The Big Short: Chapter 3 Summary & Analysis

In February 2006, Greg Lippmann shows up in the conference room of Steve Eisman’s hedge fund, where Vincent Daniel is also present. They treat Lippmann with suspicion, but Lippmann is a slick talker who doesn’t follow many of the standard “rules” of Wall Street. He tells them he isn’t loyal to Deutsche Bank; he just works there. Ultimately, he wants to sell Eisman on an idea he claims he came up with: betting against the subprime bond market.

The crux of Lippmann’s pitch is that, in order for his bet against the subprime bond market to be successful, home prices don’t have to fall—they just have to stop rising so rapidly. His plan is basically the same as Mike Burry’s and involves credit default swaps.

One of Lippmann’s most persuasive arguments is his work with Eugene Xu, a “quant” (meaning a quantitative analyst who uses math and statistics to provide information about investments). Xu is described as “a real Chinese guy—not even Chinese American—who apparently spoke no English, just numbers.” Everyone trusts Xu’s math because he finished number two in a national competition in China. As Lippmann notes, “How can a guy who can’t speak English lie?”

Though Vinny remains suspicious, surprisingly, Eisman seems very interested. He asks questions but ultimately has no problem betting against subprime mortgages.

Meanwhile, Burry is able to buy $100 million in credit default swaps from Goldman Sachs. He guesses that Goldman isn’t the company taking on the risk if the mortgage debts default, and it turns out he’s right: it’s actually the financial products division of the insurance company American International Group (AIG FP).

AIG FP started taking on all sorts of complicated financial risks for other companies, initially for events that were very unlikely to happen. Though it was initially profitable, eventually AIG FP starts taking on the worst subprime mortgage bonds (triple-B rated) and becomes the world’s biggest owner of them.

Greg Lippmann watches his peers at Goldman Sachs as they create multibillion-dollar deals where, in exchange for a few million dollars each year, they transfer all risk to AIG in the event that the worst bonds failed.

Goldman’s process is so complex that most investors and ratings agencies don’t understand it. It involves “synthetic subprime mortgage bond-backed collateralized debt obligation (CDO).” Basically, the process allows them to hide the fact that triple-B bonds are so bad by packaging them together in new bundles that get rated as triple A (which are easier to sell because they’re perceived as lower risk). Lewis calls CDO “a credit laundering service” for lower-middle-class Americans and a “machine that turned lead into gold” for Wall Street.

Wall Street firms like Goldman Sachs begin to want pessimists like Mike Burry to buy credit default swaps against triple-B bonds. They then create a “synthetic CDO” made of nothing but credit default swaps and take it over to a ratings agency like Moody’s or Standard & Poors. About 80 percent of synthetic CDOs are rated as triple-A bonds, and the remaining 20 percent are put through the same process again and again until they too are part of triple-A-rated bonds. By facilitating this complicated “synthetics” process, Goldman Sachs is able to skim a lot of money off the top without actually incurring the risk—this is why Goldman is so surprisingly helpful to Burry.

Lippmann’s bosses ask him to do what Mike Burry is doing, creating as many credit default swaps as possible before AIG realizes how much risk they’re taking on. Though Lippmann is in an unusual position, he doesn’t protest, since it gives him the opportunity to make a lot of money. By November 2005, he realizes that the odds might actually be in favor of his gamble, and that it might be good to be short.

Lippmann inspires mixed reactions from the people around him, many of whom find him scary and wonder if he has narcissistic personality disorder. He tries to sell other industry players on shorts like his, but they largely refuse him. When subprime mortgage bonds rise, decreasing the value of Lippmann’s credit default swaps, his bosses begin to wonder if he’s doing the right thing.

Lippmann decides that the best way to stop pressure from his bosses is to implode the market—because if AIG stops taking credit default swaps, the whole subprime mortgage bond market might collapse, making Lippmann’s credit default swaps much more valuable. He visits AIG FP in an attempt to persuade them and seems to succeed when AIG FP hint they might actually buy some credit swaps instead of sell. Lippmann thinks, for a brief period of time, that he’s changed the world.