; housing prices had not yet fallen but they had ceased to rise; even so, the loans against them were now going sour in their first year at amazing rates--up from 1 percent to 4 percent. Who borrowed money to buy a house and defaulted inside of twelve months? He went on for a bit, then showed Eisman this little chart that he'd created, and which he claimed was the reason he had become interested in the trade. It illustrated an astonishing fact: Since 2000, people whose homes had risen in value between 1 and 5 percent were nearly four times more likely to default on their home loans than people whose homes had risen in value more than 10 percent. Millions of Americans had no ability to repay their mortgages unless their houses rose dramatically in value, which enabled them to borrow even more.

That was the pitch in a nutshell: Home prices didn't even need to fall. They merely needed to stop rising at the unprecedented rates they had the previous few years for vast numbers of Americans to default on their home loans.

"Shorting Home Equity Mezzanine Tranches," Lippmann called his presentation. "Shorting Home Equity Mezzanine Tranches" was just a fancy way to describe Mike Burry's idea of betting against U.S. home loans: buying credit default swaps on the crappiest triple-B slices of subprime mortgage bonds. Lippmann himself described it more bluntly to a Deutsche Bank colleague who had seen the presentation and dubbed him "Chicken Little." "Fuck you," Lippmann had said. "I'm short your house."

The beauty of the credit default swap, or CDS, was that it solved the timing problem. Eisman no longer needed to guess exactly when the subprime mortgage market would crash. It also allowed him to make the bet without laying down cash up front, and put him in a position to win many times the sums he could possibly lose. Worst case: Insolvent Americans somehow paid off their subprime mortgage loans, and you were stuck paying an insurance premium of roughly 2 percent a year for as long as six years--the longest expected life span of the putatively thirty-year loans.

The alacrity with which subprime borrowers paid off their loans was yet another strange aspect of this booming market. It had to do with the structure of the loans, which were fixed for two or three years at an artificially low teaser rate before shooting up to the "go-to" floating rate. "They were making loans to lower-income people at a teaser rate when they knew they couldn't afford to pay the go-to rate," said Eisman. "They were doing it so that when the borrowers get to the end of the teaser rate period, they'd have to refinance, so the lenders can make more money off them." Thirty-year loans were thus designed to be repaid in a few years. At worst, if you bought credit default swaps on $100 million in subprime mortgage bonds you might wind up shelling out premium for six years--call it $12 million. At best: Losses on the loans rose from the current 4 percent to 8 percent, and you made $100 million. The bookies were offering you odds of somewhere between 6:1 and 10:1 when the odds of it working out felt more like 2:1. Anyone in the business of making smart bets couldn't not do it.

The argument stopper was Lippmann's one-man quantitative support team. His name was Eugene Xu, but to those who'd heard Lippmann's pitch, he was generally spoken of as "Lippmann's Chinese quant." Xu was an analyst employed by Deutsche Bank, but Lippmann gave everyone the idea he kept him tied up to his Bloomberg terminal like a pet. A real Chinese guy--not even Chinese American--who apparently spoke no English, just numbers. China had this national math competition, Lippmann told people, in which Eugene had finished second.
In all of China
. Eugene Xu was responsible for every piece of hard data in Lippmann's presentation. Once Eugene was introduced into the equation, no one bothered Lippmann about his math or his data. As Lippmann put it, "How can a guy who can't speak English lie?"

There was a lot more to it than that. Lippmann brimmed with fascinating details: the historical behavior of the American homeowner; the idiocy and corruption of the rating agencies, Moody's and S&P, who stuck a triple-B rating on subprime bonds that went bad when losses in the underlying pools of home loans reached just 8 percent;
*
the widespread fraud in the mortgage market; the folly of subprime mortgage investors, some large number of whom seemed to live in Dusseldorf, Germany. "Whenever we'd ask him who was buying this crap," said Vinny, "he always just said, 'Dusseldorf.'" It didn't matter whether Dusseldorf was buying actual cash subprime mortgage bonds or selling credit default swaps on those same mortgage bonds, as they amounted to one and the same thing: the long side of the bet.

Lippmann brimmed, also, with Lippmann. He hinted Eisman might get so rich from the trade he could buy the Los Angeles Dodgers. ("I'm not saying you're going to be able to buy the Dodgers.") Eisman might become so rich that movie stars would crave his body. ("I'm not saying you're going to date Jessica Simpson.") With one hand Lippmann presented the facts of the trade; with the other he tap-tap-tapped away, like a dowser probing for a well hidden deep in Eisman's character.

Keeping one eye on Greg Lippmann and the other on Steve Eisman, Vincent Daniel half expected the room to explode. Instead Steve Eisman found nothing even faintly objectionable about Greg Lippmann.
Great guy!
Eisman really only had a couple of questions. The first: Tell me again how the hell a credit default swap works? The second: Why are you asking me to bet against bonds your own firm is creating, and arranging for the rating agencies to mis-rate? "In my entire life I never saw a sell-side guy come in and say, 'Short my market,'" said Eisman. Lippmann wasn't even a bond salesman; he was a bond trader who might be expected to be long these very same subprime mortgage bonds. "I didn't mistrust him," says Eisman. "I didn't understand him. Vinny was the one who was sure he was going to fuck us in some way."

Eisman had no trouble betting against subprime mortgages. Indeed, he could imagine very little that would give him so much pleasure as the thought of going to bed each night, possibly for the next six years, knowing he was short a financial market he had come to know and despise and was certain would one day explode. "When he walked in and said you can make money shorting subprime paper, it was like putting a naked supermodel in front of me," said Eisman. "What I couldn't understand was why he wanted me to do it." That question, as it turned out, was more interesting than even Eisman suspected.

The subprime
mortgage market was generating half a trillion dollars' worth of new loans a year, but the circle of people redistributing the risk that the entire market would collapse was tiny. When the Goldman Sachs saleswoman called Mike Burry and told him that her firm would be happy to sell him credit default swaps in $100 million chunks, Burry guessed, rightly, that Goldman wasn't ultimately on the other side of his bets. Goldman would never be so stupid as to make huge naked bets that millions of insolvent Americans would repay their home loans. He didn't know who, or why, or how much, but he knew that some giant corporate entity with a triple-A rating was out there selling credit default swaps on subprime mortgage bonds. Only a triple-A-rated corporation could assume such risk, no money down, and no questions asked. Burry was right about this, too, but it would be three years before he knew it. The party on the other side of his bet against subprime mortgage bonds was the triple-A-rated insurance company AIG--American International Group, Inc. Or, rather, a unit of AIG called AIG FP.