Author Michael Lewis On Wall St's Delusion

If you had to pick someone to write the autopsy report on the Wall Street financial collapse 18 months ago, you couldn't do any better than Michael Lewis. He is one of the country's preeminent non-fiction writers with a knack for turning complicated, mind numbing material into fascinating yarns.

He wrote his first bestseller, "Liar's Poker," about his experiences as a young Wall Street bond trader when he was still in his 20s and has since followed up with seven more bestsellers on subjects ranging from Silicon Valley in "The New New Thing" to big time sports in "Money Ball" and "The Blind Side."

His new book, called "The Big Short: Inside the Doomsday Machine," comes out later this week and it explains how some of Wall Street's finest minds managed to destroy $1.75 trillion of wealth in the subprime mortgage markets.

"60 Minutes" and correspondent Steve Kroft spent two days debriefing Lewis at his home in California.

Full Segment, Part 1: Inside The Collapse
Full Segment, Part 2: Inside The Collapse
Web Extra: Is Wall Street Overpaid?
Web Extra: Bailout Blues
Web Extra: The $8.4 Billion Bet
Web Extra: Wall Street Misfit
Web Extra: "The Blind Side"

"This was an episode where capitalism was almost destroyed, just by the capitalists. And, in the most sensational way, they were sort of destroyed by their own folly," Lewis told Kroft.

Asked what happened, Lewis said, "The incentives for people on Wall Street got so screwed up, that the people who worked there became blinded to their own long term interests. And because the short term interests were so overpowering. And so they behaved in ways that were antithetical to their own long term interests."

Lewis, a one-time wonder boy on Wall Street, is about to turn 50 now, ensconced in a hillside compound in Berkeley, Calif. The property has a main house and three cottages and he is much happier writing about business than actually conducting it.

Asked which book produced the money to buy the home, Lewis said, "This would've been 'The New, New Thing,' that bought this place."

Lewis estimates he has sold "some millions" of books. "I don't know how many millions. Not John Grisham millions, but millions," he said.

He lives in Berkeley with his wife, former MTV News correspondent Tabitha Soren and their three children - a three-year-old son and two young daughters who he takes to all of Cal Berkley women's basketball games.

It's one of the few breaks that Lewis allowed himself over the past 18-months as he dug into the idiocy and negligence that produced the worst financial crisis since the Great Depression.

"I'm afraid that our culture will come to the conclusion, 'cause it's always the easy conclusion, that everybody was just a bunch of criminals. I think the story is much more interesting than that. I think it's a story of mass delusion," Lewis said.

Lewis' forte has always been discovering little-known facts and characters that change people's perception about a story. So when he finally sat down at his computer with sacks full of research to write about this calamity, he had no interest in Treasury Secretary Hank Paulson, or Ben Bernanke, or the CEOs of Wall Street's big investment banks, who he believes had no clue what was going on while it was going on.

He wanted to tell the story through the eyes of people who were paying attention and who knew that a financial disaster was inevitable.

"There are a handful of characters who actually had seen it coming and made a fortune off of it. And there were so few of them, and there were so many people who had been on the other side that I thought that I kind of wondered who they were and why they got themselves into that position," Lewis said. "What they saw. Almost more how they saw."

Asked how many people he thinks were in the world who understood what was going on, Lewis told Kroft, "Between 10 and 20 investors at most and this is from the universe of tens of thousands of people who could have conceivably made that bet."

The first one to see that something was seriously amiss in the burgeoning subprime mortgage market was Dr. Michael Burry, a California physician with only one good eye. He lost the other one to cancer as a child and who also suffers from Asperger's Syndrome, a condition related to autism that often produces an aversion to social contact.

Uncomfortable dealing with patients, Burry quit medicine and started a hedge fund in Cupertino, Calif., spending most of his time in a darkened office glued to his computer screen.

Beginning in 2003, he turned to something that no one else in America was doing: reading and analyzing the pools of risky subprime mortgage loans that Wall Street had been buying up and bundling into highly profitable mortgage backed securities, which they were selling to investors around the world.

"I called up the prospectuses and I read the prospectuses and I looked at these pools. I could see the credit standards within these pools deteriorating just quarter to quarter," Burry said.

Asked how he could tell, Burry told Kroft, "There was essentially crappier mortgages being put into these pools. And it didn't seem investors seemed to care and it didn't seem the ratings agencies seemed to care."

Asked if he thinks many people read these prospectuses, Burry said, "I think the lawyers that put them together to an extent maybe."

"Do you think that the executives at the big investment houses who were issuing these bonds had read them? Or understood them?" Kroft asked.

"No, they didn't read them," Burry replied. "I think that there were probably junior analysts that were given the tasks of reviewing these documents. However, I think that this was a profit center. It was a profit center. It was something the organization wanted to do."

In effect, Lewis writes, Burry was doing the first real analysis of the creditworthiness of the subprime borrowers and the structure of the complicated Wall Street mortgage securities; the kind of work that was supposed to have been done by bond rating agencies like Standard & Poor's and Moody's, so that investors could accurately judge their risks.

"What you were doing sounds to me like the job that the rating agency should have been doing," Kroft remarked.

"There's no way the rating agencies had anywhere the manpower to look through all that was being issued," Burry said.

"Yeah, but, you're one guy!" Kroft pointed out. "And you found it."

"You would think that even if they just looked at a sample maybe they would have come to a realization," Burry said.

By 2005, Burry had come to the realization that the Wall Street bond market had lost its mind. It was buying up hundreds of millions of dollars in dicey loans to unqualified buyers who were, in Michael Lewis' words, "one broken refrigerator away from default." Burry concluded that the subprime market would collapse in 2007.

"He notices for the first time that there are pools, there are mortgage bonds supported by pools of loans, and most of the loans are, what you call negative amortizing interest only loans. Which means that, you, the homeowner, and buyer, you borrow the money, and you not only don't have to repay your principal, you don't even have to repay the interest. And if you just don't pay anything, they just add to your loan," Lewis explained.

"You can't lose your house, in theory, right?" he added. "They're scraping the bottom of the barrel. Now is the time to lay a bet. And it's before anybody does."

Burry figured out that these mortgage-backed securities would become worthless if just a small percentage of the dicey loans went bad and he wanted to bet against the worst of them. He decided that the best way to do it would be to get Wall Street to sell him inexpensive insurance contracts on the securities that would pay off big time if they failed. The contracts were called "credit default swaps."

"He conceives that they are going to invent on Wall Street credit default swaps on subprime mortgages, essentially, insurance contracts on the bonds before they even do. And he helps, he participates in the creation of this instrument," Lewis explained. "And Michael Burry is the first one in."

Burry assumed a lot of people would figure out what he was up to but very few did. It took two years for the drama to play out, but the subprime mortgage market finally collapsed in 2007, just as he had predicted.

Burry acknowledged he "made a ton" of money. "Much more than I ever imagined, you know I'd ever have. We [the hedge fund] made $725 million on the funds I think in 2007," he told Kroft.

"Michael Burry's advantage was he wasn't part of the collective. That he was just this guy in a T-shirt and shorts with a glass eyeball and Asperger's Syndrome, looking at the numbers, and when nobody else really was," Lewis said.

"How can they not look at the numbers? I mean, how can Wall Street be buying all of these mortgages and repackaging them, and not realizing that they're not very good mortgages?" Kroft asked.

"Wall Street is able to delude itself because it's paid to delude itself. I mean one of the lessons of this story is that people see what they're incentivized to see. If you pay someone not to see the truth, they will not see the truth. And, Wall Street organized itself so people were paid to see something other than the truth. And that's one of the central messages of this story. You have to be very careful how you incentivize people, 'cause they will respond to the incentives," Lewis explained.

And all of the incentives in Wall Street's largely unregulated bond market were geared toward keeping the subprime money machine humming. Shortly after Burry decided the people there had lost their minds, Wall Street's most influential investment bank convinced the financial products division of insurance giant AIG insurance to join the party, a decision that would destroy the company.

"They insured tens of billions of dollars of subprime mortgage loans without even knowing they were doing it," Lewis said. "Goldman Sachs persuaded them to insure these piles of loans without them ever investigating what was in the pile. So, there's an additional level of incompetence. They didn't even know the mistake they were making."

Over a period of just a few months in 2005, Goldman Sachs got AIG to insure $20 billion worth of subprime mortgage securities that the ratings agencies had graded AAA. But in fact, Lewis says, the pools contained some of the worst "drek" on the market.

"Do you think the big banks like Goldman Sachs played AIG for a patsy?" Kroft asked.

"That's exactly what they did," Lewis replied. "I mean, I think even Goldman Sachs would admit that to themselves, which is saying something. Yes. Absolutely. Using the cover of, 'We're all big boys in this market,' the big investment banks have long sought to exploit their customers."

Asked what role the rating agencies played in this, Lewis said, "They were handmaidens to Wall Street. The ratings agencies get paid by Wall Street, by Merrill Lynch, by Citigroup, by Morgan Stanley, by Goldman Sachs, to rate the bonds that Wall Street creates. This creates a certain moral hazard."

"You write in the book that Goldman essentially took the worst stuff that they couldn't sell. They repackaged it and took it to Moody's. And got Moody's to rate it AAA?" Kroft asked. "How did they know that Moody's was gonna rate it AAA?"

"Yes. They had helped design the models I'm sure that Moody's used to rate the bonds. And I've spoken with people at Morgan Stanley and Goldman Sachs who said, 'We helped the ratings agencies understand these things,'" Lewis said.

According to Lewis, they were the educators.

Lewis calls the Goldman Sachs-AIG deal one of the original sins of the looming financial crisis. Other Wall Street firms were so jealous of the Goldman deal they got AIG to insure another $30 billion of what turned out to be worthless securities. But Lewis thinks the fiasco had more to do with Wall Street stupidity than corruption.

He said Wall Street didn't understand these things "well enough."

"I mean, there's a wonderful little vignette in the 'Big Short' about the leading bond trade, subprime mortgage bond trader at Morgan Stanley, a fellow named Howie Hubler, who manages to lose somewhere between, it's hard to know, but seven and $12 billion in a matter of six or eight months, more than any single trader has ever lost in the history of Wall Street, and no one knows his name," Lewis said.

According to Lewis, at the end of 2006 and the beginning of 2007, when the commercial bank J.P. Morgan became the first to recognize the danger and fled the subprime market, Hubler was gobbling up $16 billion worth of subprime mortgage bonds that would be worthless in nine months.

"He did not understand the forces that work in his own market. And he was supposed to be the smart guy. I mean, what were the dumb guys doing? So, I think that it's really clear that the firms themselves did not understand the machine they created," Lewis said.

Asked what happened to Hubler, Lewis said, "He's allowed to resign from Morgan Stanley and he takes with him millions of dollars in back pay, tens of millions of dollars in back pay; it was all hushed up, basically."

According to Lewis, "all" of the people who made these terrible decisions left with a lot of money. "I didn't run across a single character who didn't get rich. Anybody above a certain level in all these firms made huge sums of money by any standard. And the people who were, I mean, this is where it gets a little creepy, the people who were most instrumental in building the subprime mortgage machine also happened to be the ones who had the most detailed understanding now of the securities in the rubble," he told Kroft.

"And they're being paid all over again to sort through the mess because they're the experts. That is an age-old trick on Wall Street, 'cause generally speaking, people who create disasters make a lotta money cleaning up the disaster because they're the ones who know about the disaster," he added.

What about the CEOs?

"Stan O'Neal at Merrill Lynch, and Chuck Prince at Citigroup are the most obvious examples. But they were paid not tens, but into the hundreds of millions of dollars to run their firms into the ground," Lewis said.

By the fall of 2008, with AIG and all of the big investment banks at some risk of going under, the government stepped in to bail out the very firms that had caused the crisis. A decision was made that AIG was too big to let fail, and that its gambling debts would be paid off 100 cents on the dollar and the company that benefited the most was Goldman Sachs.

"Do you believe it had anything to do with their political connections?" Kroft asked.

"It's hard to know. There's no proof. But it certainly didn't hurt. It certainly didn't hurt that the secretary of the Treasury was a former Goldman CEO. It certainly didn't hurt that a lot of the people at the table were former Goldman employees. It certainly didn't hurt that the air that everybody breathed contained the assumption that we can never do anything to harm Goldman Sachs. So sure, I mean, I can't really see how their political influence didn't have anything to do with it," Lewis said.

Wall Street's bad bets nearly brought down the financial system in 2008. One thing that didn't end, Michael Lewis says, was the bonus culture and sense of entitlement in the financial industry.

According to the New York State comptroller, Wall Street employees split $20 billion in bonuses for 2009. That's up 17 percent over last year, but it's not a record. In fact, it's a third less than the $33 billion Wall Street divvied up in 2007 - the same year everyone on Wall Street began to acknowledge the subprime mortgage losses that would reach $1.75 trillion.

The size of the bonuses has left Lewis appalled but not really surprised.

More than 20 years ago, Lewis collected a couple of bonuses himself as a young trader at Salomon Brothers, and he still can't figure out what he did to deserve them.

"I got two bonuses in 1986 and 1987. And it was like winning the lottery. The money was so shocking, even though it seems in retrospect so quaint. It was a couple of hundred thousand dollars. But I was 24, 25 years old. It was incredible that someone was gonna give me a couple hundred thousand dollars for what I'd just done. 'Cause I couldn't figure out what was so terribly useful about what I'd just done," Lewis said.

And Lewis feels the same way about the latest round of bonuses that were paid out on $55 billion of Wall Street profits that he thinks wouldn't have been made without help from Uncle Sam. Once the government decided the banks were too important to fail, Lewis says the only way to get them back on their feet was to give them money.

"I think they assumed that in response for this gift of life that they were giving these Wall Street firms, the people who ran the Wall Street firms would behave responsibly in a way that didn't attract," Lewis said.

Asked what that means, Lewis told Kroft, "Meaning not pay themselves huge sums of money. Perhaps not even pay themselves anything. Just say, 'Thank you.' And re-jigger their compensation systems. Instead, they did not. Instead they used the market as an excuse for paying themselves. 'If we don't pay our employees of Goldman Sachs huge sums of money, they're gonna leave and go to J.P. Morgan.' And the J.P. Morgan people say, 'Well, if we don't pay these special people huge sums of money, they can leave and go to Goldman Sachs.' And you kind of wanna back away from it and say, 'Well, wait a minute. Why are they so valuable in the first place?'"

"And really what's going on is the people at the top of firm wanna make a lot of money. And if they're gonna make a lot of money they gotta pay the people under them a lot of money," he added. "So it's a very elegant form of theft right now."

"Well, their argument has been, 'Look, we're entitled to these bonuses this year because we made all of this money,'" Kroft pointed out.

"Yeah, no one ever asked 'em, they never explained how they made all this money. All right, if you look at their businesses right now they're heavily government dependent. That if you were a Goldman Sachs, a Morgan Stanley, or J.P. Morgan, you have access to a zero percent loan in virtually unlimited quantities from the Federal Reserve. You can take that money and reinvest it in Treasury bonds or in government agency securities and you will get the spread. And you could do it over and over. You're essentially borrowing from the government, and lending the government. And taking a cut," Lewis said.

"So the government's let them make the money," Kroft remarked.

"Well, the government is still subsidizing these firms because the losses were sensational. I mean, in the financial system they are now $1.75 trillion of losses from the subprime mortgage bonanza. And they're firms that really, look, they really shouldn't exist. If the market had been allowed to function they would not exist. They'd be failed enterprises," Lewis said.

"I mean even now if the government said, 'We have nothing to do with these places anymore. We're gonna let 'em fail if they fail,' They no longer have this effective government guarantee. And by the way we're gonna cut out these subsidies that we're handing them under the table, most of them would fail," he added.

But none of that has changed the Wall Street bonus culture. Lewis says there is a sense of entitlement to outrageous compensation that he thinks is way out of proportion to its contribution to the U.S. economy.

"How did that happen that somebody thinks they're automatically worth millions of dollars a year?" Kroft asked.

"Well, when you're surrounded by a lot of other people who are being paid millions of dollars of year, you're not thinking, 'Oh, it's outrageous for someone to pay me millions of dollars a year.' You're thinking, 'It's outrageous that Jim got $500,000 more than me.' That they're looking to each other as reference points rather than to the larger society," Lewis explained.

Asked if he thinks people are worth that kind of money, Lewis asked, "What do you mean are they worth that kind of money?"

"Do they deserve all that money?" Kroft asked.

"Again, what do you mean do they deserve it? They worked really hard. They spent a lot of hours in the office," Lewis said. "So you can't begrudge someone who starts a company and employs lots of people and so on and so forth for making a lot of money. I don't mind people making a lot of money. On Wall Street the business has become very obviously divorced from productivity, from productive enterprise."

"So in that sense, no. They don't deserve it. They didn't earn it," he added. What they did was finagle it. They were very good at putting themselves in the middle of large financial transactions that probably shouldn't have happened in the first place and taking out little pieces of it. They generated trillions of dollars of subprime mortgage loans that should never have been made. But the world would be better off if that whole industry had never existed. So that's crazy."

Lewis says the more people learn about what happened, the angrier they become.

Asked if he sees anything happening to reform the system, Lewis said, "There are several things that obviously should be done that have not been done. And you can't explain to my mother why they haven't been done. Only a really smart person on Wall Street could explain why they haven't been done. But for example, all right, one of the things at the bottom of this crisis, we had these ratings agencies that called a lot of things AAA, gold-plated securities that were worthless."

"And the ratings agencies are paid, of course, by the Wall Street firms for their ratings. Why is that allowed? Why can you buy a rating? That seems like a very obvious thing to change. And people talk about it, but it hadn't happened. Credit default swaps, insurance contracts that we trade freely, but it's not classified as insurance. This market is the closest thing to, sort of, ground zero of the recent calamity. And yet, nothing has been done to change the market. Nothing's been done to make it more transparent, nothing's been done to make it more like what it is, an insurance market. That's an obvious reform," Lewis said.

"From the time I was at Salomon Brothers, it was incredible to me that the firm could advise customers what to buy and sell," he added. "At the same time, they are betting on the things that they're trying to sell their customers. So I might call you up and say, 'Wow, these subprime mortgage loans, they look really, really good. This pile over here, you oughta invest in that pile. ' And meanwhile, the traders behind me are betting against it.'"

Lewis believes the financial industry is living in a world so disconnected from American life that it cannot be sustained. He thinks it may take a while, but he believes Wall Street as we know it, has done itself in.

"The leaders on Wall Street completely lost any sense of their responsibility to the society," Lewis said. "And if you know you're gonna blow up AIG by putting $20 billion of bad subprime mortgage risk into it even though it's gonna be very profitable for you, you should stop and say this shouldn't be done."

Produced by Frank Devine and Jennifer MacDonald