PDF Summary:The Big Short, by Michael Lewis

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Many investors at this time, in fact, shied away from them because the cash flows were undesirable. During this era, the bonds were made up of rock-solid mortgages to creditworthy homeowners who were in little risk of default. Ironically, this was the original problem that investors had with these securities. Borrowers could always pay off their mortgages any time they wished, and it was usually easiest for them to do so in a low-interest environment.

Buyers of mortgage-backed securities at this time weren’t concerned about default: they were worried about being paid back too quickly. As an investor, you want to be sitting on cash when interest rates are high so that you can reinvest that money and earn even greater returns. The basic nature of mortgage-backed securities seemed to cut against this basic investing principle. Because people were paying off their mortgages when interest rates were low, the holder of a mortgage-backed security received their money back precisely when it was least valuable to them.

Specialty Finance

Wall Street, however, had a workaround to this problem.** Instead of buying the whole bundle, investors could purchase a...

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The success of his blog established Burry as an acknowledged authority on value investing. Eventually, he quit medical school to pursue a career in finance. Joel Greenblatt of Gotham Capital offered Burry a million dollars to start his own fund, Scion Capital.

Scion was quickly delivering for its clients, no doubt due to Burry’s keen insights about true value and risk. He knew how to beat the market. In 2001, the S&P index fell by nearly 12 percent, but Scion was up 55 percent. In 2002, the S&P fell by over 22 percent, but Scion was up 16 percent. Burry believed that incentives were the driving force behind much of human behavior—and that his rival fund managers had poor ones. Most other managers simply took a 2 percent cut of the total assets under their portfolio, which they earned regardless of how their actually performed. Thus, their incentive was simply to hoard clients’ money, not to take the time and energy to grow that money.

Burry believed this to be inherently unfair. Scion took a different tack, only charging customers for the actual expenses incurred running the fund. Burry insisted on profiting only when his clients profited first.

The...

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He also showed Eisman the powerful compelling logic behind the credit default swap bet. You wouldn’t have to pay premium costs for long—most of these nominally 30-year mortgages were really designed to be refinanced and paid off within six years. 30 years became six when low-income Americans couldn’t afford their mortgages after the teaser rate ended and they were forced to refinance. Because the ability to refinance depends on the home’s value, ever-rising home prices meant homeowners would always be able to refinance and borrow more money. If you purchased swaps on $100 million in subprime bonds, your maximum losses would only be the fixed annual premium costs of $2 million per year—$12 million total for six years. But if the default rate rose from 4 to 8 percent, you stood to reap the full face value of the original bond—$100 million.

Finally, despite his skepticism, Eisman did the trade with Lippmann. The logic was sound. Premiums on even the worst subprime bonds were less than two percent of the face value of the referenced bond per year. This was a minor cost compared to what he would earn when the subprime market imploded, which was a certainty. It was spending $2...

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The lending standards Eisman saw were obscene. Homeowners with no credit and no proof of income were issued mortgages with no money down. In one instance, a strawberry picker earning $14,000 per year was loaned the money to buy a house worth over $700,000. Eisman even saw the bubble affecting people within his own personal circle. His housekeeper was offered an adjustable-rate, no money down-mortgage to purchase a townhouse in Queens. His daughters’ baby nurse somehow managed to purchase six townhouses in Queens through easy credit. One of his partners even knew a stripper who had five separate home equity loans.

In Eisman’s view, the willingness of borrowers to take out these kinds of loans wasn’t the shocking part. Borrowers had always tried to get as much as they could from creditors. But it had traditionally been the rigid adherence to strict lending standards that had stopped lenders from giving money to obviously un-creditworthy borrowers. Why were they suddenly now so eager to lend money like this?

The answer, of course, lies in the fact that lenders were just repackaging these loans off to the big banks to be sliced and diced into CDOs to be sold...

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Cornwall’s first test of this theory was with Capital One, a credit card company specializing in issuing credit cards to Americans with poor credit scores. In the early 2000s, their stock had tanked amid fears that they had insufficient capital reserved as collateral to cover the risky credit cards they’d issued. The company soon got into a regulatory dispute with the federal government. The market smelled fraud and investors fled in droves. Despite this, Capital One wasn’t posting unusual losses. Upon speaking with a mid-level corporate manager at Capital One (the only person who would return their phone call), Ledley and Mai discovered that he was buying stock in his own company—not the behavior they’d expect to see from officers at a company engaged in fraud. They determined that Capital One was more or less a sound company, the regulatory dispute was trivial, and that the market was irrationally penalizing them.

For Cornwall, the stock was clearly underpriced at $30-per-share. The best way to profit off this was not to buy the stock itself, but to buy the right to buy the stock at a fixed price for a defined period of time. And the options to buy Capital One...

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And, to Eisman’s disgust, Chau was paid obscenely for doing nothing more than shuffling around stacks of useless debt. He received a 0.01 percent fee off the top of the total CDO portfolio he managed, before any of the investors he theoretically served got paid anything (the opposite, if you’ll recall, of Michael Burry’s client-first business model at Scion Capital). This, of course, gave the CDO manager every incentive to grow the pile of CDOs as large as he or she could, no questions asked about the quality of the underlying loans. And 0.01 percent was a lot when you were talking about billions of dollars. In just one year, a CDO manager like Chau could take home $26 million.

Lippmann knew that a figure like Chau embodied everything that Eisman hated about Wall Street. He was arrogant, mediocre, wildly overcompensated, and had his clients’ worst interests at heart. He was a living representation of the dumb wealth that Eisman found so appalling. Meeting Chau was just the sort of boost that Steve Eisman needed to continue shorting the subprime market. Not only did Eisman stand to make lots of money, but he would do so at the expense of the Wing Chaus of the...

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Side-Pocketing

So what did Burry do? He told his investors, no, they couldn’t have their money back. He exercised a rarely used provision in his contracts with the investors that enabled him to lock up their money if it was invested in assets for which there either was no market or that could not be freely traded. He argued that credit default swaps were just such an asset and that the market for them was either fraudulent or totally dysfunctional. In doing this, he “side-pocketed” his investors’ money, keeping it invested until his bet had fully played out.

But as the aforementioned downturns in the subprime market began in 2007, Scion’s fortunes began to shift, just as Burry had told investors they would. In the first quarter of 2007, Scion was back up by 18 percent. The loans were going bad and borrowers were getting slammed with higher interest payments. The bill was finally coming due for Wall Street.

In just one pool of mortgages that Scion bet against, delinquencies, foreclosures, and bankruptcies rose from 15.6 percent to 37.7 percent from February to June 2007. More than a third of borrowers had defaulted on their loans. The bonds were suddenly worthless....