Waiting for the Flood

In the summer of 2006, the booming U.S. subprime market was starting to show cracks. Ameriquest, a medium-size subprime lender, settled a predatory lending investigation by federal prosecutors and was forced to drastically scale down its operations. The Federal Reserve, which was charged with financial consumer protection, issued an edict tightening up standards, demanding that adjustable-rate mortgage (ARM) borrowers be told the full cost of their loans. Imperceptibly, the U.S. residential housing market reached a peak and started down. The Federal Reserve was also raising interest rates.

At Goldman Sachs, though, the subprime pipeline was flowing at higher and higher speeds. Gasvoda's team was processing billions in new mortgages every month. Goldman was sucking up home loans from all over America and spitting them out through its production line of GSAMP androids. The process was running at such a fevered pace and with such a high level of automation that Sparks and Gasvoda, like the rest of Wall Street, were desensitized to what was going on at ground level. They were complacent about due diligence reports that suggested loans were declining in quality, and failed to pass this information on to investors or ratings agencies.

 They didn't see that originators such as Countrywide were encouraging borrowers to lie on their applications or were bullying real estate appraisers to inflate valuations of properties. By 2006, 40 percent of U.S. subprime mortgages had silent seconds — additional home equity loans that increased borrowing power to well above 90 percent loan-to-value (LTV); 50 percent, or $250 billion worth of subprime mortgages, were limited documentation, or liar loans, and so were Alt A mortgages, of which $450 billion were issued and turned into bonds that year. Taken together, subprime and Alt A were almost eclipsing Fannie and Freddie's annual prime mortgage lending, and the two government-sponsored giants were themselves piling into subprime bonds as investors.

Yet for all his stoking of Goldman's mortgage machine, Sparks was being told by his bosses that he had to do more. It wasn't enough for Goldman to be ranked ninth in the mortgage bond league tables. To get higher up, there was a simple solution that Goldman's competitors had pursued. Ever since Lehman Brothers had bought subprime lender BNC in 2000, Wall Street firms knew they could win instant market share by acquiring mortgage companies, thus guaranteeing an increase in loan volume. “Don't you know that First Franklin, Equifirst, and Saxon are up for sale?” Goldman's senior management would chide Sparks. “I can't understand why anyone would pay that much for them,” he would reply when Merrill or Barclays or Morgan Stanley would triumphantly announce their latest acquisition.

Although he was catching a lot of heat, Sparks stood his ground. He preferred a hands-off relationship with the originators, one that could be ended quickly. Sparks was also getting banged from the other side, from his traders, who had followed Lippmann's lead in helping hedge funds taking short positions against subprime using default swaps, and wanted to do the same trade themselves.

Charged with managing the risk of the mortgage book, Sparks had to explain the downside for his eager traders. And the bogeyman he used was that cranky angel of death, John Paulson. In the summer of 2006, the question on everyone's lips was, What if Paulson is wrong? After all, the ABX index was staying stubbornly close to 100 percent, even for the lowest tranche, which was supposed to be the canary in the coal mine for a subprime meltdown. “There's this huge short out there named John Paulson,” Sparks warned his traders. “He isn't really a mortgage guy, and nobody knows how much capital he has. If he gets margin called because the market goes against him, this market's going to go straight up, and you're never going to be able to cover your shorts. Never.”

Looking back, Paulson insists his confidence never wavered. Like a vulture circling high over the suburbs of Phoenix, Arizona, and California's Inland Empire, Paulson knew exactly where the bodies would fall. He had their zip codes; he even had their street addresses. He knew that half their income was going to mortgage payments, and he knew the date when payment shock would hit them. He knew which mortgage bonds were juiciest to short, such as those issued by Lehman Brothers, which had the worst underwriting standards, while he avoided those done by Wells Fargo, because their standards were the highest.

The dealers who traded with Paulson in 2006 tell a different tale. They say he was worried about having to explain to his investors that he would need to pay additional default swap premium to renew his bet for another year. Paulson's complaints to Lippmann about the lack of performance of his trade became strident. “Look at the facts,” he lectured Lippmann. “We should be making money. Why isn't this working?” Lippmann, beset by other hedge fund clients whom he complained were “crying like babies,” reassured Paulson. “I had to hold his hand,” he says.

Unfortunately for those on the other side of Lippmann's trades, most of them did not benefit from his hand-holding. No more so than the buyers of his virtual CDOs, the single-tranche bundles of derivatives that Lippmann's traders packaged up as Dublin-listed bonds. Deutsche's global sales force latched onto these products, and in a repetition of the first CDO boom of 2001, sold them to far-flung clients that had little understanding of what they were buying. Consider Bangkok's Bank Thai, which in October 2006 invested $50 million in a Lippmann creation called Coriolanus Series 39.

 Lippmann's traders started out with tiny slices of Countrywide and other mortgage bonds and amplified each one up to eight times. Piling leverage upon leverage, Lippmann's traders stacked together seventy-five of these subprime swaps into a notional portfolio that was $1.4 billion thick and then carved out Coriolanus Series 39 as a thin slice from close to the bottom of this virtual financial skyscraper. Within just over a year, the product would lose 98 percent of its value.

Having seen similarly thin-sliced Deutsche corporate debt CDO products like REPON-16 blow up in clients' faces after the dot-com crash, the firm might have been expected to protect its clients from products that people close to Deutsche Bank now admit were “bad.” But the problems at the beginning of the decade had barely registered with senior bankers at the firm, such as Rajeev Misra, and these executives lacked direct responsibility for the sales and compliance functions that had dealt with the earlier generation of soured deals.

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