The Big Short: Chapter 4 Summary & Analysis

But the people at AIG FP quickly forget their meeting with Lippmann. It’s Gene Park in AIG FP’s Connecticut office who figures out that all the subprime mortgages AIG FP owns are dangerous, since the company doesn’t have enough to cover the losses in the event of a default. For bringing the problem up, he gets yelled at by his boss, Joe Cassano.

Cassano is a dictator in the office who demands strict obedience. He is upset at Park for daring to contradict him, although by early 2006, he ultimately comes around to the same position Park was trying to convince him of.

Meanwhile, Lippmann is confused that AIG FP keeps refusing to take his advice. Surprisingly, the subprime market keeps growing, and in April 2006, Lippmann is asked by his bosses at Deutsche Bank to explain himself. They compromise: Lippmann can keep his expensive shorts if he can prove there are other investors who might take them off his hands. This means he has to create a credit default swap market.

Lippmann’s initial attempts to sell credit defaults are unsuccessful, but ultimately, he meets Steve Eisman. At first, Eisman doesn’t take the bet. Later, Danny Moses (Eisman’s new head trader) and Vinny Daniels call Lippmann back and ask him to explain everything all over again. Danny and Vinny keep mistrusting Lippmann, even as he keeps answering their calls and answering their difficult questions. They treat Lippmann like a witness to crack under interrogation, but he doesn’t slip up.

Ultimately, Lippmann sells credit default swaps to a different investor, and two pieces of breaking news change the whole situation. First, in May 2006, Standard & Poor’s announces it’s changing its model for rating subprime mortgage bonds. This stirs up fear, suggesting that, on some level, even the big Wall Street firms knew they were creating overrated bonds. Second, the ratio of housing prices to income has been going up, from 3:1 to 4:1, with some markets going as high as 10:1. Still, even these major pieces of news didn’t disrupt the subprime bond market.

Finally, Eisman makes a deal with Lippmann. He, Danny, and Vinny remain skeptical of the deal, so Vinny and Danny fly down to Miami to investigate more about the housing market. They find “empty neighborhoods built with subprime loans.” The best targets for shorts (i.e., “the bonds ultimately backed by the mortgages most likely to default”) are primarily in states like California, Florida, Nevada, and Arizona, where housing prices soared in the boom—and are most vulnerable to a fast crash. These states also have “dubious” mortgage lenders who make lots of fraudulent loans, such as one extreme example where a Mexican migrant worker with an income of $14,000 was lent enough to buy a $724,000 house.

These fraudulent loans are possible in part because the regulatory agencies, Moody’s and S&P, are easy for the big Wall Street firms to exploit. This is because they don’t look at individual home loans, just loan pools. Wall Street learned to manipulate these pools by bundling together borrowers with low FICO ratings (also known as credit scores) with borrowers who have higher credit scores. This hides the fact that a pool contains many low-credit-score borrowers who are very likely to default.

Wall Street further manipulates the pools by seeking out so-called “thin-file” FICO scores, or FICO scores from borrowers who have only a short credit history. This is why firms target people like migrant workers—because their short credit history sometimes enables them to have a high FICO score that could be used to offset low FICO scores in a pool, even though they’re not all that likely to be able to pay off a house.

Eisman and his team don’t know the full details of what Wall Street investment banks are doing, but they know they have a dedicated staff whose whole job is to game the rating agencies. They set out to learn more. Danny and Vinny speak to a woman at Moody’s who answers some of their questions. They find out that to get more information, they’ll have to go to Las Vegas.