Betting on the Wall Street Crash

Exclusive: The 2008 Wall Street crash resulted from a combination of unrestrained greed and political contempt for government regulators who might have prevented the devastation. In The Big Short, the tale is told from the perspective of a few players who saw the inevitable and made money on the crash, writes James DiEugenio.

By James DiEugenio

If you read Michael Lewis’s book The Big Short or see the movie by the same name, you won’t find much about how the financial crisis of 2008 was set in motion more than two decades earlier. You won’t learn much about the roles of Ronald Reagan and his disdain for big government or about Bill Clinton’s faith in neo-liberalism, trusting that the modern markets and the supposedly sophisticated investors would keep excesses in check.

Nor will you find much about economist-turned-politician Phil Gramm who incorporated many of Reagan’s and Clinton’s beliefs into legislative actions, slashing taxes on the rich in the 1980s (and thus incentivizing greed) and, in the 1990s, brushing aside Franklin Roosevelt’s painfully learned lessons from the Great Depression about the need for firewalls between the speculation of Wall Street and the hard-earned savings of Main Street.

Also out of Lewis’s narrative frame is Brooksley Born, the federal commodities regulator who foresaw the looming danger from the exotic new financial instruments that sliced and diced risky subprime mortgages and packaged them in bonds with ratings far above what they deserved and the even riskier tendency to lay bets on how the bonds would perform.

But Born was out-muscled by bigger financial stars with larger egos, the esteemed Federal Reserve Chairman Alan Greenspan (originally a Reagan appointee) and Clinton’s brash Deputy Treasury Secretary Lawrence Summers, a rising star in the neo-liberal establishment which treated the market’s “invisible hand” as a new-age god.

Michael Lewis’s Treatment

These names and that background are not mentioned because Michael Lewis did not write The Big Short as an overview of the economic meltdown. It is not remotely a historical chronicle of the crisis. Lewis chose to write about six characters who were not on the main stage of the crisis. But each knew that Brooksley Born’s grim prophecies would be fulfilled and they devised a scheme for profiting from the collapse.

They figured out that buying credit default swaps one of Wall Street’s new financial instruments and betting against subprime loans was a very good wager. In fact, the more they examined it, the more they thought it was a sure thing. It was not a matter of if the housing market would collapse, but precisely when it would fail.

That latter point created a concern for them: When the market collapsed, would the investment banks still be around to let them collect on their wagers?

Lewis’s book has two main protagonists, one on each coast. The one in New York City is named Steve Eisman, a hedge fund manager whose firm was housed at Morgan Stanley on Wall Street. The other was Michael Burry, who ran a private investment firm in Cupertino, California, called Scion Capital.

There are four supporting characters: Greg Lippmann, a trader at Deutsche Bank who accidentally gets in contact with Eisman and sells him on the idea of betting against the housing market; a Berkeley, California contingent made up of two young and relatively inexperienced investors, Charlie Lealey and Jamie Mai, who run their own investment company called Cornwall Capital; and a retired veteran of Wall Street named Ben Hockett.

Although this choice of a cast seems random, it really was not because, as Lewis notes in his book, there was a small group of people who understood what was happening as early as 2005. They were not famous at the time, neither were they well established as towering Wall Street figures, but they had taken the time to really examine what was going on with derivatives and CDO’s. And none of them liked what they saw.

As Burry told New York Magazine, he felt like he was watching a plane crash. On the last night of 2007, New Year’s Eve, he e-mailed his wife and said he was so filled with dread he couldn’t come home. He would spoil their holiday.

Weaving a Narrative  

Lewis skillfully weaves the differing strands of the book largely through the eyes and ears of these six men, but stays away from what is going on at the top levels of Wall Street finance. Lewis apparently felt the view was more informative and dramatic from the ground up.

As the narrative unfolds, a friend of Lealey who worked at Deutsch Bank sends him a presentation that Lippmann had made, saying that the mortgages in the lower-level tranches were almost worthless and it would be profitable to bet against them with credit default swaps.

Lealey thought to himself, “How can this even be possible. Why isn’t someone smarter than us doing this.” [Lewis, e-book version, p. 108]

Another link between the characters was their attendance at the American Securitization Forum in Las Vegas in January 2007, a giant convention of 7,000 subprime lenders and managers of mortgage-backed securities. [ibid, p. 150]

Lippmann invited Eisman there so Eisman could fully understand the people he was betting against. Hockett, Lealey and Mai were there to conclude a deal for the purchase of large amounts of credit default swaps from Bear Stearns (another investment bank that would soon capsize). It is here that Lewis created two memorable scenes.

The first was when Eisman met a manager of mortgage-backed securities, a man named Wing Chau, who explained to Eisman that he sold not just double-A and triple-A backed mortgage bonds, but something else called a CDO, the acronym for collateralized debt obligation. As Wing Chau explained, these were bonds made up of lower-rated mortgage securities, ones that did not sell the first time around. Or as Eisman put it, “The equivalent of three levels of dog shit lower than the original bonds.” [Lewis, p. 139]

Insuring the Collapse

The insurance giant American International Group (AIG) had been the main buyer of these bonds up to the beginning of 2006. (AIG would later be bailed out by the government to the tune of $180 billion.) But when Frank Cassano of AIG’s London office finally got out of the market, smaller brokers like Harding Advisory’s Wing Chau took his place. Chau managed $15 billion worth of CDO’s, with a large amount placed with Merrill Lynch [ibid, pgs. 140-41]

Chau then explained to Eisman something called the synthetic CDO, a creation made out of all the side bets on the original bonds, i.e. those betting the bonds would fail or succeed. As Eisman put it, “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford. They were creating them out of whole cloth. One hundred times overI was like: This is allowed?” [ibid, p. 143]

Eisman wondered who was looking out for the investors? Did they know what was in those bonds? He concluded that Chau didn’t really care. After all, a few years earlier, Chau had been making $140,000  a year managing a portfolio for New York Life. In 2006, he would make $26 million. [ibid, p. 141]

The second memorable scene took place in Las Vegas at a talk given in an auditorium by the CEO of a company called Option One, which had had some problems the previous year due to its investment in subprime loans. He assured the audience that was a thing of the past. In the future, he expected no more than a 5 percent default rate on the loans in their portfolio.

Eisman asked the man if that figure was a possibility or a probability. The reply was that it was a probability, to which Eisman raised his hand and made a circle with his thumb and index finger. The CEO asked if he had another question. Eisman said, “No, it’s a zero. There is zero probability that your default rate will be five percent.” Eisman figured it would be much higher. [ibid, p. 153]

After this conference, Eisman decided to bet against the housing market in a big way, realizing that the market was based on a collective illusion. Or as one of the traders on his team declared, “That was the moment when we said, ‘Holy shit, this isn’t just credit.  This is a fictitious Ponzi scheme.’” [ibid, p. 157]

Brad Pitt’s Interest

Brad Pitt had purchased another Michael Lewis book called Moneyball, which he had starred in and produced as a movie. Therefore, Pitt had the inside track on making a film of The Big Short. But as Pitt told New York Magazine, “the plain truth of it all is that these kinds of movies are hard to make. The studios don’t want to make them because it doesn’t fit the business model anymore.” [11/29/15]

So to give the film marquee value, Pitt had to sign on to play Hockett, and that in turn attracted Christian Bale to play Burry, Steve Carell to play Eisman, and Ryan Gosling to play Lippmann (although the last two characters have their names changed in the film.) With that many big stars, the picture was sure to be made.

But the most surprising thing about the film is that the major force behind its success as a movie is Adam McKay, who co-wrote the script with Charles Randolph and directed the film. McKay started with the famous improv group Second City in Chicago and then became a writer for Saturday Night Live. McKay accompanied SNL star Will Farrell to Hollywood and directed films like Anchorman, Talladega Nights, Step Brothers, and The Other Guys. With The Big Short, McKay’s direction and writing summoned up the best of his past career in comedy.

Not since the heyday of British director Richard Lester in the 1960s and 1970s have I seen such daring inventiveness in a comedy film. Frequently, McKay will have an actor talk directly to the audience. Indeed, half the main cast breaks the so-called Fourth Wall.

In a scene in the lobby of a huge bank, the actors who play Lealey and Mai address the audience. After their meeting with the bank representative ends, they pick up Lippmann’s presentation off a table and tell the audience that in real life, that isn’t the way it happened. Someone actually mailed them the presentation. Surprisingly, it works and doesn’t break the flow of the film, perhaps because the matters we are viewing are so absurd to begin with.

But McKay goes beyond that. Realizing that some of the terms he is using in the film, like CDS or “credit default swap,” are not easy for the audience to assimilate quickly, he will have the narrator, Gosling, cut in on the soundtrack and announce that some celebrity who is not playing a role in the film will now explain what this term means.

Explaining the Complexities

The first time its actress Margaret Robbie talking to us from an indoor pool loaded with bubble bath as she drinks champagne. The second time, from a restaurant kitchen, master chef Anthony Bourdain explains a CDO or “collateralized debt obligation” in terms of putting together a stew from leftovers.

The third time, it’s economist Richard Thaler and singer-actress Selena Gomez at a craps table with hundreds of extras behind them, explaining what a synthetic CDO is.

Another reason these scenes worked is because McKay and his editor Hank Corwin have spliced in quick montages showing rappers, dancers, sometimes bag people sitting under a bridge or living in a tent colony. This gives ballast to the “real life” demonstrations of these concepts that caused tent colonies and other depredations to happen. It also gives the film a fast-paced, almost headlong tempo with the specter of surprise lurking ahead.

But the film needed an anchor because although it’s amusing and sometimes laugh-aloud funny, the subject it deals with is a serious one, the biggest American economic blowout since 1929. The film’s anchor is provided by its strong ensemble cast.

Christian Bale as Burry delivers his usual disciplined, dedicated method-acting performance. And considering that Burry has a glass eye and Asperger’s Syndrome, a form of autism, Bale was taking on a technically difficult and unglamorous part. Steve Carell does a nice job playing the worrywart Eisman, the Wall Street shark with a conscience. With his hair dyed black and waved, Gosling is in command as Eisman’s antithesis, the slick trader.

Pitt plays Ben Rickert (Ben Hockett in the book) as something of an eccentric, the man who walked away from a millionaire’s job in Tokyo with Deutsche Bank and now lives in Berkeley and just enjoys walking his dog and playing with his child.

In Las Vegas, after Pitt’s character and the two young traders close their big deal for $15 million in credit default swaps, the two youngsters cannot contain their joy and start whooping and celebrating. Rickert/Hockett turns on them abruptly and tells them to knock it off: “Do you have any idea what you just did? You bet against the American economy. If you win, people lose their homes, their jobs, their retirement funds, their pensions.” Pitt has the quiet authority to make it real.

There is one element of the Lewis book that the film leaves out. At the end of the book, Lewis meets with his former boss John Gutfreund, former chairman of Salomon Brothers where Lewis worked for three years, an unpleasant experience that became the topic of Liar’s Poker published in 1989.

A couple of decades later, for The Big Short, Lewis asked to meet with his retired old boss. Lewis wanted to meet with Gutfreund because Salomon Brothers was the first major investment bank to go public in 1981, a decision that Gutfreund made. Lewis is convinced that shifting ownership of banks from the partners to the public encouraged the collapse of Wall Street because the losses could be passed on to shareholders. Otherwise, the owners/partners would never have seriously entertained such nonsense as subprime loans, CDOs and synthetic CDOs. No owner/partner would have allowed his investment bank to be leveraged at a rate of 35-1.

Yet, after Salomon Brothers went public, every major trading house did the same and made quick killings in the short run.

An Ironic Ending

McKay ends the film with a fantasy sequence: Gosling says that dozens of people went to jail and all the banks were broken up. He then corrects himself and says the opposite was true.

It is an ironic ending reflecting how the 1980s and 1990s marked a time when greed became good and the pain that Wall Street had inflicted on earlier generations was forgotten in the rush of speculators to amass great fortunes and the hunger of politicians and economists to share in the loot.

So, the lessons of an earlier time were deemed outdated, no longer relevant to the modern era when there was supposedly more transparency in the markets and when investors were allegedly much more sophisticated than in days gone by.

The memories of the Great Depression and the New Deal were so faded, just black-and-white relics from a distant past. Yet, it was from the ashes of the stock market crash of 1929 and bitter years of the Great Depression that President Franklin Roosevelt laid the foundations for decades of American prosperity. He applied a combination of Keynesian economic policies and institutional reforms of Wall Street. After World War II, Roosevelt’s reforms helped create the Great American Middle Class, sharing prosperity at levels never before seen while the American economy became the juggernaut that ruled the world.

To put it mildly, that is not the case today. As Paul Krugman and other economists have written, American economic performance has been unraveling in large part because the checks and balances that FDR installed to control rapacious greed and malpractice on Wall Street were, step by step, removed.

What replaced them was a pretty much “anything goes” ethos involving speculative inventions and risky ventures. For the first time, many investors did not actually own stocks, bonds or mortgages. Often they owned bets on whether or not someone else’s investments, such as a basket of sliced and diced mortgages, would fail. Wall Street investment banks were turned into giant Las Vegas-style casinos.

Busting the House

But there was one big difference. In a casino, it is almost impossible to beat the house, at least for large sums since the house has installed firewalls against such a thing happening. In 2008, however, because of the growth of wild, speculative instruments of credit and the government’s lack of supervision of these unsound vessels the Wall Street house collapsed.

And if not for a colossal intervention by both the Treasury Department and the Federal Reserve Board, virtually every investment bank on Wall Street would have fallen along with the entire American economy and possibly the world’s.

The same Wall Street voices that disdained and ridiculed government regulation on the ride up suddenly insisted on massive government intervention to avert a large thud on the spiral down.

When everything was rosy, these masters of the universe explained why they deserved their Manhattan penthouses and their Hampton mansions. It was simply a case of them being rewarded for their personal excellence, the result of being the best and brightest in a “meritocracy.”

Yet their catastrophic collapse had to be stopped by the federal government and paid for by average taxpayers intervening with an exercise in socialism. If not, the Wall Street warnings went, there would be another Great Depression or worse.

After the 2007-08 real estate/Wall Street crash, many authors wrote that it had been a long time coming with many warning signs along the way. The American economy had sustained a string of internal failures based on speculation and, at times, outright fraud. This trend traced back to the 1980s when President Ronald Reagan embraced a culture of “free enterprise” to an almost metaphysical degree. The pattern continued into the 1990s and into the new century with the anti-regulatory neo-liberalism of President Bill Clinton.

Launching Greed

It was during Reagan’s presidency followed by George H.W. Bush’s and Clinton’s White House years when a long string of domestic economic scandals (and frauds) surfaced: the savings-and-loan crisis, which lasted from 1986 to 1995; the leveraged buyouts of Michael Milken and Ivan Boesky which used insider trading to maximize profits; the collapse of the hedge fund Long-Term Capital Management, in which the government intervened and forced other investment banks to cover billions of dollars in losses; the dot.com bubble, where financial analysts completely threw out traditional standards like P/E ratios for the allure of Silicon Valley; and, of  course, the Enron collapse (under President George W. Bush), when it was revealed that the high-flying energy company’s profits were largely based on illegal accounting tricks.

Taken as a whole, there were many books written about these and other related scandals, such as Den of Thieves by James B. Stewart, Pigs at the Trough by Arianna Huffington, When Genius Failed by Roger Lowenstein, Enron: The Rise and Fall by Loren Fox, The Predator’s Ball by Connie Bruck. There were also films and documentaries made about some of these episodes, e.g. Enron: The Smartest Guys in the Room directed by Alex Gibney and Barbarians at the Gate, directed by Glenn Jordan. Those two films were based on best-selling books.

So it’s not as if the media and the public were unaware that, recurrently, something was going wrong with Wall Street and corporate America. By all indications, certain people in high positions were repeatedly at work on evading and violating the legal code, such as insider trading, the looting of savings-and-loan assets, or the defrauding and manipulation of company funds. On all these counts and more, a culture of corruption had been gaming the system for two decades.

It got so bad and so endemic that the illustrious attorney and bank regulator William K. Black was forced to invent a new criminal term to describe it: “control fraud.” This is when a person with great authority inside an institution subverts the organization and engages in extensive fraud for personal gain. Typical fraud usually referred to some lower-ranking person within the institution cheating the organization. But now the plunder was coming from the top.

Demeaning the Bureaucrats

Another syndrome common to all of these scandals was that the civil servants in charge of regulating these fields arrived well after the fires were raging. And, in each case, that tardiness cost hundreds of millions of dollars, if not billions.

For instance, when the fraud of telecommunications giant WorldCom was finally exposed, the collapse represented the largest bankruptcy in history up to that time, about $100 billion; an example of Black’s “control fraud” since the phony accounting practices meant to hide the corporation’s financial shortcomings were instituted from the top down.

The collapse of Enron put 20,000 people out of work. And, since Arthur Anderson LLP signed off on the accounting of both Worldcom and Enron, regulators forced the firm to close it doors in 2002, costing another 85,000 jobs.

In retrospect, all of this sordid history extending from about 1985 to 2005 seemed to prove the famous adage of George Santayana: “Those who cannot remember the past are condemned to repeat it.”

Though some accounting procedures were tightened up, there was another financial scandal right around the corner. And it would dwarf all of the previous ones put together.

With political hostility still running high toward “government bureaucrats” and their “red tape” and with Wall Street banks lavishing millions of dollars on politicians and their campaigns there was little interest in regulating areas that had not yet blown up.

But the situation was worse than a lack of prescience. The dominant political forces of Washington actively helped pave the way for the 2007-08 real estate/stock market crash.

A Crucial Politician

A key player was Phil Gramm, a former Texas A&M economics professor who first became a congressman and then a senator from the Lone Star state. As a Democratic congressman, he pushed through the 1981 Gramm-Latta bill, which essentially implemented Reagan’s budget and fiscal policy, including lower taxes (mostly benefiting the rich), social program cuts and higher military spending. After clashing with the Democratic leadership, Gramm switched parties and then ran successfully as a Republican for the House and later the Senate.

As a senator, Gramm was instrumental in passing two epochal bills which proved central to the future economic disasters. The first was the Gramm-Leach-Bliley Act of 1999, which repealed much of Franklin Roosevelt’s 1933 Glass-Steagall Act separating commercial banks from investment banks and insurance companies.

Along with providing government insurance for Main Street savings deposits, Roosevelt wanted to get neighborhood banks out of riskier investment strategies. The idea was that if too many local banks were involved with speculative investments, and the bubble burst, the contagion that brought down Wall Street would also bring down Main Street with it, which is what happened in 1929.

Thanks to Gramm and his fellow anti-regulatory Republican along with neo-liberal Democrats including President Bill Clinton FDR’s New Deal lessons were deemed outmoded. Glass-Steagall was largely neutered.

There were, however, some prophets who foresaw the doom. For instance, Democratic Congressman John Dingell said that the bill would create large financial superstructures that the Federal Reserve would have to protect since they would be “too big to fail.”

The other bill that Gramm sponsored was probably even more destructive to the economy, the Commodities Futures Modernization Act of 2000. This act deregulated some of the more exotic inventions that Wall Street had originated in the 1990s in order to spread risk. For instance, after Lewis Ranieri invented Mortgage Backed Securities (MBS), they evolved into Collateralized Debt Obligations (CBOs). Roughly speaking, these were a collection of mortgage bonds that were then bought by either a government agency like Fannie Mae or an investment bank like Ranieri’s Salomon Brothers.

These collectivized bonds were then divided into tranches, different levels inside the bond as classified by the ratings houses, Standard and Poor’s, Moody’s or Fitch. The lower the rating, the higher the return; but also the higher the risk if the bond went bust.

Spreading the Risk

To limit the chance of such a thing happening, J. P. Morgan created a derivative called the Credit Default Swap (CDS), which was advertised as a form of insurance premium, which the buyer paid to the holder of the bond as long as the bond was afloat. But if the bond collapsed, the buyer who was paying premiums gained a lot of money and the holder of the bond assumed the asset.

With a CDS, the buyer does not actually own anything.  He is really a gambler who is betting on a large payoff if the asset fails. (The entire story of how derivatives originated and then contaminated Wall Street was neatly told by Gillian Tett in her book Fool’s Gold.)

As derivative products became commonplace on Wall Street, there began to be a debate about their regulation. Stanford lawyer Brooksley Born, chief of the Commodity Futures Trading Commission, realized that companies were using derivatives to mask investments from normal accounting practices. [All the Devils are Here, by Bethany McLean and Joe Nocera, p. 101] That was because, though their use had spread exponentially, they were not yet standardized as products for regulation purposes, which she proposed doing.

But Sen. Gramm wanted the least amount of regulation possible. And, he was joined by Clinton’s Deputy Treasury Secretary Lawrence Summers and Federal Reserve Chairman Alan Greenspan. (ibid, p. 105) Outgunned by such powerful figures, Born lost this key battle. She was, of course, correct.

If, for example, an investment bank sold billions of credit default swaps on a poorly credited tranche of a mortgage bond, what if the bond capsized? The bank would have not just a negative performing asset on its books, but it would be out the payment to the holder of the CDS.

But, as Born suspected, it was even worse than that.  Because the derivatives market was not formally regulated, traders at the large investment banks could hide them from the asset ledger, so even the Risk Manager officer and the Chief Executive Officer would not know the full extent of how much money the bank had invested on derivatives based upon Triple B rated subprime loans. No one paid much attention because everyone was making lots of money. But the music was about to stop.

Facing the Music

At Merrill Lynch, CEO Stan O’Neal called Risk Manager John Breit in September 2007 because O’Neal had heard rumors that Breit was afraid that their potential losses in the upcoming third quarter report would be much larger than O’Neal anticipated. Those losses would mostly be due to derivatives based upon subprime loan packages.

The CEO thought they would lose a figure in the hundreds of millions of dollars. But Breit had belatedly found out that the figure was much larger. When O’Neal asked Breit how much larger, Breit replied, “Six billion” and quickly added that it could be much worse. [McLean and Nocera, p. 3] O’Neal looked physically ill.  He could not believe his employees had acted so recklessly.

And, Breit was correct. It was even worse. The quarterly loss was later billed as $8 billion, leading to O’Neal’s departure a month later. From July 2007 to July 2008, Merrill Lynch lost nearly $20 billion. By the fall of 2008, the once proud company had lost nearly $52 billion on mortgage-backed securities. [Bloomberg News, Sept. 5, 2008]

But the collapse of fellow investment bank Lehman Brothers was much larger. It ended up being the largest bankruptcy in history, eventually valued at over $600 billion.

To this day, no one knows how much the total private and public loss was in that economic meltdown.  Respected conservative economist Charles Morris pegged it at $2 trillion. Others think it was at least twice as large. Because Born had lost her battle with Gramm, Summers and Greenspan, it was almost impossible to get an accurate figure on the total losses because the accounting for many of the derivative wagers on top of the subprime loans was woefully inadequate.

In the end as The Big Short describes none of the key villains goes to jail and the big banks are not broken up. After all, President George W. Bush’s Treasury Secretary Henry Paulson, who designed the bail-out plan for Wall Street, had worked at Goldman Sachs for 30 years. We should all have friends like that in Washington.

James DiEugenio is a researcher and writer on the assassination of President John F. Kennedy and other mysteries of that era. His most recent book is Reclaiming Parkland.