The Greatest Trade Ever

by Gregory Zuckerman

  After doing one trade, Burry received a call from his broker at Goldman Sachs.

  “What are you doing?? You’re just buying, buying, buying. No one else is just going one way.”

  “I’m just buying, yeah. I think the whole system is going to hell.”

  Burry felt an urgency to boost the size of the trade—he was convinced that it was going to be huge, maybe even historic. Burry began calling and meeting with clients in an effort to try to start a new fund to just focus on buying up mortgage protection. He called it Milton’s Opus LLC, an ode to John Milton’s Paradise Lost, the seventeenth-century narrative poem. He argued that a new paradise was about to be squandered as housing crumbled.

  In late 2005, Burry wrote an impassioned letter to his investors, trying to drum up interest in his new fund:

  Markets erred when they gave America Online the currency to buy Time Warner. They erred when they bet against George Soros and for the British pound. And they are erring right now by continuing to float along as if the most significant credit bubble history has ever seen does not exist. Opportunities are rare, and large opportunities on which one can put nearly unlimited capital to work at tremendous potential returns are even more rare. Selectively shorting the most problematic mortgage-backed securities in history today amounts to just such an opportunity.

  As they learned what Burry was up to, however, some of his investors grew unhappy. Burry was supposed to be a stock investor, not someone buying up all these derivatives. To many of his clients, Burry remained a former doctor who had taught himself about the world of investing. He had a lot of potential but still was learning. Now he was making what seemed like a simplistic argument about problems in the subprime part of the housing market. Investors with degrees from some of the nation’s leading business schools were comfortable relying on the complicated risk models developed by Wall Street’s sharpest minds, models that predicted minimal housing-related losses. And here was Burry saying the emperor wore no clothes. Many of the clients didn’t even bother to read his lengthy letter.

  Longtime backers also raised questions.

  “Why are you so sure this is a top” for housing? asked Rob Goldstein, one of his original investors.

  Another client cited sophisticated models developed by Wall Street firms showing that any housing-related losses would be contained, even in the event of a slowdown in housing prices.

  “What model are you using?” the investor demanded of Burry.

  Burry responded that the models Wall Street relied on were based on the performance of mortgage loans made over the past two decades. They didn’t reflect the recent surge of aggressive home loans. As such, they were as good as useless.

  “It’s just a series of logical, commonsense conclusions,” Burry told the investor. “Three to five years, just give me three to five years” to make the trade happen.

  After spending so many long hours knee-deep in the intricacies of mortgages, Burry found he often was unable to clearly summarize his views. He became impatient that he couldn’t convince investors of his thesis and began to leave the fund-raising to his team.

  Every day, Burry rushed into the office of his chief financial officer, brimming with hope.

  “Have we heard back yet?” he would ask, referring to potential clients in his new fund.

  The answer usually was disappointing. Burry bought some positions, holding CDS protection on $1.1 billion of subprime mortgage pools by early 2006. But it wasn’t nearly enough for him.

  This should be my big trade! he fretted.

  Burry turned sullen and reclusive, figuring someone else would catch on and buy the mortgage protection, driving up the price and profiting when housing turned sour. Most days, he sat alone in his office for hours at a time, shutting his door and playing heavy-metal music on a stereo system so loudly that it worried his employees. Soon, they became afraid to approach him.

  The cost of some of the mortgage insurance soon rose a bit, making Burry furious. His trade seemed to be slipping away. Heavy-metal bands like Megadeth and Disturbed blasted out of his office, the bass shaking the entire floor. Metallica’s “Kill ’Em All” and Pantera’s “Cowboys from Hell” topped Burry’s playlist.

  Eventually, Burry could no longer take the stress and frustration. He threw in the towel and ended his efforts to launch the fund, unable to find enough investors who believed in him and his bearish views.

  5.

  AS 2005 BEGAN, GROWING CONCERNS ABOUT THE HOUSING AND debt markets gnawed at John Paulson. He wasn’t convinced that a housing storm was over the horizon, and didn’t think that risky mortgages were much of a danger. But he noticed some threatening clouds and felt compelled to find protection, an umbrella just in case the rain started to pour. He just didn’t know where to find it.

  “You can’t short a house,” Paulson told a colleague, regretfully, as he surveyed the booming real estate market.

  The CDS insurance that Pellegrini championed wasn’t doing much for the firm, but it couldn’t hurt to buy some protection on a few other financial companies, Paulson figured, particularly those dependent on consumers, who seemed up to their eyeballs in debt. So Paulson directed his trader, Brad Rosenberg, to buy CDS contracts to insure the debt of two big lenders, Countrywide Financial and Washington Financial, companies that Pellegrini had been studying.

  But rumors soon circulated that the companies might receive big takeover offers, sending their stock and bond prices soaring. That weighed on the value of CDS protection on the companies’ debt, rattling Paulson and his team. The losses were small but the fund already lagged its competitors during the early part of the year, leaving little room for error if Paulson wanted to keep the firm growing.

  One afternoon, Pellegrini walked into Paulson’s office clutching a spreadsheet. He was there to discuss the latest chatter about who might buy Countrywide, rumors that were sending shares higher and sparking still more losses for Paulson & Co.

  As he turned to leave, Pellegrini threw out an idea.

  “By the way, if you’re concerned that someone might bid for Countrywide, why don’t we figure out how to short mortgage securitizations,” Pellegrini suggested. “If they go bad, they stay bad—it’s a one-way street.”

  It was a phrase he had overheard from his ex-boss, Arif Inayatullah, at his last job, at Tricadia Capital. Insurance for bonds backed by risky mortgages couldn’t be affected by any individual corporate takeover, so it might be a perfect way to get protection for any problems that might arise in the mortgage market.

  Paulson was immediately intrigued; a smile grew on his face. As interest rates rose, all those adjustable mortgages would reset at higher levels, and consumers would have difficulty meeting their monthly payments, Paulson quickly realized. That would put pressure on the mortgage-backed bonds.

  Later, Paulson came to Pellegrini still more animated, telling him that the Fed wouldn’t want to trim rates to help borrowers because it might cripple the already-weakening dollar and stoke inflation. So when interest rates climbed, a rash of home owners would be unable to pay their monthly mortgages, and the value of the mortgage bonds based on those loans would tumble in value.

  Pellegrini agreed. But when he asked his boss which slice of mortgage bonds the firm should bet against, Paulson seemed confused. He didn’t seem to understand what Pellegrini meant.

  “Yeah, there’s billions of dollars of this stuff out there.”

  Paulson’s eyes widened. “That can’t be!” he replied, with apparent shock.

  Pellegrini only recently had learned of the complexities of the mortgage market, thanks to a series of tutorials from the firm’s brokers at Bear Stearns and contacts at other firms, and after attending an industry conference. The lessons were brief, and he still wasn’t sure of all the details of that market, but they made Pellegrini something of an in-house expert, since few others at Paulson & Co. were even vaguely familiar with the area.

  “I was flabbergasted,” Paulson recalls.r />
  In the following weeks, Pellegrini asked a few more experts, including Arif Inayatullah, to come by and teach him and Paulson more about the market.

  “When I found out there was a separate category of subprime, risky mortgages, it was a big lift,” Paulson says. “The fact that they could be tranched into eighteen layers was the ultimate; I had never seen a capital structure with more than five layers.”

  He pushed Pellegrini to find the purest way to wager against the riskiest mortgages.

  “Dig deeper, Paolo, dig deeper.”

  Pellegrini focused on buying protection for BBB-rated slices of securitization deals backed by collections of subprime mortgages, or those that credit-rating agencies viewed as just a bit safer than junk. He ignored the most noxious 5 percent of the deals, rated BBB– or even worse, figuring that it might cost too much to protect the absolute dreck of the mortgage market. The BBB slices seemed close enough to the bottom of the toxic-mortgage barrel.

  Paulson agreed. If things go wrong, “these bonds don’t have a prayer of getting paid,” he told Pellegrini.

  But it was difficult to buy CDS to protect these BBB slices, Pellegrini explained. There just weren’t enough slices available in the market, the very problem that Lippmann at Deutsche Bank and his fellow bankers were busy trying to address. Pellegrini dug up figures showing that securitized subprime mortgages made up about 10 percent of the overall $10 trillion market, but there were only about $10 billion of BBB pieces outstanding. Much like Burry, Pellegrini guessed that tradable CDS contracts were soon on the way, to sate the appetite of investors for more BBB slices. He hired lawyers to complete the necessary paperwork so Paulson & Co. could be ready.

  A month later, when Lippmann’s gang finally rolled out its first batch of CDS to protect subprime bonds in the summer of 2005, Pellegrini rushed to Paulson’s office, urging him to buy. Over the next two weeks, Paulson turned to his old firm, Bear Stearns, to buy insurance protecting $100 million of subprime mortgages from defaults or losses, agreeing to pay just over $1 million for the coverage. It was such a pittance that Paulson couldn’t figure out why others weren’t also buying the cheap protection, if only for a rainy day.

  As the summer heated up and the economy hummed along, Paulson’s anxieties over the state of the economy and the housing market grew. Giddy investors were buying the BBB-rated mortgage-backed slices and all sorts of junk bonds without demanding much in return—interest rates of just 1 percentage point above those of supersafe U.S. Treasury bonds. It seemed absurd to Paulson. Who would buy a risky bond with a yield of 6 percent when Treasury bonds yielded 5 percent?

  “This is like a casino,” Paulson said of the market in a meeting with some of his analysts. “We need to sell everything and go short.” He ordered his traders to close dozens of trades.

  Paulson asked them to find the most dangerous investments to bet against.

  “Where’s there a bubble we can short?”

  Over the next few months, Paulson trimmed holdings that seemed especially sensitive to the economy and shorted the bonds of others, such as Delphi Corp., the nation’s largest auto-parts maker. He seemed prescient, at least at first. Delphi’s bonds fell to sixty-five cents on the dollar, and in October the company’s troubles became so severe that it sought bankruptcy protection. But Delphi’s bonds suddenly began to climb in price, for no obvious reason, stunning Paulson. Seventy cents, then seventy-seven and all the way up to ninety cents on the dollar. Finally Paulson threw in the towel and ended his trade, buying back the bonds to return them to his broker and close out the short.

  The experience was painful, one more of a series of aggravating moves that year. But it convinced Paulson of the advantages of using CDS contracts to express a negative view. Unlike shorting a stock or a bond, losses from CDS contracts were capped at the annual payment of the insurance, Paulson realized. He was fast becoming a convert to the benefits of derivatives trading.

  In truth, CDS contracts weren’t quite ready for prime time. One reason Delphi’s bonds had soared was that investors holding CDS contracts protecting against a loss in Delphi’s debt needed to get their hands on the company’s bonds, to present them for payment to investors who had sold them the CDS protection. They scrambled to buy up Delphi’s bonds, bidding up their price, despite the bankruptcy.

  “What a waste—we’re obviously too early,” Paulson told another analyst. “The market’s getting more wild.”

  Paulson’s frustrations grew as he watched a series of leveraged-buyout firms make acquisitions at nosebleed levels during 2005. An $11.3 billion takeover of SunGard Data Systems became the biggest buyout since RJR Nabisco sixteen years earlier, while household names like Hertz Corp. and Metro-Goldwyn-Mayer also were gobbled up, thanks to cheap debt financing from generous lenders and investors.

  “This is insane!” Paulson said, as he pulled up a chair next to Brad Rosenberg and they watched news of a new acquisition on a business-television channel. “There’s so much money out there chasing things; they’re lending too freely.” Paulson told Pellegrini that they were up against a “wall of liquidity.”

  Paulson shook his head as he noted a surge of borrowing by Wall Street’s banks, saying “Do you realize these guys are leveraged thirty-five to one?”

  Rosenberg brought Paulson stories from the Internet about how borrowers were receiving mortgages without having to document their income or assets. Lending was getting out of hand in cities such as Phoenix, San Diego, and Las Vegas. The subprime frenzy seemed to be spreading. Paulson, Pellegrini, and Rosenberg held a series of conversations with Wall Street’s top mortgage analysts, trying to understand why so few of them were worried. They were the experts, Paulson’s team realized, and Paulson a rank outsider. Was there something he was missing? Paulson wondered.

  “Our models say don’t be worried,” said Bear Stearns’ Gyan Sinha, a top-rated analyst, on a phone call. “Home prices have never gone negative,” another analyst said. Others emphasized that investment-grade mortgage investments had rarely defaulted. “They won’t even go flat,” one expert told Pellegrini.

  “They thought we were crazy. They kept talking about ‘our models,’ ” and said we didn’t know what we were talking about,” Rosenberg recalls.

  FOR PELLEGRINI, a subprime trade that once was a mere sideshow to the fund’s merger investments had become a potential lifeline, at least to him. Pellegrini’s contributions to the merger team were negligible, and it was obvious how low in the pecking order he was. Most of the analysts reported directly to Paulson. Pellegrini, however, had to first run his ideas past Andrew Hoine, the firm’s research director, as if he was a remedial student in need of a tutor.

  In late summer, the young man he had replaced, Nikolai Petchenikov, returned to the hedge fund from a one-year stint in business school, adding to Pellegrini’s anxiety. Paulson began to give the twenty-seven-year-old, rather than Pellegrini, key assignments in the international-merger area. Pellegrini’s window of opportunity at the hedge fund seemed to be closing quickly.

  Seeing the writing on the wall, Pellegrini approached Paulson, suggesting that he focus on the subprime and financial areas, an offer Paulson accepted with enthusiasm.

  “This could be a gold mine for us,” Paulson responded, encouraging him.

  It was an enormous gamble for Pellegrini, despite his boss’s enthusiasm. Merger investing was at the core of Paulson & Co. The CDS trade was a diversion, one that Paulson might drop at a moment’s notice. The firm employed fewer than a dozen people; any deadwood wouldn’t survive long. Pellegrini was forty-eight years old and on tap to earn about $400,000 that year. It was a substantial sum, although much of it went to pay his sons’ private-school tuitions. His bank account still showed an embarrassingly small sum for a finance-industry lifer.

  “It wasn’t clear to me that I was a keeper at the firm,” Pellegrini recalls. “John wasn’t comfortable with my work, and I was just as frustrated with myself. Anyone else would have fir
ed me, but John saw I was making an effort.”

  Pellegrini was confident the subprime trade would work; he just hoped he would be allowed to stick around long enough to profit from it.

  “I had everything on the line,” Pellegrini recalls. But he had been certain before in his career, only to have something foil him.

  Rather than become nervous, however, Pellegrini was more excited than he had been in years. He came to work a bit earlier and stuck around later, unable to stop thinking about the housing market. Over the summer, on a second date with Henrietta Jones, who ran the retail division for the Donna Karan clothing label, Pellegrini spent the evening replaying a presentation he made earlier in the day about the state of real estate; over dessert, he encouraged Jones to sell her Manhattan apartment.

  Interest rates and mortgage products weren’t the most romantic topics of conversation, but Jones was taken with Pellegrini’s passion.

  Pellegrini soon realized that he and Paulson had missed something important, however. In November, Pellegrini joined a group of investors at a meeting at the Grand Hyatt hotel in Midtown Manhattan hosted by Robert Cole, the chief executive officer of New Century. Pellegrini sat quietly, listening to Cole’s rosy presentation and a series of softball questions tossed by a group of upbeat investors, some of whom congratulated Cole on the low level of defaults among New Century’s customers.

  Pellegrini was convinced that his rivals were missing it.

  Wait till rates reset, he thought.

  He resisted speaking up, though, lest they figure out how bearish his firm was, and perhaps warm to the CDS protection that Paulson was becoming enamored with, pushing prices higher.