More Money Than God_Hedge Funds and the Making of a New Elite

by Sebastian Mallaby

  Yet Amaranth’s collapse could not fully explain the calls for regulation that followed. Charles Grassley, the chairman of the Senate Finance Committee, complained in a letter to Treasury secretary Henry Paulson that ordinary Americans were increasingly exposed to hedge funds via their pension plans; he demanded to know why the funds were allowed to get away with secrecy. But Amaranth had disclosed its strategies to its investors in monthly reports; indeed, it was the lack of secrecy that had made it a target once the market turned against it. Likewise, a survey of private economists conducted by the Wall Street Journal found that a majority favored tougher oversight for hedge funds, and one popular regulatory measure was compulsory registration with the Securities and Exchange Commission. But it was not at all clear what registration would achieve. As a result of Amaranth’s failure, American taxpayers suffered no harm; there was no round-the-clock crisis meeting at the New York Fed and no apparent damage to the financial system. The pension funds that lost money were angry, but Amaranth had represented a tiny share of their assets. The effect of the fund’s collapse was no greater than the effect of a bad day for the S&P 500. In sum, the market had disciplined Amaranth for its errors while inflicting minimal damage on the wider economy. No regulatory clamp could have done better.25

  Ever since Long-Term Capital’s demise, Wall Street had worried about the next hedge-fund blowup. Now the event had taken place, and the scars were barely visible. The critics of hedge funds continued to worry that these leveraged monsters could ignite systemic fires—after all, Long-Term Capital had done so. But Citadel’s lightning purchase of Amaranth’s portfolio had proved that there was another side to this story. Perhaps hedge funds might occasionally ignite fires. But they could also be the firefighters.

  15

  RIDING THE STORM

  Daniel Sadek did not have an easy childhood. Born in Lebanon in 1968, his schooling was interrupted by the country’s civil war, and his body was scarred by a gunshot wound and a flying piece of metal. He left Lebanon for France, then fetched up in California at eighteen, landing jobs as a gas-station attendant and then later as a car salesman. But around 2000, the scales fell from his eyes. He was selling Mercedes cars—lots of them, one after the next—to customers who were in the mortgage business. Discovering that he could get a license to sell home loans without taking classes, Sadek embarked upon a fresh career. If he had wanted to become a professional barber, he would have needed 1,500 hours of training to qualify for a state license.

  By 2005, Sadek’s company, Quick Loan, had seven hundred employees. It was one of the top fifty “subprime” lenders in the nation, meaning that it specialized in customers who were too risky to qualify for normal mortgages. Its marketing campaign was not subtle. “No income verification. Instant qualification!!” promised one ad. “You can’t wait. We won’t let you,” proclaimed the company slogan. The California Department of Corporations recorded a string of complaints against Quick Loan, including allegations of fraud and underwriting errors.1 But Sadek did not let that cramp his style. He bought a mansion on the coast and an apartment in Vegas; he sported a necklace, flip-flops, and long hair; he acquired a collection of fast cars, some restaurant investments, and a movie company. When his actress girlfriend needed a film part, he bankrolled a production called Redline. It was “an action flick loaded with cars, chrome, and silicone,” the Boston Globe’s reviewer wrote, “everything you’d expect it to be, and yet so much less.” During the course of filming and promoting the movie, the cast demolished more than $2 million worth of Sadek’s sports cars. “Fear nothing; risk everything,” ran the movie’s tagline.

  In 2006, Kyle Bass, a hedge-fund manager in Dallas, heard about Sadek and his filmmaking. The story confirmed what Bass was starting to suspect: The American mortgage market was in the grips of something truly wild—a bubble that exceeded anything that might exist within the hedge-fund industry. Between 2000 and 2005, the volume of risky subprime loans had quadrupled, and a growing share of these loans was flowing to people who could not repay. “Prior bankruptcy. Tax Liens. Foreclosures. Collections and Credit Problems. OK!” proclaimed another Quick Loan ad, as though the firm was actively seeking out deadbeats. Sadek’s attitude toward this seeming suicide was summed up by his movie. As Kyle Bass put it later, “When they started catapulting Porsche Carrera GTs and he says, ‘What the hell, what are a couple of cars being thrown around?’ I’m thinking, ‘That’s the guy you want to bet against.’”2 Around the time that Amaranth was blowing up, Bass and his company, Hayman Capital, figured out how Sadek’s mortgages were being packaged together and sold off in the form of mortgage bonds. Bass shorted a large quantity of those bonds, then settled back and waited.

  Other hedge-fund managers had similar epiphanies. For Michael Litt, the cohead of a large alpha factory called FrontPoint Partners, the light went on when he visited the mortgage desk at Lehman Brothers. The mortgage team had recently relocated to a gigantic new trading floor; and while Litt was touring the premises, he heard a group of traders teasing one of their buddies. A tailor had come to measure the men for some new $6,000 suits, and this guy had ordered only one—to any self-respecting mortgage jock, he was positively wussy! A little while later, Litt was on a plane home from London, reading a report from the Bank for International Settlements that explained how sophisticated finance had suppressed market volatility. Litt remembers thinking that something was wrong; looking out the window he could see the outline of Greenland, which had once been hospitable to human settlement and then had frozen over. At forty thousand feet it suddenly hit him. Volatility was low because the world was awash with wild money; but abundant liquidity was giving the false sense that stability was due to some magical structural improvement in the financial system. Investors from Asia to Arabia were wiring billions of dollars to fund managers in New York, buying every piece of paper that Lehman’s mortgage desk could sell, and yet the smart folks at the Bank for International Settlements appeared to be missing the freeze that would follow. Litt rebalanced FrontPoint’s portfolio to get ready for a shock. In the fall of 2006, the firm bet against the subprime mortgage sector and took a bearish stance in several other trading strategies.3

  Over the course of the next year, Hayman Capital and FrontPoint both profited handsomely.4 But the man who made the mother of all killings on this mother of all bubbles was an unassuming figure called John Paulson. Neither tall nor short, neither handsome nor plain, neither glad-handingly eager nor offensively standoffish, he came across as Mr. Average. After graduating from Harvard Business School in 1980, he had progressed from a management consultancy to an early hedge fund named Odyssey Partners and thence to Bear Stearns, where he worked on mergers and acquisitions. In 1994 he had launched a tiny hedge fund of his own, setting himself up in a Park Avenue building that incubated several other hedge-fund start-ups. Over the next decade, Paulson and Company succeeded steadily, growing its capital from $2 million at inception to $600 million in 2003; then the great hedge-fund asset boom carried it away, so that by 2005 it was managing $4 billion. Even then, Paulson kept his profile low. He had only seven analysts on his staff; and although he had amassed a personal fortune, he had done so in the quietest way possible.5

  Paulson was a loner and a contrarian. He had no doubt of his own ability and no need for affirmation. Plowing his own road as a boutique-hedge-fund manager, he had honed the art of the unconventional long shot. He specialized, for example, in a form of merger arbitrage that focused on long odds: As well as investing in mergers that were expected to be consummated and collecting a modest premium, Paulson sometimes bet against the ones that might blow up, or in favor of ones where the market might be shocked by a surprise bid from a rival acquirer. Paulson also made money by calling turns in the cycle. When the economy was booming, he looked for the moment to go short, and vice versa. Some of the people who worked for him had the same maverick vibe. Paolo Pellegrini, a tall, elegant Italian with heavy-framed glasses and a permanently amused tw
inkle in his eyes, had spent years chasing fruitlessly offbeat ideas; “I’m a romantic type,” he said later.6 When Pellegrini signed on as Paulson’s analyst for financial companies in 2004, he realized that for the first time in his life, his unconventional style was welcomed.

  Much of Paulson’s skill lay in the detail of his positions. He expressed his skepticism about booms via a strategy known as capital-structure arbitrage, which started from the fact that the various bonds issued by a given company might be treated differently in bankruptcy. So-called senior bonds had the first claim on the company’s remaining assets and so would get paid back first; junior bonds made do with whatever was left over. So long as the company was healthy, investors didn’t focus on this dull legal nuance, so the senior and the junior bonds traded at similar prices. But if the economy was weakening, an opportunity arose. Paulson could assess which companies were heading for bankruptcy—they might be in a cyclical industry, for example, or they might have too much debt. Then he could short the junior bonds that would get hit the most if the company went down, sometimes hedging his position by going long the senior bonds.

  In early 2005, Paulson started to feel that the economic cycle was getting ready to turn downward. Bonds that he had bought at a discount during the previous recession were now trading at silly heights; financial markets were frothy thanks to a long period of low interest rates. Paulson began to hunt for the best way to bet against this bubble. He wanted to find American capitalism’s weakest spot—the thing that would blow up the loudest and fastest if the economy slowed even a little. The dream target would combine all the standard vulnerabilities: It would be in a cyclical industry, it would be loaded up with too much debt, and the debt would be sliced into senior and junior bonds, so that Paulson could short the junior ones, where all the risk was concentrated. Paulson experimented with shorts on car-company bonds, on the theory that consumers were taking out car loans that they could not afford. He shorted an insurance company and a couple of home lenders. But there was a risk in all these trades. The car companies, insurers, and home lenders all had value as franchises—they had buildings, brands, customer relationships—so even if they collapsed under the weight of their debts, they would probably still be worth something. If Paulson was going to be contrarian, he wanted to short something that could be totally wiped out. In the spring of 2005, he hit on the right target.

  The target was mortgage securities, which combined every imaginable charm that a short seller could wish for. Home prices, and therefore mortgages, were certainly cyclical, even though the great American public had convinced itself that home prices could only go upward. Equally, home prices were built on huge mountains of household debt, and the moment that families hit hard times, they would be unable to make their payments. As to the division of junior from senior debt, Paulson had never seen anything quite like the feast that the mortgage industry served up. Lenders like Daniel Sadek generated mortgages that were sold to Wall Street banks; the banks turned these into mortgage bonds; then other banks bought the bonds, rebundled them, and sliced the resulting “collateralized debt obligation” into layers, the most senior ones rated a rock-solid AAA, the next ones rated AA, and so on down the line to BBB and lower—there might be eighteen tranches in the pyramid. If the mortgages in the collateralized debt obligation paid back 95 percent or more of what they owed, the BBB bonds would be fine, since the first 5 percent of the losses would be absorbed by even more junior tranches. But once non-payments surpassed the 5 percent hurdle, the BBB securities would start suffering losses; and since the BBB tranche was only 1 percent thick, a nonpayment rate of 6 percent would take the whole lot of them to zero. In contrast to auto-company bonds, there was no franchise value to worry about, either. A bankrupt company might be worth something to someone. A pile of loans with zero payout is worth, simply, zero.

  In April 2005, Paulson placed his first bet against these mortgage securities. He bought a credit default swap—an insurance policy on a bond’s default—on $100 million worth of BBB-rated subprime debt. There was a huge asymmetry in the risk and the reward: He paid $1.4 million for a year’s worth of insurance, but if the securities were wiped out, he stood to pocket the full $100 million. The question was whether the odds of default were good: You can get a juicy payout by betting on a single number in roulette, but that’s because your chances of winning are abysmal. To figure out the odds, Paulson turned to Paolo Pellegrini, the offbeat Italian. Armed with a $2 million research budget, Pellegrini bought the largest mortgage database in the country, hired an outside firm to warehouse the numbers, and brought in extra analysts to figure out the past behavior of default rates.

  Pellegrini’s first discovery was not encouraging. He and Paulson had begun by thinking that families with unpayable mortgages were bound to default. But now Pellegrini saw there was a catch: so long as house prices continued to head up, homeowners would be bailed out by the option of refinancing.7 But Pellegrini made a second discovery as well. The mortgage-industrial complex argued that house prices, which in the summer of 2005 were appreciating at a rate of 15 percent annually, would never fall across the country in a synchronized way; it had never happened before, so bonds backed by bundles of mortgages drawn from different states were regarded as relatively riskless. Because Pellegrini was a newcomer to the mortgage game, he was unburdened by this article of faith, and his number crunching showed that its basis was shaky. If you adjusted house prices for inflation, there had been national slumps in both the 1980s and 1990s, so there was every reason to suppose that the extraordinary run-up of the early 2000s would be followed by another downturn. Moreover, to block the option of refinancing, it was not actually necessary for house prices to fall; if prices merely went flat, home owners would lack the collateral to take out new and larger mortgages. Pellegrini’s analysis suggested that zero house-price appreciation would eventually lead to a mortgage default rate of at least 7 percent, wiping out the value of all BBB bonds. The verdict could be summed up in a phrase: Zero would mean zero.

  By early 2006, Paulson’s initial mortgage bets had failed to make money, and some of his investors were muttering that he had strayed beyond his competence. But the more Paulson contemplated the results of Pellegrini’s research, the more he was convinced that he had found the opportunity of a lifetime. House-price appreciation was slowing as the Fed’s interest rate hikes pushed up the cost of mortgages, so the odds of flat house prices had to be at least even: This was like betting on red in a roulette game. But the potential reward was seventy or eighty times the stake, double the payout from betting on a single roulette number. Paulson drew up a simple table to describe what he could do. If he set up a fund with $600 million of capital and spent 7 percent of that taking out insurance on BBB mortgage bonds, the worst that could happen was a loss of $42 million. The rewards, on the other hand, were almost limitless. If the BBB bonds suffered a relatively mild default rate of 30 percent, the fund would gain 341 percent, or $2 billion. If they suffered a default rate of 50 percent, it would gain 568 percent, or $3.4 billion. And if the bonds suffered a default rate of 80 percent, which Paulson considered highly likely, the fund would gain 909 percent—an astonishing $5.5 billion. When Paulson explained this to investors, a few thought he had gone crazy. A gain of 909 percent? When did that ever happen? But Paulson was not a man to be deterred. In the summer of 2006, he set up a new hedge fund to do exactly what his table said, seeding it partly with his own money and enlisting Pellegrini as the comanager.

  The challenge was how to do the trades in the size that he now wanted. Paulson could bet against mortgage bonds by borrowing them and selling them short, a cumbersome operation. Or he could buy an insurance policy—a credit default swap from a bank—but that depended upon finding a bank that was interested in selling. To Paulson’s great good fortune, in July 2006 Wall Street’s top investment banks created an easier option: Hoping to earn themselves a stream of trading commissions, they launched a subprime mortgage index, known a
s the ABX. Paulson now found that, on any given day, it was easy to buy insurance on, say, $10 million of subprime paper. Then, a week or two later, he took a call from one of the big banks. The man on the line was an ABX trader.

  “What’s your picture?” the trader demanded. He was willing to deal with Paulson in size. How many millions’ worth of subprime bonds did he want to buy insurance on?

  Paulson considered. He didn’t want to scare the trader off. If the guy knew how much insurance Paulson really wanted, he surely would not be stupid enough to sell without first moving the price against him.

  “Five hundred million,” Paulson ventured.

  “Done,” the trader responded.

  “Another five hundred million,” Paulson said.

  “Done,” the man repeated. He wasn’t flinching in the least. Then he said again, “Tell us your total picture.”

  “Call me again tomorrow,” Paulson said, and the next day he bought insurance on another $1 billion of subprime bonds. In the first half of the year, he had hustled to lay his hands on $500 million of this stuff. Now, in just two days, he had bought four times that quantity.

  “Tell us your picture,” the trader said again.

  Paulson thought to himself, this is the holy grail. He remembered Soros’s words: Go for the jugular.

  “I’ll do another three billion,” he said.8 At this, there was a silence on the line. The trader agreed to another billion, then balked at doing any more. But by calling around the other banks, Paulson established positions totaling $7.2 billion for his credit fund.9 At the end of 2006, he launched a second fund with the same strategy.