The Great American Vulture

The standardization of asset-backed credit default swap (ABCDS) contracts in the summer of 2005 was like turning on a fire hose. By the end of the year, something like $100 billion of the contracts had been traded. And most of the buyers of subprime mortgage bonds in this derivative form were themselves androids — new CDOs that had been programmed to fill themselves with pieces of subprime mortgages. By 2007, this automated CDO purchasing of replicated subprime would reach the one-trillion-dollar mark.

Back in 2002, when ABS traders were still the dorks in the school band, there were flesh-and-blood investors — banks, insurers, and hedge funds — who liked to analyze and buy the riskiest pieces of U.S. mortgage bonds, keeping the market safer for more cautious investors such as pension funds. Replacement of these formerly critical buyers with CDO androids buying on the basis of credit ratings meant that no one cared about the mortgages themselves any longer. No wonder lending standards collapsed and money was handed out to NINJAs (borrowers with No Income, No Job, No Assets). No wonder that a culture of “liar loans” prevailed in America.

The traders in the new derivatives had their work cut out just feeding the great CDO factories, overcoming the bottleneck of supply in the cash market. These CDOs would sell protection on subprime mortgages, and the ABS trading desks would use the newly designed contract to buy it from them. Having bought protection, the desk would be short subprime — in other words, they would make money if the subprime mortgage market collapsed. At this point, in early 2005, dealers in the secondary ABS market had no interest in being short. If they had a view, it was to be long like everyone else, in order to meet the growing CDO demand. At Goldman, where Sparks managed Egol and his Abacus deals next to Gasvoda and his pipeline of new mortgage bonds, Egol was kept on a tight rein and was ordered to keep his position flat, balancing out Sparks's exposure elsewhere. But at Deutsche Bank, where the units buying and repackaging mortgages operated as distinct fiefdoms, the silo structure gave Lippmann the freedom to think for himself about the short view of subprime. But who would want to bet against the American consumer? At the “ABS West” industry conference in Phoenix, Arizona, in February 2005, Lippmann participated in a panel discussion with an ex-Deutsche trader, Steve Kasoff, who now worked for a hedge fund, Elliott Associates. Kasoff had been considering buying subprime CDOs but needed a way to hedge what he planned to buy. Excited, Lippmann realized he had an investor to whom he could sell a short position.

According to people familiar with the deal, Elliott was interested in shorting $500 million of subprime in a single trade. The problem was getting to that kind of size. Lippmann had a brainwave. Armed with subprime default swaps, Lippmann would turn himself into Deutsche's equivalent of Jonathan Egol.

 Shortly after the conference in Phoenix, Lippmann set up a pitch meeting at Elliott's New York offices. Kasoff listened as Lippmann proposed structuring a special Abacus-style CDO for the hedge fund's benefit. There was a fiefdom at Deutsche Bank, called “CDO primary,” that operated (on a bigger scale) the same kind of traditional CDO factory that Ostrem ran at Goldman. Lippmann agreed to work in partnership with this group to create something similar to Abacus. After both sides agreed which bundle of bonds would go into the deal, Elliott bought subprime protection from Lippmann, who in turn bought it from investors in the new $500 million CDO. Called START (Static Residential) CDO 2005-A, it was completed in June 2005.

Meanwhile, the Deutsche sales force had been speaking to John Paulson, a wiry New Yorker who ran what was then an obscure family of hedge funds that specialized in distressed debt and mergers and acquisitions (known as event arbitrage). Although Wall Street dealers would later boast about having “put John in the trade,” Paulson says that his long track record in sniffing out distressed debt opportunities had attuned him to the impending collapse. Over the years, he had transformed himself into a financial vulture, waiting for disaster. “When spreads tightened to all-time lows in early 2005,” says Paulson, “we felt that you weren't being paid enough for risk, so we shifted from a long focus to a short focus. We believed we were entering a credit bubble, so we were intensely focused on trying to find the best short opportunities in credit. By examining various credit markets, we felt the subprime mortgage market, particularly the lower tranches of subprime mortgage securities, as well as CDOs, represented the most mispriced securities.”

Had Lippmann and a handful of other dealers not succeeded in decoupling mortgage credit risk from the underlying bonds, Paulson would be an obscure figure today. But Paulson was smart enough to see that the same unchecked innovation that allowed Wall Street's CDO machine to deliver processed investment food into deepest Germany and elsewhere was giving him the opportunity of a lifetime. Recall how subprime mortgage bonds can be imagined as a fifty-story building, where CDO builders had to take the elevator down to the mezzanine level to get the juice they needed. The foundations of the building were the U.S. housing market; if the pace of house price appreciation flagged even slightly, let alone stalled or dropped, the mezzanine floors of mortgage bonds would be underwater. For that risk, investors received about 2 or 3 percent per year more in interest than they would have received for investing in Treasury bonds issued by the U.S. government. The use of derivatives innovation to strip out that credit risk from the underlying subprime bond meant that Paulson could pay 2 or 3 percent of the value of a bond like NCHET each year, with the possibility of getting paid the bond's entire value if house prices went down.

Paulson also figured out that the stream of annual 2 or 3 percent payments for this bet didn't have to go on forever, something that was public knowledge for anyone who read SEC filings for the likes of NCHET. They knew that two or three years after signing their mortgage document, the borrowers would be hit with that payment shock, which would triple or quadruple their cost of borrowing. Continuing house price growth might give them one last chance to refinance, but once that escape route closed, they were doomed. That meant you could short a $10 million–thick slice of mortgage bond for a maximum outlay of about $1 million. If subprime performed as most people then expected, Paulson would lose all of this investment, but if it went bad, he'd pocket a $10 million profit. Of course, with a credit derivative, you were no longer constrained by the size of the original bond. Scaling up the bet and paying Lippmann an annual stake of $2 million, Paulson stood to make $100 million. Put $20 million on the table, and $1 billion was there for the taking.

Paulson had already done his first $100 million subprime trade in summer 2005 with Bear Stearns, but now he wanted to do more, and was now raising $1 billion to set up a credit fund specifically focused on shorting subprime. Deutsche's CDO primary group obliged by cooperating to build more Abacus-style START CDOs as they had done for Elliott Associates, booking the default swap components through Lippmann's desk. The urbane Deutsche Bank trader became a confidant to the tetchy hedge fund manager. Despised by other Wall Street mortgage dealers for his bearish views, Paulson had found a receptive insider to talk to, while for Lippmann, exposure to the great cynic proved infectious. As he and his quants crunched the numbers, Lippmann realized that the upside of the short mezzanine subprime trade outweighed the downside so much that he really couldn't lose. In November 2005 he persuaded Deutsche Bank to allow him to make his own proprietary bet against subprime. It wasn't difficult. As a market-maker, all Lippmann needed to do was to buy slightly more protection than he was selling, leaving his trading book lopsided on the short side. In the pre-2008 unregulated era of derivatives, separating client-facing business from proprietary trading was not something large banks made a big fuss about.

But why stop there? Lippmann began to bypass the Deutsche CDO primary group in order to grow his trading business, according to former employees of the bank. He started his own virtual CDO factory, assigning London-based subordinates to attach bundles of derivatives (or correlation trades) to bonds that Deutsche was able to issue very quickly on the Irish Stock Exchange, with names like Eirles, Ixion, Syrah, and Coriolanus. Other firms like Morgan Stanley, Bear Stearns, and Citigroup ran similar operations, but Deutsche was the biggest player.

Along with the derivatives he was selling to Wall Street's mainstream CDO factories, Lippmann's virtual CDO factory helped bring in a flood of additional subprime protection from around the world, with the help of Deutsche's global salesforce. It was more than could be matched up with Lippmann's own proprietary position and Paulson's and Elliott's short, prompting Lippmann to seek out new would-be Paulsons. By early 2006 he became adept at giving rapid-fire presentations to more orthodox hedge funds that specialized in emerging markets and high-yield corporate bonds. Their first response was that shorting subprime was too unfamiliar for their comfort-level. Thinking on his feet, Lippmann shot back that shorting subprime was indeed outlandish — so much so that it would provide a perfect hedge for their big high-yield and emerging market positions. By 2007, Lippmann would become one of the biggest synthetic CDO players on Wall Street, all as a result of the special derivative he had helped design.

Meanwhile, a new innovation was being prepared that would make it even easier for hedge fund managers and traders to bet against subprime. Having agreed on a standardized subprime default swap contract in the summer of 2005, Sparks, Lippmann, and the other dealers immediately saw a further opening — to create an index of the new default swaps. Trading single-name default swaps and constructing bespoke CDOs out of them might look very profitable for the dealers on paper, but auditors were touchy about letting them recognize profits unless there was a visible market price. Hedge funds and dealer desks trading subprime derivatives also demanded liquidity, because they always needed to be able to close out their positions at a moment's notice. It was natural for Goldman, the Wall Street firm most obsessed with market pricing and hedging its own risk, to take the lead. Sparks assigned a clever young ex-nuclear physicist, Rajiv Kamilla, who convinced Lippmann and the other bankers to jointly construct a subprime derivative index based on the slices of mortgage bond they were trading the most. The dealers agreed that the new index would be sliced into five layers that mimicked the structure of mortgage-backed bonds, and would be updated every six months to include the twenty most popular subprime names. Given the name ABX, the new index was launched in January 2006.

 Because the ABX prices would be compiled and disclosed publicly every day, the broadcasting impact would be even greater.

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