Study Guide

The Big Short: Inside the Doomsday Machine Chapter 5

By Michael Lewis

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Chapter 5

Accidental Capitalists

  • In 2006, there are only a handful of people who, like Eisman and Burry, are betting against the subprime market. Anybody who is, however, can trace the idea back to Lippmann.
  • One of those people is Charles Ledley, a trader who specializes in exploiting the market's inability to see "the likelihood of dramatic change" (5.5). He hears Lippmann's pitch from a friend.
  • Ledley had started a money management firm called Cornwall Management in 2003 with his buddy Jamie Mai, despite the fact that neither had much money or financial experience. Oh, yeah, and their "office" was really a shed in their buddy's backyard in California.
  • The plan: discover inefficiencies in the market, especially those involving small, private markets and exotic goods.
  • That's when these dudes stumble across Capital One Financial, a credit card company that focuses on the low-income market. Their stock crashed in 2002, after years of success, due to questions about risk management and the trustworthiness of their CEO.
  • Capital One claims that everything's above board, and Ledley ends up agreeing after doing some research. He even roots out character references for their CEO.
  • So what does this mean? Well, Capital One stocks are currently trading at $30, which is about half of their real value. But if they're frauds, then it should be with nothing, right? And if they're legit, then it should be worth $60, right?
  • Jamie decides to buy what are called "stock options," which give him the right to purchase shares for a specific price over the next two years, no matter what the market values them as then. In this case, he buys stock options that should be $40/share for a mere $3 apiece.
  • The guys scoop up 8,000 options. When Capital One's stock rebounds, they make $526,000 from a measly $26,000 investment. That's a massive profit.
  • This becomes the guys' strategy: find something that seems like it's about to dramatically change in value and buy a bunch of options on it. By 2005, they have $12 million.
  • As the dudes become more entrenched in the Wall Street world, they realize that they're woefully unprepared to schmooze with the bigwigs. They employ the help of their friend Ben Hockett, who had worked at Deutsche Bank for many years.
  • Now that the trio is complete, everyone moves to Manhattan. Ben is a huge help to the guys, though his dark, apocalyptic perspective is a bit much sometimes.
  • To become even more legit, these guys need to get an ISDA, which is a license that allows you to trade directly with Wall Street firms. Ben somehow manages to convince Deutsche Bank to give them one, which they use to buy credit default swaps from one Greg Lippmann.
  • The dudes take a slightly different tack from the one taken by Eisman and Burry: they specifically buy only the top tranches from subprime mortgage bonds. The cost is low, and the payoff is high.
  • Remember: in theory, the top tranches are supposed to be the least risky. As we learned last chapter, however, the top tranches of bonds are now being fraudulently filled with subprime mortgages, making them in fact very risky.
  • Ledley has to do an insane amount of work to figure out what's inside the bonds. It's a crazy labyrinth: many mortgages are represented within multiple tranches, located within multiple bonds. That makes no sense.
  • After buying $7.5 million in credit default swaps from Lippmann, the guys are assured by a fellow analyst that they picked the perfect tranches to bet against. By 2007, they've purchased $110 million worth.
  • A week before "the crisis will commence" (ooh—juicy) Ledley is invited by some guys from Bear Stearns to the big subprime conference in Vegas. They want to take him to a gun range.

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