Study Guide

The Big Short: Inside the Doomsday Machine Chapter 3

By Michael Lewis

Chapter 3

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

  • Eisman and Vinny are pretty skeptical when Greg Lippmann shows up at their offices in February 2006.
  • Lippmann, by the way, is your classic shady Wall Street-type. Dude has more than a little "Gordon Gekko" in him (3.4).
  • Lippman basically pitches Burry's credit default swaps to Eisman as a presentation entitled "'Shorting Home Equity Mezzanine Tranches'" (3.10). Yeah—nonsense.
  • In addition to stealing Burry's work, Lippmann has used an analyst named Eugene Wu to further solidify the idea that the subprime mortgage market is on fire.
  • What's odd, though, is that Lippmann wants these guys to bet against bonds. He's basically telling them that his industry is going to fail.
  • Vinny is skeptical, but Eisman is uncharacteristically gung-ho. He gobbles up those credit default swaps like there's no tomorrow.
  • Background time. Based on the bank's enthusiasm, it's unlikely that they're the ones who actually own the bonds—they're just dealing them. There has to be another party in this deal.
  • That happens to be AIG, or the American International Group, Inc. To be more specific, these bonds originated in a division called AIG Financial Products, which started back in '86.
  • Since its beginning, AIG FP's bread and butter ahs been insuring assets for banks that are too risky for the banks to hold themselves. (In this context, insuring something is pretty much the same thing as buying it.)
  • AIG FP makes a stupid amount of money—roughly $300 million per year by 2001, which is "15 percent of AIG's profits" (3.23).
  • By 2004, AIG FP has dropped its smaller market segments, like student and auto loans, to focus solely on subprime mortgages. As their success continues, the market fills with new businesses aping this strategy.
  • So, basically, when a credit default swap is purchased on a mortgage bond owned AIG, the company is taking a significant amount of risk that those mortgages will hold true.
  • Remember when Goldman Sachs called Burry to buy some credit default swaps back from him? Well, they were doing this so they could sell the debt back to AIG. If that doesn't make sense, don't worry—it'll become clearer as we go on.
  • To do so, these people have to create something called a "synthetic subprime mortgage bond-backed CDO" (3.28). These things are structured in the same way as a mortgage bond (separated into levels called "tranches" that reflect their level of risk), except instead of containing mortgages, they contain mortgage bonds. Think about that for a second.
  • Even worse, Goldman Sachs creates CDOs by compiling the lower tranches (the riskiest levels) from different mortgage bonds and sticking them together. Despite the fact that these CDOs contain incredibly risky assets, however, the rating agencies somehow rate them as normal, with the upper tranches receiving high ratings despite containing bad loans.
  • This is legit nuts—it's basically "a credit laundering service" (3.30).
  • What's more, this scam allows banks to overvalue their assets by a great deal. They profit every time a trader buys a credit default swap from them.
  • Enter Greg Lippmann, who's been watching this with great interest. With the help of the aforementioned Eugene Wu, he creates his sales pitch and tries to convince institutions to buy credit default swaps.
  • And how does Lippman make money? Basically, by taking control of the market, everyone will have to go through him if they want to sell their credit default swaps, and he'll take a nice percentage then. He's also gathered plenty of credit default swaps for himself, too.
  • No one buys Lippman's pitch, however. So in frustration with his mounting losses (credit default swap owners have to pay the bank every month that the bonds retain their value), he gives his pitch to AIG FP in the hopes of killing the market altogether.
  • This trick seems to work—AIG FP hints to Lippmann that they might be looking to buy some credit default swaps themselves.