The Greatest Trade Ever (34 page)

When the ABX index suddenly snapped back in the spring and Lahde suffered losses, it seemed like a death knell for his ambitious plan. He ignored calls from friends and family, desperate to find investors to back him. His savings were almost depleted. Dispirited, Lahde spent much of the day at the nearby beach, suntanning and ogling bikini-clad women.

Fuck it, I’m just going to hang out at the beach
, he thought.

The way Lahde figured it, he hadn’t made much money. And yet, the ABX had dropped 10 percent since he started pitching his trade, making protection more expensive than it had been when he dreamed up the trade and tried to capture the interest of investors. If they didn’t care about his trade then, they surely wouldn’t care now that it was more expensive. He seemed out of luck.

Then Lahde caught a break. At a conference at Viceroy Hotel in Santa Monica, Lahde was introduced to Norman Cerk, a local investor who helped run a small hedge fund called Balestra Capital Partners. Cerk already had placed bearish bets against risky CDOs and the lowest slices of the ABX index for his own firm, but he wanted more. When he met Lahde, Cerk was stunned to meet someone even more worried about the financial world than he was.

“He was apocalyptic,” Cerk recalls. “Here was this laid-back guy who kept saying ‘The world’s gonna end, you should put all your money in gold.’ ”

At his previous job, Lahde’s histrionics turned off his boss, souring their relationship. But Cerk was impressed by Lahde’s passion and conviction, and was taken by the depth of his knowledge about the housing market. Lahde recommended that Cerk buy protection on ABX tranches with high credit ratings. He even insisted that AA-rated slices would become worthless, a view that sounded radical, even to Cerk.

Lahde won him over, though, and Cerk handed him $6.5 million to invest. It was small potatoes compared with the kinds of funds Paulson and others were investing with, but it was enough for Lahde. He put the
money to work as soon as the check cleared, buying more protection on ABX indexes tracking subprime mortgages. Finally, Lahde could execute the trade that he envisioned. He was sure he was months away from becoming a very rich young man.

L
AHDE SEEMED TO PUT
his trade on just in the nick of time. In July 2007, Standard & Poor’s, the big bond-rating company, lowered its ratings on 612 classes of residential mortgage bonds made between 2005 and 2006, a total of $12 billion of debt. These were the very same investments that Paulson, Lippmann, Greene, Burry, and Lahde were betting against. S&P even warned that it was taking a look at CDOs that used subprime mortgages as their collateral, a clear threat that tens of billions of additional bonds would see their ratings slashed. S&P also dropped its ratings on $12 billion of debt issued by Lehman Brothers and Bear Stearns, bond-market powerhouses. Both firms now faced ratings that were close to “junk” level. Moody’s, the other big rating company, reduced its own ratings on $5 billion of subprime debt and warned that it could reduce its grades on even more mortgages.

By the summer of 2007, it was clear that the subprime-mortgage market was in deep trouble. The ABX index tracking the riskiest home loans had tumbled to 37. On one brutal day for the mortgage market, Greg Lippmann’s team scored more than $100 million in profits. Sitting on the subway on his way home, Lippmann looked stunned.

Despite the gloom in the subprime-mortgage market, Wall Street’s titans seemed to breathe a sigh of relief because the rest of the economy appeared to have been spared. In late June, Blackstone Group, the leveraged-buyout kings, broke records by raising nearly $5 billion in an initial public offering that left Stephen Schwarzman, the firm’s cofounder, with a stake in the company valued at almost $8 billion.

A few months earlier, Schwarzman had thrown such an extravagant sixtieth-birthday party for himself that several lanes of Park Avenue in New York City were closed in order to allow guests to come and go more easily.
³

The message from the world’s financial leaders was that the subprime
mess was no reason for concern for the overall economy. Keep moving, nothing to see here, they seemed to say.

“Fundamental factors—including solid growth in incomes and relatively low mortgage rates—should ultimately support the demand for housing,” Federal Reserve chairman Ben Bernanke said on June 5. “We will follow developments in the subprime market closely. However, at this point, the troubles in the subprime sector seem unlikely to seriously spill over to the broader economy or the financial system.”

In Newport Beach, California, traders at Pimco, the biggest bond investors, began to buy some debt issued by big brokerage firms, convinced they were bargains. In August, Pimco’s chief, Bill Gross, said, “I think the global economy is sufficiently strong and the U.S. economy probably will avoid a recession.”

At AIG, Joseph Cassano, who ran a division for the insurer that until late 2005 wrote protection for billions of mortgage investments, said on an investor conference call: “It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing $1 on any of those transactions.”

Even the ABX index tracking risky BBB-rated subprime mortgage bonds popped up a bit, topping 40. The index following AA-rated loans surged past 95. And in early October, the Dow Jones Industrial Average hit a record 14,164, amid growing confidence that the worst was over.

While others rejoiced that the good times were back, John Paulson sat on a secret few were privy to. The subprime-mortgage domino had indeed been toppled. But many more were set to fall.

J
OHN PAULSON LEFT WORK EARLY AND WALKED TO A NEARBY SUBWAY STATION
. It was a slow Friday in early August. Manhattan was steaming, and Paulson was looking forward to a relaxed weekend with his family in the Hamptons. But first there was someone he needed to meet.

Paulson hopped on a No. 7 train heading toward the borough of Queens, one of thousands getting a jump on the weekend. Two stops later, at Hunters Point Avenue, Paulson got off and transferred to the 4:06 p.m. “Cannonball Express,” a Long Island Railroad train heading east. Paulson was a regular most Fridays in the summer and usually reached his home in Southampton less than two hours later. A car and driver, or even a helicopter, couldn’t get him there nearly as fast, he told friends, explaining why he still took the train.

Sliding into a seat already saved for him in a front car, Paulson greeted his friend Jeff Tarrant. Soon, throngs of passengers crowded in, some carrying tall beers in the aisles.

Opening a cold bottle of water, Paulson seemed to relax as the train pulled away from New York, as if a load had lifted from his shoulders. Paulson always loosened up on the weekly ride, showing a glimpse of his former self. A few weeks earlier, Paulson noticed his college mate Bruce Goodman and his son, John, on the train and invited them to sit with him.

“I want you to hear what I did,” Paulson said, more enthusiastic than boastful. He spent more than an hour patiently explaining details of his
bet against subprime mortgages, as John Goodman, an economics student who once spent a summer at Paulson & Co., listened eagerly.

On this August Friday, though, the financial markets seemed increasingly fragile, and Paulson and Tarrant met to trade intelligence and to answer a billion-dollar riddle, one that threatened the sunny day with thick, dark clouds: If Paulson was sitting on a stunning $10 billion of gains that year, who was facing dramatic losses? Which firms were hiding deep problems, and what would the consequences be?

Paulson’s tie was loose and he looked tired, if relaxed. It was the cost of making more than $100 million during that week alone. Normally, Tarrant, well dressed in a crisp blue blazer, his silver hair perfectly coifed, looked as if he had stepped out of an issue of
GQ
magazine. But this afternoon Tarrant seemed frazzled. His firm, Protégé Partners, had invested in a number of hedge funds and other kinds of financial firms; Tarrant worried there could be more shoes to drop on the economy and the market, potentially crushing his company. He needed to know if he had placed money with firms that were on the other side of Paulson’s trades.

“Who’s holding the bag on all this stuff?” Tarrant asked Paulson.

Tarrant had consulted with a round of experts who told him that European insurance companies had sold the bulk of the CDS contracts to investors like Paulson. Many of these companies didn’t need to own up to any losses, at least immediately, thanks to various accounting conventions, so the problems likely would be swept under the rug and wouldn’t cause too much damage, they assured Tarrant.

He didn’t buy it. Many of his clients were European insurers and they promised Tarrant that they hadn’t touched the insurance on subprime debt.

“Who owns this stuff?!” he again asked Paulson, before rattling off a series of his other worries about the financial system.

Paulson seemed oddly serene as Tarrant continued with his hand-wringing.

That’s when Paulson let his friend in on a secret. A few months earlier, he had reflected on how easy it was for him to buy billions of dollars
of protection on all those toxic mortgages. All day long, his trader, Brad Rosenberg, heard the same answer when he asked to purchase bucketsful of CDS protection: “You’re done”—trader lingo for a completed trade. No hassle, no problem, the insurance was theirs for the taking.

Paulson began to wonder, if his fund found it so easy to buy billions of dollars of protection, who was selling it all to them? And what would happen to them as housing came crashing down?

Back in July, Paulson popped his head into Andrew Hoine’s office and asked his research director to swing by for a chat. Hoine once had specialized in brokerage stocks as a young analyst. So Paulson put him on the case, asking Hoine the same question that was now puzzling Tarrant.

“If we’re making all this money, who’s on the other side?” Paulson wanted to know. Maybe there was a chance to pull off another big trade by wagering against some of these apparent losers, Paulson thought. Even if it was half as alluring as betting against subprime mortgages, it could be a coup.

Hoine spent days pestering the salesmen selling Paulson all that protection. Was there a big, bullish investor on the other side of the trades? Was it a group of hedge funds or some other investor?

The salesmen weren’t allowed to give Hoine much intelligence, in keeping with custom in the marketplace, where trades are supposed to take place in anonymity. But after asking enough questions, Hoine began to surmise the answer: Banks were selling subprime protection to investors like Paulson and often keeping the positions for themselves. The banks then fed the positions to CDOs and other products and kept slices of the CDOs on their balance sheets, like retailers holding on to the merchandise for their own families.

“They wouldn’t say the specific banks, but we got ideas,” Hoine says. “You could tell from traders that Merrill and some others couldn’t sell it all.”

It all made sense to Paulson. Much like Greene on the West Coast, Paulson has been struck by how far the ABX index had fallen for much of the year, even though prices of most CDOs and other mortgage pools made up of subprime mortgages were barely budging. The CDOs and
other pools didn’t trade as frequently as the ABX, so there was a lag in their pricing, Paulson understood. But he became concerned that banks were overstating the value of the CDO slices they quoted, to avoid owning up to big losses of pieces that they themselves owned. Paulson had an associate join a group of hedge funds to write a pointed letter to the Securities and Exchange Commission. Now they were asking questions of the banks.

Even if the inquiries didn’t lead anywhere, Paulson knew that as long as the ABX kept tumbling and home owners continued to have difficulties meeting their monthly mortgage payments, all the pools of dangerous mortgages, and the CDOs built from them, were bound to eventually fall in price, too. Then, the banks and others holding these investments would have to record deep losses because they held so much of it themselves. It was just a matter of time before the pain began.

It was no secret that banks and investment banks like Merrill Lynch, Morgan Stanley, Countrywide, and Bank of America had pushed into subprime lending. They hadn’t acknowledged any huge losses just yet, though, reassuring some investors. But as the ratings companies lowered their grades on various pools of subprime home loans, it would have to happen, Paulson told Hoine.

Hoine and another analyst at the fund took a guess at how exposed various banks were to CDOs, and to every kind of home loan—subprime, “Alt-A,” “jumbo,” and “Prime-rate.” They added up all the potential losses and compared them to the capital of the banks, instantly identifying which institutions likely would run into problems. Then they figured out how many of the banks’ assets could be difficult to price or sell, called Level One and Level Two assets, adding more demerits to certain banks.

Paulson kept shaking his head as he read the latest figures on how much money investment banks had borrowed to run their businesses. It made him more certain of trouble ahead. Hedge funds like his could never get away with all that leverage, he said.

“This could be the next wave!” Paulson exclaimed to Hoine as he showed him a spreadsheet of all the debt problems.

They also realized that those selling the CDS contracts didn’t have to
set aside much money to cover payments they might have to make. An investor selling Paulson CDS insurance on even $1 billion of subprime bonds didn’t have to have nearly as much money ready to pay for it.

When Rosenberg told Paulson how inexpensive it was to buy CDS protection on a range of financial companies, it reminded Paulson of his subprime trade—very little downside and tons of upside.

So the Paulson team began accumulating protection on all kinds of companies. CDS contracts to insure $100 million of Bear Stearns debt cost just $200,000? We’ll take it! Lehman protection costs $400,000? We’ll take that, too, please. UBS, Credit Suisse, and all kinds of other big financial players? Most definitely. They could have it all for well under 0.50 percent of any amount they wished to insure. It was as if Paulson’s team was shopping at a dollar store, but finding the choicest goods from Tiffany down each row.