Sunday, December 28, 2008

Another corporate governance event in India, and this time no body notices

Two weeks after Raju's family unsuccessful attempt to loot Satyam's shareholders, another promoter family has done something similar. This time, however, there is no noise in the media or amongst the institutional shareholders. It has gone quietly under the radar, like everything else in India. 

Promoters of Murugappa group are pumping 300 crore into their troubled NBFC - Cholamandalam DBS. According to Economic Times, "The NBFC will issue one crore zero coupon fully convertible preference (FCP) shares of Rs l00 each at a premium of Rs 200, aggregating to Rs 300 crores to the existing promoters of the company — The Murugappa group and DBS. The Murugappa group companies, which will be investing in these FCPs, include Tube Investment of India, EID Parry (India), Coromandel Fertilisers and Carborundum Universal." 

Carborundum Universal is an industrial company. When I buy a share of this company in the public market, I am really not interested in getting exposure to a financial NBFC through this company. I assume that the excess free cash of the company will either get reinvested in the business or be paid out as dividends. Aren't minority shareholders getting cheated out of their money by asking to invest in a troubled group company at a valuation that is not transparent?

The only difference between Satyam and this situation is simply this - Raju's own only 8% of Satyam while Murugappa's own 43% in Carborundum. So Raju's were much more brazen.  

The first criteria to evaluate any Indian stock should be simply this - do promoters have other companies into which the cash generated by the stock under consideration could be diverted? Because, in the next two years, more events like this will surely crop up.  

Saturday, December 27, 2008

Looking Back at 2008

To say the least, 2008 was a very satisfying year. While I also got some calls wrong and overall lost money, it wasn't much. And if I were to do a sleight of hand and calculate returns in rupees and not dollars (rupee is my currency of consumption these days), I would have almost ended flat on the year because of rupee depreciation vis-a-vis dollar.

Here is what I got wrong:

a) Municipal bond funds: I had chosen some better credit quality close ended municipal bond funds. I am still keen to buy the underlying assets of some of these funds, like the pre refunded bonds. What I missed was that these funds are like any other structured product that employs leverage. And when mark-to-market losses hit, such structured products are forced to delever, irrespective of underlying credit quality. Actually I didn't miss it - I advised almost all my friends not to invest in FMP's in India for these precise reasons. But I myself didn't exit these funds. Hope was not a good strategy last year. 

b) The second half rally in April-May-June: I got the timing of this wrong post Bear Sterns. I thought the "hope" rally would occur in May and June, and so invested at end of April. Actually the rally occured from the day Bear Sterns collapsed to end of April. 

c) SKF, SRS: It is only in the last month or so that I really understood the nature of these ultrashort ETFs. It was indeed very perplexing to me that while the underlying sectors have been cut in half over the past year, these ETF's are flat over the year. Now I know better - it is because they compound daily returns.

Suppose I start with 100 in SKF. Underlying benchmark goes down by 10% on day 1. Benchmark would be at 90. SKF will go to 120 (2x daily return). 

On day 2, if benchmark goes up by 10%, then the benchmark would be at 99. However, SKF would be at 96. So even though benchmark has fallen from my initial purchase price, I would end up losing money. 

The joys of structured products!! It is very important to make sure that I get exposure to what I really want to get exposure to.  

d) I also got several stocks wrong - like Aban etc. In almost all cases, I sold the stocks when they were down 20%-30% and went on to go down another 50%. So it wasn't an unqualified disaster. 

The most important lesson of the year - Selling right is more important than buying, at least in the environment that exist(ed/s). Just because something is down 80% doesn't mean it can't go down another 80%.  Almost everyone - media, newspaper, books, fund managers - is focused on the buying decision. Nobody talks of the selling decision. "Expertsin media write that - "Well the market is already down 50%, so it can't fall much more. So you should buy".  Even more funny is, "See everybody is down 50%. We told you its impossible to time the market. Our advice is correct. So remain invested in index funds."  Some people have lost their life savings following this. 

I have realized that there is one very important difference between economics and physics. Faced with facts don't match theory, physicists try to come up with alternative theories. Economists, on the other hand, try to change facts so that it matches their theory. So, today, economists on the left are arguing that defective regulation caused all the troubles. A year from now, I am sure conservative economists will come back and argue that government meddling post Lehman crises is what has caused the recession to be as long as it is going to turn out to be.  

And it is not just economists. Almost all fund managers that I meet have one particular lens through which they want to view everything in the world. All stocks in the world need to fit their theory of how stocks should behave. And if they do not, it is just a short term disruption that will be corrected duly in the course of time. "In the long run, everyone is dead", as Keynes said. It is very bizarre to say the least.

Of all the things I got right this year, the best one will remain the one on Jan 22, 2008. I got the Fed rate cut right down to the minute - and it was a "between the meeting" rate cut. Another one would be the assertion that all Indian real estate stocks are going down by 90% in April 2008 - what this meant was that some of them will go below cash. 

There is a difference between a stock and a business. Neither do stocks reflect business performance in the upcycle, nor do they reflect it in the down cycle.  It is only over long periods of time that one will observe correlations between surviving successful companies and their stock prices. But stocks will regularly deviate from their so called "fundamental" values.

Fundamentals, incidentally, is my nomination for the most abused word of our generation. "Fundametally, this stock is sound, or market is pricing the stock not on fundamentals but on irrational fears". These statements assume the price of a particular stock is not one of the factors that affects the business of the company. As events of last year show rather powerfully, the price of a stock is actually one of the most important factors that affects the business, and in turn the stock price. The operating and financing  decisions can be made separate in the excel sheet world of DCF models - in reality the financing decision impacts the operating decision. 

"Stabilizing an Unstable Economy" by Minsky should be made compulsory reading in all economics classes. It is a gem of a book. Different economics theories are true at different points of time in this world. At this point of time and in this cycle, it is Minsky's theory that is correct. 

Thursday, December 18, 2008

Bubble in Treasuries ..

Mish writes on the treasury bubble and why it might not burst soon. I agree with him - just because something gets beyond what we thought two months ago was reasonable doesn't mean it has to fall today. It can just exist for a long time.

Besides, shorting using TBT would be a bad idea - because of the structure of these ultrashort ETFs. They do double the daily returns - not annual returns. All these ultrashort ETFs are good only for day-trading, not for investing.  I want to find a way of shorting treasuries where I am happy to hold the position for 5 years. 

Satyam's board of directors should resign

Satyam has 9 directors. Of these, my guess is these 5 would be independent directors: 

a) Krishna Palepu - Harvard Prof

b) Vinod Dham 

c) Dr Rammohan Rao - ISB prof 

d) T R Prasad - IAS Officer 

e) V S Raju - former dean IIT Madras 

 If the board really had a unanimous decision, these directors should resign. If it did not, then CEO is lying and should be prosecuted. Remember Satyam is listed on NYSE, so Reg FD and Sarb-Ox will apply to it. Somewhere, there is a law that will get Mr. Raju.

P.S: In today's ET, the board of directors is defending the decision. They should definitely be taken to court to find out the truth. See Sandeep Parekh's post on their compensation. 

Wednesday, December 17, 2008

Mr. Raju backtracks - Maytas should implode

Mr. Raju has backtracked in 12 hours and will no longer steal $1.6 billion from Satyam. Is he that thin skinned? If he planned a robbery, then he should have been prepared to kill. We should soon have the first real estate blowup in India. It is Maytas Infra and Maytas Properties - if we ignore Unitech and Omaxe. 

Who will lend additional money to Maytas, and which lender will not try to recover money from these two companies? There is a really juicy story here for media to uncover.   

Fed cuts to 0

Anyone who was shorting US treasuries has been hammered, as I wrote 2 days ago ( Japanese bonds went all the way down to 1%. But yes, I agree that at 2.25% for 10 yr bonds, inflation risk is getting underpriced. I am getting tempted to buy TBT..

Tuesday, December 16, 2008

Raju steals $1.6 bn from Satyam - Why corporate fraud is an under estimated risk for Indian equities

Mr. Ramalinga Raju, hitherto esteemed Chairman and CEO of Satyam, today brazenly stole $1.6bn out of the company. Satyam, in which Mr. Raju owns a mere 8% (according to Bloomberg), decided to buy 100% stake in Maytas Properties for $1.3 billion, and $51% in Maytas Infra for $0.3billion, for a total outlay of $1.6 billion. Maytas Infra is a listed company in which Mr. Raju and family owns 36%. Maytas Properties, on the other hand is completely owned by Mr Raju. 

Satyam had about $1.2 billion cash as of Sep 30, 2008.  Effectively, that cash and a little more is being transferred to entities owned beneficially by Mr. Raju. This raises serious corporate governance issues for the following reasons:

a) Real estate has been in free fall in India since Jan 2008. Yet Satyam, which hitherto was doing IT outsourcing stuff, has suddenly decided to move into real estate and infrastructure. And to do this, it is not going through the organic route. It is taking the path of acquisitions. Specifically, acquisition of promoter controlled companies. 

b) The cash spent on acquiring promoter controlled companies is just a little bit higher than cash on books of Satyam. Is this a mere coincidence?

c) Satyam is listed on NYSE, publishes quarterly results that are filed with the SEC, and holds quarterly conference calls. Management meets regularly with investors. Yet, till last week, there was no indication from management that it is inclined to do its biggest acquisition and that too in a totally unrelated sector. Was there any discussion within the company or the board on this transaction? 

Or more likely, when Mr. Raju found his wholly owned company - Maytas Properties - in danger of defaulting of loans taken to purchase land at astronomically high prices in 2007, he unilaterally decided, as CEO and Chairman of Satyam, to use Satyam's cash balance to dig himself out of the hole? The board merely rubber stamped his decision. 

d) Is Satyam's board sleeping or what? Havent they looked at stocks of companies like DLF or Indiabulls Real Estate? The brazenness is shocking. 

One factor that investors in India have not paid adequate attention to is corporate governance. Promoters of almost 80% of Indian companies are corrupt. Historically, promoters used to steal money from companies by either making the companies fund their lavish lifestyles (like Vijay Mallaya) or simply have the company under-report numbers. Promoters kept the undeclared income - to enrich themselves as well to bribe all the beureaucrats, politicians and police officers. There is a big cash economy in India. 

In the past four years, as market multiples expanded and FII's and PE funds went crazy, India promoters found it more profitable to simply show this unaccounted for black income into the company's books. This resulted in a steep profit growth optically, high multiples on these suddenly high profit numbers and crazy valuations. Promoters got rich through the market route. Incidentally, this conversion of black income to white income and associated higher tax collection is what is behind the advance tax payments growth numbers that Indian media is so fond of tracking every pre-earnings season. 

A lot of promoters still leveraged themselves even more. Lending against stock was one of the most profitable business of brokerages till early this year. And now the promoters find themselves in trouble. Banks, brokerages and mutual funds are calling back their loans which the promoters cannot repay. Seems like a subsidiary of Maytas Properties has taken loans from HDFC mutual fund - we know HDFC has bailed out some of the FMPs (fixed maturity plans) of HDFC mutual fund because these FMP's had invested in suddenly illiquid commercial paper of certain real estate companies. The connection is complete. 

So what do you think the promoters will do? Will they honestly go bust and let someone else take their company away? Or, like Mr Raju, they are going to devise a scheme to use their company's money to bail themselves out? Will they again start stealing money out of their companies?  My belief is - an Indian promoter is unlikely to go bust in India because he/she is a crook of the highest order in 80% of the cases. Their role model - after all - is Mr. Mukesh Ambani.  Unitech's shareholders might go to 0, but its CEO wont go bust. He will simply sell Unitech's land to a 100% owned company at throw away valuations. 

Watch out for promoters with multiple companies and pressing funding needs: Zee-Dish, Reliance Power - RCOM etc. The list is long and the game is on. 

What is India's trendline GDP growth rate?

I am amazed by the number of Indian economists who keep proclaiming in the newspapers, RBI and Finance Ministry that what we are seeing is driven by fear and not reality. So once things turn to normal, India will revert to its trend GDP growth of 8%. 

First, sentiment is reality. Remember the animal spirits of Keynes. Greenspan also said that if he could figure out when greed turns to fear, he wouldn't need any other model. 

Second, the 8% growth rate of 2003-08 for India was during the years of the global credit bubble. I would not be wrong to simply lop off 2%-3% off that to come to a trend GDP growth of 5%-6%. 

And since in FY10 we will go below trendline growth, I would bet on a GDP growth rate of 3%-4%. Even agriculture growth can be negative depending on where agri commodities prices move. So far, I have seen only a few brokerages such as GS or Macquarie talk of 5.5%-6% growth in FY10. This to me is the top end of the trendline growth of 5%-6%, not the bottom end of trendline growth of 8%.  

Is there a way to short Ruble?

This is one of the easiest one-way bets out there. The way Russian Central Bank is devaluing the ruble - there is no two-way risk in shorting the ruble. The bank is implicitly admitting that the currency is overvalued. But instead of having one sharp depreciation, it is only letting it depreciate slowly.  

Now, is there a way for a retail investor to short the currency? I don't want to short the XRU - there is no volume. Besides, I am not really sure what is the structure of these ETFs themselves. 

Monday, December 15, 2008

Notes from Jim Grant's Video

Jim Grant writes the Interest Rate Observer biweekly, which is a very highly regarded publication of the buy side. This is a one-hour video in which he gives a 20 min speech on Ben Graham - his idol, and then spends the rest of time on Q&A. Worth a watch. He has also published a book recently - Mr. Market miscalculates - which I plan to buy soon.

  • Ben Graham lost 70% between 1929 and 1932. Still an outperformance as Dow lost 89%, so one can imagine the carnage. 
  • Graham's partnership went into 1929 crash in a levered position, so got hit. 
  • Recovered everything by 1936. 
  • Lost another 50% in 1938. 
  • So perseverance is key. Debilitating loss is no reason to quit investing. This is why Graham performed better than others - because he didnt leave the markets. 
  • Rule No 1: Dont lose money. Rule No 2: Dont forget rule no 1. 
  • Intrinsic value is a very dangerous concept. 
  • Market is equally disinterested in valuation at top or bottom. 
  • Graham was not interested in integrating macroeconomics in his security analysis, though he acknowledges that he should have paid attention to the backdrop of 1920's. 
  • By 1940, Graham advised institutions to invest in bonds yielding 2% and not in stocks - at the end of the second edition of his 750 page book that dealt with security analysis. Even he succumbed to fear. 

  • Mark-to-market accounting: Very self-serving the protestations of people who are now complaining on mark-to-market. They didnt complain during the upswing. Sachs (of GS fame) in his 1932 senate testimony had this view on mark-to-market accounting: Goldman Sachs Trading Corporation had blown up in 1932. One of its investments was in a company that was later to become General Mills. Mr Sachs and his accountants determined that they can carry the investment at cost price or any price right down to $1. So they took $1. Mr. Sachs, in his testimony, said that intellectually that is the correct price, whatever one believes in the future prospects of the company. (In the book 1929 - the Crash by Galbraith, there is a fascinating description of all the GS Trading Corporation) 
  • Real estate is almost always illiquid, but Wall Street has almost always made money off it. 
  • Wall Street is in a very dangerous position right now, political reprisal can be heavy. 
  • Bailout: Very troubling the way it is being implemented. Administration and treasury believe that there wont be second degree impact of the bailout, without having thought through what they are doing. They are scaring people by comparing it to 1929. Between 1929 and 1932, nominal GDP fell by 50%. Today, nominal GDP is still growing, so situation is vastly different. (This is a very important point. Real GDP growth is a concept based on some statistical calculation of inflation - and there can be hundreds of inflation numbers depending on the statistician. What we can see is nominal GDP, and stocks are priced in nominal terms, not real terms. When HDFC's CEO says that loan growth is 3x real GDP growth, he is wrong, because loan growth depends on nominal GDP growth, not real GDP growth. He is implicity assuming some constant inflation number that he doesn't specify). 
  • A big source of fear is Wahington saying "Not since 1930's." Cant they say "Not since 1974"? 
  • In 1974, hundreds of companies were selling below net cash. But there was no crash in credit, unlike today. Dow peaked in 1966, was going down till 1974, and didnt get back to old peak till 1982. 
  • Federal Reserve founded in 1914, and it took a century to reach $1 trillion balance sheet. In last 3 weeks it's balance sheet has balloneed from $1 trillion to $3 trillion. Inflation not possible today when credit is being destroyed. But who knows what happens tomorrow. Dollar is uncollateralized. Paper without any real value. 
  • Before WWI, gold standard. Then gold exchange standard. After WWII, Bretton Wodds. After 1971, dollar was free of gold. For past 37 years, dollar has been the reserve currency. Never before there has been so long a run of paper money without an inflation crash. So the system has actually worked for quite a long time. 
  • Paradox of dollar strength. Unpredictable consequence of dollar strength might be that people lose faith in all currencies - nothing is collateralized. Euro is a confederation of states. Ireland is having its difficulties. What if Spain, Portugal, France, Germany find the monetary regime too restrictive and decide to go on its own way. Since 1971, currencies haven't been collateralized, and the world doesn't mind. But the world didn't mind CDO for a long time, now it does. 
  • Private equity has devalued the "Your word is your bond" creed of Wall Street by walking out of so many deals. Hedge funds have been much better. 
  • One of the unintended consequences could be - a new wave of entreprenurial banking partneships, as the bigger banks become government departments. 

Inventory Writedowns

It will be very interesting to see how many companies take write-down on their inventories this quarter. Especially intermediate companies, such as oil refiners, should take big hits. Even if some companies don't take hits because of effective hedging programs, it will be difficult for companies to maintain margins in an environment where prices are falling. Besides, who cares about margins - companies can have higher margins but lower EPS if their product prices fall less than raw material prices. I think EPS for this quarter will be the first reality check as to how low earnings can be in times of distress.

Dollar is falling again. This sets up an interesting paradox for the US indices, especially Nasdaq, for whom a major chunk of the earnings is international.

Somehow there is a consensus that US treasuries are in bubble zone because yields have reached multi-decades low. It might be true, or it might not be true (look at Japan with 1% yields for multiple years). Besides, the mere existence of a bubble doesn't imply it is ready to pop. I think USD depreciation will precede a major treasury sell off. Now USD has started weakening since equity markets rallied. But is this the start of a full blown sell off? I don't know. Neither does anyone else. The way things evolve will determine what actually evolves.

Thursday, December 11, 2008

Udaipur-Haldighati- Mt. Abu vacation

Last weekend, I was in Udaipur to attend my colleague Sudhanshoo's wedding. Thereafter, I went to Haldighati - the site of Maharana Pratap and Akbar's fight, and proceeded to Mt Abu. Highly recommend the trip to anyone who has 4 days off.

Some thoughts:

a) Besides low cost tech outsourcing, there is one other industry in which India is globally competitive. That is hotels. And the USP is not limited to the royal palaces that have now been converted into hotels in Rajasthan. Even the smaller havelis and old houses that have been converted into hotels - whether in Jaipur, Pondicherry or Mt. Abu - have an ambience that no hotel in US can provide, all at a reasonable price. Now if we can just keep the terrorists at bay...

b) Some very good roads are under construction - the road between Udaipur and Mt. Abu was freshly built, and will rival European roads once the project is over. Apparently this road will go from Bhuj in the west to Assam in the east. Now we won't be driving 120kmph on average anytime soon, primarily because of the cows and goats, but an improvement from 40 to 65 kmph is a vast improvement in percentage terms.

c) There is a museum in Haldighati - apparently it is the private initiative of an individual. Seems like they are trying to make a historical theme park there. They are actually making the walls of a fort, to make it all seem very historical. Haldighati is where Rana Pratap fought Akbar's army and where his legendary horse, Chetak is buried.

d)In the battle of Haldighati, the general of Akbar's army was Sawai Jai Singh of Jaipur. So, essentially, it was a fight between Jaipur and Chittod. Now both these erstwhile kingdoms are part of Rajasthan. Is there a historic rivalry between different regions of Rajasthan, and indeed amongst different regions of the same states across the country that gets reflected in local, state and national politics? People are prisoners of history. Is this somewhere getting reflected within the internal dynamics of Congress and BJP? An interesting idea to explore further.

e) There is no agriculture to speak of around Udaipur. Apparently mining is where lots of people are employed. Road construction is another. Probably tourism. Tourism is a big industry in India. For all the beureaucratic indifference and official apathy, Incredible India is a relatively successful marketing campaign.

India-Pakistan Crises

Recently I came across Stratfor. It has recently published a couple of great articles on Indian-Pakistan crises.

Worth a read

Friday, December 05, 2008

Are some hedge fund strategies permanently damaged?

I am reading this article on Prime Brokerages in the Nov issue of EuroMoney. There is a very interesting point on the liquidity available in the shorting market. We know that many hedge funds are stuck in Lehman Brothers UK arm (LBIE) as LBIE lent out the securities further out, and now it is going to be impossible to figure out who owns those securities. There are many owners of the same security.

We have seen several fund companies (State Street etc) curtailing their stock lending programmes. One is the fear whether they ever get the securities back, due to heightened counterparty risks. Two is a stigma attached with helping the shorts. Regulators also keep changing the rules. People are more careful to locate the stock before it can be shorted.

If this is a permanent damage because of the counterparty risk issue, does it mean that several hedge fund strategies like long-short equity or convertible arbitrage become very difficult to implement even when markets stabilize? Because if one can't locate the stock as people are unwilling to lend it out, the shorts can't short it. Thats not good for the long-term market structure.

Thursday, December 04, 2008

Vendor Financing

I picked this up from FTAlphaville today, where Merrill Lynch is arguing that the global vendor financing model - where China finances its customer - is coming to an end. I had thought of it in the very exact terms in 2005 here (, so I feel happy that I wasn't wrong. It was one of my first posts. Though as I read that post again, I was certainly wrong on a lot of other things, like BSE being overvalued at 7000 and oil being overvalued at 55.

Merrill Lynch has published their 2009 economic outlook — the over-riding theme? Nothing less than the decline of the West’s financial supremacy.

From the report:

In the emerging world, particularly China, the vulnerability to the US financial crisis is likely to lead to a fundamental rethink of the development model. Expect long-run policies reducing ties to Anglo-Saxon consumption and a rebalancing in the global political power toward the emerging world.……

At its core, the global financial crisis brings an end to the vendor financing model, whereby excess consumption in the US was financed by a savings glut in the emerging world. The market will ensure this adjustment finally happens. This is coming from both directions…

Monday, November 24, 2008

The Banking System and Prisoner's Dilemma

Many regulators and commentrators have expressed their frustration that while US and UK governments have put billions of dollars in their banks, banks are unwilling to lend. This is exacerbating the economic problem, and we are now caught in a negative feedback loop. Some people think that banks should be forced to lend by their governments, probably at the same terms as last year.

Suppose I am the CEO of a bank. There are four ways forward for me - it is a classic case of Prisoner's dilemma.

a) I dont lend, neither does the CEO of any other bank - all of us are worse off equally - if the system doesnt crash I survive like everyone else, and if the system crashes we all go to 0 (including Wells Fargo).

b) I lend, but other CEO's don't - I might be worse off if the system survives, because I would have made certain uneconomic loans in the early days of the recession. If the system crashes, then all of us go to 0, and there is no difference.

c) I don't lend, but others do - My utopia. Hopefully everybody else lends and stabilizes the system, and when it has stabilized enough, I open up my lending and make hay when the sun is out shining.

d) I lend as well as all others - cooperation is the best (like in all PD games), as it will probably stabilize the system. Everyone will benefit equally or will be equally worse off.

In Prisoner's Dilemma, it is very hard to achieve cooperation - even amongst two prisoners. Here we are talking of hundreds of CEO's coming together and cooperating. Is it possible? Most likely not.

Are there structures of PD games that make cooperation a logical outcome? That is where regulators need to drive the system to.

Friday, November 14, 2008

The End by Michael Lewis

This is a fantastic article by Michael Lewis. He is a master storyteller. As I received it in a word document, I am just copying it here. Hope it doesn't violate any copyrights.


To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

I’d never taken an accounting course, never run a business, never even had savings of my own to manage. I stumbled into a job at Salomon Brothers in 1985 and stumbled out much richer three years later, and even though I wrote a book about the experience, the whole thing still strikes me as preposterous—which is one of the reasons the money was so easy to walk away from. I figured the situation was unsustainable. Sooner rather than later, someone was going to identify me, along with a lot of people more or less like me, as a fraud. Sooner rather than later, there would come a Great Reckoning when Wall Street would wake up and hundreds if not thousands of young people like me, who had no business making huge bets with other people’s money, would be expelled from finance.

When I sat down to write my account of the experience in 1989—Liar’s Poker, it was called—it was in the spirit of a young man who thought he was getting out while the getting was good. I was merely scribbling down a message on my way out and stuffing it into a bottle for those who would pass through these parts in the far distant future.

Unless some insider got all of this down on paper, I figured, no future human would believe that it happened.

I thought I was writing a period piece about the 1980s in America. Not for a moment did I suspect that the financial 1980s would last two full decades longer or that the difference in degree between Wall Street and ordinary life would swell into a difference in kind. I expected readers of the future to be outraged that back in 1986, the C.E.O. of Salomon Brothers, John Gutfreund, was paid $3.1 million; I expected them to gape in horror when I reported that one of our traders, Howie Rubin, had moved to Merrill Lynch, where he lost $250 million; I assumed they’d be shocked to learn that a Wall Street C.E.O. had only the vaguest idea of the risks his traders were running. What I didn’t expect was that any future reader would look on my experience and say, “How quaint.”

I had no great agenda, apart from telling what I took to be a remarkable tale, but if you got a few drinks in me and then asked what effect I thought my book would have on the world, I might have said something like, “I hope that college students trying to figure out what to do with their lives will read it and decide that it’s silly to phony it up and abandon their passions to become financiers.” I hoped that some bright kid at, say, Ohio State University who really wanted to be an oceanographer would read my book, spurn the offer from Morgan Stanley, and set out to sea.

Somehow that message failed to come across. Six months after Liar’s Poker was published, I was knee-deep in letters from students at Ohio State who wanted to know if I had any other secrets to share about Wall Street. They’d read my book as a how-to manual.

In the two decades since then, I had been waiting for the end of Wall Street. The outrageous bonuses, the slender returns to shareholders, the never-ending scandals, the bursting of the internet bubble, the crisis following the collapse of Long-Term Capital Management: Over and over again, the big Wall Street investment banks would be, in some narrow way, discredited. Yet they just kept on growing, along with the sums of money that they doled out to 26-year-olds to perform tasks of no obvious social utility. The rebellion by American youth against the money culture never happened. Why bother to overturn your parents’ world when you can buy it, slice it up into tranches, and sell off the pieces?

At some point, I gave up waiting for the end. There was no scandal or reversal, I assumed, that could sink the system.

Then came Meredith Whitney with news. Whitney was an obscure analyst of financial firms for Oppenheimer Securities who, on October 31, 2007, ceased to be obscure. On that day, she predicted that Citigroup had so mismanaged its affairs that it would need to slash its dividend or go bust. It’s never entirely clear on any given day what causes what in the stock market, but it was pretty obvious that on October 31, Meredith Whitney caused the market in financial stocks to crash. By the end of the trading day, a woman whom basically no one had ever heard of had shaved $369 billion off the value of financial firms in the market. Four days later, Citigroup’s C.E.O., Chuck Prince, resigned. In January, Citigroup slashed its dividend.

From that moment, Whitney became E.F. Hutton: When she spoke, people listened. Her message was clear. If you want to know what these Wall Street firms are really worth, take a hard look at the crappy assets they bought with huge sums of ­borrowed money, and imagine what they’d fetch in a fire sale. The vast assemblages of highly paid people inside the firms were essentially worth nothing. For better than a year now, Whitney has responded to the claims by bankers and brokers that they had put their problems behind them with this write-down or that capital raise with a claim of her own: You’re wrong. You’re still not facing up to how badly you have mismanaged your business.

Rivals accused Whitney of being overrated; bloggers accused her of being lucky. What she was, mainly, was right. But it’s true that she was, in part, guessing. There was no way she could have known what was going to happen to these Wall Street firms. The C.E.O.’s themselves didn’t know.

Now, obviously, Meredith Whitney didn’t sink Wall Street. She just expressed most clearly and loudly a view that was, in retrospect, far more seditious to the financial order than, say, Eliot Spitzer’s campaign against Wall Street corruption. If mere scandal could have destroyed the big Wall Street investment banks, they’d have vanished long ago. This woman wasn’t saying that Wall Street bankers were corrupt. She was saying they were stupid. These people whose job it was to allocate capital apparently didn’t even know how to manage their own.

At some point, I could no longer contain myself: I called Whitney. This was back in March, when Wall Street’s fate still hung in the balance. I thought, If she’s right, then this really could be the end of Wall Street as we’ve known it. I was curious to see if she made sense but also to know where this young woman who was crashing the stock market with her every utterance had come from.

It turned out that she made a great deal of sense and that she’d arrived on Wall Street in 1993, from the Brown University history department. “I got to New York, and I didn’t even know research existed,” she says. She’d wound up at Oppenheimer and had the most incredible piece of luck: to be trained by a man who helped her establish not merely a career but a worldview. His name, she says, was Steve Eisman.

Eisman had moved on, but they kept in touch. “After I made the Citi call,” she says, “one of the best things that happened was when Steve called and told me how proud he was of me.”

Having never heard of Eisman, I didn’t think anything of this. But a few months later, I called Whitney again and asked her, as I was asking others, whom she knew who had anticipated the cataclysm and set themselves up to make a fortune from it. There’s a long list of people who now say they saw it coming all along but a far shorter one of people who actually did. Of those, even fewer had the nerve to bet on their vision. It’s not easy to stand apart from mass hysteria—to believe that most of what’s in the financial news is wrong or distorted, to believe that most important financial people are either lying or deluded—without actually being insane. A handful of people had been inside the black box, understood how it worked, and bet on it blowing up. Whitney rattled off a list with a half-dozen names on it. At the top was Steve Eisman.

Steve Eisman entered finance about the time I exited it. He’d grown up in New York City and gone to a Jewish day school, the University of Pennsylvania, and Harvard Law School. In 1991, he was a 30-year-old corporate lawyer. “I hated it,” he says. “I hated being a lawyer. My parents worked as brokers at Oppenheimer. They managed to finagle me a job. It’s not pretty, but that’s what happened.”

He was hired as a junior equity analyst, a helpmate who didn’t actually offer his opinions. That changed in December 1991, less than a year into his new job, when a subprime mortgage lender called Ames Financial went public and no one at Oppenheimer particularly cared to express an opinion about it. One of Oppenheimer’s investment bankers stomped around the research department looking for anyone who knew anything about the mortgage business. Recalls Eisman: “I’m a junior analyst and just trying to figure out which end is up, but I told him that as a lawyer I’d worked on a deal for the Money Store.” He was promptly appointed the lead analyst for Ames Financial. “What I didn’t tell him was that my job had been to proofread the ­documents and that I hadn’t understood a word of the fucking things.”

Ames Financial belonged to a category of firms known as nonbank financial institutions. The category didn’t include J.P. Morgan, but it did encompass many little-known companies that one way or another were involved in the early-1990s boom in subprime mortgage lending—the lower class of American finance.

The second company for which Eisman was given sole responsibility was Lomas Financial, which had just emerged from bankruptcy. “I put a sell rating on the thing because it was a piece of shit,” Eisman says. “I didn’t know that you weren’t supposed to put a sell rating on companies. I thought there were three boxes—buy, hold, sell—and you could pick the one you thought you should.” He was pressured generally to be a bit more upbeat, but upbeat wasn’t Steve Eisman’s style. Upbeat and Eisman didn’t occupy the same planet. A hedge fund manager who counts Eisman as a friend set out to explain him to me but quit a minute into it. After describing how Eisman exposed various important people as either liars or idiots, the hedge fund manager started to laugh. “He’s sort of a prick in a way, but he’s smart and honest and fearless.”

“A lot of people don’t get Steve,” Whitney says. “But the people who get him love him.” Eisman stuck to his sell rating on Lomas Financial, even after the company announced that investors needn’t worry about its financial condition, as it had hedged its market risk. “The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “
‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

Eisman wasn’t, in short, an analyst with a sunny disposition who expected the best of his fellow financial man and the companies he created. “You have to understand,” Eisman says in his defense, “I did subprime first. I lived with the worst first. These guys lied to infinity. What I learned from that experience was that Wall Street didn’t give a shit what it sold.”

Harboring suspicions about ­people’s morals and telling investors that companies don’t deserve their capital wasn’t, in the 1990s or at any other time, the fast track to success on Wall Street. Eisman quit Oppenheimer in 2001 to work as an analyst at a hedge fund, but what he really wanted to do was run money. FrontPoint Partners, another hedge fund, hired him in 2004 to invest in financial stocks. Eisman’s brief was to evaluate Wall Street banks, homebuilders, mortgage originators, and any company (General Electric or General Motors, for instance) with a big financial-services division—anyone who touched American finance. An insurance company backed him with $50 million, a paltry sum. “Basically, we tried to raise money and didn't really do it,” Eisman says.

Instead of money, he attracted people whose worldviews were as shaded as his own—Vincent Daniel, for instance, who became a partner and an analyst in charge of the mortgage sector. Now 36, Daniel grew up a lower-middle-class kid in Queens. One of his first jobs, as a junior accountant at Arthur Andersen, was to audit Salomon Brothers’ books. “It was shocking,” he says. “No one could explain to me what they were doing.” He left accounting in the middle of the internet boom to become a research analyst, looking at companies that made subprime loans. “I was the only guy I knew covering companies that were all going to go bust,” he says. “I saw how the sausage was made in the economy, and it was really freaky.”

Danny Moses, who became Eisman’s head trader, was another who shared his perspective. Raised in Georgia, Moses, the son of a finance professor, was a bit less fatalistic than Daniel or Eisman, but he nevertheless shared a general sense that bad things can and do happen. When a Wall Street firm helped him get into a trade that seemed perfect in every way, he said to the salesman, “I appreciate this, but I just want to know one thing: How are you going to screw me?”

Heh heh heh, c’mon. We’d never do that, the trader started to say, but Moses was politely insistent: We both know that unadulterated good things like this trade don’t just happen between little hedge funds and big Wall Street firms. I’ll do it, but only after you explain to me how you are going to screw me. And the salesman explained how he was going to screw him. And Moses did the trade.

Both Daniel and Moses enjoyed, immensely, working with Steve Eisman. He put a fine point on the absurdity they saw everywhere around them. “Steve’s fun to take to any Wall Street meeting,” Daniel says. “Because he’ll say ‘Explain that to me’ 30 different times. Or ‘Could you explain that more, in English?’ Because once you do that, there’s a few things you learn. For a start, you figure out if they even know what they’re talking about. And a lot of times, they don’t!”

At the end of 2004, Eisman, Moses, and Daniel shared a sense that unhealthy things were going on in the U.S. housing market: Lots of firms were lending money to people who shouldn’t have been borrowing it. They thought Alan Greenspan’s decision after the internet bust to lower interest rates to 1 percent was a travesty that would lead to some terrible day of reckoning. Neither of these insights was entirely original. Ivy Zelman, at the time the housing-market analyst at Credit Suisse, had seen the bubble forming very early on. There’s a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1. “All these people were saying it was nearly as high in some other countries,” Zelman says. “But the problem wasn’t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.” Zelman alienated clients with her pessimism, but she couldn’t pretend everything was good. “It wasn’t that hard in hindsight to see it,” she says. “It was very hard to know when it would stop.” Zelman spoke occasionally with Eisman and always left these conversations feeling better about her views and worse about the world. “You needed the occasional assurance that you weren’t nuts,” she says. She wasn’t nuts. The world was.

By the spring of 2005, FrontPoint was fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds. But in 2005, there was $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds. Eisman couldn’t understand who was making all these loans or why. He had a from-the-ground-up understanding of both the U.S. housing market and Wall Street. But he’d spent his life in the stock market, and it was clear that the stock market was, in this story, largely irrelevant. “What most people don’t realize is that the fixed-income world dwarfs the equity world,” he says. “The equity world is like a fucking zit compared with the bond market.” He shorted companies that originated subprime loans, like New Century and Indy Mac, and companies that built the houses bought with the loans, such as Toll Brothers. Smart as these trades proved to be, they weren’t entirely satisfying. These companies paid high dividends, and their shares were often expensive to borrow; selling them short was a costly proposition.

Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible—because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.

Here’s where financial technology became suddenly, urgently relevant. The typical mortgage bond was still structured in much the same way it had been when I worked at Salomon Brothers. The loans went into a trust that was designed to pay off its investors not all at once but according to their rankings. The investors in the top tranche, rated AAA, received the first payment from the trust and, because their investment was the least risky, received the lowest interest rate on their money. The investors who held the trusts’ BBB tranche got the last payments—and bore the brunt of the first defaults. Because they were taking the most risk, they received the highest return. Eisman wanted to bet that some subprime borrowers would default, causing the trust to suffer losses. The way to express this view was to short the BBB tranche. The trouble was that the BBB tranche was only a tiny slice of the deal.

But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. “What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’
” Eisman says. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’

And short Eisman did—then he tried to get his mind around what he’d just done so he could do it better. He’d call over to a big firm and ask for a list of mortgage bonds from all over the country. The juiciest shorts—the bonds ultimately backed by the mortgages most likely to default—had several characteristics. They’d be in what Wall Street people were now calling the sand states: Arizona, California, Florida, Nevada. The loans would have been made by one of the more dubious mortgage lenders; Long Beach Financial, wholly owned by Washington Mutual, was a great example. Long Beach Financial was moving money out the door as fast as it could, few questions asked, in loans built to self-destruct. It specialized in asking home­owners with bad credit and no proof of income to put no money down and defer interest payments for as long as possible. In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $720,000.

More generally, the subprime market tapped a tranche of the American public that did not typically have anything to do with Wall Street. Lenders were making loans to people who, based on their credit ratings, were less creditworthy than 71 percent of the population. Eisman knew some of these people. One day, his housekeeper, a South American woman, told him that she was planning to buy a townhouse in Queens. “The price was absurd, and they were giving her a low-down-payment option-ARM,” says Eisman, who talked her into taking out a conventional fixed-rate mortgage. Next, the baby nurse he’d hired back in 1997 to take care of his newborn twin daughters phoned him. “She was this lovely woman from Jamaica,” he says. “One day she calls me and says she and her sister own five townhouses in Queens. I said, ‘How did that happen?’
” It happened because after they bought the first one and its value rose, the lenders came and suggested they refinance and take out $250,000, which they used to buy another one. Then the price of that one rose too, and they repeated the experiment. “By the time they were done,” Eisman says, “they owned five of them, the market was falling, and they couldn’t make any of the payments.”

In retrospect, pretty much all of the riskiest subprime-backed bonds were worth betting against; they would all one day be worth zero. But at the time Eisman began to do it, in the fall of 2006, that wasn’t clear. He and his team set out to find the smelliest pile of loans they could so that they could make side bets against them with Goldman Sachs or Deutsche Bank. What they were doing, oddly enough, was the analysis of subprime lending that should have been done before the loans were made: Which poor Americans were likely to jump which way with their finances? How much did home prices need to fall for these loans to blow up? (It turned out they didn’t have to fall; they merely needed to stay flat.) The default rate in Georgia was five times higher than that in Florida even though the two states had the same unemployment rate. Why? Indiana had a 25 percent default rate; California’s was only 5 percent. Why?

Moses actually flew down to Miami and wandered around neighborhoods built with subprime loans to see how bad things were. “He’d call me and say, ‘Oh my God, this is a calamity here,’” recalls Eisman. All that was required for the BBB bonds to go to zero was for the default rate on the underlying loans to reach 14 percent. Eisman thought that, in certain sections of the country, it would go far, far higher.

The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes. They were learning about this on the fly, shorting the bonds and then trying to figure out what they had done. Eisman knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism. For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.

But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says.

As an investor, Eisman was allowed on the quarterly conference calls held by Moody’s but not allowed to ask questions. The people at Moody’s were polite about their brush-off, however. The C.E.O. even invited Eisman and his team to his office for a visit in June 2007. By then, Eisman was so certain that the world had been turned upside down that he just assumed this guy must know it too. “But we’re sitting there,” Daniel recalls, “and he says to us, like he actually means it, ‘I truly believe that our rating will prove accurate.’ And Steve shoots up in his chair and asks, ‘What did you just say?’ as if the guy had just uttered the most preposterous statement in the history of finance. He repeated it. And Eisman just laughed at him.”

“With all due respect, sir,” Daniel told the C.E.O. deferentially as they left the meeting, “you’re delusional.”
This wasn’t Fitch or even S&P. This was Moody’s, the aristocrats of the rating business, 20 percent owned by Warren Buffett. And the company’s C.E.O. was being told he was either a fool or a crook by one Vincent Daniel, from Queens.

A full nine months earlier, Daniel and ­Moses had flown to Orlando for an industry conference. It had a grand title—the American Securitization Forum—but it was essentially a trade show for the ­subprime-mortgage business: the people who originated subprime mortgages, the Wall Street firms that packaged and sold subprime mortgages, the fund managers who invested in nothing but subprime-mortgage-backed bonds, the agencies that rated subprime-­mortgage bonds, the lawyers who did whatever the lawyers did. Daniel and Moses thought they were paying a courtesy call on a cottage industry, but the cottage had become a castle. “There were like 6,000 people there,” Daniel says. “There were so many people being fed by this industry. The entire fixed-income department of each brokerage firm is built on this. Everyone there was the long side of the trade. The wrong side of the trade. And then there was us. That’s when the picture really started to become clearer, and we started to get more cynical, if that was possible. We went back home and said to Steve, ‘You gotta see this.’

Eisman, Daniel, and Moses then flew out to Las Vegas for an even bigger subprime conference. By now, Eisman knew everything he needed to know about the quality of the loans being made. He still didn’t fully understand how the apparatus worked, but he knew that Wall Street had built a doomsday machine. He was at once opportunistic and outraged.

Their first stop was a speech given by the C.E.O. of Option One, the mortgage originator owned by H&R Block. When the guy got to the part of his speech about Option One’s subprime-loan portfolio, he claimed to be expecting a modest default rate of 5 percent. Eisman raised his hand. Moses and Daniel sank into their chairs. “It wasn’t a Q&A,” says Moses. “The guy was giving a speech. He sees Steve’s hand and says, ‘Yes?’”

“Would you say that 5 percent is a probability or a possibility?” Eisman asked.

A probability, said the C.E.O., and he continued his speech.

Eisman had his hand up in the air again, waving it around. Oh, no, Moses thought. “The one thing Steve always says,” Daniel explains, “is you must assume they are lying to you. They will always lie to you.” Moses and Daniel both knew what Eisman thought of these subprime lenders but didn’t see the need for him to express it here in this manner. For Eisman wasn’t raising his hand to ask a question. He had his thumb and index finger in a big circle. He was using his fingers to speak on his behalf. Zero! they said.

“Yes?” the C.E.O. said, obviously irritated. “Is that another question?”

“No,” said Eisman. “It’s a zero. There is zero probability that your default rate will be 5 percent.” The losses on subprime loans would be much, much greater. Before the guy could reply, Eisman’s cell phone rang. Instead of shutting it off, Eisman reached into his pocket and answered it. “Excuse me,” he said, standing up. “But I need to take this call.” And with that, he walked out.

Eisman’s willingness to be abrasive in order to get to the heart of the matter was obvious to all; what was harder to see was his credulity: He actually wanted to believe in the system. As quick as he was to cry bullshit when he saw it, he was still shocked by bad behavior. That night in Vegas, he was seated at dinner beside a really nice guy who invested in mortgage C.D.O.’s—collateralized debt obligations. By then, Eisman thought he knew what he needed to know about C.D.O.’s. He didn’t, it turned out.

Later, when I sit down with Eisman, the very first thing he wants to explain is the importance of the mezzanine C.D.O. What you notice first about Eisman is his lips. He holds them pursed, waiting to speak. The second thing you notice is his short, light hair, cropped in a manner that suggests he cut it himself while thinking about something else. “You have to understand this,” he says. “This was the engine of doom.” Then he draws a picture of several towers of debt. The first tower is made of the original subprime loans that had been piled together. At the top of this tower is the AAA tranche, just below it the AA tranche, and so on down to the riskiest, the BBB tranche—the bonds Eisman had shorted. But Wall Street had used these BBB tranches—the worst of the worst—to build yet another tower of bonds: a “particularly egregious” C.D.O. The reason they did this was that the rating agencies, presented with the pile of bonds backed by dubious loans, would pronounce most of them AAA. These bonds could then be sold to investors—pension funds, insurance companies—who were allowed to invest only in highly rated securities. “I cannot fucking believe this is allowed—I must have said that a thousand times in the past two years,” Eisman says.

His dinner companion in Las Vegas ran a fund of about $15 billion and managed C.D.O.’s backed by the BBB tranche of a mortgage bond, or as Eisman puts it, “the equivalent of three levels of dog shit lower than the original bonds.”

FrontPoint had spent a lot of time digging around in the dog shit and knew that the default rates were already sufficient to wipe out this guy’s entire portfolio. “God, you must be having a hard time,” Eisman told his dinner companion.

“No,” the guy said, “I’ve sold everything out.”

After taking a fee, he passed them on to other investors. His job was to be the C.D.O. “expert,” but he actually didn’t spend any time at all thinking about what was in the C.D.O.’s. “He managed the C.D.O.’s,” says Eisman, “but managed what? I was just appalled. People would pay up to have someone manage their C.D.O.’s—as if this moron was helping you. I thought, You prick, you don’t give a fuck about the investors in this thing.”

Whatever rising anger Eisman felt was offset by the man’s genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. “Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’

That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

This particular dinner was hosted by Deutsche Bank, whose head trader, Greg Lippman, was the fellow who had introduced Eisman to the subprime bond market. Eisman went and found Lippman, pointed back to his own dinner companion, and said, “I want to short him.” Lippman thought he was joking; he wasn’t. “Greg, I want to short his paper,” Eisman repeated. “Sight unseen.”

Eisman started out running a $60 million equity fund but was now short around $600 million of various ­subprime-related securities. In the spring of 2007, the market strengthened. But, says Eisman, “credit quality always gets better in March and April. And the reason it always gets better in March and April is that people get their tax refunds. You would think people in the securitization world would know this. We just thought that was moronic.”

He was already short the stocks of mortgage originators and the homebuilders. Now he took short positions in the rating agencies—“they were making 10 times more rating C.D.O.’s than they were rating G.M. bonds, and it was all going to end”—and, finally, the biggest Wall Street firms because of their exposure to C.D.O.’s. He wasn’t allowed to short Morgan Stanley because it owned a stake in his fund. But he shorted UBS, Lehman Brothers, and a few others. Not long after that, FrontPoint had a visit from Sanford C. Bernstein’s Brad Hintz, a prominent analyst who covered Wall Street firms. Hintz wanted to know what Eisman was up to. “We just shorted Merrill Lynch,” Eisman told him.

“Why?” asked Hintz.

“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.

There was only one thing that bothered Eisman, and it continued to trouble him as late as May 2007. “The thing we couldn’t figure out is: It’s so obvious. Why hasn’t everyone else figured out that the machine is done?” Eisman had long subscribed to Grant’s Interest Rate Observer, a newsletter famous in Wall Street circles and obscure outside them. Jim Grant, its editor, had been prophesying doom ever since the great debt cycle began, in the mid-1980s. In late 2006, he decided to investigate these things called C.D.O.’s. Or rather, he had asked his young assistant, Dan Gertner, a chemical engineer with an M.B.A., to see if he could understand them. Gertner went off with the documents that purported to explain C.D.O.’s to potential investors and for several days sweated and groaned and heaved and suffered. “Then he came back,” says Grant, “and said, ‘I can’t figure this thing out.’ And I said, ‘I think we have our story.’

Eisman read Grant’s piece as independent confirmation of what he knew in his bones about the C.D.O.’s he had shorted. “When I read it, I thought, Oh my God. This is like owning a gold mine. When I read that, I was the only guy in the equity world who almost had an orgasm.”

On July 19, 2007, the same day that Federal Reserve Chairman Ben Bernanke told the U.S. Senate that he anticipated as much as $100 billion in losses in the subprime-mortgage market, FrontPoint did something unusual: It hosted its own conference call. It had had calls with its tiny population of investors, but this time FrontPoint opened it up. Steve Eisman had become a poorly kept secret. Five hundred people called in to hear what he had to say, and another 500 logged on afterward to listen to a recording of it. He explained the strange alchemy of the C.D.O. and said that he expected losses of up to $300 billion from this sliver of the market alone. To evaluate the situation, he urged his audience to “just throw your model in the garbage can. The models are all backward-looking.

The models don’t have any idea of what this world has become…. For the first time in their lives, people in the asset-backed-securitization world are actually having to think.” He explained that the rating agencies were morally bankrupt and living in fear of becoming actually bankrupt. “The rating agencies are scared to death,” he said. “They’re scared to death about doing nothing because they’ll look like fools if they do nothing.”

On September 18, 2008, Danny Moses came to work as usual at 6:30 a.m. Earlier that week, Lehman Brothers had filed for bankruptcy. The day before, the Dow had fallen 449 points to its lowest level in four years. Overnight, European governments announced a ban on short-selling, but that served as faint warning for what happened next.

At the market opening in the U.S., everything—every financial asset—went into free fall. “All hell was breaking loose in a way I had never seen in my career,” Moses says. FrontPoint was net short the market, so this total collapse should have given Moses pleasure. He might have been forgiven if he stood up and cheered. After all, he’d been betting for two years that this sort of thing could happen, and now it was, more dramatically than he had ever imagined. Instead, he felt this terrifying shudder run through him. He had maybe 100 trades on, and he worked hard to keep a handle on them all. “I spent my morning trying to control all this energy and all this information,” he says, “and I lost control. I looked at the screens. I was staring into the abyss. The end. I felt this shooting pain in my head. I don’t get headaches. At first, I thought I was having an aneurysm.”

Moses stood up, wobbled, then turned to Daniel and said, “I gotta leave. Get out of here. Now.” Daniel thought about calling an ambulance but instead took Moses out for a walk.

Outside it was gorgeous, the blue sky reaching down through the tall buildings and warming the soul. Eisman was at a Goldman Sachs conference for hedge fund managers, raising capital. Moses and Daniel got him on the phone, and he left the conference and met them on the steps of St. Patrick’s Cathedral. “We just sat there,” Moses says. “Watching the people pass.”

This was what they had been waiting for: total collapse. “The investment-banking industry is fucked,” Eisman had told me a few weeks earlier. “These guys are only beginning to understand how fucked they are. It’s like being a Scholastic, prior to Newton. Newton comes along, and one morning you wake up: ‘Holy shit, I’m wrong!’
” Now Lehman Brothers had vanished, Merrill had surrendered, and Goldman Sachs and Morgan Stanley were just a week away from ceasing to be investment banks. The investment banks were not just fucked; they were extinct.

Not so for hedge fund managers who had seen it coming. “As we sat there, we were weirdly calm,” Moses says. “We felt insulated from the whole market reality. It was an out-of-body experience. We just sat and watched the people pass and talked about what might happen next. How many of these people were going to lose their jobs. Who was going to rent these buildings after all the Wall Street firms collapsed.” Eisman was appalled. “Look,” he said. “I’m short. I don’t want the country to go into a depression. I just want it to fucking deleverage.” He had tried a thousand times in a thousand ways to explain how screwed up the business was, and no one wanted to hear it. “That Wall Street has gone down because of this is justice,” he says. “They fucked people. They built a castle to rip people off. Not once in all these years have I come across a person inside a big Wall Street firm who was having a crisis of conscience.”

Truth to tell, there wasn’t a whole lot of hand-wringing inside FrontPoint either. The only one among them who wrestled a bit with his conscience was Daniel. “Vinny, being from Queens, needs to see the dark side of everything,” Eisman says. To which Daniel replies, “The way we thought about it was, ‘By shorting this market we’re creating the liquidity to keep the market going.’

“It was like feeding the monster,” Eisman says of the market for subprime bonds. “We fed the monster until it blew up.”

About the time they were sitting on the steps of the midtown cathedral, I sat in a booth in a restaurant on the East Side, waiting for John Gutfreund to arrive for lunch, and wondered, among other things, why any restaurant would seat side by side two men without the slightest interest in touching each other.

There was an umbilical cord running from the belly of the exploded beast back to the financial 1980s. A friend of mine created the first mortgage derivative in 1986, a year after we left the Salomon Brothers trading program. (“The problem isn’t the tools,” he likes to say. “It’s who is using the tools. Derivatives are like guns.”)

When I published my book, the 1980s were supposed to be ending. I received a lot of undeserved credit for my timing. The social disruption caused by the collapse of the savings-and-loan industry and the rise of hostile takeovers and leveraged buyouts had given way to a brief period of recriminations. Just as most students at Ohio State read Liar’s Poker as a manual, most TV and radio interviewers regarded me as a whistleblower. (The big exception was Geraldo Rivera. He put me on a show called “People Who Succeed Too Early in Life” along with some child actors who’d gone on to become drug addicts.) Anti-Wall Street feeling ran high—high enough for Rudy Giuliani to float a political career on it—but the result felt more like a witch hunt than an honest reappraisal of the financial order. The public lynchings of Gutfreund and junk-bond king Michael Milken were excuses not to deal with the disturbing forces underpinning their rise. Ditto the cleaning up of Wall Street’s trading culture. The surface rippled, but down below, in the depths, the bonus pool remained undisturbed. Wall Street firms would soon be frowning upon profanity, firing traders for so much as glancing at a stripper, and forcing male employees to treat women almost as equals. Lehman Brothers circa 2008 more closely resembled a normal corporation with solid American values than did any Wall Street firm circa 1985.

The changes were camouflage. They helped distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture.

I’d not seen Gutfreund since I quit Wall Street. I’d met him, nervously, a couple of times on the trading floor. A few months before I left, my bosses asked me to explain to Gutfreund what at the time seemed like exotic trades in derivatives I’d done with a European hedge fund. I tried. He claimed not to be smart enough to understand any of it, and I assumed that was how a Wall Street C.E.O. showed he was the boss, by rising above the details. There was no reason for him to remember any of these encounters, and he didn’t: When my book came out and became a public-relations nuisance to him, he told reporters we’d never met.

Over the years, I’d heard bits and pieces about Gutfreund. I knew that after he’d been forced to resign from Salomon Brothers he’d fallen on harder times. I heard later that a few years ago he’d sat on a panel about Wall Street at Columbia Business School. When his turn came to speak, he advised students to find something more meaningful to do with their lives. As he began to describe his career, he broke down and wept.

When I emailed him to invite him to lunch, he could not have been more polite or more gracious. That attitude persisted as he was escorted to the table, made chitchat with the owner, and ordered his food. He’d lost a half-step and was more deliberate in his movements, but otherwise he was completely recognizable. The same veneer of denatured courtliness masked the same animal need to see the world as it was, rather than as it should be.

We spent 20 minutes or so determining that our presence at the same lunch table was not going to cause the earth to explode. We discovered we had a mutual acquaintance in New Orleans. We agreed that the Wall Street C.E.O. had no real ability to keep track of the frantic innovation occurring inside his firm. (“I didn’t understand all the product lines, and they don’t either,” he said.) We agreed, further, that the chief of the Wall Street investment bank had little control over his subordinates. (“They’re buttering you up and then doing whatever the fuck they want to do.”) He thought the cause of the financial crisis was “simple. Greed on both sides—greed of investors and the greed of the bankers.” I thought it was more complicated. Greed on Wall Street was a given—almost an obligation. The problem was the system of incentives that channeled the greed.

But I didn’t argue with him. For just as you revert to being about nine years old when you visit your parents, you revert to total subordination when you are in the presence of your former C.E.O. John Gutfreund was still the King of Wall Street, and I was still a geek. He spoke in declarative statements; I spoke in questions.

But as he spoke, my eyes kept drifting to his hands. His alarmingly thick and meaty hands. They weren’t the hands of a soft Wall Street banker but of a boxer. I looked up. The boxer was smiling—though it was less a smile than a placeholder expression. And he was saying, very deliberately, “Your…fucking…book.”

I smiled back, though it wasn’t quite a smile.

“Your fucking book destroyed my career, and it made yours,” he said.

I didn’t think of it that way and said so, sort of.

“Why did you ask me to lunch?” he asked, though pleasantly. He was genuinely curious.

You can’t really tell someone that you asked him to lunch to let him know that you don’t think of him as evil. Nor can you tell him that you asked him to lunch because you thought that you could trace the biggest financial crisis in the history of the world back to a decision he had made. John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation. He ignored the outrage of Salomon’s retired partners. (“I was disgusted by his materialism,” William Salomon, the son of the firm’s founder, who had made Gutfreund C.E.O. only after he’d promised never to sell the firm, had told me.) He lifted a giant middle finger at the moral disapproval of his fellow Wall Street C.E.O.’s. And he seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today—market value: $27.) But it made fantastic sense for the investment bankers.

From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

No partnership, for that matter, would have hired me or anyone remotely like me. Was there ever any correlation between the ability to get in and out of Princeton and a talent for taking financial risk?

Now I asked Gutfreund about his biggest decision. “Yes,” he said. “They—the heads of the other Wall Street firms—all said what an awful thing it was to go public and how could you do such a thing. But when the temptation arose, they all gave in to it.” He agreed that the main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. “When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle. He was out of the game.

It was now all someone else’s fault.

He watched me curiously as I scribbled down his words. “What’s this for?” he asked.

I told him I thought it might be worth revisiting the world I’d described in Liar’s Poker, now that it was finally dying. Maybe bring out a 20th-anniversary edition.

“That’s nauseating,” he said.

Hard as it was for him to enjoy my company, it was harder for me not to enjoy his. He was still tough, as straight and blunt as a butcher. He’d helped create a monster, but he still had in him a lot of the old Wall Street, where people said things like “A man’s word is his bond.” On that Wall Street, people didn’t walk out of their firms and cause trouble for their former bosses by writing books about them. “No,” he said, “I think we can agree about this: Your fucking book destroyed my career, and it made yours.” With that, the former king of a former Wall Street lifted the plate that held his appetizer and asked sweetly, “Would you like a deviled egg?”

Until that moment, I hadn’t paid much attention to what he’d been eating. Now I saw he’d ordered the best thing in the house, this gorgeous frothy confection of an earlier age. Who ever dreamed up the deviled egg? Who knew that a simple egg could be made so complicated and yet so appealing? I reached over and took one. Something for nothing. It never loses its charm

Tuesday, November 11, 2008

Stabilizing an Unstable Economy, by Minsky

Hyman Minsky's theories and ideas are seeing a revival post the events of last year. I have previously read Manias, Panics and Crashes by Charles Kindleberger, which used Minsky's three-part taxonomy to describe various financial panics of the last few centuries. Now, I picked up one of Minsky's own book Stabilizing an Unstable Economy. As this is a fairly detailed and complex work, I think the best way to maximize efficiency is to take notes. So, I will be posting notes from various chapters going forward.

This book was written in 1986, so it deals extensively with the 1966 - 1982 era: the time frame went Dow Jones gave exactly 0% return. Sounds familiar. In particular, in Chapter 2, there is a very counter-intutive proposition. Corporate profits might increase during a recession, depending on how government deficits move. This is what happened in 1975. That is probably why stocks turn up before economy does - as is often said.

I need to understand this better, as this will lay waste to all the bear theories. Govt intervention work, even if they are inefficient, because they are massive.

Saturday, November 08, 2008

The Panic of 2007

This is a fascinating paper by Gary Gorton titled "Panic of 2007" ( He is a prof at Yale and was the brains behind the risk models of AIG.

What Gorton says is that there were some unique design features in subprime mortgages, which are not there in other mortgages. We might criticize subprime mortgages for their high LTV's and their option ARM features today. But lets step back to figure out why they came in the first place.

In late 1990's, US legislators wanted banks to make housing loans widely available - even to the poorest people. Now these people can neither put down a downpayment, nor can they pay a high interest rate - commensurate with their risk profile. So the only possible way to design these subprime mortgages was to have high LTVs (close to 100%), and low risk-adjusted interest rates. To make money on these mortgages, banks thus put an optionality in these mortgages (the option ARMs) - whereby the bank stood to benefit if house prices appreciated. Effectively, the subprime borrowers sold call options on their homes to the banks to get attractive mortgages. This feature is not present in prime mortgages.

The implication of this is huge - for Indian real estate market. We might not see massive mortgage defaults because of negative home equity here - there are no option features in mortgages. Defaults would be driven by traditional factors - overleveraging, job loss, health problems, divorce etc.

Not to say that we should buy Indian real estate stocks. My bull case scenario is that 95% of them will fall another 95% from here. Bear case is that real estate promoters hire the underworld to get some of the lenders - especially private equity investors - threatened.

Sunday, November 02, 2008

How to justify a bull market...

Wall Street always has a logic as to why markets should go up. Here are the reasons that we will hear in the next few months:

a) Stocks are very cheap, they are only trading at xx trailing (currently 12) earnings - which is the lowest it has been in last 25 years. Note however, the stress on trailing rather than forward earnings. When the bull market was on, analysts used forward earnings - because next year number was forecasted to be higher than this year. But now, when next year number is likely lower, analysts are using trailing earnings. The game is to always use the higher E, and come to a low PE.

b) Stocks bottomed at xx trailing earnings (8x, 10x etc) in the last bear market and so if things become really bad, there is only a 20% downside from here. Really. Right now, we are talking of peak trailing earnings on 2007 - not trough trailing earnings. Stocks bottomed out at low multiples of trough trailing earnings.

One of the most insightful comments came from this guy on CNBC recently. He said that there was one quarter in the 1970's when annualized earnings came in only at $5 for Dow Jones Index. That qtr, the theoretical PE of the index was close to infinite.

c) Stocks always turn up before economy turns up. Typical bear markets end when recession is xx% (40%, 50% etc) through. Since the recession started in Nov 2007 and will likely last till Dec 2009, we will be there soon. But, excuse me, till 2 months ago, we were debating whether we are in recession or not. So how is it suddenly that recession started last year.

That is not to say that there wont be massive bear market rallies, like the one which has started now. I wouldn't be surprised if we go up 20% from here in US before the year ends. However, I am not buying the argument of buying en masse before the economy turns, because nobody knows when that happens. Wasn't 2H08 supposed to be the recovery time?

S&P EPS for next year is around $50-$70, depending on the strategist. Put an appropriate multiple, and we can come to an index level. Don't forget that the corporate bond spreads are all time highs, so discount rate (WACC) for stocks needs to go up and multiples need to come down. Many analysts are using WACC's that are below the corporate debt yields of the same company - that's wrong - unless the assumption is that spreads are going to narrow.

Tuesday, October 28, 2008

What is debt deflation?

Suppose asset value today is 100. Debt is 80. Equity is 20. So leverage = debt/equity = 80/20 = 4x

Suddenly, asset value falls by 10%. So new asset value = 90. Debt = 80. Equity = 10. So new leverage = 80/10 = 8x.

And suppose at the same, the system wants you to delever to 2x leverage.

When asset prices weren't falling, one would have needed another 20 of equity to bring leverage to 2x.

When asset prices fall by 10%, we need 30 of equity. Now because we cant get that much equity, a better idea would be to sell assets. We need to sell 60 of assets to go to 2x leverage.

But if everybody tries to do that at the same time. i.e. sell assets to reduce leverage, there is only one thing that will happen, which is that asset prices will fall. Which, can actually end up increasing the leverage, as we see from the small example above. Which increases the compulsion to sell even more assets, which pushes down asset prices even more. And we go into a huge negative feedback loop, which is where we are now.

Having falling asset prices and the compulsion of delever at the same time is thus very harmful for equity owners. Equity is the first loss tranche in the capital structure. Negative momentum can wipe equity to 0. Momentum is more important than valuation today.

Time to think of a new currency regime

One of the most intriguing aspects of the current crises has been the behavior of the currency markets. One can blame the Fed for keeping interest rates low and encouraging misallocation of resources to US housing. But the way currencies have moved over the last few years, one can argue that currency markets have misallocated resources across nations.

How should a cross-currency rate be determined? In a world where there are no capital flows across borders, it should be based on interest rate and inflation differential between two countries. One can argue it is the rate at which the current account deficit between two countries goes to zero.

Put the capital flows in, and the whole picture changes. As we see now, investors rush in when something is hot. So, when a country is hot, investors will rush in and the currency of that country can appreciate meaningfully above what its "fair-value" is. This will entice even more investors, which will push the currency even more above its fair-value. A positive feedback loop develops, and a currency bubble takes shape. This is what happened in emerging markets in the last few years.

Like all bubble, however, it bursts. And then, investors rush out. But when they leave, they cause absolute mayhem and destruction, particularly in smaller countries. A huge negative feedback loop develops - some investors leave pushing the currency down, which causes even more investors to pull out, which suddenly becomes a stampede.

Lets take the case of India. In 2007, as investors suddenly warmed up to the decoupling theory, they rushed into India. Suddenly Rupee appreciated from Rs 45 to Rs 40, and people started talking of the coming golden days when Rupee will touch Rs 35 and Rs 30. Probably it was this thinking that encouraged some Indian companies to go on expensive overseas acquisition binge (take dollar loan today, and repay it 5 years later when Rupee would have appreciated 20%).

And now suddenly, India finds itself staring into the barrel. Rupee has depreciated suddenly to Rs 50. Overnight, the capital allocation decisions made in 2007 by India Inc turn into demons. Suddenly, the currency derivative bets made by importers and exporters have backfired and caused some of them to go bankrupt.

What does the current currency regime expect? That the CFO of a small local company will be smart enough to figure out how currencies are moving and hedge appropriately? Even the most educated financiers and businessmen are unable to look through the currency movements and are carried away by the momentum. The probability of a emerging market currency bust in a decade is almost 100%, if I were to extrapolate the history of last 20 years. Is a young person setting up an export unit in India really making the right career choice from a 10 year perspective, considering that the biggest variable that will affect him - the currency - is outside his control.

So what is the solution? I dont know. A fixed exchange regime doesn't work either, as we know from Bretton Woods. Different countries grow at different rates and have differing inflation and interest rates. Over time, the fixed exchange regime becomes inflexible and a black market in currency develops.

One solution could be that countries become part of larger currency blocs. Like the Euro. But this means that countries need to give up their sovereignity, which is something not a lot of countries would like to do. One currency means a broad consensus on fiscal and political philosophy.

If the outcome of this crises is that more countries come together and better global institutions are created, it would all be worthwhile. It could also go the other away - like it did in the 1930s. So lets hope for the best.