In early 2005 Burry saw that what appeared to him to be very risky securities were being priced extraordinarily cheaply, as though they carried almost no risk at all. He went looking for a way to bet against subprime mortgage bonds, but quickly discovered that the nascent market had no mechanism by which to do so. Undeterred, he convinced Deutsche Bank and Goldman Sachs to create and sell him a type of insurance policy – the infamous credit default swap – that paid out if the subprime bonds went bad.
In addition to its improbably low cost, the most peculiar quality of this type of insurance was that Burry did not have to buy the underlying bonds in order to purchase the policy. It was roughly equivalent to owning fire insurance on your neighbor’s home. He cherry-picked the worst of the worst bonds (the ones comprising home loans most likely to be defaulted on) and to his surprise found that Wall Street was almost blithely eager to insure them. (Later, Burry discovered that Goldman and Deutsche Bank were only acting as intermediaries, taking a cut off the top and then passing the insurance through to the witless and now notorious financial products group at American International Group.)
A first bona fide of “The Big Short” is the lucidity with which Lewis explains credit default swaps and the other complex financial instruments behind the crash. He describes how Wall Street, when it ran out of subprime mortgage bonds to insure, invented a new way for speculators to gamble on the market called a collateralized debt obligation (or CDO). CDOs took the worst pieces of each subprime bond and recombined them into a new product that was meant to appear less risky than the sum of its parts. The gambit was like a meatpacker grinding together bits of bone and gristle and calling it top sirloin, and it worked because Moody’s and Standard and Poor’s – the meat inspectors of the financial world – were either asleep at the wheel or on the take, depending on your level of cynicism. Regardless, CDOs opened the possibility of an infinite regress of wagers – a bet on a bet on a bet – and enabled speculation in subprime mortgage bonds to reach the economy-destroying heights that it did.