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He concluded that teaser-rate loans would default en masse once rates reset in 2007, and persuaded Goldman Sachs and Deutsche Bank to create credit default swaps on specific mortgage bonds so he could bet against them. His investors revolted and he restricted withdrawals while the position bled premiums for two years, until the collapse returned roughly $750 million to his fund.
Wall Street pooled the lowest-rated, riskiest tranches of subprime mortgage bonds into a new security, the collateralized debt obligation, and then sliced that pool into tranches again. Rating agencies treated the pooled BBB-rated pieces as diversified, so about 80% of the new CDO received a AAA rating. This turned unsellable risk into apparently safe assets, and the demand it created for more raw material pushed lenders to make ever-worse loans.
The crash was not mainly a failure of intelligence but of incentives. Mortgage originators were paid on volume, bond traders on annual bonuses, and rating agencies by the banks whose products they rated, so no one inside the chain was rewarded for noticing that the loans would fail.
Every trade has a counterparty, so a bet that looks absurdly cheap should prompt the question of who is selling it and why they believe it. The Cornwall Capital founders and Steve Eisman kept asking why the market priced catastrophic outcomes as nearly impossible. The answer was often that the seller was mispricing risk through a model or through institutional habit, not that the seller knew something they didn't. Treating the price as a claim someone is making, rather than as a fact, reveals where consensus has stopped being examined.