The Greatest Trade Ever (28 page)

Lahde remained convinced that housing was set to crack. New Century and other lenders were starting to come under pressure because as interest rates rose, their borrowing costs were approaching those of the loans they were making to customers, crimping profits. It was a sure sign that their business couldn’t last.

His unpleasant experience at Dalton weighed on Lahde. As he gazed out his window at the beach next to his apartment, he was tempted to give up on the financial business, find a girl, and go on a long vacation. But Lahde figured that if he could set up a hedge fund of his own dedicated to wagering against real estate, the payoff could be huge.

“It was always going to be a two-year thing,” Lahde says. “I knew they couldn’t hold it together longer than that.”

He set up Lahde Capital in his 800-square-foot apartment, angling his chair to get a good view of the blue water glistening just a few hundred yards away. Some days the weather was so warm that Lahde took a break from his steamy apartment, which lacked central air-conditioning, to jump in the nearby Pacific Ocean.

All summer, the sun shone brightly outside the apartment while darkness grew within. Lahde was sure that housing was on its last legs, but he worried that all kinds of financial firms would be devastated by the fallout. The way he viewed it, he was about to get on a surfboard ahead of a tsunami. The wave would be huge but it could turn out at the last second, knocking him cold before he reached shore.

To avoid that, Lahde decided to buy only CDS protection on the ABX index of subprime residential mortgages, rather than on various MBS pools like other bearish investors. He figured the ABX was more actively traded and would be easier to exit on a dime when things surely crumbled.

In truth, Lahde didn’t really know much about the ins and outs of trading CDS contracts. At Dalton, he had focused on New Century and other lenders. Persky didn’t let him tackle the firm’s CDS moves. So
Lahde asked advice from the few traders he knew who were willing to spare him some time.

Lahde began to pitch potential investors on his two-year strategy of betting against risky mortgages, asking for minimum investments of $5 million, aiming to start with at least $100 million. But every meeting was another strikeout. No one was interested in Lahde or his bearish arguments. Pressure grew; Lahde felt he had only several weeks to place his trades before it all unraveled.

In a desperate moment, Lahde even tried Persky, who also turned him down. Lahde began leaving his tie and suit at home, wearing a polo shirt to meetings with investors, and adopting a jaded attitude; it was as if he had given up.

“Andrew’s not a perfect guy to persuade you to invest,” says Dr. Norman Zada, one of those who received a call from Lahde asking for an investment. Zada, founder of
Perfect 10
, an adult magazine featuring women willing to pose nude but unwilling to undertake cosmetic surgery, ignored Lahde’s entreaties for months before finally giving him some cash. “He’s a youngster and a little strange … and he seems sort of nervous around people.”

At first, Lahde couldn’t convince brokers to enter into ISDA (International Swaps and Derivatives Association) agreements with him and serve as counterparties to his new firm, making it impossible for Lahde to buy the CDS contracts he so coveted. The brokers said his firm was too small. Lahde didn’t even have much of his own money to invest, compounding matters. He was worth only about $150,000 and needed most of it to pay the firm’s bills, not to mention his own living expenses.

After weeks of frustration, Lahde sweet-talked brokers at Lehman Brothers and Bear Stearns into considering selling him CDS contracts, telling them that big money was on the way and soon he’d be managing $100 million or more. They were skeptical but began working on complicated trading agreements just in case the money came through.

By November, Lahde had managed to raise $2 million from a few investors, but he was exhausted from the chase, and it didn’t seem like he’d be able to turn up other investors. Holding his breath, he asked the Bear
Stearns and Lehman brokers if he could begin putting his trades on with the money he already had. He reminded them that his firm was sure to grow quickly and pointed out how much work they’d already done on the complex agreements. Why put it all to waste, Lahde argued.

He picked an opportune time to ask. By late 2006, Wall Street firms were squeezing every last drop from the housing market. After hemming and hawing, his contacts at Lehman Brothers and Bear Stearns agreed to sell him CDS contracts, as long as the paperwork was approved by their superiors. But they insisted that their credit departments approve Lahde before each trade he made, much like a parent insisting on accompanying a new driver.

One day in November, just after 5:30 a.m., the phone rang in Lahde’s bedroom, startling him. His broker at Lehman Brothers called to say the paperwork was complete and Lahde could begin trading. Not only that, but the CDS insurance contracts he wanted were so unpopular that Lahde actually would be paid an up-front fee if he agreed to pay regular premiums on this insurance for risky mortgages. Lahde fumbled with the phone in the dark, trying to make out the implications of the quote.

Do you want the trade, the broker asked?

“Do it,” Lahde responded, before he rolled over and went back to sleep.

Over the next few weeks, Lahde accumulated more protection on slices of the ABX index, ranging from those rated BBB– all the way up to AA, focusing on mortgages handed out during the first half of 2006, when the market was at its most exuberant.

But Lahde’s stress level was building as the new year approached. He’d hired an associate for his firm, legal bills were due, and Lahde was down to $100,000 of savings. Even after raising another $1.5 million and buying more CDS contracts, he owned protection on just $17 million of risky mortgages, a figure so puny by Wall Street’s standards that it was embarrassing. The trade of a lifetime was slipping through his fingers. Unless Lahde could quickly raise some serious money, he would have to shutter the firm and look for a job.

A friend called to level with Lahde: The brochures with the summary
of his investment thesis that he’d been sending out to prospective investors made him look like a rank amateur. Lahde had to concede the point.

A week before Christmas, Lahde sat down at his circular, glass desk, which doubled as his apartment’s dining-room table, to rework his marketing materials. He kept at it, writing and rewriting the presentation, again and again. He canceled Christmas plans. Pretend I’m in a submarine and out of touch, he told his mother. Lahde put in a series of all-nighters, including one on New Year’s Eve, finally finishing on January 7. The marketing materials now looked impressive. But he wasn’t sure he had enough time left to pull off his trade.

I
N LATE 2006
, Paulson stayed upbeat. He was waiting for his trade finally to begin to work. In November, he closed his fund, the Paulson Credit Opportunities Fund, to new investors. He had raised $700 million and spent it all on various mortgage protection. Paulson immediately launched a sister fund to make the same bets, even though his trade, though profitable, wasn’t clicking.

To let off stress, he spent hours swimming and sailing in Southampton, and playing tennis with his friend Tarrant, displaying a nasty serve. To keep his employees loose and upbeat, Paulson sometimes adopted a faux British accent, keeping the ruse going during an entire dinner with one client. Paulson started one meeting about the mortgage business with a spot-on imitation of a current television commercial:

“You just filed for bankruptcy? No job? No problem! No money down!”

For all his equanimity, however, his concern was growing. What if the subprime market really did collapse—who would be on the hook for the billions of insurance he was buying?

“We didn’t know who was selling it all to us,” recalls Rosenberg, who traded with investment banks, not directly with those who sold Paulson & Co. insurance. “But if the sellers got in trouble, it would hurt the investment banks.”

Concerns about the health of his brokers led Pellegrini to set up
separate accounts for the firm at various banks, and to settle positions with his trading partners on a daily basis.

Paulson’s outlook for the financial system became downright glum as a new advisor gained his ear. Paulson came across a newsletter published by an obscure economist in suburban New Jersey named A. Gary Shilling that predicted dour things for the economy. Paulson was so taken with the forecast that he asked Rosenberg to call Shilling and invite him to come by, to discuss his views. Shilling had spent more than a decade publishing a newsletter and periodic articles, usually with a single theme: The bad times were around the bend—sell everything! Most dismissed Shilling’s warnings, sometimes with a laugh. The end was never as near as Shilling predicted.

Paulson was a merger guy—he didn’t know Shilling was Wall Street’s version of the Boy Who Cried Wolf. When Shilling met with Paulson and predicted a collapse of home prices and a sharp rise in mortgages foreclosures, Paulson took notice.

Shilling, a septuagenarian with bushy eyebrows and a balding pate, favored bright-red pocket handkerchiefs in his blue blazers. He emphasized to Paulson’s team that the subprime market wasn’t a fringe area, but rather a key underpinning to the entire real estate market. When it went, so would housing, bringing down much more.

“Boy, if you’re right, the financial system will fall apart,” Paulson said to Shilling, after one more dire forecast to a room of Paulson’s analysts.

“Yes, John, it will.”

Shilling, who vividly recalled the tears in his father’s eyes during the Great Depression, predicted that housing prices would fall 37 percent.

“Do you really think it’s going to get that bad?” Paulson asked, after another dire forecast.

“As sure as you can be.”

Paulson began to focus on the linkages, and how troubles for subprime borrowers could topple housing, which might in turn bring down the financial system and the global economy.

This could really get bad. We need to broaden the trade
.

But even Paulson didn’t realize how quickly his prediction would come true.

P
AOLO PELLEGRINI RECEIVED AN URGENT PHONE CALL IN EARLY 2007
from a trader at a major bank eager to lend him a hand. The prices of some home-mortgage bonds had weakened a bit, helping Paulson & Co.’s positions. But the trader reminded Pellegrini that those same subprime investments had dropped in price in late 2005, before quickly snapping back. It could happen again, costing Paulson the small profits it had achieved from its trade, he warned.

“Why don’t you sell us back your positions so you can buy them back cheaper in March?” the trader advised Pellegrini.

Pellegrini was convinced his counterpart was trying to sow seeds of doubt. If Pellegrini followed his advice and exited positions, the trader might be able to get out of CDS insurance he had sold Paulson & Co. Or maybe he was trying to discourage Paulson from buying more protection, given the pressure it put on mortgage investments owned by the trader’s bank.

“I actually don’t know how much we have,” Pellegrini replied. “We may have sold already.”

Pellegrini was playing coy. He knew his boss was quietly raising the stakes of his bet, rather than cashing in his chips, putting to work money that was arriving daily from new investors. Paulson even had Rosenberg buy CDS insurance on mortgages with a high A rating—investments that others saw as relatively safe—not just BBB bonds.

To Paulson, it seemed obvious that housing was about to crack. Borrowers with spotty credit were running into trouble paying their loans. HSBC and others were dealing with problems, and subprime
lenders, worried they were running out of borrowers, dropped already-low underwriting standards to hand mortgages to those with even weaker credit.

Despite those concerns, investment banks were fighting with one another to acquire subprime lenders, as if they were picking over the last jewels of a treasure chest. In January 2007, Stanley O’Neal and Merrill Lynch proudly unveiled an agreement to pay $1.3 billion to buy First Franklin Financial, one of the largest subprime lenders; Merrill now had more than $11 billion of such loans, even though the firm’s own economists predicted a decline in housing prices of up to 5 percent. Morgan Stanley and Deutsche Bank, with billions of their own loans to borrowers with sketchy credit, also purchased subprime-lending companies.

Reading about it all on his Bloomberg computer terminal, Paulson shook his head, bewildered. He picked up the phone to speak with his old friend Howard Gurvitch.

“It just doesn’t make sense.… These are supposedly the smart people.”

But so far the prices of mortgage bonds hadn’t fallen very much and CDOs built on risky BBB-rated loans were barely moving, preventing Paulson from making much money.

When will the market catch on?
he thought.

Paulson was particularly aggravated by New Century Financial. The nation’s second-largest lender to borrowers with iffy credit was smashing earnings records and enjoying a climb in its share price, even as other subprime lenders reported growing problems. Some home buyers weren’t even making their first payments. Yet New Century claimed its performance was getting better. New Century executives explained that its underwriting was more thorough than its competitors’, allowing it to grab business as the rivals faltered.

Paulson wasn’t buying it. He asked an analyst to track loans made by New Century; he found its mortgages were running into
more
problems than those of its rivals, not fewer, feeding Paulson’s suspicions.

“They’re lying through their teeth. It’s just not possible!” Paulson told Pellegrini, displaying unusual emotion after another aggravating day of
watching New Century’s shares rise. “These guys are preying on poor people!”

In early January, when Paulson shorted the company’s shares, betting that they would go down, competitors snickered. New Century’s largest shareholder was David Einhorn, the frequently praised investor and poker-tournament champ who counted actor Michael J. Fox among his loyal clients.