Revenge of the Dorks

Greg Lippmann had grown up in New Jersey's strip-mall suburbia and joined the investment bank First Boston (now Credit Suisse) immediately after graduating from college in 1991. He didn't look like your father's banker. Swarthy and lanky, with a piece of gum permanently wedged in his cheek, Lippmann grew his sideburns almost down to his jawline and shaved the ends into knifepoints, which gave him a faintly menacing, rockabilly look. By the mid-2000s he was trading asset-backed securities (ABSs) for Deutsche Bank, doing well enough to afford a big Manhattan loft apartment with a vast kitchen that he rented out to Italian cooking classes.

But Wall Street, like the rest of life, most often resembles high school, and ABS traders such as Lippmann looked enviously at people like Rajeev Misra, who had made it big in CDOs linked to corporate debt. With an office full of plastic trophies and a retinue of personal trainers and public relations flunkies, the black-clad Misra was a Deutsche Bank rock star. The way Lippmann saw it, these credit derivatives superstars were like the American football players in high school, with their body armor and bevy of girlfriends. The lowly ABS traders were the dorks in the marching band.

 Theirs was a small business that most people didn't pay much attention to.

A few blocks away from Lippman's office, at the bottom of the island of Manhattan, Dan Sparks would bristle at that analogy. In his eyes, the Goldman Sachs mortgage desk was the football team — after all, he had briefly been a college player, spending a season as a walk-on for Texas A&M in his freshman year. Sure, he may have gone to a non-Ivy League business school (Texas A&M) and had eschewed Lippmann's frenetic Manhattan lifestyle for deepest suburban Connecticut. But Sparks was not stuck trading secondhand mortgage bonds, as Lippmann was. Having been made a partner in 2002 because of his trading prowess, Sparks became head of Goldman's structured product business a year later, putting him in control of trading and repackaging mortgages.

UBS's success with subprime-linked CDOs such as North Street was a sign that cautious investors around the world would buy into this obscure asset class, so long as it could be packaged with a good credit rating and had a prestigious fund manager involved. The problem was that the very nature of the subprime mortgage market kept it small — and safe. First there was the challenge of finding the mortgages. If Sparks wanted to compete with market-leading firms like Lehman Brothers and Bear Stearns that specialized in packaging newly originated mortgages into securitized bonds, he would need his own supply of product. The big suppliers at that time — such as New Century and Long Beach — were already selling their product to other Wall Street firms, and Goldman's head of loan origination, Kevin Gasvoda, was frequently on a plane to California and Nevada, where many subprime lenders were based. His carrot was a proposal to finance their operations — Goldman would lend them cash they could advance subprime borrowers, and in return would receive the mortgages it needed.

Building this pipeline took time. Assembling the half-billion dollars' worth of subprime loans needed for a new mortgage bond meant waiting six months while brokers rounded up enough financially strapped consumers. And that required a lot of boots on the ground. Sparks wanted to keep some control over the process and didn't like the idea of outsourcing. That meant hiring hundreds of people to run an in-house mortgage-servicing business for Goldman, and basing them in South Carolina and Texas to avoid paying expensive Manhattan overheads.

Even creating a mortgage bond factory was not enough to deal with the next challenge — rounding up enough mortgage bonds to supply a second factory building CDOs. In 2003, Sparks began hearing from asset managers — from well-known firms, like BlackRock, Trust Company of the West (TCW), and PIMCO, to obscure outfits — who wanted Wall Street firms to arrange subprime CDOs for them to manage. Unlike the North Street 4 CDO, where UBS's role was heavily conflicted, these new CDOs would depend on the independence of the manager to keep investors out of trouble. Knowing that it was their credibility as much as the credit ratings that underpinned investor confidence in these ABS CDOs, the better-known asset managers exploited their gatekeeper status. Wall Street firms would have to come to them and pitch for the privilege of CDO underwriting. Sparks assigned a member of his team, Pete Ostrem, to manufacture these CDOs, but he was quickly stymied by the bottleneck in Goldman's incomplete subprime pipeline. Ostrem grumbled to Sparks about the challenge of satisfying the fund managers. “They're like, 'Hey, Goldman, you take all the risk, or most of the risk. Are you going to be able to deliver the longs? Do you have enough product?'” Ostrem had to scour the market to buy pieces of mortgage bond in the market to satisfy the CDO managers and win deals, but this highlighted a more fundamental issue. As with CDOs, the packagers of American mortgages depended on a carefully constructed pecking order of risk to convince investors that the product was safe. But if, like Sparks, you wanted to repackage these finely graded parcels of debt, they came in inconveniently small pieces. While the debt of companies such as Ford or IBM had hundreds of billions in outstanding bonds that could be traded in a flash, making CDOs out of mortgage bonds was tough. Consider again NCHET, the resliced bundle of New Century subprime mortgages in the North Street 4 portfolio.

At first sight, with $500 million advanced by New Century to subprime borrowers across America, there should have been plenty of debt for CDO builders to play with. Recall, however, that the arbitrage engine that kept the CDO business running was powered by cheap raw materials in the market, where cheapness is measured by the premium earned over government bonds. The triple-A output of this engine was an upper limit; there was nothing to be gained by feeding in expensive ingredients, because that cut into profits. To make CDOs built out of mortgage bonds work for dealers, the mortgage bonds needed to pay about 2 percent more than Treasury bonds. Think of NCHET as a large office building, say, thirty stories high, with the riskiest “floor” in the basement and the safest at the top. To find something suitable for North Street 4, imagine Ken Karl getting into an elevator on the top floor and descending floor by floor until he gets paid 2 or 3 percent more than the government bond rate. He has a long ride, because most of the floors of NCHET are triple-A rated — these parts of mortgage bonds would be bought by American pension funds and insurance companies, as well as Freddie Mac. Only when he gets down near ground level, perhaps four or five floors up, does Karl find what he needs. Just like the floors of a building that connect the entrance levels with the main part of the property, these ABS tranches of interest are called mezzanine, with ratings that vary from triple-B to single-A. And they represent a very thin slice of the building overall. The “M-2” slice of debt that Karl picked out of NCHET amounted to only $13 million. That may sound like a lot of money, but it would have been backed by just a couple of hundred homes and was, in Wall Street terms, no more than a rounding error.

Compare that with the $80 million of WorldCom debt that J.P. Morgan placed in Poste Vita's Mayu CDO at the beginning of 2002. That was the kind of building block you needed to attract European investors. By contrast, North Street's tiny piece of NCHET was all there was at that rating and spread; such things were slow and tricky to trade. The only good news was that it was impossible to lose more than $13 million. If Sparks or Lippmann wanted to use the same piece of NCHET that Karl had secreted away in North Street 4 for another CDO, there was nothing to be done except wait until Karl decided to sell it. Although the margins you could earn in this thinly traded market might be high, volume would always be low, and for Wall Street traders, volume equals status. As Lippmann was acutely aware, credit derivatives gave the industry rock stars a twofold advantage. They could trade in whatever size was appropriate to the products they were creating for investors, and by hedging themselves, they could make risk apparently disappear, further increasing their trading volume and profit. And investors were eager to lap it up.

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