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 FINANCIAL CRISIS INQUIRY COMMISSION REPORT

than a year earlier to bet exclusively against the subprime housing market, was up
. “Each MBS tranche typically would be  mortgages in California,  in
Florida,  in New York, and when you aggregate  MBS positions you still have
the same geographic diversification. To us, there was not much diversification in
CDOs.” Shu’s research convinced him that if home prices were to stop appreciating,
BBB-rated mortgage-backed securities would be at risk for downgrades. Should
prices drop , CDO losses would increase -fold. 
And if a relatively small number of the underlying loans were to go into fore -
closure, the losses would render virtually all of the riskier BBB-rated tranches worth-
less. “The whole system worked fine as long as everyone could refinance,” Steve
Eisman, the founder of a fund within FrontPoint Partners, told the FCIC. The minute
refinancing stopped, “losses would explode. . . . By , about half [the mortgages
sold] were no-doc or low-doc. You were at max underwriting weakness at max hous-
ing prices. And so the system imploded. Everyone was so levered there was no ability

to take any pain.” On October , , James Grant wrote in his newsletter about the
“mysterious alchemical processes” in which “Wall Street transforms BBB-minus-rated
mortgages into AAA-rated tranches of mortgage securities” by creating CDOs. He es-
timated that even the triple-A tranches of CDOs would experience some losses if na-
tional home prices were to fall just  or less within two years; and if prices were to
fall , investors of tranches rated AA- or below would be completely wiped out. 
In , Eisman and others were already looking for the best way to bet on this
disaster by shorting all these shaky mortgage-related securities. Buying credit default
swaps was efficient. Eisman realized that he could pick what he considered the most
vulnerable tranches of the mortgage-backed bonds and bet millions of dollars against
them, relatively cheaply and with considerable leverage. And that’s what he did.
By the end of , Eisman had put millions of dollars into short positions on
credit default swaps. It was, he was sure, just a matter of time. “Everyone really did
believe that things were going to be okay,” Eisman said. “[I] thought they were certifi-
able lunatics.” 
Michael Burry, another short who became well-known after the crisis hit, was a
doctor-turned-investor whose hedge fund, Scion Capital, in Northern California’s
Silicon Valley, bet big against mortgage-backed securities—reflecting a change of
heart, because he had invested in homebuilder stocks in . But the closer he
looked, the more he wondered about the financing that supported this booming mar-
ket. Burry decided that some of the newfangled adjustable rate mortgages were “the
most toxic mortgages” created. He told the FCIC, “I watched those with interest as
they migrated down the credit spectrum to the subprime market. As [home] prices
had increased on the back of virtually no accompanying rise in wages and incomes, I
came to the judgment that in two years there will be a final judgment on housing

when those two-year [adjustable rate mortgages] seek refinancing.” By the middle
of , Burry had bought credit default swaps on billions of dollars of mortgage-
backed securities and the bonds of financial companies in the housing market, in-
cluding Fannie Mae, Freddie Mac, and AIG.
Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing mar-