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How A Few Made Millions Betting Against The Market

Writer Michael Lewis is the author of Moneyball, Liar's Poker, and The Blind Side, books with vastly different subjects but a common theme: outsiders with innovative ideas who find astonishing success. Lewis' newest book continues that narrative. The Big Short: Inside the Doomsday Machine chronicles the 2008 financial collapse through stories of the people who realized what was happening to the U.S. economy while it was happening — and then made vast fortunes by betting against the markets.

"Everybody [on Wall Street] was working with the same set of facts about subprime mortgage lending — about how subprime mortgage loans were turned into bonds and repackaged and turned into CDOs and so on and so forth," Lewis tells Terry Gross. "[And] the vast majority of the people in the markets took those facts and painted one kind of picture with it; it was a very pleasant picture. And a very small handful of people took the same facts and painted a completely different kind of picture with it. [I wanted to find out] 'What is it that enables [the people who bet against the market] to paint that picture?' and 'Why do these people look at the world differently?' "

Dr. Michael Burry

The Big Short: Inside the Doomsday Machine
By Michael Lewis
Hardcover, 288 pages
W. W. Norton & Co.
List price: $27.95

Read an Excerpt

One of the most compelling stories Lewis tells in The Big Short follows a doctor, Michael Burry, who decided to leave his neurology residency after his investment blog attracted attention from money managers across the country. Burry started a hedge fund named Scion Capital, which, Lewis writes, was "madly, almost comically successful" — even when the Standard & Poors index fell.

While investigating stocks to invest for his customers, Burry discovered that the bond market was absorbing subprime mortgage loans in incredible volumes. Soon he realized that the millions of dollars of credit swirling around the market were artificially inflated and almost worthless.

Burry figured that he could bet against pools of these subprime mortgage loans using an instrument called a "credit default swap," essentially insurance on a corporate loan. Burry persuaded the investment banks to create credit default swaps for the subprime mortgage market.

"As the pools of loans that are underneath these bonds start to default," Lewis says, the investment banks that gambled on the subprime mortgage loans were forced to send Burry money daily as the bonds went bad. "Wall Street firms, they were on the other side of the bets."

Charles Ledley and Jaime Mai

Ledley and Mai were two guys in their early 30s who decided to start their own hedge fund with just over $100,000. They quickly made more than $15 million by betting on financial events that are extremely unlikely to occur — and therefore didn't cost much to bet against.

"They thought that Wall Street underestimated the likelihood of really unlikely events," Lewis says. "So they would buy options to buy stocks at prices far, far away from where the stocks were currently trading. They did this with currencies, they did it with commodities. They scoured the world, essentially looking to make bets on extreme things happening."

Soon, Ledley and Mai stumbled into the subprime mortgage market and realized that they could bet against not only the loans but also the financial institutions themselves.

"They're able to piece together a clear picture of what's going on in a matter of months," Lewis says. "They become less interested in the bet than the social implications of what they're learning. They go to the SEC. They go to The Wall Street Journal. They're screaming at the top of their lungs, 'My God, there's fraud in the system.' "

By betting against subprime mortgages, Ledley and Mai's $15 million investment ballooned to $120 million. Soon, Ledley began to experience migraines and anxiety attacks.

"They were stressed about being right," Lewis says. "I think they were so stressed that they realized that this wasn't a bet against a company, this was a bet against an entire system. And it was a bet that arose from their insight that the system had become rigged — that, essentially, Wall Street had become a giant Ponzi scheme."

Lewis says the two men — like Dr. Burry — were able to see the failures of the market before the rest of the world did because they viewed the world differently.

"This is the story of human perception as much as it is anything else. And their attitude toward the financial markets was peculiar," Lewis says. "It was peculiar to be running around the world looking for unlikely things that might happen. ... And it told you something about Wall Street and ... the way the markets were functioning when they were dysfunctional. There weren't enough people thinking this way. There weren't enough people taking into account the real likelihood of extreme change in the world."

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Transcript

TERRY GROSS, host:

This is FRESH AIR. I'm Terry Gross.

During the financial crisis of 2008, when investment banks collapsed and the market crashed, a few people had made a fortune betting against the system. These were people who knew that the bonds bundling subprime mortgages were bad and would inevitably create a meltdown. These people and how they managed to see what other investors didnt are the subject of the new book "The Big Short: Inside the Doomsday Machine" by my guest, Michael Lewis.

His first book, "Liar's Poker," was about what he witnessed from 1985 to '88, when he worked on Wall Street at Solomon Brothers. He says he thought he was writing about a period when America had lost its financial mind. He never imagined that the future reader might look back on that and say: How quaint. How innocent. Lewis is also the author of "Moneyball" and "The Blind Side," which was adapted into the hit film starring Sandra Bullock.

Michael Lewis, welcome back to FRESH AIR. Why did you want to write about the few people who managed to make a fortune on the collapse of the financial system?

Mr. MICHAEL LEWIS (Author, "The Big Short: Inside the Doomsday Machine"): There were several reasons, but the main was that, you know, so much of what's been written and reported about the financial crisis is through the eyes of people who clearly had no idea what was happening when it was happening.

I mean, the treasury secretary and the chairman of the Federal Reserve and the heads of the large investment banks, you know about all these people one thing: They were clueless when the crisis was gathering force.

And there were a handful of people who weren't clueless, who actually saw what was happening while it was happening, who made a lot of noise about it and who placed bets, essentially, on the collapse of the financial system. And I thought that point of view was a very interesting point of view.

Here you had this very strange situation in the financial markets, where everybody had - was working with the same set of facts about subprime mortgage lending, about how subprime mortgage loans were turned into bonds and repackaged and turned into CDOs, and so on and so forth.

And the vast majority of the people in the markets took those facts and painted one kind of picture with it. It was a very pleasant picture. And a very small handful of people took the same facts and painted a completely different kind of picture with it.

And what I really wondered, and what drove me to write a book about these people, was: What is it about a person to enables them to paint that picture? Why do these people look at the world differently?

GROSS: Let's talk about one of the characters who you write about in the book, Michael Barry, who had been studying to be a doctor. I mean, actually, he was a resident. And then while he was a resident, he was keeping an investment blog, and so many people started to follow his blog that he eventually decided to give up medicine and go full-time into investing, and he actually started a hedge fund. Then he immersed himself in the bond market, as opposed to choosing stocks. Why the bond market?

Mr. LEWIS: Well, he found - after several years of choosing stocks, which he'd done very successfully - that what was going on in the bond market was going to overwhelm the stock market, because the bond market was absorbing into it all these subprime mortgage loans that were being made in America in incredible volumes.

And he realized that he couldn't, in good conscience, make investments in these stocks without knowing what was going to happen to these subprime mortgage loans, because they were going to affect his stocks. And before long, he's essentially conceived a way to turn his portfolio from a stock market portfolio into a portfolio that is devoted to betting against the bond market and betting specifically against subprime mortgage bonds.

GROSS: Now, I should mention here that Michael Barry has Asperger's Syndrome, although he didn't know it at the time when he started his hedge fund, and he thinks that helped him be very kind of obsessive in reading the kind of reports that he needed to read. But how did he figure out that these subprime mortgage bonds were bad?

Mr. LEWIS: It was interesting because there are a number of different ways to get to that conclusion, but he does it really by studying the prospectuses of subprime mortgage bonds. And as he put it, no one who didn't have Asperger's Syndrome would read these things, they're so tedious.

But he sees that the way that money is being lent to people is changing rapidly and for the worse in 2003, 2004, early 2005. And in particular, he sees that an awful lot of subprime mortgage loans are suddenly interest-only and negatively amortizing, so that - which is to say that the borrower not only does not have to repay principal, but if he can't afford to repay the interest, it just rolls into a higher principal balance.

And at that point, when there are pools of subprime mortgage loans that are nothing but these, he thinks to himself the lending couldn't get any worse, that this real estate bubble is being driven by people being lent money to buy houses, and there's no - nothing worse the lenders could do to get the money. So we're arriving at the end of the madness, and that's the point when he can bet against pools of loans that are nothing but interest-only, negatively-amortizing subprime mortgage loans that he begins to bet against the subprime mortgage market.

GROSS: Now, when he wanted to start betting against the subprime mortgage market, he didn't have a way of doing it, initially. He had to find a way of doing it.

Mr. LEWIS: This is a curious thing, because the bond market is a - for someone who doesn't know it and is an outsider like he was, it's a strange, complicated, arcane thing. It's also the Wild West. I mean, the stock market is regulated much more carefully than the bond market, and bond market investors - it's much easier to get ripped off in the bond market by Wall Street firms than it is to be ripped off in the stock market.

And he's aware of that, and he's aware there's a lot he doesn't know. And he starts to read complicated books about the bond market, and he discovers that in one sphere of the bond market, the corporate bond market, there is this instrument known as a credit-default swap, which is essentially insurance. You can buy insurance on a corporate loan, in effect, and this has existed for roughly a decade.

And he realizes, as the subprime mortgage bond market starts to mushroom, that Wall Street's bound to invent a credit-default swap for subprime mortgage bonds. They're bound to invent an insurance contract. And if you could buy insurance on a subprime mortgage bond, you could bet against it. If it went bad, the insurance would pay it off. And so he begins to pester Wall Street firms to create this product specifically so he can make this bet.

GROSS: So this is the guy who helped create, who urged the investment banks to create credit-default swaps for subprime mortgage bonds.

Mr. LEWIS: He's the guy who urged them to create something that he could use. There were some one-off contracts done before that between the investment banks, but basically, they don't exist until he starts pestering them.

So yes, he's ground zero. He's the patient number one. He is the person who is the first investor to make this specific bet.

GROSS: And this is, what, in 2005?

Mr. LEWIS: Yes, it's March - kind of March to May, 2005. He actually is able to persuade a couple of the investment banks to allow him to make the bet before the contracts even exist. I think he makes the bet in March of 2005, and finally he gets a contract in May.

GROSS: Now, Goldman Sachs is one of the banks that he convinced to do these credit-default swaps for subprime mortgage bonds. Why was Goldman Sachs willing to do it?

Mr. LEWIS: Well, this is where the story gets really interesting, because Goldman Sachs had just - weeks before they do their trades with Michael Barry where they're selling him insurance on subprime mortgage bonds, Goldman Sachs had persuaded AIG, the insurance company, to sell them huge dollops of insurance on subprime mortgage bonds in a slightly form, but nevertheless, it's roughly the same thing.

And AIG had virtually unlimited appetite for this business, that they were - in a matter of a few months, they sold to Goldman Sachs $20 billion of credit-default swaps on subprime mortgages. So Goldman Sachs - very cheaply, very low prices, close to free.

And so Goldman Sachs was in the position of an intermediary, looking to lay off the other side of that. And part of what Goldman Sachs did, I think, is just take some of it on as a bet. They, too, wanted to be betting against specific subprime mortgage bonds, but part of what they did is they turned around and multiplied the price by 10 and sold them on to Michael Barry.

And these transactions between AIG and Goldman Sachs are the very beginning of this financial crisis - the narrow part of the financial crisis, the subprime crisis. This is where, all of a sudden, there is some big institution in the middle of the financial markets that's willing to take huge amounts of subprime mortgage bond risk, and it's AIG.

GROSS: So if Michael Barry basically had to convince Goldman Sachs to create credit-default swaps for subprime mortgage bonds, how could it be that AIG was already so invested in those kinds of swaps for subprime mortgage bonds?

Mr. LEWIS: Well, it was all pretty much happening at the same time. I mean, Goldman Sachs does its first trades with AIG in March of '05, which is when Michael Barry is doing his first trades with Goldman Sachs and Deutsche Bank. But I'm not convinced that Michael Barry pushing the investment banks to create credit-default swaps on subprime mortgage bonds was the only reason they did it.

They were already thinking along these lines. And when he calls them up to do with these trades with them, they're already thinking, yeah, we'd kind of like to do this, I think.

But there - can I start - because there's a slightly different answer, too, and it's that AIG had been insuring corporate bonds for almost a decade. And in corporate bonds, there's these pools of corporate loans. And in 2004, 2005, Goldman Sachs starts to come to AIG with pools of what they say are diversified consumer loans. They include some subprime mortgages in it and other things.

And AIG says, yeah, this is roughly the same thing as we've always been doing. We'll do that, too. And it's in March of 2005 when Goldman -there's some conversation that is still a mystery. We don't know exactly what happened, but Goldman Sachs effectively went to AIG with a pool of something that was nothing but subprime mortgage loans, and they said: Do you want to do this, too? And AIG said: Yup. We'll insure that. And that, at that moment, there is a seller of insurance on subprime mortgage loans, and Goldman Sachs can turn around and peddle that to Michael Barry in the form of a credit-default swap.

GROSS: So when the financial system collapsed, how did Michael Barry get paid off? Like, who - he bet against the subprime mortgage market, and he won. The market collapsed. He won, but who had the money to pay him when he won?

Mr. LEWIS: Well, he had done deals with Goldman Sachs and Deutsche Bank and Morgan Stanley and Bank of America, and I think a few with Merrill Lynch, too. And as the pools of loans that are underneath it, these bonds, start to default, they actually have to send him daily collateral. So he's getting paid daily as the bonds go bad. So Wall Street firms had to pay him. They were on the other side of the bets.

Now, the question is: Were they ultimately on the other side of the bets, or did they have someone that they had sold the bets on to who they were collecting from? And for the most part, they had sold the bets on, and AIG was on the other side of some of those.

GROSS: My guest is Michael Lewis, author of the new book "The Big Short." We'll talk more after a break. This is FRESH AIR.

(Soundbite of music)

GROSS: My guest is Michael Lewis, who is, among other things, the author of "The Blind Side," which was adapted into the movie, and his new book is called "The Big Short: Inside the Doomsday Machine."

Let's talk about a couple of other people who made a killing when the financial system collapsed in 2007, and this is Charlie Ledley and Jamie Mai, two people who basically started a hedge fund in their garage and called it Cornwall Capital. How did they get into this business?

Mr. LEWIS: They literally started with $100,000 in a Schwab account, and they came into the subprime mortgage market in a completely different way. They had a kind of theory about financial markets when they started. They thought that Wall Street generally underestimated the likelihood of really unlikely events, underestimated the likelihood of various catastrophes.

They went looking, essentially, to make bets on unlikely things happening. So they would buy options to buy stocks at prices far, far away from where the stocks were currently trading. They did this with currencies. They did it with commodities. They scoured the world, essentially looking to make bets on extreme things happening.

And each bet cost them very little, because it was an unlikely event, and if they were right it paid off in multiples. So they would be wrong most of the time, but they were right enough that they were doing very, very well, and they turned $100,000 into something like $15 million by late 2006.

And then they stumble into the subprime mortgage market, and they see that there's this bet that's very similar to the kind of bets they've been making to be made here. For a couple of percent a year, they can buy insurance on what seems to them to be very dicey pools of subprime mortgage loans, and they start to learn about the subprime mortgage market.

And they know nothing about the bond market at this point. It's bewildering to them, yet they're able to piece together a very clear picture of what's going on in a matter of months, to the point where they become less interested in their bet than in sort of the social implications of what they're learning.

They go to the FCC. They go to the New York Times and the Wall Street Journal. They start screaming at the top of their lungs that, my God, there's fraud in the system. But they make their bet, and they turn $15 million into $120 million with their bet.

But the thing that was, to me, so interesting about them was that all these people who were in a handful who saw the disaster happening before it happened, they all had something about them that enabled to see it.

I mean, this is a story of human perception as much as it is anything else. And their attitude toward the financial markets was peculiar. It was peculiar to be running around the world just looking for unlikely things that might happen that the markets were underestimating.

And it told you something about Wall Street and about the way the markets were functioning when they were dysfunctional. It told you that there weren't enough people thinking this way. There weren't enough people taking into account the real likelihood of extreme change in the world, and they were.

GROSS: One of the things I found interesting about this duo was they started betting against the financial institutions themselves. They started betting against Bear Stearns and other financial institutions around the country. What made them realize the financial institutions themselves were vulnerable, not just the instruments that they sold?

Mr. LEWIS: Well, as they conduct their investigation of the subprime mortgage market, they ask the question that's a very natural question to ask: If these Wall Street firms are willing to sell me this really cheap insurance on subprime mortgage bonds, who's on the other side? Who's taking all this risk? If I'm right and this subprime mortgage market is going to lead to a financial catastrophe, who's going to be affected?

And they pretty quickly figured out that the Wall Street firms themselves were taking a lot of the risk. And even if they weren't, huge amounts of their profits were coming out of the subprime mortgage machine. So they were vulnerable that way, too.

And so they become concerned, because if they're buying insurance from Bear Stearns, it's no good if, when the catastrophe happens, Bear Stearns collapses, too, and they become afraid that Bear Stearns won't be able to honor their contracts. So they turn around and they buy insurance on Bear Stearns, too.

GROSS: And just months before Bear Stearns collapsed, they bought very cheap insurance against the collapse of Bear Stearns. So when Bear Stearns collapsed, they made a fortune.

Mr. LEWIS: Yes. They made more of a fortune from their bets against the subprime mortgage bonds, but yes. You know, in a matter of a few years, pursuing this strategy, they turned 100 grand into $120 million. So they did very, very well.

You know, one of the aspects of this story, though, that is curious is that none of these characters are natural - really natural short-sellers in that most of them had some other purpose. They were people who wanted to be investing in the stock markets. And it was interesting to see the way they were affected by the realization that they could no longer have such a positive and productive relationship with a larger financial society when they were essentially set up just to bet against the system.

And Charlie and Jamie are the leading examples of this. The effect of getting rich this way almost kills their interest in the business. They don't take actual pleasure in it. They're happy to be successful up to a point, but they become disillusioned, really, in the process, and to this day can't believe that the world doesn't understand what they figured out in a matter of months.

GROSS: Wait, well, you write how Charlie Ledley, one of the co-founders of Cornwall Capital, started getting, like, migraines and terrible anxiety attacks during the collapse of the system, when he's making a fortune. But it's physically hurting him at the same time.

Mr. LEWIS: All of the characters who made their fortunes betting against the subprime mortgage market experience health problems: panic attacks, heart problems. I mean, it's riveting. They're all changed by the experience, and Charlie is no exception.

They were all stressed by it. They were stressed at being right. I mean, you've got to wonder what would happen to them if they'd been wrong. And I think they're so stressed because they realized that - I mean, this wasn't a bet against a company. This was a bet against an entire financial system, and it was a bet that arose from their insight that the system had become rigged, that essentially Wall Street had become a giant Ponzi scheme.

And they worried - Charlie in particularly worried - what it meant for democracy. I mean, he worried that essentially the population was going to wake up to the fact that Wall Street was rigged and there'd be riots. They're still worried that because there's been very little in the way of financial reform since the crisis, that we're living in a very unstable world, and they found that naturally distressing.

GROSS: Michael Lewis will be back in the second half of the show. His new book is called "The Big Short." I'm Terry Gross, and this is FRESH AIR.

(Soundbite of music)

GROSS: This is FRESH AIR. I'm Terry Gross, back with Michael Lewis, the author of "Liar's Poker, "Moneyball" and "The Blind Side," which was adapted into a hit film starring Sandra Bullock. His new book, "The Big Short" is about a few of the investors who anticipated the meltdown of the subprime mortgage market and made a fortune by shorting - by betting against - the bonds that bundled subprime mortgage loans.

Did you come to see the people who bet against the financial system as vultures or as just really, really the smartest guys around or some of both? Because a lot of people see short sellers as vultures, people who want to feed off of the death of something - the death of a bond, the death of a company, the death of the financial system.

Mr. LEWIS: I didnt see them as vultures. And I saw them, you know, I didnt have a view going into the story about who they were or why theyd done what theyd done. So in the first place, I was surprised that for the most part, they weren't what you think of as short sellers. They didnt have funds, the whole point of which was to short things. They were by nature and experience, ordinary stock market investors, that they were looking for stocks to bet on and the facts made it very difficult for them to do that. So they kind of - the world forced them into this position in a way.

They had a job to do, invest people's money - other people's money shrewdly. And with the facts on the ground as they understood them, the only way they could do that well was to make this bet against the subprime mortgage market. So that they weren't what you think of as the stereotypical short seller in the first place.

Having said that, there's then the question of, to what extent do they contribute to this problem, to this crisis? And in their defense to start with, one of the things they tried to do was tell the world what was going on when it was going on and no one would listen. I mean...

GROSS: All of them tried to do that? All the people you write about?

Mr. LEWIS: They were all extremely noisy. They had various ways of being noisy. But Jamie Mai and Charlie Ledley went to the SEC and tried to get the SEC to investigate the ratings agencies and the Wall Street firms that were creating subprime mortgage bonds and so on and so forth, and the SEC didnt want to have anything to do with them.

Michael Berry was writing very persuasive letters that were widely circulated in the investment community about the madness of subprime mortgage lending well before he started shorting subprime mortgage bonds.

Steve Eisman, the third main character in the book, ran around Wall Street being rude to as many people as possible who were involved in the business, telling them that they were going to blow up their firms and nobody would listen to him. So they ended up being ineffective messengers but they tried.

If everybody had thought the way they thought and behaved the way they behaved, the crisis never would've happened. So whatever you think of short sellers, you have at least to admit that of all the people who were involved in making financial decisions in the last few years, they were the best. Now, having said all that, they do bear some responsibility.

GROSS: What is the responsibility you think they bear for the collapse of the financial system?

Mr. LEWIS: It's interesting. It's a responsibility that they themselves did not perceive until pretty late in their game. But it's complicated, so are you ready for it?

GROSS: Give it a shot.

Mr. LEWIS: All right, I'm going to give it shot. You just have to take this on faith. But, when you buy - when you, Terry Gross, buy a credit default swap, youre buying insurance on a subprime mortgage bond. When you buy that thing, youre effectively replicating the bonds that are being insured. So youre doubling the risk in the system. It's like you created a whole nother pool of subprime mortgage loans simply by buying that credit default swap.

And so, in betting against the market, these people increased the amount of bad debts in the system. And they - in addition, they did it in such a way, the credit default swap is a very - it's not an openly traded thing. It's a deal between you and Goldman Sachs or you and Lehman Brothers or you and Bear Sterns, and it's not articulated on Bear Sterns or Lehman Brothers or Goldman Sachs' balance sheet.

So you could do, you know, a trillion dollars of credit default swaps with Goldman Sachs and no one would know. The combination of adding to the bad debts in the system and doing it in a way that is mysterious and unaccounted for openly greatly increased the problems when they finally became clear in 2008. They increase, A, the raw number of losses in the system, but also when the panic hits Wall Street in the fall of 2008 nobody knows who has losses and how many. And that's the big problem is nobody knows who has the losses and how many. Nobody knows who's going to go down.

One of the big reasons are these deals - these credit default swap deals. So they aren't completely blameless, the short sellers, but theyre as close to blameless as anybody who was a part of that market.

GROSS: Well, isn't it true also that the way they made their fortune was in a way by helping to collapse the financial institutions they made the deals with? Because...

Mr. LEWIS: No.

GROSS: No?

Mr. LEWIS: No. The last thing they wanted was to collapse the financial institutions they made the deals with because then the financial institutions...

GROSS: They wouldnt get paid.

(Soundbite of laughter)

Mr. LEWIS: They wouldnt get paid.

GROSS: Right. Okay.

Mr. LEWIS: Yeah. No. The last thing they wanted.

GROSS: But I mean, didnt paying them off help collapse the financial institutions?

Mr. LEWIS: Well, yeah, but it's true that in making smart bets that are essentially zero sum bets with big Wall Street firms they cost the big Wall Street firms money. The big Wall Street firms became the dumb money at the table. That's one of the strange subplots of this whole period is, how on earth did these big Wall Street firms become the dumb money at the table? But it wasnt really the job of Charlie Ledley or Steve Eisman or Michael Berry to worry about whether Wall Street firms knew what they were doing.

I mean, historically, it was the Wall Street who were ripping off their customers. I dont think it occurred to them that they had the wherewithal to rip off Goldman Sachs. So I think when they cut these deals with the big Wall Street firms I think they assumed that the Wall Street firms know what they're doing and theyve hedged their risk in some way.

GROSS: So you see these guys who made a fortune by betting against the financial system as basically being people who were running around saying, the emperor has no clothes. Nobody listened, so they finally just bet against the emperor.

Mr. LEWIS: Yes. Once they realized the emperor had no clothes their impulse wasnt to tell everybody. Their impulse was to make a bet against the emperor. But once they'd made their bets, then they wanted to tell everybody.

GROSS: Got it. Okay.

(Soundbite of laughter)

Mr. LEWIS: I dont regard these people as saints. I dont think there's a lot of room for saints on Wall Street. I just regard them as sensible. And the big problem on Wall Street in recent history was there's been so few sensible people.

GROSS: My guest is Michael Lewis. His new book is called "The Big Short." We'll talk more after a break. This is FRESH AIR.

(Soundbite of music)

GROSS: My guest is Michael Lewis, author of the new book "The Big Short." It's about investors who anticipated the subprime mortgage meltdown and made a killing by betting against subprime mortgage bonds.

So I want you to give us - and this is where it gets like really crazy, but give us an example of the kind of trench...

(Soundbite of laughter)

Mr. LEWIS: Tranch.

GROSS: Tranch.

Mr. LEWIS: Tranch.

GROSS: That these guys, that the guys who betted against the system investigated and realized that this is crazy, investing in something like this is crazy, we're going to bet against. So its complicated to explain but it's fascinating for its badness.

(Soundbite of laughter)

GROSS: It's fascinating for how...

Mr. LEWIS: All right. Well, let's just take - since Charlie Ledley knew nothing about the bond market when he started this...

GROSS: Yeah.

Mr. LEWIS: ...let's take the example of Charlie Ledley and what he decides to bet against.

GROSS: Great.

Mr. LEWIS: All right. So Charlie Ledley sees they are these things called subprime mortgage loans, which he knows absolutely nothing about. But he kicks or he calls people who are originating subprime mortgage loans, he talks to friends in the market and he realizes that a lot of them are squirrely. A lot of people are borrowing money to buy houses and lying on their forms about how much money they make. They're being encouraged to take out loans they couldnt possibly repay, all that. So these loans, they go into a big pool where they - so a Wall Street firm, Goldman Sachs takes pools of thousands of loans and turns them into bonds.

And the way it does that is it says, as they say in Wall Street, they tranched them up, they sliced them up. They say, all right, here's this pool of loans. The money's coming into the pool from the people paying off their mortgages. The money goes out to the people who buy bonds in the pool. And the people who are willing to buy the bonds that lose their value when the first loans aren't paid off, they get a higher rate of interest because they have the most risk.

The people who buy the bonds that are the last to get hit, that get the final payments, whatever money trickles into this pool goes out to them first. Those people get the lowest rate of interest and are - the highest rated bonds, triple-A-rated bonds. So the dregs of this pool are the triple-B-rated bonds, the lowest rated bonds. If you own the triple-B-rated bonds associated with this pool, your bonds are going to be wiped out if the pool experiences losses of just eight percent. So if just eight percent of the loans go bad youre not going to have a bond anymore. That's a very risky bond, especially when youre dealing with subprime mortgage loans.

But that's not where it ends. The Wall Street firms, having trouble selling these triple-B-rated bonds to people, pool and find all the pieces of triple-B-rated bonds and they put them into another pool. And they go to the ratings agencies, Moody's and Standard & Poor, and they say, say look, there are all these triple-B-rated subprime mortgage bonds but some of them are loans that are made in California and some are loans that are made in Florida and some are loans that are made in Michigan. They're diversified. They're not all the same thing.

Surely some of them are going to be money good. So if we put these all into one big pool and tranch it up again, how much of it will you rate triple-A? And the ratings agency says, 80 percent. They say, we think that this pool is diversified enough that, you know, if things go really bad only about 20 percent of them are going to be really seriously at risk. So, 80 percent are really safe. So you have now this called this is called a CDO, a collateralized debt obligation. And 80 percent of this is rated triple-A.

Bear in mind now, that underneath this all are subprime mortgage loans and pool of subprime mortgage loans in which only eight percent have to go bad for the whole CDO to be worth zero.

Charlie Ledley sees this and he says, I want to bet against those triple-A CDOs because I think basically all these subprime mortgage loans are the same thing. So Charlie Ledley goes to Bear Sterns and says, I want to buy insurance. I want to buy a credit default swap on a double-A or a triple-A tranch of a CDO. And Bear Sterns says, fine. No one's done that before but we're happy to do it and you only have to pay one half of one percent in premium a year to do it.

And Charlie Ledley can't believe it because he thinks that the odds of these pools of subprime mortgage loans going bad are very high and certainly they - more than eight percent of them are going to go bad. And yet, he can basically buy insurance on them for free - for almost free.

GROSS: So its kind of amazing that Charlie Ledley was able to see this but all of the financial institutions selling these subprime mortgage bonds didnt see how vulnerable the institutions themselves would be when these things collapsed. How - like, how did they not see it?

Mr. LEWIS: This is the great question and this is why I think this is a story of human perception as much as anything else. I think people see what they're incentivized to see. And I think that basically when you back away from this crisis what happened was this: Wall Street firms were able to make a lot of money arranging for loans to be made that should never have been made. The way they did it was by disguising in various ways the risk of those loans.

They did this so well that after a while they disguised the risk for themselves. And the great irony of this whole crisis is that the people who orchestrated it ended up losing fortune from it. That they themselves wound up heavily invested in the worst sorts of bonds that they created.

GROSS: So when you look at the reforms of the financial system that are being proposed now, what do you see?

Mr. LEWIS: Well, for the last 18 months, we have been dealing with the symptoms of the crisis rather than the cause. There has been no reform. And so its been delayed and that's not surprising. I mean, financial markets move quickly and democracy moves slowly. The crash of 1929 happens in 1929 in Glass-Steagall, which reforms Wall Street in a radical way, doesnt happen until 1933. There aren't even proper hearings on Capitol Hill about the crisis of '29 until I think late '32.

And so it's not that surprising it's taken a while. But the ideas that are now being batted around - and it does look like financial reform is about to get moved to the front burner - they're some really good ones. It's just a question of whether they can be pushed through over the objections of Wall Street because they're all antithetical to the interest of Wall Street.

The first is, it's crazy that a Wall Street firm can advise customers to buy and sell stocks and bonds and at the same time be making bets with its own money on those stocks and bonds. That...

GROSS: Theyre betting against them.

Mr. LEWIS: Yes. Exactly.

GROSS: So, in other words, youre the broker. You tell me buy the bonds and then you bet against those bonds.

Mr. LEWIS: Yeah.

GROSS: They're going to fail.

(Soundbite of laughter)

Mr. LEWIS: Yeah. That it creates a natural, horrible, poisonous relationship between Wall Street and the people it advises if the Wall Street firm is making its own side bets at the same time it's advising the customers what to do.

GROSS: Yeah. It's such a conflict of interest because youre telling me to buy it and that whatever I'm buying is going to succeed and Ill make money, but at the same time, youre betting that what you tell me is going to succeed is going to fail, and if it fails you make money.

Mr. LEWIS: That's right.

GROSS: That's a terrible conflict, isn't it?

Mr. LEWIS: Well, yes, and especially since the Wall Street firms increasingly make their money with their own side bets. So inevitably what happens is the customers get used as part of - as a tool for their own portfolio to get out of things they dont want to own and so on and so forth. So that, there needs to be a - the so-called Volker rule, named for Paul Volker because he's advocating it, makes total sense, is to say to these firms, you can't trade for your own accounts in things when youre advising customers. So that's a really simple reform but its going to be devastating to Wall Street.

Another simple reform, I mean, it's so obvious that you can't believe it hasnt happened yet, just simply eliminate these bilateral private transactions that go on between these firms that leave them exposed to each other, like credit default swaps. Why should Deutsche Bank be able to call up Morgan Stanley and do, you know, make an $8 billion bet that neither one of them actually records on their balance sheets. It creates horrible uncertainty and instability to have this kind of murky world of side bets going on and nobody knows who's got them. So you never know how actually healthy these institutions are. So, all things that are traded, credit default swaps, for example, should be traded through exchanges and on screens so everybody can see them.

Now that kind of transparency, again, is an anathema to Wall Street because they make a lot of money off the opacity. They make a lot of money out of people not seeing what the right price of things should be. So - but they're fighting that tooth and nail.

And the third thing that's very obvious, so obvious you can't believe that it hasnt happened is, why on earth are the ratings agencies, Moody's and Standard & Poor, paid by the people whose bonds they are rating? It's inevitably going to lead to problems because they're incentivized to please the people who pay them.

GROSS: Well, Michael Lewis, weve been talking about some incredibly important, really complicated stuff, so let me move to a different subject, which is congratulations on your Oscar, and by that...

(Soundbite of laughter)

GROSS: ...by that I mean that your book "The Blind Side" was adapted into a film starring Sandra Bullock, for which she won an Oscar. You were actually at the Oscars. So was that fun for you?

Mr. LEWIS: It was a gas. And I dont think it's healthy for a writer to spend too much time in the presence of movie stars. He's quickly made aware of his own insignificance. But it was a lot of fun. Id say the other funny thing about the event, about the Oscars is that at some point there's so many famous people in the room that nobody's famous. That in fact, the best thing you can be is someone no one's ever heard of because at least youre interesting then.

But the whole experience was fabulous. Who would've thought? Who would've thought that "The Blind Side" would win an Oscar?

GROSS: And since you write about finance so much, was the book purchased outright or do you get some kind of points for...

(Soundbite of laughter)

Mr. LEWIS: Are you asking me if I got rich off the movie? This is what happens, when I wrote my first book, "Liar's Poker," Tom Wolf, the author took me out to lunch and he said to me about the movie business, have nothing to do with it. Go across the country, hurl your book in, have them hurl the money out and come back as fast as possible. And that's sort of what happens. You dont keep a stake, even if you try to insist on it. I suppose maybe John Grisham does but I dont. You get what's called net profits. And there are no such thing as net profits. They give them to you because there are no such thing, so you never see a nickel. So even "The Blind Side"...

GROSS: Because of the accounting...

Mr. LEWIS: Yeah, because of the accounting. "The Blind Side" I think cost $29 million to make and another $20 million to promote and it's going to take in 400 million when it's all said and done with the DVD sales and it will not make a cent. And if you can figure it out, how they do that, you know, more power to you.

(Soundbite of laughter)

GROSS: Maybe that's your next book. So the movie rights have already been purchased to the book that weve been talking about, your new book, "The Big Short, right?

Mr. LEWIS: Brad Pitt and Paramount bought the movie rights a few weeks ago.

GROSS: You think it'll actually get made? Not everything that gets bought gets made.

Mr. LEWIS: No, most things dont get made. But the odd thing is Brad Pitt is starring in the movie adaptation of "Money Ball," my baseball book, which starts filming in June. And I think what I've learned from that process is that if a star wants to make a movie, the movie gets made. And he really wanted to make "Money Ball." And if he bought this and he really wants to make it, I think it will get made.

It's hard to turn Wall Street into on-screen drama. But these characters are so bizarre and unusual and interesting, I think there's at least hope.

GROSS: Okay, so I'm going to bet that he would want to play Michael Berry, the guy who has Aspergers and started as a doctor and ended up with the hedge fund and bet against the system.

Mr. LEWIS: I dont know but it's a good guess.

GROSS: Okay.

(Soundbite of laughter)

GROSS: But I'm not a betting person.

Mr. LEWIS: No, I've already cast the movie in my head. Philip Seymour Hoffman plays Eisman. I was going to have Matt Damon play Michael Berry and then get the Judd Apatow crowd to play the Cornwall Capital guy.

(Soundbite of laughter)

GROSS: Very good.

Mr. LEWIS: And just have - Brad Pitt can direct it.

GROSS: Very good. Very good. Michael Lewis, thank you so much for explaining some really complicated, really important stuff for us. Thank you very much.

Mr. LEWIS: Thank you. I did my best.

GROSS: Michael Lewis' new book is called "The Big Short." You can read the first chapter on our Web site, freshair.npr.org. Or you can also hear an excerpt of the interview that we didnt have time for. It's more about his experiences with movie adaptations of his books. Transcript provided by NPR, Copyright NPR.

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