Corrupt, Not Stupid! The Michael Lewis Lawsuit as Literary Criticism

Late last month a defamation lawsuit was filed against the journalist Michael Lewis. The irony of Mr. Lewis being sued for vilifying anybody is that his body of work is so scrupulously villain-free as to cause the reader to suspect the author has some skeletons in his closet. He wrote a book about baseball in 2003 that made zero mention of the word "steroids," and in similar fashion, he declares at the outset of his financial crisis page-turner, The Big Short: Inside the Doomsday Machine, that pervasive stupidity, not corruption, was the novelty distinguishing the financial crisis of 2008 from all those before it. The embodiment of this system-shattering new strain of cluelessness makes a cameo appearance in the form a saké-slurping financier labeled "the enemy" by an associate of Mr. Lewis' pathologically indignant chief protagonist, Steve Eisman, upon their encounter at a Las Vegas subprime mortgage conference in January 2007.

The enemy was Wing Chau, a pudgy but well-dressed man who specialized in packaging and "managing" the infamous subprime-mortgage-backed collateralized debt obligations on the verge of nuking the financial system. Mr. Eisman, like Mr. Lewis' other heroes, was accumulating credit default swaps betting on an epidemic of foreclosures that were in the process of destroying such CDOs. Mr. Chau, whose CDO manager Harding Advisory had then been in business for only six months, effusively explained to his dinner companion that they were actually rooting for the same team. "I love guys like you who short my market," he said, to Mr. Eisman's self-professed horror. "Without you, I don't have anything to buy."

It has been 12 months since The Big Short first appeared in stores, embedding the episode in the collective consciousness of the moderately finance-minded. Like the real estate crash itself, it happened in Vegas but did not stay in Vegas. As Mr. Lewis tells it, Mr. Chau was the embodiment of the "sucker": a new money "moron" with a mid-tier education who had spent the years prior to the subprime gravy train toiling at an insurance company for $140,000 a year.

It is unclear why it took until last week for Mr. Chau to formally strike back at Mr. Lewis and Mr. Eisman with an acerbic double character assassination disguised as an audaciously flimsy defamation lawsuit. (Sample transition: "7. Lewis admits that he was so unqualified [for his job as a junior bond salesman during the 1980s] that he feared that 'someone was going to identify me, along with a lot of other people more or less like me, as a fraud.' 8. Lewis escaped any charges of fraud and went on to write Liar's Poker concerning his brief experience at Salomon Brothers, which became a bestseller and made him rich.") Neither Mr. Chau nor his formidable attorney, Steven Molo, who now represents, among others, two of Bernard Madoff's oldest investors in his bankruptcy case, returned calls from The Observer.

"I was really surprised to hear about the lawsuit, because I didn't think anything [Mr. Lewis] wrote was that bad," said Tony Huang, a Cornell physics Ph.D. and derivatives veteran who worked for Mr. Chau for three years at Harding, reached at his new job at a Princeton, N.J., wealth management firm.

"Although the book did get one thing wrong" about his old boss, Mr. Huang said. "He is not stupid."

One of the more exotic characteristics of the subprime mortgage crisis was the unprecedented opportunity it afforded a few curious-minded money managers like the paladins of The Big Short to become ludicrously rich, practically overnight, without having to get their hands dirty. So Mr. Eisman manages a multibillion-dollar hedge fund and fancies himself, in Lewis' phrase "Wall Street's socialist." Michael Burry has a glass eye and Asperger's syndrome and doesn't believe in charging investors a management fee. Mr. Lewis' big shorts are all a bit socially displaced and somehow honorable, except in the cases in which he fails to mention their dishonorable qualities.

Mr. Chau's is not that kind of story. In the summer of 2006, barely a year after he founded Harding, he was personally "overseeing" more than $20 billion (theoretical) worth of the most dubious deals in the history of Wall Street. Through a diversified regimen of fees, bonuses and "incentive" payments, he made $26 million in 2006 alone, according to Mr. Lewis.

Harding specialized in "mezzanine CDOs," notorious scams in which pools of unsellable BBB-rated slices of mortgage-backed securities were somehow spun into a more complex vehicle that could by the magical math of decorrelation upgrade its ratings to triple-A. Since a foundational delusion of this and all mortgage-based financial "innovation" was the assumption that housing prices would rise every year in perpetuity, this sort of madness should have ground to a halt in late 2005, when the housing market began its descent. Instead, the CDO market surged. At least $500 billion in mostly subprime-backed CDOs were issued in 2006 and 2007—as delinquencies were rocketing, prices were falling and panic took hold.

This was the result of an invention called the "synthetic" mortgage security, a derivative pegged to the value of an underlying mortgage bond, with the crucial distinction that interest payments were made not by homeowners but by speculators investing in credit default swaps that increase in value once those homeowners start to default. By 2006, just as Mr. Chau pointed out at the dinner, "demand" for mortgage-backed financial products was effectively being "driven" by pessimists, like Mr. Eisman, betting on collapse, although the market was too opaque for almost anyone to grasp this. But Mr. Chau understood because the mezzanine CDOs that were Harding's specialty were a vehicle for creating discount-priced credit protection.

In one of Harding's first transactions, the $1.5 billion Octans I, the Illinois hedge fund Magnetar agreed to buy the lowest "toxic waste" slice of the deal in exchange for the right to choose which bonds and "synthetics" Octans would comprise. Octans also contained a slice of another CDO called TABS—and TABS in turn "invested" in a slice of Octans—that closed the same month, October 2006. TABS was the invention of the hedge fund Tricadia, which like Magnetar "sponsored" CDO deals by footing the bill for the untouchable "toxic waste" of the lowest tranche, in order to lay claim to the credit default swaps that would pay out when the deal fell apart.