"How Can a Guy Who Can't Speak English Lie?"

By the time Greg Lippmann turned up in the FrontPoint conference room, in February 2006, Steve Eisman knew enough about the bond market to be wary, and Vincent Daniel knew enough to have decided that no one in it could ever be trusted. An investor who went from the stock market to the bond market was like a small, furry creature raised on an island without predators removed to a pit full of pythons. It was possible to get ripped off by the big Wall Street firms in the stock market, but you really had to work at it. The entire market traded on screens, so you always had a clear view of the price of the stock of any given company. The stock market was not only transparent but heavily policed. You couldn't expect a Wall Street trader to share with you his every negative thought about public companies, but you could expect he wouldn't work very hard to sucker you with outright lies, or blatantly use inside information to trade against you, mainly because there was at least a chance he'd be caught if he did. The presence of millions of small investors had politicized the stock market. It had been legislated and regulated to at least seem fair.

The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure. Even as it came to dwarf the stock market, the bond market eluded serious regulation. Bond salesmen could say and do anything without fear that they'd be reported to some authority. Bond traders could exploit inside information without worrying that they would be caught. Bond technicians could dream up ever more complicated securities without worrying too much about government regulation--one reason why so many derivatives had been derived, one way or another, from bonds. The bigger, more liquid end of the bond market--the market for U.S. Treasury bonds, for example--traded on screens, but in many cases the only way to determine if the price some bond trader had given you was even close to fair was to call around and hope to find some other bond trader making a market in that particular obscure security. The opacity and complexity of the bond market was, for big Wall Street firms, a huge advantage. The bond market customer lived in perpetual fear of what he didn't know. If Wall Street bond departments were increasingly the source of Wall Street profits, it was in part because of this: In the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.

And so it was no particular reflection on Greg Lippmann that, upon entering Steve Eisman's office, he collided with a wall of suspicion. "Moses could have walked in the door, and if he said he came from fixed income, Vinny wouldn't have trusted him," said Eisman.

Still, if a team of experts had set out to create a human being to maximize the likelihood that he would terrify a Wall Street customer, they might have designed something like Lippmann. He traded bonds for Deutsche Bank, but, like most people who traded bonds for Deutsche Bank--or for Credit Suisse or UBS or one of the other big foreign banks that had purchased a toehold in the U.S. financial markets--he was an American. Thin and tightly wound, he spoke too quickly for anyone to follow exactly what he was saying. He wore his hair slicked back, in the manner of Gordon Gekko, and the sideburns long, in the fashion of an 1820s Romantic composer or a 1970s porn star. He wore loud ties, and said outrageous things without the slightest apparent awareness of how they might sound if repeated unsympathetically. He peppered his conversation with cryptic references to how much money he made, for instance. People on Wall Street had long ago learned that their bonuses were the last thing they should talk about with people off Wall Street. "Let's say they paid me six million last year," Lippmann would say. "I'm not saying they did. It was less than that. I'm not saying how much less." Before you could protest--But I never asked!--he'd say, "The kind of year I had, no way they pay me less than four million." Now he had you thinking about it: So the number is between $4 million and $6 million. You could have started out talking about New York City Ballet, and you wound up playing Battleship. Lippmann kept giving you these coordinates, until you were almost forced to identify the location of the ship--exactly what just about everyone else on Wall Street hoped you'd never do.

In further violation of the code, Lippmann was quick to let people know that whatever he'd been paid by his employer was not anything like what he'd been worth. "Senior management's job is to pay people," he'd say. "If they fuck a hundred guys out of a hundred grand each, that's ten million more for them. They have four categories: happy, satisfied, dissatisfied, disgusted. If they hit happy, they've screwed up: They never want you happy. On the other hand, they don't want you so disgusted you quit. The sweet spot is somewhere between dissatisfied and disgusted." At some point in between 1986 and 2006 a memo had gone out on Wall Street, saying that if you wanted to keep on getting rich shuffling bits of paper around to no obvious social purpose, you had better camouflage your true nature. Greg Lippmann was incapable of disguising himself or his motives. "I don't have any particular allegiance to Deutsche Bank," he'd say. "I just work there." This was not an unusual attitude. What was unusual was that Lippmann said it.

The least controversial thing to be said about Lippmann was that he was controversial. He wasn't just a good bond trader, he was a great bond trader. He wasn't cruel. He wasn't even rude, at least not intentionally. He simply evoked extreme feelings in others. A trader who worked near him for years referred to him as "the asshole known as Greg Lippmann." When asked why, he said, "He took everything too far."

"I love Greg," said one of his bosses at Deutsche Bank. "I have nothing bad to say about him except that he's a fucking whack job." But when you cleared away the controversy around Lippmann's persona you could see it was rooted in two simple complaints. The first was that he was transparently self-interested and self-promotional. The second was that he was excessively alert to the self-interest and self-promotion of others. He had an almost freakish ability to identify shadowy motives. If you had just donated $20 million to your alma mater, say, and were feeling the glow of selfless devotion to a cause greater than yourself, Lippmann would be the first to ask, "So you gave twenty million because that's the minimum to get your name on a building, right?"

Now this character turns up out of nowhere to sell Steve Eisman on what he claims is his own original brilliant idea for betting against the subprime mortgage bond market. He made his case with a long and involved forty-two-page presentation: Over the past three years housing prices had risen far more rapidly than they had over the previous thirty; housing prices had not yet fallen but they had ceased to rise; even so, the loans against them were now going sour in their first year at amazing rates--up from 1 percent to 4 percent. Who borrowed money to buy a house and defaulted inside of twelve months? He went on for a bit, then showed Eisman this little chart that he'd created, and which he claimed was the reason he had become interested in the trade. It illustrated an astonishing fact: Since 2000, people whose homes had risen in value between 1 and 5 percent were nearly four times more likely to default on their home loans than people whose homes had risen in value more than 10 percent. Millions of Americans had no ability to repay their mortgages unless their houses rose dramatically in value, which enabled them to borrow even more.

That was the pitch in a nutshell: Home prices didn't even need to fall. They merely needed to stop rising at the unprecedented rates they had the previous few years for vast numbers of Americans to default on their home loans.

"Shorting Home Equity Mezzanine Tranches," Lippmann called his presentation. "Shorting Home Equity Mezzanine Tranches" was just a fancy way to describe Mike Burry's idea of betting against U.S. home loans: buying credit default swaps on the crappiest triple-B slices of subprime mortgage bonds. Lippmann himself described it more bluntly to a Deutsche Bank colleague who had seen the presentation and dubbed him "Chicken Little." "Fuck you," Lippmann had said. "I'm short your house."

The beauty of the credit default swap, or CDS, was that it solved the timing problem. Eisman no longer needed to guess exactly when the subprime mortgage market would crash. It also allowed him to make the bet without laying down cash up front, and put him in a position to win many times the sums he could possibly lose. Worst case: Insolvent Americans somehow paid off their subprime mortgage loans, and you were stuck paying an insurance premium of roughly 2 percent a year for as long as six years--the longest expected life span of the putatively thirty-year loans.

The alacrity with which subprime borrowers paid off their loans was yet another strange aspect of this booming market. It had to do with the structure of the loans, which were fixed for two or three years at an artificially low teaser rate before shooting up to the "go-to" floating rate. "They were making loans to lower-income people at a teaser rate when they knew they couldn't afford to pay the go-to rate," said Eisman. "They were doing it so that when the borrowers get to the end of the teaser rate period, they'd have to refinance, so the lenders can make more money off them." Thirty-year loans were thus designed to be repaid in a few years. At worst, if you bought credit default swaps on $100 million in subprime mortgage bonds you might wind up shelling out premium for six years--call it $12 million. At best: Losses on the loans rose from the current 4 percent to 8 percent, and you made $100 million. The bookies were offering you odds of somewhere between 6:1 and 10:1 when the odds of it working out felt more like 2:1. Anyone in the business of making smart bets couldn't not do it.

The argument stopper was Lippmann's one-man quantitative support team. His name was Eugene Xu, but to those who'd heard Lippmann's pitch, he was generally spoken of as "Lippmann's Chinese quant." Xu was an analyst employed by Deutsche Bank, but Lippmann gave everyone the idea he kept him tied up to his Bloomberg terminal like a pet. A real Chinese guy--not even Chinese American--who apparently spoke no English, just numbers. China had this national math competition, Lippmann told people, in which Eugene had finished second. In all of China. Eugene Xu was responsible for every piece of hard data in Lippmann's presentation. Once Eugene was introduced into the equation, no one bothered Lippmann about his math or his data. As Lippmann put it, "How can a guy who can't speak English lie?"

There was a lot more to it than that. Lippmann brimmed with fascinating details: the historical behavior of the American homeowner; the idiocy and corruption of the rating agencies, Moody's and S&P, who stuck a triple-B rating on subprime bonds that went bad when losses in the underlying pools of home loans reached just 8 percent;* the widespread fraud in the mortgage market; the folly of subprime mortgage investors, some large number of whom seemed to live in Dusseldorf, Germany. "Whenever we'd ask him who was buying this crap," said Vinny, "he always just said, 'Dusseldorf.'" It didn't matter whether Dusseldorf was buying actual cash subprime mortgage bonds or selling credit default swaps on those same mortgage bonds, as they amounted to one and the same thing: the long side of the bet.

Lippmann brimmed, also, with Lippmann. He hinted Eisman might get so rich from the trade he could buy the Los Angeles Dodgers. ("I'm not saying you're going to be able to buy the Dodgers.") Eisman might become so rich that movie stars would crave his body. ("I'm not saying you're going to date Jessica Simpson.") With one hand Lippmann presented the facts of the trade; with the other he tap-tap-tapped away, like a dowser probing for a well hidden deep in Eisman's character.

Keeping one eye on Greg Lippmann and the other on Steve Eisman, Vincent Daniel half expected the room to explode. Instead Steve Eisman found nothing even faintly objectionable about Greg Lippmann. Great guy! Eisman really only had a couple of questions. The first: Tell me again how the hell a credit default swap works? The second: Why are you asking me to bet against bonds your own firm is creating, and arranging for the rating agencies to mis-rate? "In my entire life I never saw a sell-side guy come in and say, 'Short my market,'" said Eisman. Lippmann wasn't even a bond salesman; he was a bond trader who might be expected to be long these very same subprime mortgage bonds. "I didn't mistrust him," says Eisman. "I didn't understand him. Vinny was the one who was sure he was going to fuck us in some way."

Eisman had no trouble betting against subprime mortgages. Indeed, he could imagine very little that would give him so much pleasure as the thought of going to bed each night, possibly for the next six years, knowing he was short a financial market he had come to know and despise and was certain would one day explode. "When he walked in and said you can make money shorting subprime paper, it was like putting a naked supermodel in front of me," said Eisman. "What I couldn't understand was why he wanted me to do it." That question, as it turned out, was more interesting than even Eisman suspected.

The subprime mortgage market was generating half a trillion dollars' worth of new loans a year, but the circle of people redistributing the risk that the entire market would collapse was tiny. When the Goldman Sachs saleswoman called Mike Burry and told him that her firm would be happy to sell him credit default swaps in $100 million chunks, Burry guessed, rightly, that Goldman wasn't ultimately on the other side of his bets. Goldman would never be so stupid as to make huge naked bets that millions of insolvent Americans would repay their home loans. He didn't know who, or why, or how much, but he knew that some giant corporate entity with a triple-A rating was out there selling credit default swaps on subprime mortgage bonds. Only a triple-A-rated corporation could assume such risk, no money down, and no questions asked. Burry was right about this, too, but it would be three years before he knew it. The party on the other side of his bet against subprime mortgage bonds was the triple-A-rated insurance company AIG--American International Group, Inc. Or, rather, a unit of AIG called AIG FP.

AIG Financial Products was created in 1987 by refugees from Michael Milken's bond department at Drexel Burnham, led by a trader named Howard Sosin, who claimed to have a better model to trade and value interest rate swaps. Nineteen eighties financial innovation had all sorts of consequences, but one of them was a boom in the number of deals between big financial firms that required them to take each other's credit risks. Interest rate swaps--in which one party swaps a floating rate of interest for another party's fixed rate of interest--was one such innovation. Once upon a time, Chrysler issued a bond through Morgan Stanley, and the only people who wound up with credit risk were the investors who bought the Chrysler bond. Chrysler might sell its bonds and simultaneously enter into a ten-year interest rate swap transaction with Morgan Stanley--and just like that, Chrysler and Morgan Stanley were exposed to each other. If Chrysler went bankrupt, its bondholders obviously lost; depending on the nature of the swap, and the movement of interest rates, Morgan Stanley might lose, too. If Morgan Stanley went bust, Chrysler, along with anyone else who had done interest rate swaps with Morgan Stanley, stood to suffer. Financial risk had been created out of thin air, and it begged to be either honestly accounted for or disguised.

Enter Sosin, with his supposedly new and improved interest rate swap model--even though Drexel Burnham was not at the time a market leader in interest rate swaps. There was a natural role for a blue-chip corporation with the highest credit rating to stand in the middle of swaps and long-term options and the other risk-spawning innovations. The traits required of this corporation were that it not be a bank--and thus subject to bank regulation, and the need to reserve capital against risky assets--and that it be willing and able to bury exotic risks on its balance sheet. It needed to be able to insure $100 billion in subprime mortgage loans, for instance, without having to disclose to anyone what it had done. There was no real reason that company had to be AIG; it could have been any triple-A-rated entity with a huge balance sheet. Berkshire Hathaway, for instance, or General Electric. AIG just got there first.

In a financial system that was rapidly generating complicated risks, AIG FP became a huge swallower of those risks. In the early days it must have seemed as if it was being paid to insure events extremely unlikely to occur, as it was. Its success bred imitators: Zurich Re FP, Swiss Re FP, Credit Suisse FP, Gen Re FP. ("Re" stands for Reinsurance.) All of these places were central to what happened in the last two decades; without them, the new risks being created would have had no place to hide and would have remained in full view of bank regulators. All of these places, when the crisis came, would be washed away by the general nausea felt in the presence of complicated financial risks, but there was a moment when their existence seemed cartographically necessary to the financial world. AIG FP was the model for them all.

The division's first fifteen years were consistently, amazingly profitable--there wasn't the first hint that it might be running risks that would cause it to lose money, much less cripple its giant parent. In 1993, when Howard Sosin left, he took with him nearly $200 million, his share of what appeared to be a fantastic money machine. In 1998, AIG FP entered the new market for corporate credit default swaps: It sold insurance to banks against the risk of defaults by huge numbers of investment-grade public corporations. The credit default swap had just been invented by bankers at J.P. Morgan, who then went looking for a triple-A-rated company willing to sell them--and found AIG FP.* The market began innocently enough, by Wall Street standards.

Large numbers of investment-grade companies in different countries and different industries were indeed unlikely to default on their debt at the same time. The credit default swaps sold by AIG FP that insured pools of such loans proved to be a good business. By 2001, AIG FP, now being run by a fellow named Joe Cassano, could be counted on to generate $300 million a year, or 15 percent of AIG's profits.

But then, in the early 2000s, the financial markets performed this fantastic bait and switch, in two stages. Stage One was to apply a formula that had been dreamed up to cope with corporate credit risk to consumer credit risk. The banks that used AIG FP to insure piles of loans to IBM and GE now came to it to insure much messier piles, which included credit card debt, student loans, auto loans, prime mortgages, aircraft leases, and just about anything else that generated a cash flow. As there were many different sorts of loans, to different sorts of people, the logic that had applied to corporate loans seemed to apply to them, too: They were sufficiently diverse that they were unlikely all to go bad at once.

Stage Two, beginning at the end of 2004, was to replace the student loans and the auto loans and the rest with bigger piles consisting of nothing but U.S. subprime mortgage loans. "The problem," as one AIG FP trader put it, "is that something else came along that we thought was the same thing as what we'd been doing." The "consumer loan" piles that Wall Street firms, led by Goldman Sachs, asked AIG FP to insure went from being 2 percent subprime mortgages to being 95 percent subprime mortgages. In a matter of months, AIG FP, in effect, bought $50 billion in triple-B-rated subprime mortgage bonds by insuring them against default. And yet no one said anything about it--not AIG CEO Martin Sullivan, not the head of AIG FP, Joe Cassano, not the guy in AIG FP's Connecticut office in charge of selling his firm's credit default swap services to the big Wall Street firms, Al Frost. The deals, by all accounts, were simply rubber-stamped inside AIG FP, and then again by AIG brass. Everyone concerned apparently assumed they were being paid insurance premiums to take basically the same sort of risk they had been taking for nearly a decade. They weren't. They were now, in effect, the world's biggest owners of subprime mortgage bonds.

Greg Lippmann watched his counterparts at Goldman Sachs find and exploit someone else's willingness to sell huge amounts of cheap insurance on subprime mortgage bonds and pretty much instantly guessed the seller's identity. Word spread quickly in the small world of subprime mortgage bond creators and traders: AIG FP was now selling credit default swaps on triple-A-rated subprime bonds for a mere 0.12 percent a year. Twelve basis points! Lippmann didn't know exactly how Goldman Sachs had persuaded AIG FP to provide the same service to the booming market in subprime mortgage loans that it provided to the market for corporate loans. All he knew was that, in rapid succession, Goldman created a bunch of multibillion-dollar deals that transferred to AIG the responsibility for all future losses from $20 billion in triple-B-rated subprime mortgage bonds. It was incredible: In exchange for a few million bucks a year, this insurance company was taking the very real risk that $20 billion would simply go poof. The deals with Goldman had gone down in a matter of months and required the efforts of just a few geeks on a Goldman bond trading desk and a Goldman salesman named Andrew Davilman, who, for his services, soon would be promoted to managing director. The Goldman traders had booked profits of somewhere between $1.5 billion and $3 billion--even by bond market standards, a breathtaking sum.

In the process, Goldman Sachs created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation. Like the credit default swap, the CDO had been invented to redistribute the risk of corporate and government bond defaults and was now being rejiggered to disguise the risk of subprime mortgage loans. Its logic was exactly that of the original mortgage bonds. In a mortgage bond, you gathered thousands of loans and, assuming that it was extremely unlikely that they would all go bad together, created a tower of bonds, in which both risk and return diminished as you rose. In a CDO you gathered one hundred different mortgage bonds--usually, the riskiest, lower floors of the original tower--and used them to erect an entirely new tower of bonds. The innocent observer might reasonably ask, What's the point of using floors from one tower of debt simply to create another tower of debt? The short answer is, They are too near to the ground. More prone to flooding--the first to take losses--they bear a lower credit rating: triple-B. Triple-B-rated bonds were harder to sell than the triple-A-rated ones, on the safe, upper floors of the building.

The long answer was that there were huge sums of money to be made, if you could somehow get them re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. Their--soon to be everyone's--nifty solution to the problem of selling the lower floors appears, in retrospect, almost magical. Having gathered 100 ground floors from 100 different subprime mortgage buildings (100 different triple-B-rated bonds), they persuaded the rating agencies that these weren't, as they might appear, all exactly the same things. They were another diversified portfolio of assets! This was absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally exposed. But never mind: The rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, pronounced 80 percent of the new tower of debt triple-A.

The CDO was, in effect, a credit laundering service for the residents of Lower Middle Class America. For Wall Street it was a machine that turned lead into gold.

Back in the 1980s, the original stated purpose of the mortgage-backed bond had been to redistribute the risk associated with home mortgage lending. Home mortgage loans could find their way to the bond market investors willing to pay the most for them. The interest rate paid by the homeowner would thus fall. The goal of the innovation, in short, was to make the financial markets more efficient. Now, somehow, the same innovative spirit was being put to the opposite purpose: to hide the risk by complicating it. The market was paying Goldman Sachs bond traders to make the market less efficient. With stagnant wages and booming consumption, the cash-strapped American masses had a virtually unlimited demand for loans but an uncertain ability to repay them. All they had going for them, from the point of view of Wall Street financial engineers, was that their financial fates could be misconstrued as uncorrelated. By assuming that one pile of subprime mortgage loans wasn't exposed to the same forces as another--that a subprime mortgage bond with loans heavily concentrated in Florida wasn't very much like a subprime mortgage bond more concentrated in California--the engineers created the illusion of security. AIG FP accepted the illusion as reality.

The people who worked on the relevant Goldman Sachs mortgage bond trading desk were all extremely intelligent. They'd all done amazingly well in school and had gone to Ivy League universities. But it didn't require any sort of genius to see the fortune to be had from the laundering of triple-B-rated bonds into triple-A-rated bonds. What demanded genius was finding $20 billion in triple-B-rated bonds to launder. In the original tower of loans--the original mortgage bond--only a single, thin floor got rated triple-B. A billion dollars of crappy home loans might yield just $20 million of the crappiest triple-B tranches. Put another way: To create a billion-dollar CDO composed solely of triple-B-rated subprime mortgage bonds, you needed to lend $50 billion in cash to actual human beings. That took time and effort. A credit default swap took neither.

There was more than one way to think about Mike Burry's purchase of a billion dollars in credit default swaps. The first was as a simple, even innocent, insurance contract. Burry made his semiannual premium payments and, in return, received protection against the default of a billion dollars' worth of bonds. He'd either be paid zero, if the triple-B-rated bonds he'd insured proved good, or a billion dollars, if those triple-B-rated bonds went bad. But of course Mike Burry didn't own any triple-B-rated subprime mortgage bonds, or anything like them. He had no property to "insure" it was as if he had bought fire insurance on some slum with a history of burning down. To him, as to Steve Eisman, a credit default swap wasn't insurance at all but an outright speculative bet against the market--and this was the second way to think about it.

There was also a third, even more mind-bending, way to think of this new instrument: as a near-perfect replica of a subprime mortgage bond. The cash flows of Mike Burry's credit default swaps replicated the cash flows of the triple-B-rated subprime mortgage bond that he wagered against. The 2.5 percent a year in premium Mike Burry was paying mimicked the spread over LIBOR* that triple-B subprime mortgage bonds paid to an actual investor. The billion dollars whoever had sold Mike Burry his credit default swaps stood to lose, if the bonds went bad, replicated the potential losses of an actual bond owner.

On its surface, the booming market in side bets on subprime mortgage bonds seemed to be the financial equivalent of fantasy football: a benign, if silly, facsimile of investing. Alas, there was a difference between fantasy football and fantasy finance: When a fantasy football player drafts Peyton Manning to be on his team, he doesn't create a second Peyton Manning. When Mike Burry bought a credit default swap based on a Long Beach Savings subprime-backed bond, he enabled Goldman Sachs to create another bond identical to the original in every respect but one: There were no actual home loans or home buyers. Only the gains and losses from the side bet on the bonds were real.

And so, to generate $1 billion in triple-B-rated subprime mortgage bonds, Goldman Sachs did not need to originate $50 billion in home loans. They needed simply to entice Mike Burry, or some other market pessimist, to pick 100 different triple-B bonds and buy $10 million in credit default swaps on each of them. Once they had this package (a "synthetic CDO," it was called, which was the term of art for a CDO composed of nothing but credit default swaps), they'd take it over to Moody's and Standard & Poor's. "The ratings agencies didn't really have their own CDO model," says one former Goldman CDO trader. "The banks would send over their own model to Moody's and say, 'How does this look?'" Somehow, roughly 80 percent of what had been risky triple-B-rated bonds now looked like triple-A-rated bonds. The other 20 percent, bearing lower credit ratings, generally were more difficult to sell, but they could, incredibly, simply be piled up in yet another heap and reprocessed yet again, into more triple-A bonds. The machine that turned 100 percent lead into an ore that was now 80 percent gold and 20 percent lead would accept the residual lead and turn 80 percent of that into gold, too.

The details were complicated, but the gist of this new money machine was not: It turned a lot of dicey loans into a pile of bonds, most of which were triple-A-rated, then it took the lowest-rated of the remaining bonds and turned most of those into triple-A CDOs. And then--because it could not extend home loans fast enough to create a sufficient number of lower-rated bonds--it used credit default swaps to replicate the very worst of the existing bonds, many times over. Goldman Sachs stood between Michael Burry and AIG. Michael Burry forked out 250 basis points (2.5 percent) to own credit default swaps on the very crappiest triple-B bonds, and AIG paid a mere 12 basis points (0.12 percent) to sell credit default swaps on those very same bonds, filtered through a synthetic CDO, and pronounced triple-A-rated. There were a few other messy details*--some of the lead was sold off directly to German investors in Dusseldorf--but when the dust settled, Goldman Sachs had taken roughly 2 percent off the top, risk-free, and booked all the profit up front. There was no need on either side--long or short--for cash to change hands. Both sides could do a deal with Goldman Sachs by signing a piece of paper. The original home mortgage loans on whose fate both sides were betting played no other role. In a funny way, they existed only so that their fate might be gambled upon.

The market for "synthetics" removed any constraint on the size of risk associated with subprime mortgage lending. To make a billion-dollar bet, you no longer needed to accumulate a billion dollars' worth of actual mortgage loans. All you had to do was find someone else in the market willing to take the other side of the bet.

No wonder Goldman Sachs was suddenly so eager to sell Mike Burry credit default swaps in giant, $100 million chunks, or that the Goldman Sachs bond trader had been surprisingly indifferent to which subprime bonds Mike Burry bet against. The insurance Mike Burry bought was inserted into a synthetic CDO and passed along to AIG. The roughly $20 billion in credit default swaps sold by AIG to Goldman Sachs meant roughly $400 million in riskless profits for Goldman Sachs. Each year. The deals lasted as long as the underlying bonds, which had an expected life of about six years, which, when you did the math, implied a profit for the Goldman trader of $2.4 billion.

Wall Street's newest technique for squeezing profits out of the bond markets should have raised a few questions. Why were supposedly sophisticated traders at AIG FP doing this stuff? If credit default swaps were insurance, why weren't they regulated as insurance? Why, for example, wasn't AIG required to reserve capital against them? Why, for that matter, were Moody's and Standard & Poor's willing to bless 80 percent of a pool of dicey mortgage loans with the same triple-A rating they bestowed on the debts of the U.S. Treasury? Why didn't someone, anyone, inside Goldman Sachs stand up and say, "This is obscene. The rating agencies, the ultimate pricers of all these subprime mortgage loans, clearly do not understand the risk, and their idiocy is creating a recipe for catastrophe"? Apparently none of those questions popped into the minds of market insiders as quickly as another: How do I do what Goldman Sachs just did? Deutsche Bank, especially, felt something like shame that Goldman Sachs had been the first to find this particular pay dirt. Along with Goldman, Deutsche Bank was the leading market maker in abstruse mortgage derivatives. Dusseldorf was playing some kind of role in the new market. If there were stupid Germans standing ready to buy U.S. subprime mortgage derivatives, Deutsche Bank should have been the first to find them.

None of this was of any obvious concern to Greg Lippmann. Lippmann did not run Deutsche Bank's CDO business--a fellow named Michael Lamont did. Lippmann was merely the trader responsible for buying and selling subprime mortgage bonds and, by extension, credit default swaps on subprime mortgage bonds. But with so few investors willing to make an outright bet against the subprime bond market, Lippmann's bosses asked Lippmann to take one for the team: in effect, to serve as a stand-in for Mike Burry, and to make an explicit bet against the market. If Lippmann would buy credit default swaps from Deutsche Bank's CDO department, they, too, might do these trades with AIG, before AIG woke up and stopped doing them. "Greg was forced to get short into the CDOs," says a former senior member of Deutsche Bank's CDO team. "I say forced, but you can't really force Greg to do anything." There was some pushing and pulling with the people who ran his firm's CDO operations, but Lippmann found himself uncomfortably short subprime mortgage bonds.

Lippmann had at least one good reason for not putting up a huge fight: There was a fantastically profitable market waiting to be created. Financial markets are a collection of arguments. The less transparent the market and the more complicated the securities, the more money the trading desks at big Wall Street firms can make from the argument. The constant argument over the value of the shares of some major publicly traded company has very little value, as both buyer and seller can see the fair price of the stock on the ticker, and the broker's commission has been driven down by competition. The argument over the value of credit default swaps on subprime mortgage bonds--a complex security whose value was derived from that of another complex security--could be a gold mine. The only other dealer making serious markets in credit default swaps was Goldman Sachs, so there was, in the beginning, little price competition. Supply, thanks to AIG, was virtually unlimited. The problem was demand: investors who wanted to do Mike Burry's trade. Incredibly, at this critical juncture in financial history, after which so much changed so quickly, the only constraint in the subprime mortgage market was a shortage of people willing to bet against it.

To sell investors on the idea of betting against subprime mortgage bonds--on buying his pile of credit default swaps--Greg Lippmann needed a new and improved argument. Enter the Great Chinese Quant. Lippmann asked Eugene Xu to study the effect of home price appreciation on subprime mortgage loans. Eugene Xu went off and did whatever the second smartest man in China does, and at length returned with a chart illustrating default rates in various home price scenarios: home prices up, home prices flat, home prices down. Lippmann looked at it...and looked again. The numbers shocked even him. They didn't need to collapse; they merely needed to stop rising so fast. House prices were still rising, and yet default rates were approaching 4 percent; if they rose to just 7 percent, the lowest investment-grade bonds, rated triple-B-minus, went to zero. If they rose to 8 percent, the next lowest-rated bonds, rated triple-B, went to zero.

At that moment--in November 2005--Greg Lippmann realized that he didn't mind owning a pile of credit default swaps on subprime mortgage bonds. They weren't insurance; they were a gamble; and he liked the odds. He wanted to be short.

This was new. Greg Lippmann had traded bonds backed by various consumer loans--auto loans, credit card loans, home equity loans--since 1991, when he had graduated from the University of Pennsylvania and taken a job at Credit Suisse. He'd never before been able to sell them short, because they were impossible to borrow. The only choice he and every other asset-backed bond trader ever had to make was whether to like them or to love them. There was never any point in hating them. Now he could, and did. But hating them set him apart from the crowd--and that represented, for Greg Lippmann, a new career risk. As he put it to others, "If you're in a business where you can do only one thing and it doesn't work out, it's hard for your bosses to be mad at you." It was now possible to do more than one thing, but if he bet against subprime mortgage bonds and was proven wrong, his bosses would find it easy to be mad at him.

In the righteous spirit of a man bearing an inconvenient truth, Greg Lippmann, a copy of "Shorting Subprime Mezzanine Tranches" tucked under his arm, launched himself at the institutional investing public. He may have begun his investigation of the subprime mortgage market in the spirit of a Wall Street salesman, searching less for the truth than for a persuasive-sounding pitch. Now, shockingly, he thought he had an ingenious plan to make customers rich. He'd charge them fat fees to get in and out of their credit default swaps, of course, but these would prove trivial compared to the fortunes they stood to make. He was no longer selling; he was dispensing favors. Behold. A gift from me to you.

Institutional investors didn't know what to make of him, at least not at first. "I think he has some kind of narcissistic personality disorder," said one money manager who heard Lippmann's pitch but did not do his trade. "He scared the shit out of us," said another. "He comes in and describes this brilliant trade. It makes total sense. To us the risk was, we do it, it works, then what? How do we get out? He controls the market; he may be the only one we can sell to. And he says, 'You have no way out of this swimming pool but through me, and when you ask for the towel I'm going to rip your eyeballs out.' He actually said that, that he was going to rip our eyeballs out. The guy was totally transparent."

They loved it, in a way, but decided they didn't want to experience the thrill of eyeball removal. "What worked against Greg," this fund manager said, "was that he was too candid."

Lippmann faced the usual objections any Wall Street bond customer voiced to any Wall Street bond salesmen--If it's such a great trade, why are you offering it to me?--but other, less usual ones, too. Buying credit default swaps meant paying insurance premiums for perhaps years as you waited for American homeowners to default. Bond market investors, like bond market traders, viscerally resisted any trade that they had to pay money to be in, and instinctively sought out trades that paid them just for showing up in the morning. (One big bond market investor christened his yacht Positive Carry.) Trades where you fork over 2 percent a year just to be in them were anathema. Other sorts of investors found other sorts of objections. "I can't explain credit default swaps to my investors" was a common response to Greg Lippmann's pitch. Or "I have a cousin who works at Moody's and he says this stuff [subprime mortgage bonds] is all good." Or "I talked to Bear Stearns and they said you were crazy." Lippmann spent twenty hours with one hedge fund guy and thought he had him sold, only to have the guy call his college roommate, who worked for some home builder, and change his mind.

But the most common response of all from investors who heard Lippmann's argument was, "I'm convinced. You're right. But it's not my job to short the subprime market."

"That's why the opportunity exists," Lippmann would reply. "It's nobody's job."

It wasn't Lippmann's, either. He was meant to be the toll booth, taking a little from buyers and sellers as they passed through his trading books. He was now in a different, more opinionated relationship to his market and his employer. Lippmann's short position may have been forced upon him, but by the end of 2005 he'd made it his own, and grown it to a billion dollars. Sixteen floors above him inside Deutsche Bank's Wall Street headquarters, several hundred highly paid employees bought subprime mortgage loans, packaged them into bonds, and sold them off. Another group packaged the most repellent, unsalable tranches of those bonds, and CDSs on the bonds, into CDOs. The bigger Lippmann's short position grew, the greater the implicit expression of contempt for these people and their industry--an industry quickly becoming Wall Street's most profitable business. The running cost, in premiums Lippmann paid, was tens of millions of dollars a year, and his losses looked even bigger. The buyer of a credit default swap agreed to pay premiums for the lifespan of the underlying mortgage bond. So long as the underlying bonds remained outstanding, both buyer and seller of credit default swaps were obliged to post collateral, in response to their price movements. Astonishingly, the prices of subprime mortgage bonds were rising. Within a few months, Lippmann's credit default swap position had to be marked down by $30 million. His superiors repeatedly asked him to explain why he was doing what he was doing. "A lot of people wondered if this was the best use of Greg's time and our money," said a senior Deutsche Bank official who watched the growing conflict.

Rather than cave to the pressure, Lippmann instead had an idea for making it vanish: kill the new market. AIG was very nearly the only buyer of triple-A-rated CDOs (that is, triple-B-rated subprime mortgage bonds repackaged into triple-A-rated CDOs). AIG was, ultimately, the party on the other side of the credit default swaps Mike Burry was buying. If AIG stopped buying bonds (or, more exactly, stopped insuring them against default), the entire subprime mortgage bond market might collapse, and Lippmann's credit default swaps would be worth a fortune. At the end of 2005, Lippmann flew to London to try to make that happen. He met with an AIG FP employee named Tom Fewings, who worked directly for AIG FP's head, Joe Cassano. Lippmann, who was forever adding data to his presentation, produced his latest version of "Shorting Mezzanine Home Equity Tranches" and walked Fewings through his argument. Fewings offered him no serious objections, and Lippmann left AIG's London office feeling as if Fewings had been converted to his cause. Sure enough, shortly after Lippmann's visit, AIG FP stopped selling credit default swaps. Even better: AIG FP hinted that they might actually like to buy some credit default swaps. In anticipation of selling them some, Lippmann accumulated more.

For a brief moment, Lippmann thought he'd changed the world, all by himself. He had walked into AIG FP and had shown them how Deutsche Bank, along with every other Wall Street firm, was playing them for fools, and they'd understood.