The Greatest Trade Ever (25 page)

The growing toll the trade placed on Burry seeped into an unusually frank letter that he sent his clients at the end of 2006: “A money manager does not go from being a near nobody to being nearly universally applauded to being nearly universally vilified without some effect.”

G
REG LIPPMANN
had convinced his bosses at Deutsche Bank to let him buy protection on about $1 billion of subprime mortgages. But as the trade stalled in the summer of 2006, the Deutsche Bank executives became impatient, expressing doubts about his tactics. They seemed tempted to close Lippmann’s trade.

“Just give me four years,” Lippmann asked Rajeev Misra, his boss. Most subprime borrowers refinanced their mortgage loans after just a few years, Lippmann reminded him, so his trade surely would be over by then. “Give it a chance to work.”

“Show me the research,” Misra responded.

When he did so, Lippmann’s bosses reluctantly gave him a green light to continue with the trade. The regular payments he was making for all the CDS insurance were slowly adding up, so those above him at the bank weren’t thrilled. Yet for all his bluster and self-confidence, Lippmann wasn’t prepared to quit Deutsche and go off on his own. Instead, he had to figure out a way to keep his trade alive and hold on to his job.

Lippmann managed a group that placed bond trades for investors. He realized that if he could convince enough investors to do the same trade he was undertaking, he might be able to rack up sufficient commissions to offset the costs of his bearish housing trade and placate his bosses. And if new investors could be convinced to buy the same CDS contracts that he owned, the price of these investments was bound to climb, which also would help Lippmann.

He traveled uptown to the offices of a hedge fund called Wesley Capital to meet two senior executives, to try to sell them on the idea. At first, they seemed impressed. Then they asked a friend who happened to be in the office, Larry Bernstein, who once managed a powerhouse bond-trading team at Wall Street firm Salomon Brothers, to weigh in on the trade.

Bernstein was dubious. “Coase Law says you’ll be wrong,” he said, dismissively.

The executives looked at each other. Lippmann had no clue what Bernstein was talking about. Neither did the Wesley executives. Coase Law turned out to be an economic theorem—but it didn’t seem to have much to do with the trade. Then the meeting turned contentious. If problems arose, Bernstein argued, the government likely would step in to bail out troubled borrowers. Even if you’re right and the price of the mortgage protection rises, when investors began to sell their insurance, the price would be pushed down, sinking the trade, Bernstein said.

Ultimately Lippmann walked out with nothing.

Jeremy Grantham’s GMO LLC seemed like a certain client. The Boston money-management firm had been cautious about the market for years, and Grantham was among the most vocal doomsayers, writing downbeat op-ed columns for various newspapers warning of “a sensational bust.”

But when GMO executives consulted their resident bond expert, Allen Barlient, he shot down the idea, arguing that most mortgage deals had so much protection that they likely would be fine.

Some investors he met with leveled abuse at Lippmann. “My brother works for Fidelity and he’s buying this stuff,” one said, referring to subprime-related investments. “You’re either an idiot or a liar” trying to wring trading commissions.

Behind his back, some on Wall Street called Lippmann names, such as “Chicken Little” or “Bubble Boy,” chuckling at his quixotic effort. At conferences, some traders teased him, saying “Your crazy trade is losing money.” Others repeated an industry maxim: “A rolling loan gathers no moss.”

Lippmann began avoiding investors with deep knowledge of mortgages or complex bond investments. They understood his maneuver but were lost causes, wed to their markets and reliant on sophisticated models that suggested everything would be fine. Instead, Lippmann asked salesmen at his bank who catered to investors in the stock, junk-bond, and emerging markets worlds if they would help arrange meetings for clients with a potential interest in his idea.

He sometimes stumbled onto tough questions—why were the rates of mortgage delinquencies so different in North Dakota and South Dakota?

“You’re missing it, you have to take a look at employment,” an investor said.

Lippmann was stumped. North and South Dakota sure seemed the same; the fact was that Lippmann didn’t know why the rate of delinquencies was so different. He had never even visited those states. So he and Xu went back to the data. Sure enough, the two states had similar levels of employment and seemed alike in other ways, but home prices
were rising much more rapidly in North Dakota, explaining why delinquencies were lower. It confirmed that the biggest factor on default rates was whether or not houses were rising in value. It made Lippmann more certain than ever of his thesis.

Slowly, he began to win converts. A number of investors signed up in London, eager to profit from a U.S. economy they viewed as fragile. It took less than an hour for Lippmann to convince Phil Falcone, a hedge-fund manager in New York, who seized on the limited downside and huge potential windfall of the trade. Falcone didn’t even ask about the technical aspects of the mortgage market. The next day, he called Lippmann’s team to buy insurance on $600 million of subprime mortgages. Later he made even more purchases.

By September, Lippmann had pitched the trade more than a hundred times and had his spiel down pat.

Lippmann won over dozens of investors, and CDS contracts began to fly out the door of Deutsche’s Lower Manhattan office, $1 billion of protection a day. One investor even made a T-shirt that he gave to Lippmann and others saying “I shorted your house,” a joke that seemed amusing at the time.

“What Lippmann did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” says Steve Eisman, a hedge-fund manager. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ ”
²

A few hedge funds were such eager converts that they became as evangelical as Lippmann after doing their own research.

“You better get up to speed on the mortgage market … fast,” Alan Fournier, founder of New Jersey hedge fund Pennant Capital, wrote to a journalist in an e-mail in the summer of 2006. “All these crappy loans have been gobbled up by investors and they’re gonna get burned … the credit unwind is really just getting started.”

In all, Lippmann bought insurance on $35 billion of subprime mortgages, keeping about $5 billion of CDS protection for his own firm’s account while selling the rest to eighty or so hedge-fund investors. A few others who already had placed the trade, like John Paulson, compared notes with Lippmann, shared intelligence, and then did some buying
through Deutsche. The growing commissions enabled Lippmann to buy even more subprime insurance for his own account.

Nonetheless, by the end of 2006, most of Lippmann’s clients had lost money on the trade. He shared with a friend that his career would be affected if his scheme didn’t work out. Within his bank, Lippmann had become an object of derision. When Paulson’s trader, Brad Rosenberg, called to ask for him, a salesman answering the phone let out a loud laugh: “Why do you want to talk to him? That guy’s crazy!”

Others at Deutsche Bank resented Lippmann. Yes, he was generating commissions, but his trade also was costing the bank about $50 million a year, reducing the firm’s bonus pool, some traders grumbled.

B
Y LATE 2006
, housing prices finally had leveled off. Subprime lenders, including Ownit Mortgage Solutions and Sebring Capital, had begun to fail. John Paulson, Lippmann, Greene, and Burry should have been making oodles of money. But their positions barely nudged higher.

Late one afternoon, following another day of lackluster gains, Paulson picked up the phone to dial Lippmann, his subprime consigliere. To his investors and employees, Paulson showed absolute faith that the protection his firm owned on $25 billion of subprime mortgages would pay off.

With Lippmann, though, he could share his fears.

“Is there something I’m missing?” Paulson asked Lippmann. “Don’t these people realize this stuff is crap? This is absurd!”

Paulson sounded like he might be wavering, surprising Lippmann.

“Relax, John. The trade will work.”

Lippmann remained cocky because he was on the trading floor, buying and selling mortgage protection all day long. He knew better than almost anyone who the mysterious investors were on the other side of all the trades, a group so eager to sell insurance on all of those risky mortgages. And he knew their time would come to an end.

A
SIMPLE, THREE-LETTERED ACRONYM EXPLAINED WHY PAULSON
, Lippmann, Greene, and Burry weren’t making much money in late 2006, even though housing was stalling out and home owners were running into problems: CDO.

A 1980s invention of some of the brightest financial minds, collateralized debt obligations, or CDOs, were investment vehicles that seemed to make the world a safer place—that is, until they fell into the wrong hands, not unlike other weapons of mass destruction.

Mortgage-backed bonds gave investors a claim on the cash flow of a group of mortgage loans; CDOs took it one step further. They were claims on giant pools of all kinds of debt that could include slices of loan and bond payments made by companies and municipalities, and even monthly payments by those leasing aircraft, cars, and mobile homes.

Investors were sold a set of securities with claims on all that flow of cash, each bearing a different degree of risk, like any securitization. The riskiest pieces of a CDO paid investors the highest returns but were first in line to suffer if the CDO received slimmer cash payments than it expected. Pieces with lower risk had lower returns but received the first income payments.

By the middle of the 2000s, the financial engineers were convinced that securitizations had spread the risk of all those loans, all but eliminating the chance of any big economic disaster. So they went back to the laboratory and concocted something called a mortgage CDO, featuring claims on a hundred or so mortgage-backed bonds, each of which in turn was a claim on thousands of individual mortgages.

The investments proved popular but their returns left something to be desired, spurring the bankers to craft CDOs that used the seemingly plentiful cash flow from slices of mortgage bonds rated BBB– and BBB—the ones backed by loans to borrowers with sketchy or limited credit histories—along with a sprinkling of other mortgages and loans. This investment was named a “mezzanine” CDO, after those dangerous BBB tranches.

The new CDO investments were an instant hit because they had juicy returns, thanks to all those high-interest subprime mortgages. Some slices promised annual returns of nearly 10 percent. Just as important, rating companies were convinced that most of the pieces of these CDOs should receive sky-high AAA ratings, or close to it, even though they simply were claims on huge stacks of risky home loans. The bankers argued that more cash was coming into the CDO than it needed to pay out, and that the mortgages came from all over the country and from more than one mortgage lender, making them safe. They had taken the straw of the mortgage market and spun gold: It was modern-day alchemy.

Lending by these CDOs powered the real estate market, ushering in the music, wine, and women chapter of the housing surge. In 2006, about $560 billion of CDOs were sold, including those using the cash flows from risky mortgages, almost three times 2004’s levels. The “CDO system” had replaced the banking system, in the words of writer James Grant.

Few were as good at concocting CDOs as Chris Ricciardi. Growing up in affluent Westchester County, north of New York City, the son of a stock salesman, Ricciardi tagged along with his father to the floors of Wall Street firms and the New York Stock Exchange, captivated by the fast pace and huge sums of money changing hands.

Ricciardi couldn’t find a job as a stock trader or an investment banker when he graduated during the economic slump of the early 1990s, so he started trading mortgage bonds. A few years later, as Wall Street pushed for ways to drum up higher fees and investors searched for better returns, Ricciardi was among the first to bundle the monthly payments from groups of dicey home mortgages with other debt to back securities with especially high interest rates.

Other bankers came up with their own CDOs but Ricciardi stayed a step ahead. As he moved from Prudential Securities to Credit Suisse Group, his groups always towered over competitors, as Ricciardi pushed his staff to churn out still more CDOs. Lured in 2003 to Merrill Lynch, a firm eager to take more risks under then-chief Stanley O’Neal, Ricciardi pushed Merrill to first place in the business, vaulting over bond powerhouse Lehman Brothers. New Century and others who made risky loans knew that Merrill Lynch was eager for their product so it could sell more CDOs—the more the better.

Soon Merrill was the Wal-Mart of the business, producing CDOs at a furious pace. By 2005, the firm underwrote $35 billion of CDO securities, of which $14 billion were backed mostly by securities tied to subprime mortgages.

Every quarter, Ricciardi taped rankings near Merrill’s trading desk, highlighting in yellow the firm’s top-place finish. Staff members were pushed to grow sales by 15 percent a year. They hopped the globe to Australia, Austria, Korea, and France, selling CDOs to pension funds, insurance companies, and other investors. Back in the United States, they pitched hedge-fund investors such as Ralph Cioffi of Bear Stearns on the manicured lawns of the Sleepy Hollow Country Club in West chester, New York, the ski slopes of Jackson Hole, Wyoming, and elsewhere.