12.09.08
The end
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[1]http://www.portfolio.com/news-markets/national-news/portfolio/2008/
11/11/The-End-of-Wall-Streets-Boom
Portfolio.com [2]December 2008
Issue
The End
by Michael Lewis
The era that defined Wall Street is finally, officially over. Michael
Lewis, who chronicled its excess in Liars Poker, returns to his old
haunt to figure out what went wrong.
To this day, the willingness of a Wall Street investment bank to pay
me hundreds of thousands of dollars to dispense investment advice to
grownups remains a mystery to me. I was 24 years old, with no
experience of, or particular interest in, guessing which stocks and
bonds would rise and which would fall. The essential function of Wall
Street is to allocate capitalto decide who should get it and who
should not. Believe me when I tell you that I hadnt the first clue.
Id never taken an accounting course, never run a business, never even
had savings of my own to manage. I stumbled into a job at Salomon
Brothers in 1985 and stumbled out much richer three years later, and
even though I wrote a book about the experience, the whole thing still
strikes me as preposterouswhich is one of the reasons the money was so
easy to walk away from. I figured the situation was unsustainable.
Sooner rather than later, someone was going to identify me, along with
a lot of people more or less like me, as a fraud. Sooner rather than
later, there would come a Great Reckoning when Wall Street would wake
up and hundreds if not thousands of young people like me, who had no
business making huge bets with other peoples money, would be expelled
from finance.
When I sat down to write my account of the experience in 1989Liars
Poker, it was calledit was in the spirit of a young man who thought he
was getting out while the getting was good. I was merely scribbling
down a message on my way out and stuffing it into a bottle for those
who would pass through these parts in the far distant future.
Unless some insider got all of this down on paper, I figured, no
future human would believe that it happened.
I thought I was writing a period piece about the 1980s in America. Not
for a moment did I suspect that the financial 1980s would last two
full decades longer or that the difference in degree between Wall
Street and ordinary life would swell into a difference in kind. I
expected readers of the future to be outraged that back in 1986, the
C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I
expected them to gape in horror when I reported that one of our
traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250
million; I assumed theyd be shocked to learn that a Wall Street C.E.O.
had only the vaguest idea of the risks his traders were running. What
I didnt expect was that any future reader would look on my experience
and say, How quaint.
I had no great agenda, apart from telling what I took to be a
remarkable tale, but if you got a few drinks in me and then asked what
effect I thought my book would have on the world, I might have said
something like, I hope that college students trying to figure out what
to do with their lives will read it and decide that its silly to phony
it up and abandon their passions to become financiers. I hoped that
some bright kid at, say, Ohio State University who really wanted to be
an oceanographer would read my book, spurn the offer from Morgan
Stanley, and set out to sea.
Somehow that message failed to come across. Six months after Liars
Poker was published, I was knee-deep in letters from students at Ohio
State who wanted to know if I had any other secrets to share about
Wall Street. Theyd read my book as a how-to manual.
In the two decades since then, I had been waiting for the end of Wall
Street. The outrageous bonuses, the slender returns to shareholders,
the never-ending scandals, the bursting of the internet bubble, the
crisis following the collapse of Long-Term Capital Management: Over
and over again, the big Wall Street investment banks would be, in some
narrow way, discredited. Yet they just kept on growing, along with the
sums of money that they doled out to 26-year-olds to perform tasks of
no obvious social utility. The rebellion by American youth against the
money culture never happened. Why bother to overturn your parents
world when you can buy it, slice it up into tranches, and sell off the
pieces?
At some point, I gave up waiting for the end. There was no scandal or
reversal, I assumed, that could sink the system.
Then came Meredith Whitney with news. Whitney was an obscure analyst
of financial firms for Oppenheimer Securities who, on October 31,
2007, ceased to be obscure. On that day, she predicted that Citigroup
had so mismanaged its affairs that it would need to slash its dividend
or go bust. Its never entirely clear on any given day what causes what
in the stock market, but it was pretty obvious that on October 31,
Meredith Whitney caused the market in financial stocks to crash. By
the end of the trading day, a woman whom basically no one had ever
heard of had shaved $369 billion off the value of financial firms in
the market. Four days later, Citigroups C.E.O., Chuck Prince,
resigned. In January, Citigroup slashed its dividend.
From that moment, Whitney became E.F. Hutton: When she spoke, people
listened. Her message was clear. If you want to know what these Wall
Street firms are really worth, take a hard look at the crappy assets
they bought with huge sums of borrowed money, and imagine what theyd
fetch in a fire sale. The vast assemblages of highly paid people
inside the firms were essentially worth nothing. For better than a
year now, Whitney has responded to the claims by bankers and brokers
that they had put their problems behind them with this write-down or
that capital raise with a claim of her own: Youre wrong. Youre still
not facing up to how badly you have mismanaged your business.
Rivals accused Whitney of being overrated; bloggers accused her of
being lucky. What she was, mainly, was right. But its true that she
was, in part, guessing. There was no way she could have known what was
going to happen to these Wall Street firms. The C.E.O.s themselves
didnt know.
Now, obviously, Meredith Whitney didnt sink Wall Street. She just
expressed most clearly and loudly a view that was, in retrospect, far
more seditious to the financial order than, say, Eliot Spitzers
campaign against Wall Street corruption. If mere scandal could have
destroyed the big Wall Street investment banks, theyd have vanished
long ago. This woman wasnt saying that Wall Street bankers were
corrupt. She was saying they were stupid. These people whose job it
was to allocate capital apparently didnt even know how to manage their
own.
At some point, I could no longer contain myself: I called Whitney.
This was back in March, when Wall Streets fate still hung in the
balance. I thought, If shes right, then this really could be the end
of Wall Street as weve known it. I was curious to see if she made
sense but also to know where this young woman who was crashing the
stock market with her every utterance had come from.
It turned out that she made a great deal of sense and that shed
arrived on Wall Street in 1993, from the Brown University history
department. I got to New York, and I didnt even know research existed,
she says. Shed wound up at Oppenheimer and had the most incredible
piece of luck: to be trained by a man who helped her establish not
merely a career but a worldview. His name, she says, was Steve Eisman.
Eisman had moved on, but they kept in touch. After I made the Citi
call, she says, one of the best things that happened was when Steve
called and told me how proud he was of me.
Having never heard of Eisman, I didnt think anything of this. But a
few months later, I called Whitney again and asked her, as I was
asking others, whom she knew who had anticipated the cataclysm and set
themselves up to make a fortune from it. Theres a long list of people
who now say they saw it coming all along but a far shorter one of
people who actually did. Of those, even fewer had the nerve to bet on
their vision. Its not easy to stand apart from mass hysteriato believe
that most of whats in the financial news is wrong or distorted, to
believe that most important financial people are either lying or
deludedwithout actually being insane. A handful of people had been
inside the black box, understood how it worked, and bet on it blowing
up. Whitney rattled off a list with a half-dozen names on it. At the
top was Steve Eisman.
Steve Eisman entered finance about the time I exited it. Hed grown up
in New York City and gone to a Jewish day school, the University of
Pennsylvania, and Harvard Law School. In 1991, he was a 30-year-old
corporate lawyer. I hated it, he says. I hated being a lawyer. My
parents worked as brokers at Oppenheimer. They managed to finagle me a
job. Its not pretty, but thats what happened.
He was hired as a junior equity analyst, a helpmate who didnt actually
offer his opinions. That changed in December 1991, less than a year
into his new job, when a subprime mortgage lender called Ames
Financial went public and no one at Oppenheimer particularly cared to
express an opinion about it. One of Oppenheimers investment bankers
stomped around the research department looking for anyone who knew
anything about the mortgage business. Recalls Eisman: Im a junior
analyst and just trying to figure out which end is up, but I told him
that as a lawyer Id worked on a deal for the Money Store. He was
promptly appointed the lead analyst for Ames Financial. What I didnt
tell him was that my job had been to proofread the documents and that
I hadnt understood a word of the fucking things.
Ames Financial belonged to a category of firms known as nonbank
financial institutions. The category didnt include J.P. Morgan, but it
did encompass many little-known companies that one way or another were
involved in the early-1990s boom in subprime mortgage lendingthe lower
class of American finance.
The second company for which Eisman was given sole responsibility was
Lomas Financial, which had just emerged from bankruptcy. I put a sell
rating on the thing because it was a piece of shit, Eisman says. I
didnt know that you werent supposed to put a sell rating on companies.
I thought there were three boxesbuy, hold, selland you could pick the
one you thought you should. He was pressured generally to be a bit
more upbeat, but upbeat wasnt Steve Eismans style. Upbeat and Eisman
didnt occupy the same planet. A hedge fund manager who counts Eisman
as a friend set out to explain him to me but quit a minute into it.
After describing how Eisman exposed various important people as either
liars or idiots, the hedge fund manager started to laugh. Hes sort of
a prick in a way, but hes smart and honest and fearless.
A lot of people dont get Steve, Whitney says. But the people who get
him love him. Eisman stuck to his sell rating on Lomas Financial, even
after the company announced that investors neednt worry about its
financial condition, as it had hedged its market risk. The single
greatest line I ever wrote as an analyst, says Eisman, was after Lomas
said they were hedged. He recited the line from memory: The Lomas
Financial Corp. is a perfectly hedged financial institution: It loses
money in every conceivable interest-rate environment. I enjoyed
writing that sentence more than any sentence I ever wrote. A few
months after hed delivered that line in his report, Lomas Financial
returned to bankruptcy.
Eisman wasnt, in short, an analyst with a sunny disposition who
expected the best of his fellow financial man and the companies he
created. You have to understand, Eisman says in his defense, I did
subprime first. I lived with the worst first. These guys lied to
infinity. What I learned from that experience was that Wall Street
didnt give a shit what it sold.
Harboring suspicions about peoples morals and telling investors that
companies dont deserve their capital wasnt, in the 1990s or at any
other time, the fast track to success on Wall Street. Eisman quit
Oppenheimer in 2001 to work as an analyst at a hedge fund, but what he
really wanted to do was run money. FrontPoint Partners, another hedge
fund, hired him in 2004 to invest in financial stocks. Eismans brief
was to evaluate Wall Street banks, homebuilders, mortgage originators,
and any company (General Electric or General Motors, for instance)
with a big financial-services divisionanyone who touched American
finance. An insurance company backed him with $50 million, a paltry
sum. Basically, we tried to raise money and didn’t really do it,
Eisman says.
Instead of money, he attracted people whose worldviews were as shaded
as his ownVincent Daniel, for instance, who became a partner and an
analyst in charge of the mortgage sector. Now 36, Daniel grew up a
lower-middle-class kid in Queens. One of his first jobs, as a junior
accountant at Arthur Andersen, was to audit Salomon Brothers books. It
was shocking, he says. No one could explain to me what they were
doing. He left accounting in the middle of the internet boom to become
a research analyst, looking at companies that made subprime loans. I
was the only guy I knew covering companies that were all going to go
bust, he says. I saw how the sausage was made in the economy, and it
was really freaky.
Danny Moses, who became Eismans head trader, was another who shared
his perspective. Raised in Georgia, Moses, the son of a finance
professor, was a bit less fatalistic than Daniel or Eisman, but he
nevertheless shared a general sense that bad things can and do happen.
When a Wall Street firm helped him get into a trade that seemed
perfect in every way, he said to the salesman, I appreciate this, but
I just want to know one thing: How are you going to screw me?
Heh heh heh, cmon. Wed never do that, the trader started to say, but
Moses was politely insistent: We both know that unadulterated good
things like this trade dont just happen between little hedge funds and
big Wall Street firms. Ill do it, but only after you explain to me how
you are going to screw me. And the salesman explained how he was going
to screw him. And Moses did the trade.
Both Daniel and Moses enjoyed, immensely, working with Steve Eisman.
He put a fine point on the absurdity they saw everywhere around them.
Steves fun to take to any Wall Street meeting, Daniel says. Because
hell say Explain that to me 30 different times. Or Could you explain
that more, in English? Because once you do that, theres a few things
you learn. For a start, you figure out if they even know what theyre
talking about. And a lot of times, they dont!
At the end of 2004, Eisman, Moses, and Daniel shared a sense that
unhealthy things were going on in the U.S. housing market: Lots of
firms were lending money to people who shouldnt have been borrowing
it. They thought Alan Greenspans decision after the internet bust to
lower interest rates to 1 percent was a travesty that would lead to
some terrible day of reckoning. Neither of these insights was entirely
original. Ivy Zelman, at the time the housing-market analyst at Credit
Suisse, had seen the bubble forming very early on. Theres a simple
measure of sanity in housing prices: the ratio of median home price to
income. Historically, it runs around 3 to 1; by late 2004, it had
risen nationally to 4 to 1. All these people were saying it was nearly
as high in some other countries, Zelman says. But the problem wasnt
just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami,
8.5 to 1. And then you coupled that with the buyers. They werent real
buyers. They were speculators. Zelman alienated clients with her
pessimism, but she couldnt pretend everything was good. It wasnt that
hard in hindsight to see it, she says. It was very hard to know when
it would stop. Zelman spoke occasionally with Eisman and always left
these conversations feeling better about her views and worse about the
world. You needed the occasional assurance that you werent nuts, she
says. She wasnt nuts. The world was.
By the spring of 2005, FrontPoint was fairly convinced that something
was very screwed up not merely in a handful of companies but in the
financial underpinnings of the entire U.S. mortgage market. In 2000,
there had been $130 billion in subprime mortgage lending, with $55
billion of that repackaged as mortgage bonds. But in 2005, there was
$625 billion in subprime mortgage loans, $507 billion of which found
its way into mortgage bonds. Eisman couldnt understand who was making
all these loans or why. He had a from-the-ground-up understanding of
both the U.S. housing market and Wall Street. But hed spent his life
in the stock market, and it was clear that the stock market was, in
this story, largely irrelevant. What most people dont realize is that
the fixed-income world dwarfs the equity world, he says. The equity
world is like a fucking zit compared with the bond market. He shorted
companies that originated subprime loans, like New Century and Indy
Mac, and companies that built the houses bought with the loans, such
as Toll Brothers. Smart as these trades proved to be, they werent
entirely satisfying. These companies paid high dividends, and their
shares were often expensive to borrow; selling them short was a costly
proposition.
Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He
arrived at FrontPoint bearing a 66-page presentation that described a
better way for the fund to put its view of both Wall Street and the
U.S. housing market into action. The smart trade, Lippman argued, was
to sell short not New Centurys stock but its bonds that were backed by
the subprime loans it had made. Eisman hadnt known this was even
possiblebecause until recently, it hadnt been. But Lippman, along with
traders at other Wall Street investment banks, had created a way to
short the subprime bond market with precision.
Heres where financial technology became suddenly, urgently relevant.
The typical mortgage bond was still structured in much the same way it
had been when I worked at Salomon Brothers. The loans went into a
trust that was designed to pay off its investors not all at once but
according to their rankings. The investors in the top tranche, rated
AAA, received the first payment from the trust and, because their
investment was the least risky, received the lowest interest rate on
their money. The investors who held the trusts BBB tranche got the
last paymentsand bore the brunt of the first defaults. Because they
were taking the most risk, they received the highest return. Eisman
wanted to bet that some subprime borrowers would default, causing the
trust to suffer losses. The way to express this view was to short the
BBB tranche. The trouble was that the BBB tranche was only a tiny
slice of the deal.
But the scarcity of truly crappy subprime-mortgage bonds no longer
mattered. The big Wall Street firms had just made it possible to short
even the tiniest and most obscure subprime-mortgage-backed bond by
creating, in effect, a market of side bets. Instead of shorting the
actual BBB bond, you could now enter into an agreement for a
credit-default swap with Deutsche Bank or Goldman Sachs. It cost money
to make this side bet, but nothing like what it cost to short the
stocks, and the upside was far greater.
The arrangement bore the same relation to actual finance as fantasy
football bears to the N.F.L. Eisman was perplexed in particular about
why Wall Street firms would be coming to him and asking him to sell
short. What Lippman did, to his credit, was he came around several
times to me and said, Short this market, Eisman says. In my entire
life, I never saw a sell-side guy come in and say, Short my market.
And short Eisman didthen he tried to get his mind around what hed just
done so he could do it better. Hed call over to a big firm and ask for
a list of mortgage bonds from all over the country. The juiciest
shortsthe bonds ultimately backed by the mortgages most likely to
defaulthad several characteristics. Theyd be in what Wall Street
people were now calling the sand states: Arizona, California, Florida,
Nevada. The loans would have been made by one of the more dubious
mortgage lenders; Long Beach Financial, wholly owned by Washington
Mutual, was a great example. Long Beach Financial was moving money out
the door as fast as it could, few questions asked, in loans built to
self-destruct. It specialized in asking homeowners with bad credit and
no proof of income to put no money down and defer interest payments
for as long as possible. In Bakersfield, California, a Mexican
strawberry picker with an income of $14,000 and no English was lent
every penny he needed to buy a house for $720,000.
More generally, the subprime market tapped a tranche of the American
public that did not typically have anything to do with Wall Street.
Lenders were making loans to people who, based on their credit
ratings, were less creditworthy than 71 percent of the population.
Eisman knew some of these people. One day, his housekeeper, a South
American woman, told him that she was planning to buy a townhouse in
Queens. The price was absurd, and they were giving her a
low-down-payment option-ARM, says Eisman, who talked her into taking
out a conventional fixed-rate mortgage. Next, the baby nurse hed hired
back in 1997 to take care of his newborn twin daughters phoned him.
She was this lovely woman from Jamaica, he says. One day she calls me
and says she and her sister own five townhouses in Queens. I said, How
did that happen? It happened because after they bought the first one
and its value rose, the lenders came and suggested they refinance and
take out $250,000, which they used to buy another one. Then the price
of that one rose too, and they repeated the experiment. By the time
they were done, Eisman says, they owned five of them, the market was
falling, and they couldnt make any of the payments.
In retrospect, pretty much all of the riskiest subprime-backed bonds
were worth betting against; they would all one day be worth zero. But
at the time Eisman began to do it, in the fall of 2006, that wasnt
clear. He and his team set out to find the smelliest pile of loans
they could so that they could make side bets against them with Goldman
Sachs or Deutsche Bank. What they were doing, oddly enough, was the
analysis of subprime lending that should have been done before the
loans were made: Which poor Americans were likely to jump which way
with their finances? How much did home prices need to fall for these
loans to blow up? (It turned out they didnt have to fall; they merely
needed to stay flat.) The default rate in Georgia was five times
higher than that in Florida even though the two states had the same
unemployment rate. Why? Indiana had a 25 percent default rate;
Californias was only 5 percent. Why?
Moses actually flew down to Miami and wandered around neighborhoods
built with subprime loans to see how bad things were. Hed call me and
say, Oh my God, this is a calamity here, recalls Eisman. All that was
required for the BBB bonds to go to zero was for the default rate on
the underlying loans to reach 14 percent. Eisman thought that, in
certain sections of the country, it would go far, far higher.
The funny thing, looking back on it, is how long it took for even
someone who predicted the disaster to grasp its root causes. They were
learning about this on the fly, shorting the bonds and then trying to
figure out what they had done. Eisman knew subprime lenders could be
scumbags. What he underestimated was the total unabashed complicity of
the upper class of American capitalism. For instance, he knew that the
big Wall Street investment banks took huge piles of loans that in and
of themselves might be rated BBB, threw them into a trust, carved the
trust into tranches, and wound up with 60 percent of the new total
being rated AAA.
But he couldnt figure out exactly how the rating agencies justified
turning BBB loans into AAA-rated bonds. I didnt understand how they
were turning all this garbage into gold, he says. He brought some of
the bond people from Goldman Sachs, Lehman Brothers, and UBS over for
a visit. We always asked the same question, says Eisman. Where are the
rating agencies in all of this? And Id always get the same reaction.
It was a smirk. He called Standard & Poors and asked what would happen
to default rates if real estate prices fell. The man at S&P couldnt
say; its model for home prices had no ability to accept a negative
number. They were just assuming home prices would keep going up,
Eisman says.
As an investor, Eisman was allowed on the quarterly conference calls
held by Moodys but not allowed to ask questions. The people at Moodys
were polite about their brush-off, however. The C.E.O. even invited
Eisman and his team to his office for a visit in June 2007. By then,
Eisman was so certain that the world had been turned upside down that
he just assumed this guy must know it too. But were sitting there,
Daniel recalls, and he says to us, like he actually means it, I truly
believe that our rating will prove accurate. And Steve shoots up in
his chair and asks, What did you just say? as if the guy had just
uttered the most preposterous statement in the history of finance. He
repeated it. And Eisman just laughed at him.
With all due respect, sir, Daniel told the C.E.O. deferentially as
they left the meeting, youre delusional.
This wasnt Fitch or even S&P. This was Moodys, the aristocrats of the
rating business, 20 percent owned by Warren Buffett. And the companys
C.E.O. was being told he was either a fool or a crook by one Vincent
Daniel, from Queens.
A full nine months earlier, Daniel and Moses had flown to Orlando for
an industry conference. It had a grand titlethe American
Securitization Forumbut it was essentially a trade show for the
subprime-mortgage business: the people who originated subprime
mortgages, the Wall Street firms that packaged and sold subprime
mortgages, the fund managers who invested in nothing but
subprime-mortgage-backed bonds, the agencies that rated subprime-Â
mortgage bonds, the lawyers who did whatever the lawyers did. Daniel
and Moses thought they were paying a courtesy call on a cottage
industry, but the cottage had become a castle. There were like 6,000
people there, Daniel says. There were so many people being fed by this
industry. The entire fixed-income department of each brokerage firm is
built on this. Everyone there was the long side of the trade. The
wrong side of the trade. And then there was us. Thats when the picture
really started to become clearer, and we started to get more cynical,
if that was possible. We went back home and said to Steve, You gotta
see this.
Eisman, Daniel, and Moses then flew out to Las Vegas for an even
bigger subprime conference. By now, Eisman knew everything he needed
to know about the quality of the loans being made. He still didnt
fully understand how the apparatus worked, but he knew that Wall
Street had built a doomsday machine. He was at once opportunistic and
outraged.
Their first stop was a speech given by the C.E.O. of Option One, the
mortgage originator owned by H&R Block. When the guy got to the part
of his speech about Option Ones subprime-loan portfolio, he claimed to
be expecting a modest default rate of 5 percent. Eisman raised his
hand. Moses and Daniel sank into their chairs. It wasnt a Q&A, says
Moses. The guy was giving a speech. He sees Steves hand and says, Yes?
Would you say that 5 percent is a probability or a possibility?
Eisman asked.
A probability, said the C.E.O., and he continued his speech.
Eisman had his hand up in the air again, waving it around. Oh, no,
Moses thought. The one thing Steve always says, Daniel explains, is
you must assume they are lying to you. They will always lie to you.
Moses and Daniel both knew what Eisman thought of these subprime
lenders but didnt see the need for him to express it here in this
manner. For Eisman wasnt raising his hand to ask a question. He had
his thumb and index finger in a big circle. He was using his fingers
to speak on his behalf. Zero! they said.
Yes? the C.E.O. said, obviously irritated. Is that another question?
No, said Eisman. Its a zero. There is zero probability that your
default rate will be 5 percent. The losses on subprime loans would be
much, much greater. Before the guy could reply, Eismans cell phone
rang. Instead of shutting it off, Eisman reached into his pocket and
answered it. Excuse me, he said, standing up. But I need to take this
call. And with that, he walked out.
Eismans willingness to be abrasive in order to get to the heart of the
matter was obvious to all; what was harder to see was his credulity:
He actually wanted to believe in the system. As quick as he was to cry
bullshit when he saw it, he was still shocked by bad behavior. That
night in Vegas, he was seated at dinner beside a really nice guy who
invested in mortgage C.D.O.scollateralized debt obligations. By then,
Eisman thought he knew what he needed to know about C.D.O.s. He didnt,
it turned out.
Later, when I sit down with Eisman, the very first thing he wants to
explain is the importance of the mezzanine C.D.O. What you notice
first about Eisman is his lips. He holds them pursed, waiting to
speak. The second thing you notice is his short, light hair, cropped
in a manner that suggests he cut it himself while thinking about
something else. You have to understand this, he says. This was the
engine of doom. Then he draws a picture of several towers of debt. The
first tower is made of the original subprime loans that had been piled
together. At the top of this tower is the AAA tranche, just below it
the AA tranche, and so on down to the riskiest, the BBB tranchethe
bonds Eisman had shorted. But Wall Street had used these BBB
tranchesthe worst of the worstto build yet another tower of bonds: a
particularly egregious C.D.O. The reason they did this was that the
rating agencies, presented with the pile of bonds backed by dubious
loans, would pronounce most of them AAA. These bonds could then be
sold to investorspension funds, insurance companieswho were allowed to
invest only in highly rated securities. I cannot fucking believe this
is allowedI must have said that a thousand times in the past two
years, Eisman says.
His dinner companion in Las Vegas ran a fund of about $15 billion and
managed C.D.O.s backed by the BBB tranche of a mortgage bond, or as
Eisman puts it, the equivalent of three levels of dog shit lower than
the original bonds.
FrontPoint had spent a lot of time digging around in the dog shit and
knew that the default rates were already sufficient to wipe out this
guys entire portfolio. God, you must be having a hard time, Eisman
told his dinner companion.
No, the guy said, Ive sold everything out.
After taking a fee, he passed them on to other investors. His job was
to be the C.D.O. expert, but he actually didnt spend any time at all
thinking about what was in the C.D.O.s. He managed the C.D.O.s, says
Eisman, but managed what? I was just appalled. People would pay up to
have someone manage their C.D.O.sas if this moron was helping you. I
thought, You prick, you dont give a fuck about the investors in this
thing.
Whatever rising anger Eisman felt was offset by the mans genial
disposition. Not only did he not mind that Eisman took a dim view of
his C.D.O.s; he saw it as a basis for friendship. Then he said
something that blew my mind, Eisman tells me. He says, I love guys
like you who short my market. Without you, I dont have anything to
buy.
Thats when Eisman finally got it. Here hed been making these side bets
with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche
without fully understanding why those firms were so eager to make the
bets. Now he saw. There werent enough Americans with shitty credit
taking out loans to satisfy investors appetite for the end product.
The firms used Eismans bet to synthesize more of them. Here, then, was
the difference between fantasy finance and fantasy football: When a
fantasy player drafts Peyton Manning, he doesnt create a second Peyton
Manning to inflate the leagues stats. But when Eisman bought a
credit-default swap, he enabled Deutsche Bank to create another bond
identical in every respect but one to the original. The only
difference was that there was no actual homebuyer or borrower. The
only assets backing the bonds were the side bets Eisman and others
made with firms like Goldman Sachs. Eisman, in effect, was paying to
Goldman the interest on a subprime mortgage. In fact, there was no
mortgage at all. They werent satisfied getting lots of unqualified
borrowers to borrow money to buy a house they couldnt afford, Eisman
says. They were creating them out of whole cloth. One hundred times
over! Thats why the losses are so much greater than the loans. But
thats when I realized they needed us to keep the machine running. I
was like, This is allowed?
This particular dinner was hosted by Deutsche Bank, whose head trader,
Greg Lippman, was the fellow who had introduced Eisman to the subprime
bond market. Eisman went and found Lippman, pointed back to his own
dinner companion, and said, I want to short him. Lippman thought he
was joking; he wasnt. Greg, I want to short his paper, Eisman
repeated. Sight unseen.
Eisman started out running a $60 million equity fund but was now short
around $600 million of various subprime-related securities. In the
spring of 2007, the market strengthened. But, says Eisman, credit
quality always gets better in March and April. And the reason it
always gets better in March and April is that people get their tax
refunds. You would think people in the securitization world would know
this. We just thought that was moronic.
He was already short the stocks of mortgage originators and the
homebuilders. Now he took short positions in the rating agenciesthey
were making 10 times more rating C.D.O.s than they were rating G.M.
bonds, and it was all going to endand, finally, the biggest Wall
Street firms because of their exposure to C.D.O.s. He wasnt allowed to
short Morgan Stanley because it owned a stake in his fund. But he
shorted UBS, Lehman Brothers, and a few others. Not long after that,
FrontPoint had a visit from Sanford C. Bernsteins Brad Hintz, a
prominent analyst who covered Wall Street firms. Hintz wanted to know
what Eisman was up to. We just shorted Merrill Lynch, Eisman told him.
Why? asked Hintz.
We have a simple thesis, Eisman explained. There is going to be a
calamity, and whenever there is a calamity, Merrill is there. When it
came time to bankrupt Orange County with bad advice, Merrill was
there. When the internet went bust, Merrill was there. Way back in the
1980s, when the first bond trader was let off his leash and lost
hundreds of millions of dollars, Merrill was there to take the hit.
That was Eismans logicthe logic of Wall Streets pecking order. Goldman
Sachs was the big kid who ran the games in this neighborhood. Merrill
Lynch was the little fat kid assigned the least pleasant roles, just
happy to be a part of things. The game, as Eisman saw it, was Crack
the Whip. He assumed Merrill Lynch had taken its assigned place at the
end of the chain.
There was only one thing that bothered Eisman, and it continued to
trouble him as late as May 2007. The thing we couldnt figure out is:
Its so obvious. Why hasnt everyone else figured out that the machine
is done? Eisman had long subscribed to Grants Interest Rate Observer,
a newsletter famous in Wall Street circles and obscure outside them.
Jim Grant, its editor, had been prophesying doom ever since the great
debt cycle began, in the mid-1980s. In late 2006, he decided to
investigate these things called C.D.O.s. Or rather, he had asked his
young assistant, Dan Gertner, a chemical engineer with an M.B.A., to
see if he could understand them. Gertner went off with the documents
that purported to explain C.D.O.s to potential investors and for
several days sweated and groaned and heaved and suffered. Then he came
back, says Grant, and said, I cant figure this thing out. And I said,
I think we have our story.
Eisman read Grants piece as independent confirmation of what he knew
in his bones about the C.D.O.s he had shorted. When I read it, I
thought, Oh my God. This is like owning a gold mine. When I read that,
I was the only guy in the equity world who almost had an orgasm.
On July 19, 2007, the same day that Federal Reserve Chairman Ben
Bernanke told the U.S. Senate that he anticipated as much as $100
billion in losses in the subprime-mortgage market, FrontPoint did
something unusual: It hosted its own conference call. It had had calls
with its tiny population of investors, but this time FrontPoint opened
it up. Steve Eisman had become a poorly kept secret. Five hundred
people called in to hear what he had to say, and another 500 logged on
afterward to listen to a recording of it. He explained the strange
alchemy of the C.D.O. and said that he expected losses of up to $300
billion from this sliver of the market alone. To evaluate the
situation, he urged his audience to just throw your model in the
garbage can. The models are all backward-looking.
The models dont have any idea of what this world has become. For the
first time in their lives, people in the asset-backed-securitization
world are actually having to think. He explained that the rating
agencies were morally bankrupt and living in fear of becoming actually
bankrupt. The rating agencies are scared to death, he said. Theyre
scared to death about doing nothing because theyll look like fools if
they do nothing.
On September 18, 2008, Danny Moses came to work as usual at 6:30 a.m.
Earlier that week, Lehman Brothers had filed for bankruptcy. The day
before, the Dow had fallen 449 points to its lowest level in four
years. Overnight, European governments announced a ban on
short-selling, but that served as faint warning for what happened
next.
At the market opening in the U.S., everythingevery financial assetwent
into free fall. All hell was breaking loose in a way I had never seen
in my career, Moses says. FrontPoint was net short the market, so this
total collapse should have given Moses pleasure. He might have been
forgiven if he stood up and cheered. After all, hed been betting for
two years that this sort of thing could happen, and now it was, more
dramatically than he had ever imagined. Instead, he felt this
terrifying shudder run through him. He had maybe 100 trades on, and he
worked hard to keep a handle on them all. I spent my morning trying to
control all this energy and all this information, he says, and I lost
control. I looked at the screens. I was staring into the abyss. The
end. I felt this shooting pain in my head. I dont get headaches. At
first, I thought I was having an aneurysm.
Moses stood up, wobbled, then turned to Daniel and said, I gotta
leave. Get out of here. Now. Daniel thought about calling an ambulance
but instead took Moses out for a walk.
Outside it was gorgeous, the blue sky reaching down through the tall
buildings and warming the soul. Eisman was at a Goldman Sachs
conference for hedge fund managers, raising capital. Moses and Daniel
got him on the phone, and he left the conference and met them on the
steps of St. Patricks Cathedral. We just sat there, Moses says.
Watching the people pass.
This was what they had been waiting for: total collapse. The
investment-banking industry is fucked, Eisman had told me a few weeks
earlier. These guys are only beginning to understand how fucked they
are. Its like being a Scholastic, prior to Newton. Newton comes along,
and one morning you wake up: Holy shit, Im wrong! Now Lehman Brothers
had vanished, Merrill had surrendered, and Goldman Sachs and Morgan
Stanley were just a week away from ceasing to be investment banks. The
investment banks were not just fucked; they were extinct.
Not so for hedge fund managers who had seen it coming. As we sat
there, we were weirdly calm, Moses says. We felt insulated from the
whole market reality. It was an out-of-body experience. We just sat
and watched the people pass and talked about what might happen next.
How many of these people were going to lose their jobs. Who was going
to rent these buildings after all the Wall Street firms collapsed.
Eisman was appalled. Look, he said. Im short. I dont want the country
to go into a depression. I just want it to fucking deleverage. He had
tried a thousand times in a thousand ways to explain how screwed up
the business was, and no one wanted to hear it. That Wall Street has
gone down because of this is justice, he says. They fucked people.
They built a castle to rip people off. Not once in all these years
have I come across a person inside a big Wall Street firm who was
having a crisis of conscience.
Truth to tell, there wasnt a whole lot of hand-wringing inside
FrontPoint either. The only one among them who wrestled a bit with his
conscience was Daniel. Vinny, being from Queens, needs to see the dark
side of everything, Eisman says. To which Daniel replies, The way we
thought about it was, By shorting this market were creating the
liquidity to keep the market going.
It was like feeding the monster, Eisman says of the market for
subprime bonds. We fed the monster until it blew up.
About the time they were sitting on the steps of the midtown
cathedral, I sat in a booth in a restaurant on the East Side, waiting
for John Gutfreund to arrive for lunch, and wondered, among other
things, why any restaurant would seat side by side two men without the
slightest interest in touching each other.
There was an umbilical cord running from the belly of the exploded
beast back to the financial 1980s. A friend of mine created the first
mortgage derivative in 1986, a year after we left the Salomon Brothers
trading program. (The problem isnt the tools, he likes to say. Its who
is using the tools. Derivatives are like guns.)
When I published my book, the 1980s were supposed to be ending. I
received a lot of undeserved credit for my timing. The social
disruption caused by the collapse of the savings-and-loan industry and
the rise of hostile takeovers and leveraged buyouts had given way to a
brief period of recriminations. Just as most students at Ohio State
read Liars Poker as a manual, most TV and radio interviewers regarded
me as a whistleblower. (The big exception was Geraldo Rivera. He put
me on a show called People Who Succeed Too Early in Life along with
some child actors whod gone on to become drug addicts.) Anti-Wall
Street feeling ran highhigh enough for Rudy Giuliani to float a
political career on itbut the result felt more like a witch hunt than
an honest reappraisal of the financial order. The public lynchings of
Gutfreund and junk-bond king Michael Milken were excuses not to deal
with the disturbing forces underpinning their rise. Ditto the cleaning
up of Wall Streets trading culture. The surface rippled, but down
below, in the depths, the bonus pool remained undisturbed. Wall Street
firms would soon be frowning upon profanity, firing traders for so
much as glancing at a stripper, and forcing male employees to treat
women almost as equals. Lehman Brothers circa 2008 more closely
resembled a normal corporation with solid American values than did any
Wall Street firm circa 1985.
The changes were camouflage. They helped distract outsiders from the
truly profane event: the growing misalignment of interests between the
people who trafficked in financial risk and the wider culture.
Id not seen Gutfreund since I quit Wall Street. Id met him, nervously,
a couple of times on the trading floor. A few months before I left, my
bosses asked me to explain to Gutfreund what at the time seemed like
exotic trades in derivatives Id done with a European hedge fund. I
tried. He claimed not to be smart enough to understand any of it, and
I assumed that was how a Wall Street C.E.O. showed he was the boss, by
rising above the details. There was no reason for him to remember any
of these encounters, and he didnt: When my book came out and became a
public-relations nuisance to him, he told reporters wed never met.
Over the years, Id heard bits and pieces about Gutfreund. I knew that
after hed been forced to resign from Salomon Brothers hed fallen on
harder times. I heard later that a few years ago hed sat on a panel
about Wall Street at Columbia Business School. When his turn came to
speak, he advised students to find something more meaningful to do
with their lives. As he began to describe his career, he broke down
and wept.
When I emailed him to invite him to lunch, he could not have been more
polite or more gracious. That attitude persisted as he was escorted to
the table, made chitchat with the owner, and ordered his food. Hed
lost a half-step and was more deliberate in his movements, but
otherwise he was completely recognizable. The same veneer of denatured
courtliness masked the same animal need to see the world as it was,
rather than as it should be.
We spent 20 minutes or so determining that our presence at the same
lunch table was not going to cause the earth to explode. We discovered
we had a mutual acquaintance in New Orleans. We agreed that the Wall
Street C.E.O. had no real ability to keep track of the frantic
innovation occurring inside his firm. (I didnt understand all the
product lines, and they dont either, he said.) We agreed, further,
that the chief of the Wall Street investment bank had little control
over his subordinates. (Theyre buttering you up and then doing
whatever the fuck they want to do.) He thought the cause of the
financial crisis was simple. Greed on both sidesgreed of investors and
the greed of the bankers. I thought it was more complicated. Greed on
Wall Street was a givenalmost an obligation. The problem was the
system of incentives that channeled the greed.
But I didnt argue with him. For just as you revert to being about nine
years old when you visit your parents, you revert to total
subordination when you are in the presence of your former C.E.O. John
Gutfreund was still the King of Wall Street, and I was still a geek.
He spoke in declarative statements; I spoke in questions.
But as he spoke, my eyes kept drifting to his hands. His alarmingly
thick and meaty hands. They werent the hands of a soft Wall Street
banker but of a boxer. I looked up. The boxer was smilingthough it was
less a smile than a placeholder expression. And he was saying, very
deliberately, Yourfuckingbook.
I smiled back, though it wasnt quite a smile.
Your fucking book destroyed my career, and it made yours, he said.
I didnt think of it that way and said so, sort of.
Why did you ask me to lunch? he asked, though pleasantly. He was
genuinely curious.
You cant really tell someone that you asked him to lunch to let him
know that you dont think of him as evil. Nor can you tell him that you
asked him to lunch because you thought that you could trace the
biggest financial crisis in the history of the world back to a
decision he had made. John Gutfreund did violence to the Wall Street
social orderand got himself dubbed the King of Wall Streetwhen he
turned Salomon Brothers from a private partnership into Wall Streets
first public corporation. He ignored the outrage of Salomons retired
partners. (I was disgusted by his materialism, William Salomon, the
son of the firms founder, who had made Gutfreund C.E.O. only after hed
promised never to sell the firm, had told me.) He lifted a giant
middle finger at the moral disapproval of his fellow Wall Street
C.E.O.s. And he seized the day. He and the other partners not only
made a quick killing; they transferred the ultimate financial risk
from themselves to their shareholders. It didnt, in the end, make a
great deal of sense for the shareholders. (A share of Salomon Brothers
purchased when I arrived on the trading floor, in 1986, at a then
market price of $42, would be worth 2.26 shares of Citigroup
todaymarket value: $27.) But it made fantastic sense for the
investment bankers.
From that moment, though, the Wall Street firm became a black box. The
shareholders who financed the risks had no real understanding of what
the risk takers were doing, and as the risk-taking grew ever more
complex, their understanding diminished. The moment Salomon Brothers
demonstrated the potential gains to be had by the investment bank as
public corporation, the psychological foundations of Wall Street
shifted from trust to blind faith.
No investment bank owned by its employees would have levered itself 35
to 1 or bought and held $50 billion in mezzanine C.D.O.s. I doubt any
partnership would have sought to game the rating agencies or leap into
bed with loan sharks or even allow mezzanine C.D.O.s to be sold to its
customers. The hoped-for short-term gain would not have justified the
long-term hit.
No partnership, for that matter, would have hired me or anyone
remotely like me. Was there ever any correlation between the ability
to get in and out of Princeton and a talent for taking financial risk?
Now I asked Gutfreund about his biggest decision. Yes, he said.
Theythe heads of the other Wall Street firmsall said what an awful
thing it was to go public and how could you do such a thing. But when
the temptation arose, they all gave in to it. He agreed that the main
effect of turning a partnership into a corporation was to transfer the
financial risk to the shareholders. When things go wrong, its their
problem, he saidand obviously not theirs alone. When a Wall Street
investment bank screwed up badly enough, its risks became the problem
of the U.S. government. Its laissez-faire until you get in deep shit,
he said, with a half chuckle. He was out of the game.
It was now all someone elses fault.
He watched me curiously as I scribbled down his words. Whats this for?
he asked.
I told him I thought it might be worth revisiting the world Id
described in Liars Poker, now that it was finally dying. Maybe bring
out a 20th-anniversary edition.
Thats nauseating, he said.
Hard as it was for him to enjoy my company, it was harder for me not
to enjoy his. He was still tough, as straight and blunt as a butcher.
Hed helped create a monster, but he still had in him a lot of the old
Wall Street, where people said things like A mans word is his bond. On
that Wall Street, people didnt walk out of their firms and cause
trouble for their former bosses by writing books about them. No, he
said, I think we can agree about this: Your fucking book destroyed my
career, and it made yours. With that, the former king of a former Wall
Street lifted the plate that held his appetizer and asked sweetly,
Would you like a deviled egg?
Until that moment, I hadnt paid much attention to what hed been
eating. Now I saw hed ordered the best thing in the house, this
gorgeous frothy confection of an earlier age. Who ever dreamed up the
deviled egg? Who knew that a simple egg could be made so complicated
and yet so appealing? I reached over and took one. Something for
nothing. It never loses its charm.
References
1. http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom
2. http://www.portfolio.com/in-this-issue-dec-2008