As Easy as ABCDS

In the summer of 2004, Daniel Sparks took a nonstop flight from New York to Dusseldorf in Germany, accompanied by Jonathan Egol, a junior Goldman analyst to whom Sparks had recently given a trading job. As Barclays and UBS had already demonstrated, any self-respecting credit derivative innovator needed a German investor in its back pocket. But Sparks and Egol, who could barely find Dusseldorf on the map, needed help in finding one. Bleary-eyed from their overnight flight, Sparks and Egol were met at the airport by two Goldman salespeople who had flown in from London, the center of Goldman's European empire run by Michael Sherwood. One of Goldman's original default swap visionaries, Sherwood was the man behind the firm's secret derivatives deal with Greece in 2001. Since that deal, his European power base within Goldman had grown. It wasn't just the fact that London was eclipsing New York as a financial center, attracting some of the firm's best traders and corporate advisors. Sherwood had built a network of super-intelligent derivatives salespeople and marketers, poaching from J.P. Morgan and Deutsche Bank and fostering relationships with clients on the continent. Stepping off the red-eye, Sparks and Egol slotted seamlessly into this network as Sherwood's salesmen guided the sleep-deprived Americans into a chauffeured Mercedes that swept them to the shiny headquarters of a bank called IKB.

The tubby German man on the other side of IKB's boardroom table was Dirk Röthig, and he had been complaining for months to London-based salespeople about the obstacles he faced in buying CDOs linked to subprime and other forms of securitized debt. Like LB Kiel, he saw the robot-on-robot investments as a safe means of cashing in on the American consumer, and he had a secret, behind-the-scenes mechanism to invest far more than LB Kiel ever could. However, as more Europeans latched onto the trend in 2003, Röthig saw deals that had been promised to him by London banks being snatched away as prices soared. The problem was what in industry jargon was called the “ramp-up period” — it took six months or a year for a CDO arranger and asset managers such as PIMCO to purchase all the small pieces of subprime mortgage bonds that met the necessary criteria for the deal, a time-lag that allowed dealers to profiteer at IKB's expense. As he explained to Sparks, what Röthig was looking for was something that could be cobbled together fast and invisibly, like the synthetic CDOs that J.P. Morgan and Deutsche Bank had pioneered in Europe using corporate debt.

Egol had been working to satisfy Röthig's request for months, and as they had dinner with the Germans before catching the evening flight back to New York, Sparks gave his blessing to an innovation that would bring the excitement of credit default swaps into the subprime mortgage bond business. Recall that derivatives have the subversive property of being able to instantly and invisibly replicate things that traditional finance makes difficult. In great secrecy, Egol had done precisely that, devising new default swap contracts that were subtly different from the normal corporate kind. A collection of several hundred New Century mortgages scattered across California and Florida don't all default on the same day, as Enron did in December 2001. First comes delinquency, when homeowners fall behind on their interest payments, followed by foreclosure, and finally the sale of real estate owned (REO) properties. It happens in dribs and drabs; every time a warning letter goes out in Florida or a sheriff changes the locks in California, the valves and pumps inside the robo-corporation's cash plumbing system silently open and close according to their programmed instructions.

Seasoned mortgage bond traders such as Lippmann were familiar with these robot cash plumbing systems. Since the 1990s, mortgage packagers had adopted a standard software package, called Intex, that worked out the plumbing on a computer. The traders had not only their own copies of Intex, but also Bloomberg terminals that did the same calculations. These were used by traders to value secondhand mortgage bonds like NCHET. With all this standardization in place, it was straightforward to construct a derivatives replicant of a subprime mortgage bond, overlaying virtual reality on top of what was already robo-finance. Soon after the Dusseldorf meeting, in June 2004, Goldman sold IKB a tailor-made synthetic CDO called Abacus 2004-1. Like J.P. Morgan's Mayu, the deal was static — it didn't have a manager such as TCW involved — and it was constructed entirely from the new mortgage bond default swaps. The revenge of the dorks was under way.

Goldman may have got there first, but Deutsche and other dealers were close behind, designing similar contracts. Toward the end of 2004, Lippmann realized that other dealers were doing what he was doing, when his clients starting demanding subprime derivatives resembling ones they had already traded with someone else. He saw that niggling legal differences would increase risk and damage client confidence in the new derivatives, so he contacted four other dealers with a proposal: “If we all agree to the same contract, we can avoid these legal risks and grow our businesses.” Gathering for weekly evening meetings over take-out food at Deutsche Bank's U.S. headquarters on Wall Street, Lippmann and his rivals thrashed out a standardized version of the new default swap contract that paid out gradually as the piecemeal subprime default process took place.

This Wall Street get-together would have important ramifications. Until then, mortgage bonds typically sat inside insurance company or pension fund balance sheets (and more recently CDOs) until maturity. The consequences of gradual default were hidden from view. Each ABS owner had made an actuarial bet on repayment and house prices, and dealt with the outcome in private. In that sense, despite being securitized, the U.S. mortgage market had something in common with traditional banking in Europe. What Lippmann and the others did was turn subprime mortgage investment into a two-way horse race where the market could bet on the outcome. No longer would traders be “shackled to the cash market,” as Lippmann liked to complain had been his sorry fate.

As with the earlier version of credit default swaps linked to corporate debt, the derivatives would allow him and other dealers to go short, or bet against mortgage bonds — bonds they owned, or bonds they didn't own. And the new contract ensured you got paid — or had to pay up — immediately, because the contract stipulated that counterparties had to settle up each time new homeowner defaults eroded a subprime bond beyond an initial threshold. Rather than waiting until the official maturity date of the bond, when, as Lippmann put it, “the entire cookie was eaten,” he convinced his fellow dealers that “a payment is made each time a bite of the cookie is taken.” That meant the price of these default swaps was acutely sensitive to shifts in the housing market, serving as a broadcasting system from one trading desk to the next.

As the discussions among dealers continued into 2005, Lippmann invited more of his competitors to participate. When arguments broke out, Lippmann patiently explained how standardization would be the key to volume. By June, the contract was agreed upon, and it was ready to trade.

Sparks was pleased to have the tools he needed to leapfrog his competitors and satisfy the demand for CDOs. But he and his more old-fashioned colleagues also felt troubled. “This is a long-only business — this might ruin it,” complained one of them. Sparks agreed. “I think these derivatives are going to spread risk throughout the world.”

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