All The Devils Are Here: Unmasking the Men Who Bankrupted the World (50 page)

In the corporate bond market, traders were using credit default swaps not just as protection against the possibility that a bond they owned might default. They were also using them to make a bet—a bet that a company might default, even when the trader didn’t own the underlying bonds. These credit default swaps had become standardized, meaning that the conditions under which the buyers and sellers got paid were always the same. That’s the way markets tend to evolve: first comes hedging, and then comes speculation. To Wall Street, this is all good, because the more players in the market—whatever their reasons—the more trading there is.

In the mortgage-backed securities market, the credit default swaps that people were using to insure those super-seniors
were
a kind of short, since the buyer of the protection would be paid off if the super-senior tranches defaulted. But no one thought of them this way—they were focused on the regulatory capital advantages. And they were a customized agreement between two parties, which made them hard to trade, because any buyer would have to understand all the complex terms of the deal.

But why couldn’t you create a standardized credit default swap on mortgage-backed securities? That way, anyone could play. Instead of having to painstakingly scratch out terms with the party on the other side, you could trade these instruments the way people do stocks. That would dramatically expand the market—and all the more so if you also published an index of the prices of mortgage-backed securities. Wall Street likes to say that indices are good because they offer transparency—everyone can see what the prices
are—and liquidity, meaning it’s easier to get in and out of trades that are based on a public index. That’s probably true. But it’s also true that indices reduce complexity to the simplicity of a published number, allow investors to think they understand a market when they really don’t, and create a frenzy of trading activity that mainly benefits Wall Street.

Developing a big market of tradable credit default swaps on mortgage-backed securities would have several consequences. It would encourage Wall Street firms that were nervous about having mortgage risk on their own books to stay in the business, because now they could hedge their exposure. It would encourage people who had no economic interest in the underlying mortgage-backed securities to simply place bets on whether or not they could decline, because now it was relatively easy to do so. And it would also mean that someone had to take the other side of those bets, because that is, by definition, the way a credit default swap works.

Three firms—Deutsche Bank, Goldman Sachs, and Bear Stearns—led the drive to turn credit default swaps on mortgage-backed securities into easily tradable, standardized instruments. The group, which included Deutsche Bank trader Greg Lippman, Goldman trader Rajiv Kamilla, and Bear trader Todd Kushman, began meeting in February 2005 to figure out what the holders of a short interest should receive, and when they should receive it. Should the protection buyer—as Wall Street called the counterparty on the short side—get his or her money when the mortgage defaulted? When it was ninety days delinquent? The traders decided that the protection buyer should get paid as the mortgage lost value—which would be determined by the Street firm that sold the instrument—in sums that made up for the lost value. They called their concept Pay As You Go, or PAUG. (The correct pronunciation rhymes with “hog,” says one person who was involved.) “To tell the truth, it’s not very glamorous,” Lippman later told Bloomberg reporter Mark Pittman.

In January 2006, an index based on subprime mortgages began trading for the first time. (“THE market event of 1H ’06,” proclaimed a Goldman analyst.) Just as an index like the S&P 500 has five hundred big company stocks, this new index, called the ABX, would list specific tranches of mortgage-backed securities. Once the ABX was up and running, investors could buy or sell contracts linked to the price of mortgage-backed securities, sorted by rating and by year. So, for instance, an investor could short the ABX 06-1 triple-A, meaning a triple-A slice that was originated in the first half of 2006. “Before that, no one ever thought about whether to be long or short mortgages,
because everyone was always long and it always worked,” says one trader who was involved.

That wasn’t quite true. The ABX made shorting the mortgage market much easier than it had been before. But even before its creation, a handful of investors—skeptical hedge fund managers, primarily—had sought a way to make a bearish bet on the mortgage market. They had pushed Wall Street firms to sell them customized credit default swaps on specific tranches of mortgage-backed securities. The most famous of these hedge fund managers was John Paulson, who would wind up making $4 billion in 2007 betting against subprime mortgages. He was hardly the only one, though. Michael Burry, a hedge fund manager in California, had become convinced after digging through mountains of paper and actually looking at the underlying loans that the housing market was going to crack. As early as the spring of 2005, he began to enter into trades with Wall Street firms in which he took a short position.

Greg Lippman at Deutsche Bank was one of the few traders operating inside the CDO machine who openly turned against subprime mortgages; indeed, his growing negative view was part of his incentive for getting involved in creating tradable credit default swaps in the first place. Having been, he later said, “balls long in 2005,” he did an about-face when he saw a chart showing that people whose homes had appreciated only slightly were far more likely to default than those whose homes had risen by double digits. Everyone had always thought that unemployment caused mortgage defaults. Lippman realized that the world had changed—now all you’d need was a slowdown in the rate in home appreciation. Lippman would later say that it “takes a certain kind of person to acknowledge that what they spent a lifetime toiling away at doesn’t work anymore.” In the classic fashion of the convert, Lippman became Wall Street’s most enthusiastic salesman for shorting subprime mortgages, making presentations to anyone who would listen. An exuberant, crude man, he had T-shirts made up that read, “I’m short your house.”

Another skeptic was Andrew Redleaf, who ran a big hedge fund in Minneapolis called Whitebox Advisors. His hedge fund traded primarily in what he liked to call “stressed” bonds. (“If a distressed bond has an 80 to 90 percent chance of default, a stressed bond has a 50 percent chance of default,” he explained.) Shaky mortgage bonds were right in his wheelhouse.

A brilliant mathematics student at Yale, Redleaf became an options trader who searched for anomalies between the prices of two different but related
securities. By taking advantage of those anomalies, he made money. From a standing start in 1999, Redleaf built Whitebox into a $4 billion hedge fund.

An advocate of the new field of behavioral economics, Redleaf believed that markets were not always rational, that models were not always right, and that Wall Street’s blind adherence to both gave him plenty of opportunity to make money. To him, the mortgage market was as good an example of Wall Street’s shortsightedness as anything you could possibly find. After the crisis, he wrote a book with a Whitebox colleague, Richard Vigilante, entitled
Panic
, in which he spelled out his philosophy:

To Redleaf, the cause of the crisis was simple: Wall Street had “substituted elaborate, statistically based insurance schemes that, with the aid of efficient financial markets, were assumed to make old-fashioned credit analysis and human judgment irrelevant.”

Redleaf’s subprime epiphany had come years before, when he listened to a presentation by a New Century executive at an investment conference. He was struck by the fact that 85 percent of New Century’s mortgages were cash-out refinancings. He asked the New Century executive about the default rate for the refinancings as opposed to mortgages that were used to purchase a new home. The man said he didn’t know, but speculated that they probably weren’t any different. This didn’t ring true to Redleaf, whose experience with corporate bonds suggested that defaults were much higher when the debt went to pay off insiders than when it went for general corporate purposes. Cash-out refis struck him as the homeowner’s version of paying off insiders.

Redleaf had another insight. Even back then, he could see that the business model so long touted by the subprime originators made no sense. The
companies were saying that they could grow market share, on the one hand, while still using underwriting standards that weeded out borrowers likely to default. “I’ve seen this movie before,” he said. “You can’t have tighter standards
and
grow share. You can’t even have
different
standards. In the end, you wind up lending money to people who can’t pay it back, and that isn’t a good business model for a public company.”

Still, Redleaf didn’t immediately act on his insight. “Seeing the New Century guys in 2002 just put the thought in the back of my head,” he said later. He knew it was early in the cycle, and “being early is often the same as being wrong.” Besides, there was no way to short the subprime market except by shorting the mortgage originators themselves, an unappealing prospect given how fast their stocks were climbing.

By 2006, though, the combination of the ABX index and the new credit default swap market made it possible to short subprime securitizations. Redleaf was ready to take the plunge. “We had negative feelings about New Century, about Ameriquest, about a few other lenders. We looked for securities with those mortgages.” He also looked for mortgage bonds that were heavily weighted toward cash-out refis. In the spring of 2006, he began “massively” buying credit default swaps on hundreds of millions of dollars worth of securitized subprime mortgages.

Redleaf and Vigilante would later write that their biggest fear was that the trade would quickly disappear. “The mortgage market was so obviously headed for trouble that by early 2006, when we started shorting mortgage-backed securities, we feared the fun would be over before we were fully invested,” they wrote in
Panic
. “We needn’t have worried,” they continued. “Rather than the trade vanishing too quickly, we repeatedly found ourselves scratching our heads in disbelief that we could short still more mortgage securities that were obviously going to blow up.” All year long, as the headlines blared about subprime originators running into trouble and with foreclosures rising, Redleaf added to his short position. Every time there was a big piece of news—like the New Century restatement—he expected Wall Street to come to its senses. It didn’t happen. On the contrary: the swaps were so cheap, it was clear Wall Street still didn’t understand the risks it was insuring. The big Wall Street firms continued to view the triple-A tranches as utterly safe; the new ABX index would show them trading at par—that is, 100 percent of their stated value—for at least another year.

After the crisis hit, and writers and journalists began to look back at what had happened in those critical years of 2006 and 2007, a conventional wisdom sprang up according to which only a tiny handful of people had had the insight to realize that subprime mortgages were kegs of dynamite ready to blow. But Redleaf believes that his insight was not nearly as unique as it’s been portrayed in such books as Michael Lewis’s
The Big Short
or Gregory Zuckerman’s
The Greatest Trade Ever
, which chronicles John Paulson’s massive bet against the housing market. By Redleaf’s count, there were maybe fifty or so hedge funds that would likely have considered this kind of trade. At least twenty of them, maybe more, were heavily short subprime bonds. “If you look at the disinterested smart players,” he says, “a lot got it.”

Indeed, the market took off. Credit default swaps “grew faster than even we predicted with more than $150B of structured product CDS outstanding at year end ’05 vs. $2B at year end ’04,” Goldman Sachs reported in a presentation in early 2006. But it didn’t take off because Wall Street firms wanted to be on the other side of the bets their smart hedge fund clients were taking. The reason it exploded had to do with one last little wrinkle Wall Street had dreamed up—the one that turned that keg of dynamite into the financial equivalent of a nuclear bomb: the synthetic CDO.

Long before anybody thought to use credit default swaps to short mortgage bonds, Street firms had taken to combining credit default swaps on a variety of corporate bonds and creating CDOs out of them. They were called synthetic CDOs because the CDOs didn’t contain “real” collateral; rather they were based on the performance of existing bonds held by someone else. In Street parlance, they “referenced” the real bonds. The gains and losses would be real enough, but the underlying collateral was at one remove. Unlike a cash CDO that held collateral, and in which all the investors were long and got their payments from the underlying corporate bonds, a synthetic CDO could work only if there were investors on both the long side and the short side of every tranche. To put it another way, each position required two counterparties. Those who were long got cash flows that mimicked those of the underlying bonds, while those who were short paid a fee for the swap protection (which created the cash flows), but got the right to a big payoff should enough companies default on their debt. As ever, the cash flows were carved into tranches that were rated all the way from triple-A to junk.