JOHN PAULSON WASN’T FINDING MANY INVESTORS WILLING TO TAKE A chance on his new fund. If it was going to get off the ground, he’d have to turn to friends and family. Jeffrey Tarrant, his tennis buddy, finally convinced his partners to pony up $60 million from their investors. A few of Tarrant’s clients put several million dollars of their own into Paulson’s new fund. The parents of Andrew Hoine, one of Paulson’s executives, pitched in a few hundred thousand dollars. And Paulson drained a personal savings account at his local bank, J.P. Morgan Chase, to invest about $30 million of his own, almost all of the money he held outside his firm.
The total was just $147 million, a puny sum in an era when new funds sometimes launched with billions of dollars. Even some of those who signed up weren’t true believers. A few were real estate pros seeking to protect their holdings. Privately, they confided that they wouldn’t mind if Paulson flamed out because that would mean good things for their real estate portfolio.
Like hunters waiting on their prey, Paulson and his team eyed home prices, searching for a sign of weakness as a signal to pull the trigger on their trade.
One morning in early June, Brad Rosenberg raced into Paulson’s office clutching a news release fresh off the printer: Data from the National Association of Realtors showed that home prices had risen a paltry 1 percent over the previous twelve months. Paulson flashed a grin—this was just what he was hoping for. His team already had anticipated that if housing prices went flat the BBB-rated slices of all the mortgage bonds would start to see losses. That time seemed at hand.
It was “a defining moment,” Paulson says.
Every trader up and down Wall Street pored over the same data that morning. Paulson worried that his window of opportunity was in danger of closing. And yet he sat on his hands. His other funds had purchased mortgage insurance, but Paulson hadn’t made a single trade for his new “credit” fund dedicated to betting against housing. He realized that if he was going to swing for the fences, it was now or never. Any more delay and he risked missing it all.
The $147 million would have to be enough, he decided, at least to start. So Paulson formally launched his fund and told Rosenberg to start buying.
A short, bespectacled thirty-four-year old, Rosenberg had worked at the hedge fund for four years. He sat right outside Paulson’s office, close enough to share market intelligence throughout the day. He tended to get to work early, usually greeted Paulson around 8 a.m., and often wished him a good-night after 6 p.m.
But Rosenberg still didn’t know what made his boss tick. They exchanged few pleasantries. Paulson had never met his wife or family, and Rosenberg couldn’t remember having a single personal conversation.
That was true of most of Paulson’s staff. Rosenberg didn’t mind the lack of camaraderie, though. The son of a Long Island shoe-sales executive and a graduate of Tulane University, he was focused, serious, and bookish. The only adornment on his desk was a faux turtle made of two rocks and cardboard, a present from his young son. He didn’t wish for a high five after a successful trade—he was just as uncomfortable with that kind of celebration as Paulson.
From the moment Paulson gave him the green light, the pressure was on Rosenberg to buy as much mortgage protection as possible before it rose in price. At the same time, he had to avoid tipping off competitors to prevent them from copying the idea and driving up prices of the CDS contracts. Rosenberg began working the phones, placing orders with major banks up and down Wall Street to spend the $147 million on insurance for mortgage slices with BBB ratings, trying to be as casual about it as possible.
“So what’s the level here?” he asked one trader, as calmly as he could, fishing for a price quote. Later, Rosenberg placed a contact on hold, trying to convey marked indifference, before getting back on the line to do some buying. Rosenberg’s customary lack of emotion came in handy—few of the brokers seemed to have a clue how desperate he was to buy boatloads of the CDS insurance. Paulson often stood over Rosenberg’s shoulder, a slightly intimidating presence; Rosenberg ignored him and kept on calling.
He hit immediate pay dirt. Each time Rosenberg asked to buy protection, as many as a half-dozen banks offered shockingly inexpensive prices. The reaction confounded Paulson—it was as if the bull market for housing was just beginning, rather than showing signs of age.
Didn’t anyone else see the news today about housing prices?
Paulson raced to do even more buying.
“It was like a vacuum, people just sucked it up,” Paulson recalls. “We’d send lists of what protection we wanted to buy and it would get snapped up. I couldn’t believe it.”
When the ABX index tracking subprime mortgages was introduced in July 2006, Paulson’s team immediately bought CDS protection on that, too. It was yet another arrow in their quiver. The cost was a bit more expensive than for the CDS contracts he had been buying on slices of selected mortgage bonds, but the ABX was more heavily traded, promising Paulson an easier exit later on. The fund even purchased a bit of insurance on the index tracking supposedly safer, A-rated slices of subprime mortgage bonds.
At first, traders were happy to sell CDS insurance to Paulson, thrilled at the mounting commissions. By selling Paulson mortgage protection, they also could create product for bullish investment vehicles to buy.
At Morgan Stanley, a trader hung up the phone after yet another Paulson order and turned to a colleague in disbelief.
“This guy is nuts,” he said with a chuckle, amazed that Paulson was agreeing to make so many annual insurance payments. “He’s just going to pay it all out?”
Soon, however, the traders began to wonder when all the buying would stop. The more CDS insurance they sold Paulson, the more they were on the hook to find bullish investors willing to take the other side of the transactions. Some worried that they might be stuck with Paulson’s trades if they couldn’t find enough investors to take the contracts off their hands, a dangerous position if housing crumbled.
Others seemed to be making the trades for their own banks’ investment vehicles, relying on mathematical models that deemed it safe to sell protection to Paulson. If he bought much more, though, the price of the insurance investments the banks were selling might go up, dealing losses to their own investment vehicles.
Josh Birnbaum, Goldman Sachs’s top trader of CDS protection on the ABX index, kept calling Rosenberg, asking how much protection Paulson ultimately planned to buy. When Paulson and Pellegrini got wind of Birnbaum’s inquiries, they told Rosenberg to keep him in the dark. They worried that Birnbaum might raise his prices on the CDS insurance if he knew more buying was on the way.
Birnbaum persisted, asking to come by the office. A slim thirty-four-year-old who looked several years younger despite streaks of silver in his hair, Birnbaum came alone. Sitting across from Paulson, Pellegrini, and Rosenberg in a small conference room, he quickly got to the point.
“If you want to keep selling, I’ll keep buying,” he said. “We have a few clients who will take the other side of your trades. And I’ll join them.”
Birnbaum was trying to tell Paulson he was making a big mistake. Not only were Birnbaum’s clients eager to wager against him, but Birnbaum was, too. He urged caution if Paulson’s team was going to stay bearish on even safer parts of the subprime market.
“Look, we’ve done the work and we don’t see them taking losses,” Birnbaum said.
Some on Paulson’s team couldn’t figure out what Birnbaum was up to. Was he truly looking out for them or did he want to discourage the firm from shorting more of the ABX index? Was he afraid their trading might cost Goldman?
“It felt foolishly presumptuous to suggest we knew better than Goldman,” with its army of professionals and sterling reputation, Pellegrini recalls.
After Birnbaum left, Rosenberg walked into Paulson’s office, a bit shaken. Birnbaum was the expert on the market—should they change their stance?
Paulson seemed unmoved. “Keep buying, Brad,” Paulson told Rosenberg.
Almost as soon as Birnbaum returned to Goldman’s trading floor, Rosenberg phoned him to place more bets against the ABX.
“Really??” Birnbaum responded, apparently surprised that he hadn’t persuaded them to stop.
Paulson invited mortgage experts from Bear Stearns to challenge his team to make sure they weren’t missing anything. The group walked into the “Park” conference room, next to Pellegrini’s office. The room featured a long set of windows looking north. In past meetings, the view sometimes proved distracting. Inside a gleaming, glass building across the street was a huge showroom with a long runway where female models sometimes gathered, wearing revealing Christian Dior swimsuits.
This afternoon there was less to ogle. The Bear Stearns team, among the most bullish on Wall Street, began by saying that subprime-mortgage losses of more than 3 percent were highly unlikely and that BBB slices of mortgage deals wouldn’t fall much.
“You guys are good customers and we’re concerned about you,” one Bear pro said. “You guys need to do more research on historical price appreciation.”
“What are your models based on?” Paulson responded. “The market has changed—now you can get a loan without any documentation. Are you including that in your models?”
“Our models are fine,” the Bear Stearns expert responded, polite but self-assured. “We’ve been doing this for twenty years.”
Scott Eichel, a senior Bear Stearns trader, chimed in that buying a huge amount of mortgage protection on a few mortgage pools was misguided. Don’t concentrate your bets, he warned.
Eichel was struck by the thesis of the Paulson team. It sounded too simple for a firm that he suspected had placed billions of dollars of trades. Didn’t they understand the complexities of the mortgage market?
Pellegrini listened closely to the conversation, displaying little emotion. He became convinced that some of the executives didn’t fully believe their own arguments. They simply were aiming to stop Paulson from shorting so much and causing trouble for Bear Stearns, Pellegrini concluded. He quietly seethed.
Two could play this game, Pellegrini eventually decided. He started to act as if he was having second thoughts about his bearish stance, pretending he was being swayed by the arguments of the guests.
As the meeting wrapped up, Pellegrini turned to the Bear Stearns executives with a smile. “We really appreciate the help; thanks, guys.” He didn’t dare reveal what really was on his mind.
“We said, ‘Oh, thank you for your help,’ but really we were saying ‘Fuck you,’ ” Pellegrini recalls. “We were both pretending.”
Paulson remained poker-faced during most of the firm’s meetings with the Wall Street pros. He digested their points and made doubly sure he hadn’t missed anything, but he didn’t hint at how bearish he truly was. If he wanted to keep buying at inexpensive prices, Paulson couldn’t reveal his true appetite for the insurance.
“They concluded that I was an inexperienced manager,” he recalls. “I had to play dumb. But I got tired of people saying I was stupid or wrong.”
Although the new fund wasn’t large, there weren’t many others doing much buying of mortgage protection, so Paulson’s activity quickly became the buzz of the market. Over the next few months, he received checks from new clients who sensed that housing might be peaking. He put the money to work, placing even more trades. Paulson’s team soon became more fearful about rivals catching on. When some of his investors shared details of the fund’s tactics, Paulson turned furious, installing technology to prevent clients from forwarding his e-mails.
Paulson called on Hank Greenberg, the founder of insurance giant American International Group, to see if his investment firm, C.V. Starr, wanted to invest in the Paulson fund. AIG had spent the last few years selling tens of billions of dollars of CDS contracts on subprime mortgages, and Paulson knew AIG could be at risk if housing crumbled. An investment in Paulson’s fund might be a good way to offset that position, he argued.
Greenberg and his team didn’t know Paulson, though, so they asked an outside specialist, Anauth Crishnamurthy, to vet the idea. Visiting the firm after the close of trading one day, Crishnamurthy grilled Pellegrini and Jim Wong, Paulson’s head of investor relations, pushing for details of their moves. When Paulson dropped by the meeting, Crishnamurthy asked why C.V. Starr should pay the hedge fund to invest in the ABX index when it could do that on its own.
“What’s your trading advantage?”
“That doesn’t matter,” Paulson responded. “The bonds are going to zero.”
Listening to Crishnamurthy’s detailed questions, the Paulson team worried that he might steal the trade and teach his bosses to do it themselves.
After the meeting broke up, Pellegrini pulled aside Wong, saying, “Don’t waste your time with him.”
Paulson pored over mortgage-servicing reports and noticed rising delinquencies among borrowers. The Fed already had raised its short-term interest rate back to 5.25 percent from 4.25 percent at the beginning of the year. Borrowers surely would come under more pressure.
In July 2006, Paulson got more enthused. Option One Mortgage Company, a subprime lending unit of H&R Block that was accounting for about half of the profits of the tax-filing company, reported poor earnings and acknowledged problems with loans it had issued. So many customers were skipping even their first payments that the company was being forced to take mortgages back from banks to which it had sold them.
“It was one of the first signals that something was wrong with the business,” Paulson recalls.
As Paulson’s confidence grew, he couldn’t resist bidding on a 6,800-square-foot, seven-bedroom home in Southampton with an indoor glass-enclosed pool, agreeing to a $12.75 million purchase.
In the summer of 2006, Paulson and his wife and daughters joined Bruce Goodman and his family at the fashionable Southampton Bath and Tennis Club for lunch. After their meal, the old friends walked to the beach to watch Paulson’s daughters play on the sand. As they chatted about work, Paulson seemed cagier than usual, as if he was hiding some big secret.
Finally, Paulson opened up: “I’m working on a situation where I’ve made a major investment of my personal funds,” Paulson confided. “Bruce, if this works out, it will be extraordinary.”
Paulson beamed—Goodman hadn’t seen his friend this excited in years. He pushed for details of what Paulson was up to but all he got was an impish smile.
“I’d love to tell you, Bruce, but I can’t,” Paulson said.
Paulson’s trade started off with a thud, however, as the price of his protection slipped in August. Complicating matters, the Federal Reserve stopped raising interest rates, worried that if they got too high, home owners would feel pressure. Some investors expected the Fed to lower rates at some point, and mortgage costs fell in anticipation. It seemed that housing might survive. Paulson’s trade might be a bust.
At home, Paulson’s wife, Jenny, expressed concerns, asking her husband if he was having second thoughts.
“It’s just a matter of waiting,” he reassured her, before heading out to Central Park for his three-mile run.
Friends phoned to see if Paulson was going to cut his losses and exit some of his positions.
“How are you holding up?” Peter Soros asked. “What are you going to do?”
“I’m adding to the bet,” he responded.
The way Paulson saw it, it wasn’t bad news that these CDS investments remained unpopular and he was losing a bit of money. Instead, it was an “absolute gift” because it allowed him to buy even more, he told a friend.
Peter Soros was so impressed by Paulson’s conviction that he invested in the fund, after months of sitting on the fence. Soon, Paulson’s fund was up to $700 million, and he made plans to start a second fund to make additional wagers.
Paulson and Pellegrini soon realized that they had made a major mistake in their trade, however. Data emerged that home prices had dropped almost 2 percent in 2006. But most of the subprime mortgages that the firm had bet against were handed out before 2006, and were for homes that already had appreciated in value. These borrowers were unlikely to run into problems because they easily could refinance their mortgages. Paulson had taken aim at the wrong target.
“We were too early,” Pellegrini acknowledges. “Even though home prices were down over the previous year, people in the market didn’t care.”
Paulson walked out of his office toward Rosenberg’s desk, a new plan in hand. “We’ve got to roll everything,” he told his trader. “We need protection on the latest vintages”—in other words, on houses that had not enjoyed any appreciation; those owners would not be able to refinance because they had no equity in their homes.
Quietly, Rosenberg traded the firm’s CDS protection for similar insurance on more recent mortgages. Once again, Paulson and Pellegrini chose the riskiest subprime bonds to insure. Not only were they made to borrowers with sketchy histories but they were made at a time when home prices no longer were rising.
Rosenberg called every contact he had to get his hands on more mortgage protection.
“What do you have, what do you have?” Rosenberg asked trader after trader. He made himself something of a pest. On Fridays in the summer, when some senior traders took their time getting back to him, hoping to push off the transaction to Monday and get an early jump on the weekend, Rosenberg kept after them, prodding them with repeated calls.
Luckily for Paulson & Co., the exchange for insurance on the latest mortgages proved relatively painless because the ABX index tracking the most recent mortgages remained around 100, close to the level where it began trading, reflecting continuing enthusiasm for housing. Because the index was so high, the cost of the CDS contracts on the mortgages remained cheap. Paulson had dodged a bullet.
OUT ON THE WEST COAST, Jeff Greene was experiencing more serious setbacks. He had placed his own trades a few months before Paulson launched his fund. As the market continued to rally in the summer of 2006 and the cost of mortgage protection fell further, it caused Greene deeper losses than Paulson was experiencing. By the summer, Greene was down about $5 million.
He ached to reach out to his old friend, to discuss the market and ask whether he should hold on to his trades. And Greene still remained interested in Paulson’s fund. But Greene’s account was down so much, he was even less eager to exit his trades and lock in the losses. He knew he had to confess to Paulson that he had kept his investments, despite Paulson’s demand that he sell them.
Sitting in his Malibu home, the wind chimes playing a gentle tune, Greene booted up his computer and wrote a new e-mail to Paulson. When he had finished, he took a deep breath and pressed the send button. In his e-mail, Greene had written that he was looking forward to getting together when he was back on the East Coast. He asked if he could still invest in Paulson’s fund. Then Greene casually mentioned that he still held his own subprime trades.
Greene quickly got a sense of Paulson’s reaction: He was livid.
“I don’t want you in my fund,” Paulson fired back in an e-mail. “You’re not an honorable person.”
Paulson stormed out of his office to alert his staff not to have anything more to do with Greene.
A few days later, Paulson called Jeffrey Tarrant, sounding hurt: “You build a relationship with someone and this is what happens?”
“We really could have used Greene’s money at the time,” Paulson said later, explaining why he felt so betrayed. “And he said he unwound the trade after I asked him to and he didn’t.”
Greene felt some regret over his actions, and his friend’s reaction. But a part of him also wondered what the big deal was. Paulson had given him dozens of investment tips over the years. He had acted on most of them. And Paulson had told dozens of investors about the trade; he already owned billions of insurance protection. Surely the word was out. It’s not like it’s a secret, he thought to himself.
“He never told me ‘Don’t do it,’ ” Greene says.
For Greene, the dustup was a downer, especially since few of his other friends managed to find brokers willing to place the trades for them.
Greene never did see Paulson on his trip back east. Well after midnight on a warm Saturday night, he anchored off Sag Harbor to check out another party. There, at the back of a room crowded with people, Greene met an attractive woman, Mei Sze Chan, a Chinese refugee from Malaysia who had grown up in Australia. Like Greene, Chan was in the real estate business and was a fixture in the late-night scene, sometimes attending a half-dozen parties a night in the Hamptons or New York. The thirty-two-year-old also had begun to wonder whether she would ever find Mr. Right.
Greene and Chan hit it off. She touched his shoulder. He held her hand. Then they found a quiet spot in the back of the room and began to discuss mortgages.1
A few months later they were engaged.
Greene was less successful with his short trade, however, and his frustrations began to boil over. Every day at 11 a.m., soon after rolling out of bed, he called his broker, Alan Zafran, to ask, “What’s the pricing today?”
Most mornings Zafran came back with data showing that Greene’s protection was worth less than the day before. Demand for subprime mortgages was growing, not shrinking, Zafran told him.
“It doesn’t make any sense to me,” Greene responded one morning. “It just doesn’t make any sense.”
Zafran visited Greene’s Hollywood Hills home to go over the results of the trade, and they pored over a giant spreadsheet of figures together.
Soon Greene’s calls to Zafran became more heated. Greene couldn’t even get a quote on his investments without asking a bond dealer for an estimate, feeding his frustrations. He also couldn’t figure out why the insurance wasn’t rising in price, even as housing seemed to falter. The Merrill traders seemed reluctant to lower the value on all those subprime mortgages, he decided.
“How can you justify this price?!” Greene asked at a rapid-fire clip, his voice rising with anger. “It doesn’t make any sense to me. Does it make sense to you!? Call me back!”
After Greene read a newspaper article about growing difficulties at Countrywide Financial, he called Zafran, who patched in a Merrill executive in New York, Cliff Lanier.
“I have to be in the money, right?” Greene said, bitterly.
Lanier retrieved a fresh quote for Greene from a trader, along with an update on the market: The ABX index tracking subprime mortgages indeed was falling. But Greene held insurance on a range of mortgage bonds, not just the ABX, and those positions showed even more losses for Greene.
“Come on!!” Greene responded. “Countrywide’s on the front page of the paper. I don’t understand it!”
With each call, he noticed that the quotes were getting a little better. That pleased him, but it also sowed suspicions about how Merrill was coming up with its quotes. The Merrill team said it was merely passing along the latest quotes.
Greene had spent millions investing in an obscure, opaque market. Now, as housing was slipping, his mortgage insurance wasn’t budging. He couldn’t even be sure what they were worth.
“I don’t understand it, Alan. Explain it to me,” Greene pleaded to Zafran.
MICHAEL BURRY was under even more pressure. He’d become bearish on housing a full year ahead of Paulson & Co., buying protection against mortgage securities and financial firms when no one else wanted it. But by mid-2006, his investments, too, were falling in value. And unlike the previous year, Burry couldn’t find many winners with his stock picks to offset the losses. His trade was dealing his fund its worst setback ever.
Before long, he began to get calls from concerned clients. They weren’t nearly as skeptical as Burry about real estate; in fact, many were openly dubious about his housing investments. A few advised him to stick with stock investing. What do you know about mortgages? he was asked.
In August 2006, Burry’s brokers called to tell him that someone was buying up every piece of subprime mortgage protection out there, CDS on RMBS (residential mortgage-backed securities), CDS on the ABX, anything and everything. Huge chunks of credit-default swap contracts were flying off the shelf, sometimes more than a billion dollars of protection in a single day. Angela Chang, his broker, told Burry the buying was so lightning-quick and overwhelming, “it was like a drive-by.” Another trader passed on chatter that an investor named John Paulson was doing the buying.
Burry was thrilled. He was sure all the activity would boost the value of his firm’s positions. But Burry’s brokers refused to adjust the value of his investments, making it impossible for him to show any gains. Sometimes, the prices seemed dated or inconsistent. Brokers gave him different prices for the same protection on the very same day. Other times, they wouldn’t update a quote for a full week.
Burry couldn’t believe it—Paulson was buying protection every day, housing prices finally had flattened out, the ABX index was dropping, and shares of home builders were weakening. But Burry was being told by his brokers that the value of his firm’s protection on over $8.5 billion of mortgages and corporate debt was barely budging. Some brokers explained that Burry’s positions didn’t trade frequently, making it hard to prove they had risen in value.
Burry fumed. He started to come home late at night, creeping up the stairs of his luxury home and going straight to bed, to avoid his family. He was afraid his kids might see him bristling with anger.
Fed up, Burry finally decided to pull the mortgage investments out of his hedge fund and place them in a separate account, called a sidepocket. There they’d sit, frozen in price, until Burry was ready to sell them. That way he could place a more exact value on the fund himself and treat his investors more fairly, without relying on quotes from unreliable brokers.
Hours after he announced his move to his investors, however, Burry’s firm was in turmoil. His clients already were skeptical of his housing investments. Now Burry was telling them that they were stuck with the housing protection until he decided it was time to exit. The fine print of his agreements with his investors allowed Burry to undertake this kind of move. But it seemed like a money grab—a heavy-handed way to prevent the investors from fleeing, and to stop the mortgage protection from weighing down his fund.
In October, Joel Greenblatt, Burry’s original supporter, demanded a face-to-face meeting. Several days later, he and his partner, John Petry, flew to San Jose and rented a car to drive to Burry’s office for a late-afternoon sit-down. Months earlier, Greenblatt had told a financial-television network that Burry was among the world’s top investors. But now, as Greenblatt grabbed a seat across from Burry in his small office, he fumed.
Greenblatt told Burry how foolish he was to set up the side account; it was harming Greenblatt’s reputation, as well as his own, he said.
“Cut your losses now,” he told Burry, and advised him to get out of his mortgage positions before clients revolted and his firm was ruined. Greenblatt could barely contain his anger. The trades could be “a zero in the making.”
For Burry, it felt like an uppercut to the jaw. One of Wall Street’s most respected investors—the first to show any faith in him—was ordering him to cut short the biggest trade of his life, one that he had spent more than a year crafting. Like the rest of his investors, Greenblatt and Petry didn’t even bother to try to understand his trade, or to read his letters that mapped it all out, Burry felt. Now, in the first rough period of Burry’s career, they were turning on him.*
Sitting behind his desk, Burry shifted in his seat, growing increasingly uncomfortable under the onslaught. As he listened to Greenblatt and Petry, he realized he might not have enough support to keep his firm going if he held on to the positions and was proved wrong.
Then it dawned on Burry that Greenblatt wasn’t saying anything new. He had no information that in any way negated or changed Burry’s original investing premise.
Looking past his guests through a window just behind their chairs, he could make out the red roof of a condominium, one of countless overpriced units recently erected in an area already teeming with new supply.
If Greenblatt wants proof, he thought, it’s just a rock’s throw away!
Greenblatt was facing his own pressures. His firm, Gotham Capital Management, which made investments but also placed money in various hedge funds for clients, had received withdrawal requests from 20 percent of its investors. If Burry refused to sell investments and hand money back to Greenblatt and Petry, they would be in a bind.
Greenblatt tried to compromise with Burry, suggesting that he cash in some of his trades, rather than freeze them all. But Burry wouldn’t budge.
“I can’t sell any of them,” Burry responded. “The market’s just not functioning properly.”
“You can sell some of them,” Greenblatt responded, his anger rising again. “I know what you’re doing, Michael.”
To Burry, Greenblatt seemed to be suggesting that he was clinging to the trades to avoid handing back cash to his clients. Burry turned livid.
“Look, I’m not going to back down,” Burry told his visitors. He was going to put the mortgage investments in the side account, as planned.
Greenblatt and Petry stormed out of the office, ignoring Burry’s employees on their way to the door. Days later, Greenblatt’s lawyers called Burry, threatening a lawsuit if he went through with his move.
Other investors, angry that Scion now was down about 18 percent on the year, also turned on Burry, withdrawing all the money they could from other accounts at the firm, pulling out $150 million over the next few weeks. A few potential clients, learning about the squabble, suddenly lost interest in Scion.
Burry turned sullen, stress obvious on his face. His wife began to worry about his health.
Late in 2006, Burry felt he had to do something to save his firm and his reputation. So, reluctantly, he began selling some of the CDS insurance, raising money to hand back to disgruntled investors. Over three weeks, he sold almost half of the protection he held on $7 billion of corporate debt of companies like Countrywide, Washington Mutual, AIG, and other financial players that seemed in dangerous positions.
Burry couldn’t have picked a worse time to sell. At that point, Wall Street still held few worries about housing. The protection on $3 billion of debt, which originally cost Burry roughly $15 million or so a year, now cost new buyers only $6 million a year. In selling the insurance, he took a substantial loss. To Burry, it was like giving away a collection of family jewels, accumulated with loving care over two long years.
Money continued to flow out of the fund, though. Burry scrambled to cut his expenses, slashing salaries and firing employees. He flew to Hong Kong to close a small office there.
“Mike, you can’t do this,” a recently hired trader told Burry, his anger growing.
Burry tried to calm him down, explaining that he had no choice. But the trader turned even more agitated.
“You owe me the difference between what I would have made” at his previous job and the severance Burry now was promising. He demanded $5 million.
“I can’t do that,” Burry replied meekly.
His cost-cutting moves destroyed the morale of his remaining employees back in San Jose. In a tailspin, Burry withdrew from his friends, family, and employees. Each morning, Burry walked into his firm and made a beeline to his office, head down, locking the door behind him. He didn’t emerge all day, not even to eat or use the bathroom. His remaining employees, who were still pulling for Burry, turned worried. Sometimes he got to the office so early, and kept the door closed for so long, that when his staff left at the end of the day, they were unsure if their boss had ever come in. Other times, Burry pounded his fists on his desk, trying to release his tension, as heavy-metal music blasted from nearby speakers.
The growing toll the trade placed on Burry seeped into an unusually frank letter that he sent his clients at the end of 2006: “A money manager does not go from being a near nobody to being nearly universally applauded to being nearly universally vilified without some effect.”
GREG LIPPMANN had convinced his bosses at Deutsche Bank to let him buy protection on about $1 billion of subprime mortgages. But as the trade stalled in the summer of 2006, the Deutsche Bank executives became impatient, expressing doubts about his tactics. They seemed tempted to close Lippmann’s trade.
“Just give me four years,” Lippmann asked Rajeev Misra, his boss. Most subprime borrowers refinanced their mortgage loans after just a few years, Lippmann reminded him, so his trade surely would be over by then. “Give it a chance to work.”
“Show me the research,” Misra responded.
When he did so, Lippmann’s bosses reluctantly gave him a green light to continue with the trade. The regular payments he was making for all the CDS insurance were slowly adding up, so those above him at the bank weren’t thrilled. Yet for all his bluster and self-confidence, Lippmann wasn’t prepared to quit Deutsche and go off on his own. Instead, he had to figure out a way to keep his trade alive and hold on to his job.
Lippmann managed a group that placed bond trades for investors. He realized that if he could convince enough investors to do the same trade he was undertaking, he might be able to rack up sufficient commissions to offset the costs of his bearish housing trade and placate his bosses. And if new investors could be convinced to buy the same CDS contracts that he owned, the price of these investments was bound to climb, which also would help Lippmann.
He traveled uptown to the offices of a hedge fund called Wesley Capital to meet two senior executives, to try to sell them on the idea. At first, they seemed impressed. Then they asked a friend who happened to be in the office, Larry Bernstein, who once managed a powerhouse bond-trading team at Wall Street firm Salomon Brothers, to weigh in on the trade.
Bernstein was dubious. “Coase Law says you’ll be wrong,” he said, dismissively.
The executives looked at each other. Lippmann had no clue what Bernstein was talking about. Neither did the Wesley executives. Coase Law turned out to be an economic theorem—but it didn’t seem to have much to do with the trade. Then the meeting turned contentious. If problems arose, Bernstein argued, the government likely would step in to bail out troubled borrowers. Even if you’re right and the price of the mortgage protection rises, when investors began to sell their insurance, the price would be pushed down, sinking the trade, Bernstein said.
Ultimately Lippmann walked out with nothing.
Jeremy Grantham’s GMO LLC seemed like a certain client. The Boston money-management firm had been cautious about the market for years, and Grantham was among the most vocal doomsayers, writing downbeat op-ed columns for various newspapers warning of “a sensational bust.”
But when GMO executives consulted their resident bond expert, Allen Barlient, he shot down the idea, arguing that most mortgage deals had so much protection that they likely would be fine.
Some investors he met with leveled abuse at Lippmann. “My brother works for Fidelity and he’s buying this stuff,” one said, referring to subprime-related investments. “You’re either an idiot or a liar” trying to wring trading commissions.
Behind his back, some on Wall Street called Lippmann names, such as “Chicken Little” or “Bubble Boy,” chuckling at his quixotic effort. At conferences, some traders teased him, saying “Your crazy trade is losing money.” Others repeated an industry maxim: “A rolling loan gathers no moss.”
Lippmann began avoiding investors with deep knowledge of mortgages or complex bond investments. They understood his maneuver but were lost causes, wed to their markets and reliant on sophisticated models that suggested everything would be fine. Instead, Lippmann asked salesmen at his bank who catered to investors in the stock, junk-bond, and emerging markets worlds if they would help arrange meetings for clients with a potential interest in his idea.
He sometimes stumbled onto tough questions—why were the rates of mortgage delinquencies so different in North Dakota and South Dakota?
“You’re missing it, you have to take a look at employment,” an investor said.
Lippmann was stumped. North and South Dakota sure seemed the same; the fact was that Lippmann didn’t know why the rate of delinquencies was so different. He had never even visited those states. So he and Xu went back to the data. Sure enough, the two states had similar levels of employment and seemed alike in other ways, but home prices were rising much more rapidly in North Dakota, explaining why delinquencies were lower. It confirmed that the biggest factor on default rates was whether or not houses were rising in value. It made Lippmann more certain than ever of his thesis.
Slowly, he began to win converts. A number of investors signed up in London, eager to profit from a U.S. economy they viewed as fragile. It took less than an hour for Lippmann to convince Phil Falcone, a hedge-fund manager in New York, who seized on the limited downside and huge potential windfall of the trade. Falcone didn’t even ask about the technical aspects of the mortgage market. The next day, he called Lippmann’s team to buy insurance on $600 million of subprime mortgages. Later he made even more purchases.
By September, Lippmann had pitched the trade more than a hundred times and had his spiel down pat.
Lippmann won over dozens of investors, and CDS contracts began to fly out the door of Deutsche’s Lower Manhattan office, $1 billion of protection a day. One investor even made a T-shirt that he gave to Lippmann and others saying “I shorted your house,” a joke that seemed amusing at the time.
“What Lippmann did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” says Steve Eisman, a hedge-fund manager. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ ”2
A few hedge funds were such eager converts that they became as evangelical as Lippmann after doing their own research.
“You better get up to speed on the mortgage market … fast,” Alan Fournier, founder of New Jersey hedge fund Pennant Capital, wrote to a journalist in an e-mail in the summer of 2006. “All these crappy loans have been gobbled up by investors and they’re gonna get burned … the credit unwind is really just getting started.”
In all, Lippmann bought insurance on $35 billion of subprime mortgages, keeping about $5 billion of CDS protection for his own firm’s account while selling the rest to eighty or so hedge-fund investors. A few others who already had placed the trade, like John Paulson, compared notes with Lippmann, shared intelligence, and then did some buying through Deutsche. The growing commissions enabled Lippmann to buy even more subprime insurance for his own account.
Nonetheless, by the end of 2006, most of Lippmann’s clients had lost money on the trade. He shared with a friend that his career would be affected if his scheme didn’t work out. Within his bank, Lippmann had become an object of derision. When Paulson’s trader, Brad Rosenberg, called to ask for him, a salesman answering the phone let out a loud laugh: “Why do you want to talk to him? That guy’s crazy!”
Others at Deutsche Bank resented Lippmann. Yes, he was generating commissions, but his trade also was costing the bank about $50 million a year, reducing the firm’s bonus pool, some traders grumbled.
BY LATE 2006, housing prices finally had leveled off. Subprime lenders, including Ownit Mortgage Solutions and Sebring Capital, had begun to fail. John Paulson, Lippmann, Greene, and Burry should have been making oodles of money. But their positions barely nudged higher.
Late one afternoon, following another day of lackluster gains, Paulson picked up the phone to dial Lippmann, his subprime consigliere. To his investors and employees, Paulson showed absolute faith that the protection his firm owned on $25 billion of subprime mortgages would pay off.
With Lippmann, though, he could share his fears.
“Is there something I’m missing?” Paulson asked Lippmann. “Don’t these people realize this stuff is crap? This is absurd!”
Paulson sounded like he might be wavering, surprising Lippmann.
“Relax, John. The trade will work.”
Lippmann remained cocky because he was on the trading floor, buying and selling mortgage protection all day long. He knew better than almost anyone who the mysterious investors were on the other side of all the trades, a group so eager to sell insurance on all of those risky mortgages. And he knew their time would come to an end.
*Greenblatt says he didn’t disagree with Burry’s housing bet, but he was frustrated with how large it had become, and how many investments Burry had placed in the side account.