The Big Short: Inside the Doomsday Machine (28 page)

Morgan Stanley management, for its part, always feared that Hubler and his small team of traders might quit and create their own hedge fund. To keep them, they offered Hubler a special deal: his own proprietary trading group, with its own grandiose name: GPCG, or the Global Proprietary Credit Group. In his new arrangement, Hubler would keep for himself some of the profits this group generated. "The idea," says a member of the group, "was for us to go from making one billion dollars a year to two billion dollars a year, right away." The idea, also, was for Hubler and his small group of traders to keep for themselves a big chunk of the profits this group generated. As soon as feasible, Morgan Stanley promised, Hubler would be allowed to spin it off into a separate money management business, of which he'd own 50 percent. Among other things, this business would manage subprime-backed CDOs. They would compete, for instance, with Wing Chau's Harding Advisory.

The putative best and brightest on Morgan Stanley's bond trading floor lobbied to join him. "It was supposed to be the elite of the elite," said one of the traders. "Howie took all the smartest people with him." The chosen few moved to a separate floor in Morgan Stanley's midtown Manhattan office, eight floors above their old trading desks. There they erected new walls around themselves, to create at least the illusion that Morgan Stanley had no conflict of interest. The traders back down on the second floor would buy and sell from customers and not pass any information about their dealings to Hubler and his group on the tenth floor. Tony Tufariello, the head of Morgan Stanley's global bond trading and thus in theory Howie Hubler's boss, was so conflicted that he built himself an office inside Howie's group, and bounced back and forth between the second floor and the tenth.
*
Howie Hubler didn't want only people. He wanted, badly, to take with him his group's trading positions. Their details were complicated enough that one of Morgan Stanley's own subprime mortgage bond traders said, "I don't think any of the people above Howie fully understood the trade he had on." But their gist was simple: Hubler and his group had made a massive bet that subprime loans would go bad. The crown jewel of their elaborate trading positions was still the $2 billion in bespoke credit default swaps Hubler felt certain would one day very soon yield $2 billion in pure profits. The pools of mortgage loans were just about to experience their first losses, and the moment they did, Hubler would be paid in full.

There was, however, a niggling problem: The running premiums on these insurance contracts ate into the short-term returns of Howie's group. "The group was supposed to make two billion dollars a year," said one member. "And we had this credit default swap position that was costing us two hundred million dollars." To offset the running cost, Hubler decided to sell some credit default swaps on triple-A-rated subprime CDOs, and take in some premiums of his own.
*
The problem was that the premiums on the supposedly far less risky triple-A-rated CDOs were only one-tenth of the premiums on the triple-Bs, and so to take in the same amount of money as he was paying out, he'd need to sell credit default swaps in roughly ten times the amount he already owned. He and his traders did this quickly, and apparently without a great deal of discussion, in half a dozen or so massive trades, with Goldman Sachs and Deutsche Bank and a few others.

By the end of January 2007, when the entire subprime mortgage bond industry headed to Las Vegas to celebrate itself, Howie Hubler had sold credit default swaps on roughly 16 billion dollars' worth of triple-A tranches of CDOs. Never had there been such a clear expression of the delusion of the elite Wall Street bond trader and, by extension, the entire subprime mortgage bond market: Between September 2006 and January 2007, the highest-status bond trader inside Morgan Stanley had, for all practical purposes, purchased $16 billion in triple-A-rated CDOs, composed entirely of triple-B-rated subprime mortgage bonds, which became valueless when the underlying pools of subprime loans experienced losses of roughly 8 percent. In effect, Howie Hubler was betting that some of the triple-B-rated subprime bonds would go bad, but not all of them. He was smart enough to be cynical about his market but not smart enough to realize how cynical he needed to be.

Inside Morgan Stanley, there was apparently never much question whether the company's elite risk takers should be allowed to buy $16 billion in subprime mortgage bonds. Howie Hubler's proprietary trading group was of course required to supply information about its trades to both upper management and risk management, but the information the traders supplied disguised the nature of their risk. The $16 billion in subprime risk Hubler had taken on showed up in Morgan Stanley's risk reports inside a bucket marked "triple A"--which is to say, they might as well have been U.S. Treasury bonds. They showed up again in a calculation known as value at risk (VaR). The tool most commonly used by Wall Street management to figure out what their traders had just done, VaR measured only the degree to which a given stock or bond had jumped around in the past, with the recent movements receiving a greater emphasis than movements in the more distant past. Having never fluctuated much in value, triple-A-rated subprime-backed CDOs registered on Morgan Stanley's internal reports as virtually riskless. In March 2007 Hubler's traders prepared a presentation, delivered by Hubler's bosses to Morgan Stanley's board of directors, that boasted of their "great structural position" in the subprime mortgage market. No one asked the obvious question: What happens to the great structural position if subprime mortgage borrowers begin to default in greater than expected numbers?

Howie Hubler was taking a huge risk, even if he failed to communicate it or, perhaps, understand it. He'd laid a massive bet on very nearly the same CDO tranches that Cornwall Capital had bet against, composed of nearly the same subprime bonds that FrontPoint Partners and Scion Capital had bet against. For more than twenty years, the bond market's complexity had helped the Wall Street bond trader to deceive the Wall Street customer. It was now leading the bond trader to deceive himself.

At issue was how highly correlated the prices of various subprime mortgage bonds inside a CDO might be. Possible answers ranged from zero percent (their prices had nothing to do with each other) to 100 percent (their prices moved in lockstep with each other). Moody's and Standard & Poor's judged the pools of triple-B-rated bonds to have a correlation of around 30 percent, which did not mean anything like what it sounds. It does not mean, for example, that if one bond goes bad, there is a 30 percent chance that the others will go bad too. It means that if one bond goes bad, the others experience very little decline at all.

The pretense that these loans were not all essentially the same, doomed to default en masse the moment house prices stopped rising, had justified the decisions by Moody's and S&P to bestow triple-A ratings on roughly 80 percent of every CDO. (And made the entire CDO business possible.) It also justified Howie Hubler's decision to buy 16 billion dollars' worth of them. Morgan Stanley had done as much as any Wall Street firm to persuade the rating agencies to treat consumer loans as they treated corporate ones--as assets whose risks could be dramatically reduced if bundled together. The people who had done the persuading saw it as a sales job: They knew there was a difference between corporate and consumer loans that the rating agencies had failed to grapple with. The difference was that there was very little history to work with in the subprime mortgage bond market, and no history at all of a collapsing national real estate market. Morgan Stanley's elite bond traders did not spend a lot of time worrying about this. Howie Hubler trusted the ratings.

The Wall Street bond traders on the other end of the phone from Howie Hubler came away with the impression that he considered these bets entirely risk-free. He'd collect a tiny bit of interest...for nothing. He wasn't alone in this belief, of course. Hubler and a trader at Merrill Lynch argued back and forth about a possible purchase by Morgan Stanley, from Merrill Lynch, of $2 billion in triple-A CDOs. Hubler wanted Merrill Lynch to pay him 28 basis points (0.28 percent) over the risk-free rate, while Merrill Lynch only wanted to pay 24. On a $2 billion trade--a trade that would, in the end, have transferred a $2
billion
loss from Merrill Lynch to Morgan Stanley--the two traders were arguing over interest payments amounting to $800,000 a year. Over that sum the deal fell apart. Hubler had the same nit-picking argument with Deutsche Bank, with a difference. Inside Deutsche Bank, Greg Lippmann was now hollering at the top of his lungs that these triple-A CDOs could one day be worth zero. Deutsche Bank's CDO machine paid Hubler the 28 basis points he craved and, in December 2006 and January 2007, cut two deals, of $2 billion each. "When we did the trades, the whole time we were both like, 'We both know there is no risk in these things,'" said the Deutsche Bank CDO executive who dealt with Hubler.

In the
murky and curious period from early February to June 2007, the subprime mortgage market resembled a giant helium balloon, bound to earth by a dozen or so big Wall Street firms. Each firm held its rope; one by one, they realized that no matter how strongly they pulled, the balloon would eventually lift them off their feet. In June, one by one, they silently released their grip. By edict of CEO Jamie Dimon, J.P. Morgan had abandoned the market by the late fall of 2006. Deutsche Bank, because of Lippmann, had always held on tenuously. Goldman Sachs was next, and did not merely let go, but turned and made a big bet against the subprime market--further accelerating the balloon's fatal ascent.
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When its subprime hedge funds crashed in June, Bear Stearns was forcibly severed from its line--and the balloon drifted farther from the ground.

Not long before that, in April 2007, Howie Hubler, perhaps having misgivings about the size of his gamble, had struck a deal with the guy who ran the doomed Bear Stearns hedge funds, Ralph Cioffi. On April 2, the nation's largest subprime mortgage lender, New Century, was swamped by defaults and filed for bankruptcy. Morgan Stanley would sell Cioffi $6 billion of his $16 billion in triple-A CDOs. The price had fallen a bit--Cioffi demanded a yield of 40 basis points (0.40 percent) over the risk-free rate. Hubler conferred with Morgan Stanley's president, Zoe Cruz; together they decided that they'd rather keep the subprime risk than realize a loss that amounted to a few tens of millions of dollars. It was a decision that wound up costing Morgan Stanley nearly $6 billion, and yet Morgan Stanley's CEO, John Mack, never got involved. "Mack never came and talked to Howie," says one of Hubler's closest associates. "The entire time, Howie never had a single sit-down with Mack."
*

By May 2007, however, there was a growing dispute between Howie Hubler and Morgan Stanley. Amazingly, it had nothing to do with the wisdom of owning $16 billion in complex securities whose value ultimately turned on the ability of a Las Vegas stripper with five investment properties, or a Mexican strawberry picker with a single $750,000 home, to make rapidly rising interest payments. The dispute was over Morgan Stanley's failure to deliver on its promise to spin Hubler's proprietary trading group off into its own money management firm, of which he would own 50 percent. Outraged by Morgan Stanley's foot-dragging, Howie Hubler threatened to quit. To keep him, Morgan Stanley promised to pay him, and his traders, an even bigger chunk of GPCG's profits. In 2006, Hubler had been paid $25 million; in 2007, it was understood, he would make far more.

A month after Hubler and his traders improved the terms of trade between themselves and their employer, Morgan Stanley finally asked the uncomfortable question: What happened to their massive subprime mortgage market bet if lower-middle-class Americans defaulted in greater than expected numbers? How did the bet perform, for instance, using the assumption of losses generated by the most pessimistic Wall Street analyst? Up to that point, Hubler's bet had been "stress tested" for scenarios in which subprime pools experienced losses of 6 percent, the highest losses from recent history. Now Hubler's traders were asked to imagine what would become of their bet if losses reached 10 percent. The demand came directly from Morgan Stanley's chief risk officer, Tom Daula, and Hubler and his traders were angered and disturbed that he would issue it. "It was more than a little weird," says one of them. "There was a lot of angst about it. It was sort of viewed as, These folks don't know what they're talking about. If losses go to ten percent there will be, like, a million homeless people." (Losses in the pools Hubler's group had bet on would eventually reach 40 percent.) As a senior Morgan Stanley executive outside Hubler's group put it, "They didn't want to show you the results. They kept saying,
That state of the world can't happen.
"

It took Hubler's traders ten days to produce the result they really didn't want to show anyone: Losses of 10 percent turned their complicated bet in subprime mortgages from a projected profit of $1 billion into a projected loss of $2.7 billion. As one senior Morgan Stanley executive put it, "The risk officers came back from the stress test looking very upset." Hubler and his traders tried to calm him down. Relax, they said, those kinds of losses will never happen.

The risk department had trouble relaxing, however. To them it seemed as if Hubler and his traders didn't fully understand their own gamble. Hubler kept saying he was betting against the subprime bond market. But if so, why did he lose billions if it collapsed? As one senior Morgan Stanley risk manager put it, "It's one thing to bet on red or black and know that you are betting on red or black. It's another to bet on a form of red and not to know it."

In early
July, Morgan Stanley received its first wake-up call. It came from Greg Lippmann and his bosses at Deutsche Bank, who, in a conference call, told Howie Hubler and his bosses that the $4 billion in credit default swaps Hubler had sold Deutsche Bank's CDO desk six months earlier had moved in Deutsche Bank's favor. Could Morgan Stanley please wire $1.2 billion to Deutsche Bank by the end of the day? Or, as Lippmann actually put it--according to someone who heard the exchange--
Dude, you owe us one point two billion
.