Free The Big Short: Inside the Doomsday Machine by Michael Lewis Page B

interest payment, you had to settle. The insurance buyer might not collect the full 100 cents on the dollar--just as the bondholder might not lose 100 cents on the dollar, as the company's assets were worth something--but an independent judge could decide, in a way that was generally fair and satisfying, what the recovery would be. If the bondholders received 30 cents on the dollar--thus experiencing a loss of 70 cents--the guy who had bought the credit default swap got 70 cents.
    Buying insurance on a pool of U.S. home mortgages was more complicated, because the pool didn't default all at once; rather, one homeowner at a time defaulted. The dealers--led by Deutsche Bank and Goldman Sachs--came up with a clever solution: the pay-as-you-go credit default swap. The buyer of the swap--the buyer of insurance--would be paid off not all at once, if and when the entire pool of mortgages went bust, but incrementally, as individual homeowners went into default.
    The ISDA agreement took months of haggling among lawyers and traders from the big Wall Street firms, who would run the market. Burry's lawyer, Steve Druskin, was for some reason allowed to lurk on the phone calls--and even jump in from time to time and offer the Wall Street customer's point of view. Historically, a Wall Street firm worried over the creditworthiness of its customers; its customers often took it on faith that the casino would be able to pay off its winners. Mike Burry lacked faith. "I'm not making a bet against a bond," he said. "I'm making a bet against a system." He didn't want to buy flood insurance from Goldman Sachs only to find, when the flood came, Goldman Sachs washed away and unable to pay him off. As the value of the insurance contract changed--say, as floodwaters approached but before they actually destroyed the building--he wanted Goldman Sachs and Deutsche Bank to post collateral, to reflect the increase in value of what he owned.
    On May 19, 2005--a month before the terms were finalized--Mike Burry did his first subprime mortgage deals. He bought $60 million in credit default swaps from Deutsche Bank--$10 million each on six different bonds. "The reference securities," these were called. You didn't buy insurance on the entire subprime mortgage bond market but on a particular bond, and Burry had devoted himself to finding exactly the right ones to bet against. He'd read dozens of prospectuses and scoured hundreds more, looking for the dodgiest pools of mortgages, and was still pretty certain even then (and dead certain later) that he was the only human being on earth who read them, apart from the lawyers who drafted them. In doing so, he likely also became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made. He was the opposite of an old-fashioned banker, however. He was looking not for the best loans to make but the worst loans--so that he could bet against them.
    He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans. It surprised him that Deutsche Bank didn't seem to care which bonds he picked to bet against. From their point of view, so far as he could tell, all subprime mortgage bonds were the same. The price of insurance was driven not by any independent analysis but by the ratings placed on the bond by the rating agencies, Moody's and Standard & Poor's. * If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier A-rated tranches, he might pay 50 basis points (0.50 percent); and, on the even less safe triple-B-rated tranches, 200 basis