The Big Short_ Inside the Doomsday Machine - Michael Lewis [34]
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