The Greatest Trade Ever (13 page)

He read that PMI Group, one of the largest insurers of home mortgages and a stock that had become quite popular, had moved beyond its traditional business of writing insurance for individual mortgages to now insure mortgage-backed securities, or MBS. The world of MBS and other complex-bond investments seemed to exist in another galaxy from Burry’s easy-to-follow stocks, but he decided to try to understand them.

Banks and other lenders who made home loans didn’t usually hold on to them anymore, Burry realized. Instead, 80 percent of home mortgages were sold to Wall Street firms and large companies, like Fannie Mae and Freddie Mac, soon after the closing on a home. These players pooled a hundred or so home mortgages, and used the stream of cash from the monthly principal and interest payments of the loans to back bond investments called mortgage-backed securities that were sold to investors around the globe. Burry also learned about the various slices, or tranches, of mortgage-backed securities, and how each carried a different yield and risk profile.

To PMI’s executives, insuring against missed payments from these MBS slices seemed like a natural extension of their traditional business. But Burry couldn’t help wonder whether PMI might be hurt if real estate slowed and borrowers ran into problems, something that could send the value of all those mortgage bonds falling. Remembering his experience with WorldCom, he picked up the phone to dial Veronica Grinstein, his broker at Deutsche Bank, at her office in New York.

“You guys trade credit derivatives, don’t you?” Burry asked her. “How do I get started trading?”

Over the next few months, Burry purchased credit-default swaps protecting $800 million of bonds issued by a range of financial companies, including PMI and other mortgage insurers, as well as housing-related institutions like Fannie Mae. If the debt went bad, the value of his protection would soar in value, Burry figured; if it didn’t, he was out just the $6 million or so annual cost of the insurance. By the end of 2003, 20 percent of Scion’s portfolio was made up of these CDS contracts. He
kept buying more throughout 2004. Scion’s positions fell in value as housing strengthened throughout the year, but Burry offset the losses with gains from stocks in the rest of his portfolio, like McDonald’s.

By the spring of 2005, Burry was managing about $600 million of investor money. He had also agreed to payouts totaling about $100 million over the course of five years for CDS protection against $6.5 billion of debt issued by various financial companies. But his positions dropped further in value as housing climbed. Burry grumbled to his wife that the Fed chairman Greenspan had replaced the tech bubble with a housing bubble. The country, he complained, eventually would suffer.

“It’s just not right; it’s manipulation,” he insisted. His wife nodded patiently, already accustomed to her husband’s periodic rants.

Years earlier, during an e-mail discussion on his Web site about the origins of past real estate bubbles, an older reader warned Burry: “Watch the lenders, not the borrowers—borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint. When they lose it, watch out.”

So that’s where Burry looked next. Traditional lenders, such as Bank of America, J.P. Morgan Chase, and Countrywide, were being elbowed out of the mortgage business by upstart lenders with vaguely New Age names, including Ameriquest, Novastar, and New Century Financial.

Burry trolled the Internet for mortgage-lending Web sites; the terms were foreign but they seemed slightly ominous. “Interest-only loans” reminded Burry of a type of loan flogged in the 1920s by door-to-door mortgage salesmen and later sworn off by bankers because borrowers had problems making the payments. Burry did a Google search for terms such as
quick approval
and
no down payment
and was stunned by the number of hits he got. Burry found some borrowers were taking out loans that were bigger than the purchase price of homes they were buying. A fifth-grader with an allowance could qualify for some of the loans offered, it seemed.

Burry holed up in his office, hour after hour, wearing a T-shirt, surfer shorts and Birkenstocks, reading abstruse mortgage documents. Then he’d turn off the lights, close his eyes, and think.

Lenders have finally lost it
, he realized
. I have to take advantage of this
.

Burry’s wagers against various financial companies hadn’t worked so far. But maybe there was a way to bet against mortgages themselves. He called a trader, asking if he could buy CDS protection for pools of risky mortgages, rather than on companies in the mortgage business, as he had done so far. The bank might be able to write a CDS contract for him, the trader responded, but it would take time to work out the complicated language of the agreement. And it wasn’t the kind of thing Burry could sell to another investor.

No dice, Burry said. He was worried that if he entered into such a deal, he’d be stuck. If financial markets quaked and the bank suffered, it might not make good on its end of any contract with him.

Burry had another idea, though. He called Angela Chang, who had replaced Grinstein as his broker at Deutsche Bank. I want to be your first call when they standardize these things, he told her, making them easy to buy and sell. Wall Street loved to roll out new products—protection on toxic mortgages had to be their next trick, Burry concluded.

“It’s going to happen; you’ll be selling it eventually,” Burry said. “When this starts, call me right away. It’s going to be huge.”

Hanging up, Burry thought,
This will be my Soros trade
.

B
ACK IN NEW YORK
, Greg Lippmann, a trader at Deutsche Bank who had never quite fit in on Wall Street, was meeting with a few rivals to plot a change in the way debt was traded. He would set the groundwork for Burry and others to bet against housing, just as Burry had anticipated.

From the time he first arrived at Credit Suisse First Boston a decade earlier, Lippmann seemed out of place. He wore his hair a bit long and slicked back, as if he was an extra in the movie
Wall Street
. A strong chin further distinguished him. Lippmann favored European suits, and his shirts often were untucked and loose. Lippmann didn’t have even a fleeting interest in sports and couldn’t keep up with much of the banter on the trading desk. But he knew where to find the best sushi in the city
and eventually published an online guide to the best restaurants in New York, earning him the moniker of the “Robert Parker of raw fish.”
¹

On the trading desk, Lippmann had the confidence of a veteran, and he seemed not to care what his colleagues thought of him. He was so over the top and had so many affectations—such as pronouncing the word “tranche” with a soft
ch
, as if to remind colleagues that it was the French word for slice—that they grew to enjoy his company.

“He always struck me as a little odd,” recalls Craig Knutson, a colleague at First Boston. “But he was an easy guy to like. He wasn’t looking for others to accept his viewpoint or who he was—it was like he didn’t care.”

Lippmann traded the riskiest slices of securitized bond deals. These slices, at the bottom rung of deals, paid off big-time if the loans backing the debt paid off, but saw the first losses if they didn’t. This section of the market had such little activity that Lippmann was forced to get on the phone with a potential investor and wax poetic about the beauty of these obscure debt slices. Nearby, traders listened with appreciation, or some times rolled their eyes. Lippmann told them that he considered himself “more of an art dealer than a broker.”

In 2000, after Lippmann was hired by Deutsche Bank, he warned colleagues about the risks of mobile-home companies. He soon learned the dangers of challenging the market’s bullish consensus. When Lippmann offered lowball bids to purchase debt of these companies, making it clear how little he valued it, a senior salesman turned to him with a scowl, saying, “You’re making us look stupid.” Six months later, mobile-home debt collapsed in price.

Lippmann eventually rose to become a senior trader, running a group that dealt with mortgage-related bonds and other complicated debt investments. But he still couldn’t bring himself to conform. Lippmann sometimes wore his sideburns unusually long and thick, ending in a point below the ear, Elvis Presley–like. At times, he wore bulky, pointed, brown dress shoes and a brown pinstriped suit, amid a sea of blue and beige at the trading desk.

By early 2005, Lippmann was thirty-six years old and impatient to
grow his firm’s lagging mortgage-bond business. But he ran into an issue frustrating others in the market: There just weren’t enough mortgages to go around. Thousands of investors all over the globe were eager to buy slices of mortgage bonds backed by risky loans because they carried such high interest rates. For all its growth, though, the subprime-mortgage market couldn’t keep up with the investor demand.

Lippmann’s radical thought was,
What if an investment could be created to mimic the existing mortgages? That way, new mortgages wouldn’t have to be created to satisfy hungry investors; rather, a “synthetic” mortgage could be sold to them
.

In February, Lippmann called traders from Bear Stearns, Goldman Sachs, and a few other firms struggling with the same issues, inviting them, along with a battalion of lawyers, to a conference room at Deutsche. Sitting around a blond-wood conference table, they debated ideas into the night, while picking at take-out Chinese food. Their light-bulb idea: Create a standardized, easily traded CDS contract to insure mortgage-backed securities made up of subprime loans. Yes, they’d be signed contracts between two parties, rather than a loan. But since they were contracts that insured all those aggressive mortgages, they would smell, touch, and feel like the mortgages themselves, rising when they looked safer and falling as borrowers ran into problems.

“We called up the guys we felt like we knew and could work with,” Lippmann told a reporter. “It’s not very glamorous.… Just a bunch of guys eating Chinese discussing legal arcana.”

The discussions went back and forth for months; other banks soon demanded to be part of the conversations. By June, the group had introduced a new, standardized credit-default contract that would adjust in price as the underlying mortgages became more or less valuable. A buyer of a CDS contract protecting $1 million of risky debt would pay annual premiums to the seller of the contract. If the debt became worthless, the seller of the protection would hand over $1 million to the buyer. Buyers of the CDS protection would be paid in cash by those selling the insurance when something happened to affect the cash flows of the bonds underlying the CDS, something they called pay-as-you-go. Those bullish on subprime mortgages would sell the insurance and pocket
cash, while bears might buy it. And because the language of the contracts was standardized, they could easily be traded, like any other bond.

Just as bettors on the Super Bowl enter an array of wagers on a single game, such as which team will score first and how many points will be racked up at the end of each quarter, to multiply the bets on the game, Lippmann and his colleagues had invented derivative instruments to multiply the wagers on a single, finite pool of home mortgages. The credit-default swaps were tied to actual mortgages—but the number of insurance bets on subprime loans now was essentially unlimited. Finally, Burry and other housing skeptics had a way to short the market, while those who were bullish, such as insurance giant AIG, could make extra money by selling the insurance, confident they would never have to pay out any claims. Their actuaries produced sophisticated models that showed the chances of a housing meltdown were minimal.

With a feat of financial and legal engineering, the subprime mortgage market had effectively grown by leaps and bounds, a fact that would come back to haunt both Wall Street and global economies. In the months ahead, the bankers created similar insurance contracts for securities backed by loans for commercial buildings and collateralized debt obligations. They’d even create a CDS insurance contract for an index that tracked a group of subprime mortgages, called the ABX, a sort of a Dow Jones Industrial Average for risky home mortgages.

Lippmann and the other bankers had no idea of the impact their change would have on Wall Street, banks, and the entire global economy. They just wanted another product to sell to their clients.

In fact, when the trading of CDS on subprime mortgage–backed securities began, Lippmann’s first move was to
sell
protection on about $400 million of subprime mortgages to a hedge fund. He was oblivious to any looming problems for housing.

M
ICHAEL BURRY
was taking his four-year-old son to an ophthalmologist in nearby Sunnyvale for a checkup when he received a call on his cell phone from his broker, Angela Chang. He stepped outside the waiting room to the nearby parking lot to take it.

“Okay, Mike, we’re ready to sell that protection you asked about,” she told him. Lippmann and the other bankers had just finished the paperwork on the “synthetic” CDS and were offering them to clients.

Burry could hardly contain his excitement. Pacing the length of the parking lot, Burry listened as Chang described details of the investment. Deutsche would sell him CDS protection for six slices of mortgage-backed securities backed by the iffiest subprime mortgages, each with a $10 million face value. The bank had lined up a European pension fund that was bullish on housing and willing to sell the protection and pocket some cash to juice its returns. Deutsche would act as the middleman. The slices of the mortgage securities were rated BBB, or one notch above the “junk bond” category, the lowest level of so-called investment-grade bonds. That seemed safe enough to the pension plan.

Burry’s cost to buy CDS protection for each of the six slices would be about 155 basis points above the London Interbank Lending Rate, or about $155,000 annually—just under $1 million for all six, Chang said. Do you want it?