All The Devils Are Here: Unmasking the Men Who Bankrupted the World (51 page)

By 2005, the hot new thing in the market was “correlation trading”: going long one tranche, maybe triple-A, while shorting another tranche, the triple-B, say. It was all driven by demand by investors for a particular slice of risk and models that purported to show what the spread, or the difference in price,
between various tranches “should” be. It also allowed firms to make these correlation trades with immense leverage, because their models told them that the trades balanced out and therefore carried little risk. Remember 2004, when the SEC allowed Wall Street firms to use their own models to calculate the amount of capital they had to hold? Here was the consequence of that decision: because the models for correlation trading said they were near riskless trades, the firms didn’t have to put much capital against those trades. It was like Long-Term Capital Management on steroids.

In the spring of 2005, a warning shot was fired about the dangers of this brave new world when the credit rating agencies unexpectedly downgraded the debt of General Motors and Ford. All the models went haywire; press reports speculated that some hedge funds—and some Wall Street banks—had lost huge sums. That May,
Investment Dealers’ Digest
ran an article entitled “The Synthetic CDO Shell Game: Could the Hottest Market in All of Fixed Income Be a Disaster in the Making?” It noted ominously that many players in the market weren’t capable of assessing the risks. Michael Gibson, the Federal Reserve’s chief of trading risk analysis, told the magazine, “What we are hearing from market participants is that there is a minority of CDO investors—perhaps 10 percent—who do not really understand what they are getting into.” Said an unnamed market participant: “I imagine the number is higher. It’s mind-boggling how much data you have to get a handle on to measure your exposure.” Risk expert Leslie Rahl explained, “[T]here could be a substantial difference between what a theoretical model tells you something is worth and where a buyer and seller are willing to transact.”

As usual, what should have been a wake-up call was ignored. Quickly, the synthetic CDO market in corporate bonds rebounded. And Wall Street took the next step: it began repackaging credit default swaps on mortgage-backed securities into synthetic CDOs. (Some of these synthetic CDOs only referenced mortgage-backed securities; others also included some actual mortgage-backed securities, or even other asset-backed securities, such as commercial mortgages, credit card debt, student loans, and so on.) Not only did this up the ante in complexity, but it also upped the amount of leverage at work. A corporate credit default swap had its share of leverage, but at least the underlying instrument was an obligation of a real company. More often than not, the underlying instrument being referenced in these new synthetic CDOs was a 100 percent loan-to-value mortgage made to a homeowner who probably couldn’t pay.

And yet the appeal was overpowering. There was so much demand for
these securities that no matter how fast the originators made mortgages, it wasn’t fast enough. In 2005, Lars Norell, who worked with Chris Ricciardi at Merrill Lynch, told U.S. Credit, “In ABS [asset-backed securities], the availability of assets has been a sticking point. There’s a finite amount of them issued.” He pointed out that after subprime mortgages were crafted into residential mortgage-backed securities, there was only about $10 billion to $12 billion in the lowest-rated triple-B tranches. Since those were the tranches with the best yield, and therefore were the most attractive raw material for CDOs, it had the effect of putting a “natural cap,” as Norell put it, on CDO issuance. Plus, buying all the securities for a CDO could take up to six to nine months.

But with a synthetic CDO, it didn’t matter anymore if the originators could make new mortgages—or even if they went out of business entirely. Because synthetic CDOs made of credit default swaps referenced mortgage bonds that already existed, you didn’t need any more bonds. You could clone the same risky tranches again and again—five, ten, twenty times if you wanted. And you could do this quickly, without waiting around to buy real securities. Even if there wasn’t a single new mortgage bond created, the supply of securities was now infinite and immediate, thanks to credit default swaps and synthetic CDOs. But that also meant that as subprime mortgages continued to default—and those losses eventually began to erode the value of the CDOs—those losses were going to be greatly amplified because so many side bets had been made so quickly through the purchase of synthetic CDOs.

The gains were amplified, too, because synthetic CDOs are a zero-sum game: someone has to lose and someone has to win. Even after all the damage had been done, some would make the argument that there was nothing wrong with this. In a free market, shouldn’t all participants be able to “express their views”—a euphemism for placing a bet—on the direction of mortgage-backed securities? Maybe so. But if the ability to short a mortgage-backed security, and maybe even the construction of the index, brought a kind of transparency to the market, then the synthetic CDO took it away. That’s because the synthetic CDO allowed Wall Street to take all of Mike Burry’s and Andy Redleaf’s bets, and instead of holding the other side of those bets—or finding investors who actually wanted to be long a tranche of triple-B-rated mortgage-backed securities backed by New Century loans—it could instead reassemble those bets into triple-A-rated securities. (And, yes, the rating agencies put those triple-A ratings on large chunks of synthetic CDOs.)
That way, the other side of the bet wasn’t someone who had investigated the mortgage-backed security—like Burry and Redleaf did—and thought he was betting on its performance. It was someone who was buying a rating and thought he couldn’t lose money.

“Negative news on housing nags the market,” Burry wrote in an early 2006 letter to his investors. “Yet mortgage spreads in the cash market fell substantially.” What he meant by that was that the market was acting as if there was less risk instead of more. This development, Burry wrote, is “indicative of ramping synthetic CDO activity.”

“We’re not trying to outsmart the smart guys. We’re trying to sell bonds to the dumb guys.”

“This list [of potential buyers] may be a little skewed toward sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work … vs. buy-and-hold ratings buyers who we should be focused on a lot more to make incremental $$$ next year….”

On one level, the creation of synthetic CDOs was the apotheosis of the previous twenty-five years of modern finance. They were stuffed with risk, yet, thanks to the complex probabilistic risk models developed by Wall Street’s quants, large chunks of them were considered as safe as Treasury bonds. They were Wall Street’s version of a lab experiment gone mad. Unlike a corporate bond, backed by the assets of a corporation—or even a mortgage-backed security, backed by actual mortgages—they existed solely to make complex bets on securities that existed somewhere else in the system (which, as often as not, were themselves bets on securities that existed somewhere else in the
system). They had the imprimatur of the rating agencies, whose profits depended on stamping these complex bets with triple-A ratings. They massively increased leverage in the system. They were made possible by the invention of the credit derivative, the most glittering innovation in finance. And their raw material—the debt upon which everything else was built—was mortgages, quite often poorly underwritten subprime mortgages. The stew was now complete.

On another level, synthetic CDOs were a classic example of how things never really changed on Wall Street. The sellers of synthetic CDOs had a huge informational advantage over the buyers, just as bond sellers have historically had an advantage over bond buyers. Buying a synthetic CDO was like playing poker with an opponent who knew every card in your hand. Conflicts abounded. Those “buy-and-hold ratings-based investors,” as Tourre described them—or the “dumb guys,” to use Mike Vranos’s less polite words—weren’t necessarily less intelligent; they were simply less plugged in, and either unwilling or unable to do the analysis necessary to compensate for that. Stretching to get the extra yield that synthetic CDOs seemed to offer, lacking a clear understanding of what they were buying, they were the perfect willing dupes.

What’s remarkable, in hindsight, is that despite their many advantages, so many Wall Street firms, blinded by the rich fees and huge bonuses the CDO machine made possible, duped themselves as well. As one close observer says, “There was plenty of dumb smart money.” There was also some smart money that was genuinely smart.

Chief among the smart guys was Goldman Sachs. In the aftermath of the crisis, Goldman Sachs would be excoriated by the press and the public—and investigated by Congress, the SEC, and the Justice Department—for the way it used synthetic mortgage-backed securities to advance its own interests, often at the expense of its clients. There was something a tad unfair about this focus on Goldman; its mercenary behavior wasn’t all that unique. Goldman was simply more skilled than its peers in looking out for its own interests. The firm had no grand scheme to destroy Wall Street. Its executives had no idea how bad the destruction would be. Mainly, Goldman’s traders were just doing what they had always been taught to do:
Protect the firm at all costs.

Yet somehow it was inevitable that Goldman would land at the center of the storm. The modern Goldman attitude—that there was no conflict it couldn’t manage, no complex product too complex, and few trades the firm
should turn its back on—was bound to leave a bad taste in the mouths of people who were not part of Wall Street. Other members of the Wall Street tribe often resented Goldman for the way it ran roughshod over its clients and counterparties. But they accepted it. It was just “Goldman being Goldman.”

But for large swatches of the American public, many of whom lost their homes or jobs because of the financial crisis, Goldman’s behavior was deeply offensive. Taking advantage of clients to save its own skin—and then denying that that’s what it had done—was not the way companies were supposed to act. People were also offended as they realized that Goldman had played as big a role as the rest of Wall Street in blowing the bubble bigger. Yet unlike millions of subprime borrowers, it largely escaped the damage it helped create.

It was the mortgage market that definitively put the lie to Goldman’s famous, sanctimonious first business principle, the one John Whitehead had articulated three-plus decades earlier:
Our clients’ interests always come first
. They didn’t—and hadn’t for quite some time. As a 2007 training guide for the Goldman Sachs mortgage department noted, “However, this [the first business principle] is not always straightforward, as we are a market maker to multiple clients,” meaning that even when Goldman was servicing clients, it often had to choose which clients’ interests would come first. The presentation could have added that one of those clients, as often as not, was Goldman Sachs itself.

What Goldman never lost sight of was Dick Pratt’s old warning: the mortgage was the most dangerous financial product ever created. It’s what Goldman forgot that caused all its problems. It wasn’t just dealing with a financial product. It was dealing with people’s homes.

The Goldman Sachs mortgage department, which at its peak had some four hundred people, was, by its nature, conflict central. It underwrote mortgage-backed securities, which it sold to clients. It built CDOs that included its own mortgage-backed securities and those of others. It created synthetic CDOs, allowing clients to take either the long or short side of the bet. Sometimes Goldman itself was on the other side of a client bet. Most of the time, the client had no knowledge of Goldman’s position. It also actively traded all those instruments for its clients—and itself. Sometimes it bought or shorted mortgage-related securities because it couldn’t get the deal done without committing its own capital. Other times, it did so because it had its
own “view” about which way the securities were headed and it was trading for its own account. In any case, the line between client-related trading and proprietary trading was very blurry: if Goldman hedged a position that was a result of facilitating a client trade, did that count as a client trade or a proprietary trade?