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Video: ‘Blind Side’ author trades sports for subprimes

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    >>> we are back now at 8:43. sandra bullock won the oscar for her role in "the blindside" written by michael lewis . now the best-selling author is tackling the latest economic meltdown. can you find an excerpt in this month's " vanity fair ." thanks for coming back. how are you doing?

    >> i'm doing well. thanks for having me back.

    >> some go as far to say this is the book you need to read about the economic meltdown. but a lot has been written about it. it's been dissected and looked at under the micro -- or magnifying glass . why did you decide to tackle it?

    >> oddly, because you're right so much has been written about it, but -- two reasons. one is i had come in at the beginning of this story with "liar's poker," about me working on wall street in the '80s and a lot of what happened, the seeds of the ka tas trocatastrophe were plante d then.

    >> most of the books that you read about economic meltdown go into september and october of '08. your story starts and ends kind of before that.

    >> that was the other thing. i felt like there was this great untold story with these wonderful characters that just hadn't been told and it was this period from kind of the early '05 to the end of '07 when, in effect, the bombs were built and laid and the fuses were lit and by the end of '07, the story is basically over in the sense that the bad things are going to happen. it's just a question of when.

    >> you hear people say all the time about this economic meltdown, no one saw this collapse coming. well, no, there were a lot of people who saw it coming and found a way to sell short on some of these awful mortgages and cash in when things really got bad. explain it to me.

    >> well, you can almost think of the financial system leading up to the crisis as having gathered itself around a giant bet. most of the financial system was betting on the subprime mortgages and actual ly only a relative handful of investors saw what was happening and made big bets against them. they shorted them, betted on the price of mortgage bonds falling. the thing that was so curious to me is that there were so few of them. maybe the greatest bet in modern financial history to be made and it was sort of like, why did those people figure it out? what was it about them that led them to figure it out?

    >> you tackle some of these people and kind of delve into their character and their personalities. some reading it or listening to this might say, michael , these are bad people because they're as bad as the other guys because they profited off the misery of people. do you see it that way?

    >> no. when you put it that way, it sounds pretty horrible, but i don't see it that way. for a start, if more people had seen the world the way they saw the world, none of this would have happened and they were screaming to high heaven that this stuff shouldn't be -- these loans shouldn't be being made. in one case, they go to the scc, "the new york times," " wall street journal " to try to get people to pay attention . this whole question of the role of people who short things in the marketplace has been badly distorted, especially by big wall street firms.

    >> because they're made out to be cashing in. in some ways, they are a check and balance.

    >> they are the check and balance. they are the way the information gets into the marketplace. someone has to have the incentive to dig out the bad information as well as the good. and the ability to sell short something create that is incentive.

    >> you tackle a couple of these guys, michael bury who was studying to become a neurologist.

    >> he was a neurologist.

    >> didn't love medicine before he got into finance. why did he stand out for you?

    >> he was the first person to really see -- to see that the smartest thing he could do -- he was a stock market investor, an ordinary stock market investor. he couldn't invest in stocks in good conscience, because he saw what was happening in subprime mortgage market and knew it was going to affect everything. he actually starts, sets out to make a bet against the subprime mortgages. the thing that was so interesting about him, there were some deep character logical quality that is led these people to do what they did. he has aspberger's syndrome but didn't know it. but in retrospect he said only someone with aspberger's syndrome would bother to read subprime mortgages. he spent a lot of time alone in a room looking at data. and that set him up to see it, because he wasn't -- he was sort of outside the fog machine that wall street had created to disguise what was actually going on and he was looking at just the raw numbers . when you looked at just the raw numbers , they told you that, my god, there's a catastrophe in the making.

    >> a fascinating study. before i let you go, sandra bullock wins best actress oscar for her role in "the blindside." did you ever dream when you sat down to tell that story years ago that it would result in something like that?

    >> you know, i thought it was a wonderful story that i could only screw up. and when i was done with it, i thought some great actress could really do something with it, but she did. what she did was a miracle. i mean, it was a miracle. and she took a risk to do it. and you know, i was very proud of her.

    >> good for you as well. michael , nice to see you, as always.

    >> thanks for having me.

    >> the book is called "the big short."

TODAY books
updated 3/15/2010 9:24:02 AM ET 2010-03-15T13:24:02

In “The Big Short,” Michael Lewis tells an illuminating and often frightening tale of the current global financial catastrophe from an unusual perspective: that of the winners — the very small but very intelligent set of contrarians skeptical enough not to be fooled by soaring house prices. And because they were also willing to bet money on the boom going bust, these people made enormous profits even as the world’s financial markets shattered. An excerpt.

Chapter two: The Land of the Blind
In early 2004 another stock market investor, Michael Burry, immersed himself for the first time in the bond market. He learned all he could about how money got borrowed and lent in America. He didn’t talk to anyone about what became his new obsession; he just sat alone in his office, in San Jose, California, and read books and articles and financial filings. He wanted to know, especially, how subprime mortgage bonds worked. A giant number of individual loans got piled up into a tower. The top floors got their money back first and so got the highest ratings from Moody’s and S&P and the lowest interest rate. The low floors got their money back last, suffered the first losses, and got the lowest ratings from Moody’s and S&P. Because they were taking on more risk, the investors in the bottom floors received a higher rate of interest than investors in the top floors. Investors who bought mortgage bonds had to decide in which floor of the tower they wanted to invest, but Michael Burry wasn’t thinking about buying mortgage bonds. He was wondering how he might short subprime mortgage bonds.

Every mortgage bond came with its own mind-numbingly tedious 130-page prospectus. If you read the fine print, you saw that each was its own little corporation. Burry spent the end of 2004 and early 2005 scanning hundreds and actually reading dozens of them, certain he was the only one apart from the lawyers who drafted them to do so — even though you could get them all for $100 a year from 10KWizard.com. As he explained in an e-mail:

So you take something like NovaStar, which was an originate and sell subprime mortgage lender, an archetype at the time. The names [of the bonds] would be NHEL 2004-1, NHEL 2004-2, NHEL 2004-3, NHEL 2005-1, etc. NHEL 2004-1 would for instance contain loans from the first few months of 2004 and the last few months of 2003, and 2004-2 would have loans from the middle part, and 2004-3 would get the latter part of 2004. You could pull these prospectuses, and just quickly check the pulse of what was happening in the subprime mortgage portion of the originate-and-sell industry. And you’d see that 2/28 interest only ARM mortgages were only 5.85% of the pool in early 2004, but by late 2004 they were 17.48% of the pool, and by late summer 2005 25.34% of the pool. Yet average FICO [consumer credit] scores for the pool, percent of no-doc [“Liar”] loan to value measures and other indicators were pretty static.... The point is that these measures could stay roughly static, but the overall pool of mortgages being issued, packaged and sold off was worsening in quality, because for the same average FICO scores or the same average loan to value, you were getting a higher percentage of interest only mortgages.

Video: Report: Lehman hid financial problems As early as 2004, if you looked at the numbers, you could clearly see the decline in lending standards. In Burry’s view, standards had not just fallen but hit bottom. The bottom even had a name: the interest-only negative-amortizing adjustable-rate subprime mortgage. You, the home buyer, actually were given the option of paying nothing at all, and rolling whatever interest you owed the bank into a higher principal balance. It wasn’t hard to see what sort of person might like to have such a loan: one with no income. What Burry couldn’t understand was why a person who lent money would want to extend such a loan. “What you want to watch are the lenders, not the borrowers,” he said. “The borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint, and when they lose it, watch out.” By 2003 he knew that the borrowers had already lost it. By early 2005 he saw that lenders had, too.

A lot of hedge fund managers spent time chitchatting with their investors and treated their quarterly letters to them as a formality. Burry disliked talking to people face-to-face and thought of these letters as the single most important thing he did to let his investors know what he was up to. In his quarterly letters he coined a phrase to describe what he thought was happening: “the extension of credit by instrument.” That is, a lot of people couldn’t actually afford to pay their mortgages the old-fashioned way, and so the lenders were dreaming up new instruments to justify handing them new money. “It was a clear sign that lenders had lost it, constantly degrading their own standards to grow loan volumes,” Burry said. He could see why they were doing this: They didn’t keep the loans but sold them to Goldman Sachs and Morgan Stanley and Wells Fargo and the rest, which packaged them into bonds and sold them off. The end buyers of subprime mortgage, he assumed, were just “dumb money.” He’d study up on them, too, but later.

He now had a tactical investment problem. The various floors, or tranches, of subprime mortgage bonds all had one thing in common: The bonds were impossible to sell short. To sell a stock or bond short, you needed to borrow it, and these tranches of mortgage bonds were tiny and impossible to find. You could buy them or not buy them, but you couldn’t bet explicitly against them; the market for subprime mortgages simply had no place for people in it who took a dim view of them. You might know with certainty that the entire subprime mortgage bond market was doomed, but you could do nothing about it. You couldn’t short houses. You could short the stocks of home building companies — Pulte Homes, say, or Toll Brothers — but that was expensive, indirect, and dangerous. Stock prices could rise for a lot longer than Burry could stay solvent.

A couple of years earlier, he’d discovered credit default swaps. A credit default swap was confusing mainly because it wasn’t really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing. It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million. It was also an asymmetric bet, like laying down money on a number in roulette. The most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money. “Credit default swaps remedied the problem of open-ended risk for me,” said Burry. “If I bought a credit default swap, my downside was defined and certain, and the upside was many multiples of it.”

He was already in the market for corporate credit default swaps. In 2004 he began to buy insurance on companies he thought might suffer in a real estate downturn: mortgage lenders, mortgage insurers, and so on. This wasn’t entirely satisfying. A real estate market meltdown might cause these companies to lose money; there was no guarantee that they would actually go bankrupt. He wanted a more direct tool for betting against subprime mortgage lending. On March 19, 2005, alone in his office with the door closed and the shades drawn, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit default swaps on subprime mortgage bonds.

The idea hit him as he read a book about the evolution of the U.S. bond market and the creation, in the mid-1990s, at J.P. Morgan, of the first corporate credit default swaps. He came to a passage explaining why banks felt they needed credit default swaps at all. It wasn’t immediately obvious — after all, the best way to avoid the risk of General Electric’s defaulting on its debt was not to lend to General Electric in the first place. In the beginning, credit default swaps had been a tool for hedging: Some bank had loaned more than they wanted to General Electric because GE had asked for it, and they feared alienating a long-standing client; another bank changed its mind about the wisdom of lending to GE at all. Very quickly, however, the new derivatives became tools for speculation: A lot of people wanted to make bets on the likelihood of GE’s defaulting. It struck Burry: Wall Street is bound to do the same thing with subprime mortgage bonds, too. Given what was happening in the real estate market — and given what subprime mortgage lenders were doing — a lot of smart people eventually were going to want to make side bets on subprime mortgage bonds. And the only way to do it would be to buy a credit default swap.

The credit default swap would solve the single biggest problem with Mike Burry’s big idea: timing. The subprime mortgage loans being made in early 2005 were, he felt, almost certain to go bad. But as their interest rates were set artificially low, and didn’t reset for two years, it would be two years before that happened. Subprime mortgages almost always bore floating interest rates, but most of them came with a fixed, two-year “teaser” rate. A mortgage created in early 2005 might have a two-year “fixed” rate of 6 percent that, in 2007, would jump to 11 percent and provoke a wave of defaults. The faint ticking sound of these loans would grow louder with time, until eventually a lot of people would suspect, as he suspected, that they were bombs. Once that happened, no one would be willing to sell insurance on subprime mortgage bonds. He needed to lay his chips on the table now and wait for the casino to wake up and change the odds of the game. A credit default swap on a thirty-year subprime mortgage bond was a bet designed to last for thirty years, in theory. He figured that it would take only three to pay it off.

The only problem was that there was no such thing as a credit default swap on a subprime mortgage bond, not that he could see. He’d need to prod the big Wall Street firms to create them. But which firms? If he was right and the housing market crashed, these firms in the middle of the market were sure to lose a lot of money. There was no point buying insurance from a bank that went out of business the minute the insurance became valuable. He didn’t even bother calling Bear Stearns and Lehman Brothers, as they were more exposed to the mortgage bond market than the other firms. Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his mind, the most likely to survive a crash. He called them all. Five of them had no idea what he was talking about; two came back and said that, while the market didn’t exist, it might one day. Inside of three years, credit default swaps on subprime mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of dollars’ worth of losses inside big Wall Street firms. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.

Excerpted from “The Big Short” by Michael Lewis. Copyright (c) 2010, reprinted with permission from W.W. Norton & Company, Inc.

© 2012 MSNBC Interactive


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