Investors were sold a set of securities with claims on all that flow of cash, each bearing a different degree of risk, like any securitization. The riskiest pieces of a CDO paid investors the highest returns but were first in line to suffer if the CDO received slimmer cash payments than it expected. Pieces with lower risk had lower returns but received the first income payments.
By the middle of the 2000s, the financial engineers were convinced that securitizations had spread the risk of all those loans, all but eliminating the chance of any big economic disaster. So they went back to the laboratory and concocted something called a mortgage CDO, featuring claims on a hundred or so mortgage-backed bonds, each of which in turn was a claim on thousands of individual mortgages.
The investments proved popular but their returns left something to be desired, spurring the bankers to craft CDOs that used the seemingly plentiful cash flow from slices of mortgage bonds rated BBB– and BBB—the ones backed by loans to borrowers with sketchy or limited credit histories—along with a sprinkling of other mortgages and loans. This investment was named a “mezzanine” CDO, after those dangerous BBB tranches.
The new CDO investments were an instant hit because they had juicy returns, thanks to all those high-interest subprime mortgages. Some slices promised annual returns of nearly 10 percent. Just as important, rating companies were convinced that most of the pieces of these CDOs should receive sky-high AAA ratings, or close to it, even though they simply were claims on huge stacks of risky home loans. The bankers argued that more cash was coming into the CDO than it needed to pay out, and that the mortgages came from all over the country and from more than one mortgage lender, making them safe. They had taken the straw of the mortgage market and spun gold: It was modern-day alchemy.
Lending by these CDOs powered the real estate market, ushering in the music, wine, and women chapter of the housing surge. In 2006, about $560 billion of CDOs were sold, including those using the cash flows from risky mortgages, almost three times 2004’s levels. The “CDO system” had replaced the banking system, in the words of writer James Grant.
Few were as good at concocting CDOs as Chris Ricciardi. Growing up in affluent Westchester County, north of New York City, the son of a stock salesman, Ricciardi tagged along with his father to the floors of Wall Street firms and the New York Stock Exchange, captivated by the fast pace and huge sums of money changing hands.
Ricciardi couldn’t find a job as a stock trader or an investment banker when he graduated during the economic slump of the early 1990s, so he started trading mortgage bonds. A few years later, as Wall Street pushed for ways to drum up higher fees and investors searched for better returns, Ricciardi was among the first to bundle the monthly payments from groups of dicey home mortgages with other debt to back securities with especially high interest rates.
Other bankers came up with their own CDOs but Ricciardi stayed a step ahead. As he moved from Prudential Securities to Credit Suisse Group, his groups always towered over competitors, as Ricciardi pushed his staff to churn out still more CDOs. Lured in 2003 to Merrill Lynch, a firm eager to take more risks under then-chief Stanley O’Neal, Ricciardi pushed Merrill to first place in the business, vaulting over bond powerhouse Lehman Brothers. New Century and others who made risky loans knew that Merrill Lynch was eager for their product so it could sell more CDOs—the more the better.
Soon Merrill was the Wal-Mart of the business, producing CDOs at a furious pace. By 2005, the firm underwrote $35 billion of CDO securities, of which $14 billion were backed mostly by securities tied to subprime mortgages.
Every quarter, Ricciardi taped rankings near Merrill’s trading desk, highlighting in yellow the firm’s top-place finish. Staff members were pushed to grow sales by 15 percent a year. They hopped the globe to Australia, Austria, Korea, and France, selling CDOs to pension funds, insurance companies, and other investors. Back in the United States, they pitched hedge-fund investors such as Ralph Cioffi of Bear Stearns on the manicured lawns of the Sleepy Hollow Country Club in West chester, New York, the ski slopes of Jackson Hole, Wyoming, and elsewhere.
For each CDO Merrill underwrote, the investment bank earned fees of 1 percent to 1.5 percent of the deal’s total size, or as much as $15 million for a typical $1 billion CDO. Soon Merrill’s CDO profits topped $400 million a year or more.
Ricciardi’s bosses cheered the activity, convinced profits would roll. “We’ve got the right people in place as well as good risk management and controls,” Merrill’s CEO, Stanley O’Neal, said in 2005.
But as the CDOs became increasingly risky, some of Merrill’s troops grew so uncomfortable selling certain products that they began lying to Ricciardi, telling him that clients had no interest in his group’s latest creations, even before testing the waters. Ricciardi bolted Merrill in early 2006, after pocketing an $8 million paycheck for his work the previous year, to join Cohen & Co., a small firm that managed CDO deals. He continued to champion CDOs.
“These are the trades that make people famous,” he told staff at his new firm that year, trying to drum up enthusiasm for CDOs, according to The Wall Street Journal. His new firm eventually would manage CDOs with the most defaults.1
By the time Ricciardi left Merrill, the investment bank was hooked on profits from risky CDOs. Dow Kim, then head of markets and investment banking at Merrill, vowed to do “whatever it takes” to stay number one in CDOs. In 2006, the firm pushed even harder to get these deals out the door, racking up $700 million of fees and issuing $44 billion subprime CDOs, up from $14 billion in 2005. That year, O’Neal was paid an $18.5 million cash bonus and $48 million in total pay.
Investors who bought the CDO slices often believed in their safety, or were assured by the top-notch investment ratings they received. Like firefighters going into yet another burning building, they had survived for so long, they began to see their work as routine.
Ralph Cioffi, a twenty-two-year Bear veteran who ran two hedge funds at Bear Stearns, first became worried about subprime borrowers in early 2006. But the military-history buff put almost all of his funds’ cash in high-rated slices of CDOs, borrowing so much money that the funds owned $20 billion of these investments. Cioffi, who was personally worth $100 million at one point that year, didn’t buy blindly; he also owned CDS contracts insuring other, lower-rated mortgage bonds, a strategy that seemed more conservative to him.
His investors had utmost confidence in Cioffi and his partner, Matthew Tannin.
“I often bragged about the fund because it didn’t have a single down month in three years, and that was just amazing to me,” says Ted Moss, a sixty-seven-year-old real estate developer from Cleveland, Tennessee, who invested about $1 million in one of Cioffi’s funds at Bear Stearns.
It seemed like investors hungered for these CDO slices because housing was rising. But in reality, many were taking advantage of a slick accounting maneuver. When a bank purchased the AAA piece of a CDO while simultaneously buying credit-default swap insurance on that same slice, it often could immediately book as profit the present value of the future cash flows from that CDO as long as it had a higher interest payout than the cost of the CDS. Traders buying a CDO slice yielding 5 percent a year, e.g., while at the same time paying 4.8 percent a year to purchase a CDS contract on that same slice, could boast an easy 0.20 percent annual profit. They sometimes even claimed an immediate windfall based on the expected profit of these trades over the subsequent ten years.
Borrow enough money, repeat this trade frequently, and a huge bonus was in store for the traders, a windfall that even those harboring suspicions about housing found hard to turn down. Eventually, these “negative basis” trades led to a major percentage of the losses on CDOs, according to UBS Securities.2
THROUGHOUT 2006, Greg Lippmann was eager to find evidence of cracks in housing. Most mornings, after taking a cab or bus from his downtown loft to Deutsche Bank’s Wall Street–area office, he uncovered fresh proof that real estate was weakening. But the subpr
ime mortgages he had bet against were not dropping. Sometimes colleagues would see Lippmann shake his head, a bemused smile on his face. He knew the CDOs were still buying, propping up the market.
It didn’t make much sense to Lippmann. He got on the phone, urging investors to short the very same mortgage bonds that the CDOs were purchasing, reassuring those with losing trades that the CDO buying would have to stop, at some point.
Demand only grew, however. In fact, there weren’t enough subprime mortgages to meet the rabid interest for the high-return “mezz” CDOs. So investment bankers turned ingenious, creating CDOs with claims on the income of other CDOs, calling these “CDO squared.” They crafted other CDOs from the cash generated by selling CDS protection to investors like John Paulson. These “synthetic” CDOs, in fact, became the dominant form of CDOs by late 2006.
Investment banks favored synthetic CDOs because they were easier to construct, a quick way to generate fees. They didn’t require the purchase of actual mortgage bonds, a process that typically took months. A billion-dollar CDO could be assembled in mere weeks by selling enough CDS contracts on home mortgages. By the end of 2006, there were $1.2 trillion of subprime loans, about 10 percent of the overall mortgage market. But by introducing so many CDOs, more than $5 trillion of investments had been created based on all those risky loans, according to some estimates. This is the secret to why debilitating losses resulted from a market that seemed small to most outsiders, unaware of the breakneck growth of CDOs.3
There was just one hitch: The top-rated slices of these CDOs could be hard to sell, since they had lower yields than riskier CDO slices. So the banks often kept or bought these “supersenior” pieces for themselves. Giant insurance company AIG stopped selling insurance on these investments by 2006, but the banks kept piling them on, eager to get CDOs out the door. (At the time, AIG Finance, an arm of AIG, still had perhaps the most exposure to these investments.)
Merrill Lynch, Citigroup, Morgan Stanley, and UBS, the same investment banks creating CDO deals from toxic mortgages, all placed these supersenior CDO slices in their own accounts, like butchers bringing home noxious sausage to share with the family. Top management either approved the process or were clueless it was happening, assured by underlings that the securities were safe. Yes, the CDO investments they held shared AAA ratings with the debt of the U.S. government. That’s where the similarities ended. They were both AAA rated the way that Miley Cyrus and Meryl Streep both get high marks from audiences. In other words, they were worlds apart.
Some bankers had vague worries, but they felt pressure to get as many CDOs completed before it all ended, like a giant game of musical chairs.
Charles “Chuck” Prince, chief executive of Citigroup, the largest bank in the world, who received a $13.2 million cash bonus and $25.6 million in overall pay in 2006, captured the sentiment in an unusually frank statement: “When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he told the Financial Times. (By June 2008, Prince would resign from his job as the bank dealt over $15 billion in losses, much of it from CDO investments.)
Others believed in the safety of the high-rated debt slices, or relied on brainy quants and their whiz-bang computer models, which deemed the CDO slices safe, like illusionists fooling even themselves with a trick they had performed.
JOHN PAULSON already had purchased billions in CDS investments that would pay off if the home mortgages of borrowers with sketchy credit ran into problems. And he bought insurance contracts that would rack up profits if groups of subprime mortgages tracked by the ABX index suffered.
But if he was genuinely going to make the trade of a lifetime, he needed more. Like a cocksure Las Vegas card-counter, he was eager to split his winning blackjack hand, again and again.
“Given where the credit markets were, we had to find short opportunities,” Paulson says.
As Paulson eyed the raging CDO market, he realized it, too, was bound to collapse. He decided he had to get his hands on insurance for these investments as well.
Pellegrini and the rest of Paulson’s team searched the market for especially bad CDOs, like a shopper picking through a fruit bin. Rather than find the healthiest and ripest of the lot, though, Pellegrini and his team searched for the most rotten. Then they bought CDS insurance contracts on those CDO slices. A CDO with a lot of loans made by New Century? Throw it in the basket. One dominated by liar loans and interest-only mortgages? Definitely. A CDO with lots of mortgages from the superheated real estate markets of California and Nevada? Grab two handfuls.
But as Paulson’s shorting became an open secret in the business, Pellegrini noticed that the Wall Street pros were treating him less warmly, as if he was throwing a wrench in their well-oiled machine. At one point in 2006, Pellegrini was eager to learn about a group of CDOs filled with mortgage bonds put together by Carrington Capital Management LLC, run by hedge-fund manager Bruce Rose. Pellegrini recognized that he remained an amateur in this world and he was worried that he might miss something if he didn’t see the “tape” detailing the actual mortgages in the CDOs. He told his broker at Bear Stearns that if he sent the tapes of Carrington’s mortgage-bond deals, he might consider buying safer slices of the CDOs.
After a few hours, the broker called Pellegrini with some bad news.
“I’m sorry,” the broker said, sheepishly. “The issuer doesn’t want you to see it.”
“What do you mean? How is that even possible!?”
Later that day, Pellegrini got Bruce Rose on the phone to express his displeasure at the unusual blackballing.
“I’ve seen your investment presentation,” Rose replied. “I find it amusing. But I don’t want anything to do with you.”
Rose then hung up, leaving Pellegrini boiling.
“They were closing ranks on us,” Pellegrini says.
The activity began to wear on Rosenberg, the firm’s only debt trader. Sometimes Paulson wanted him to buy protection on mortgage bonds. Other times he’d sell the ABX index of subprime bonds—it was another way to be bearish on housing. None of the investments was traded on public exchanges or had clear pricing, making it harder to know if it had been a good deal. Rosenberg also bought protection on a few financial companies. And once in a while, Paulson asked him to buy some bonds, too.
Each morning before 10 a.m. Rosenberg e-mailed seven or eight Wall Street dealers an “OWIC” list, or Offers Wanted in Competition, a list of the names of mortgage slices that Paulson & Co. wanted to buy CDS protection for. At 2:30 p.m. he’d receive a spreadsheet of their best offers. Pellegrini took the list to Paulson, and they’d huddle in his office, speaking in undertones. Rosenberg would emerge an hour later for a new round of furious phone calls.
There was no time for breaks. Paulson ordered lunch in for his staff, and Rosenberg ate at his desk.
Rosenberg left the office exhausted, although he claimed the pace didn’t faze him.
“I’m from Bear Stearns, the toughest firm on the Street. I didn’t need a pat on the back,” says Rosenberg. “They ranked everyone and fired the lowest guy on the desk each year.”
Rosenberg didn’t know exactly how much mortgage protection Paulson wanted, but he knew Paulson hungered for more.
“We had to get on as many trades as possible before it was too late,” Rosenberg says.
JOHN PAULSON, focused on creating a huge trade, soon took a controversial step that would lead to some resentment for his role in indirectly contributing to more toxic debt for investors.
Paulson and Pellegrini were eager to find ways to expand their wager against risky mortgages; accumulating it in the market sometimes proved a slow process. So they made appointments with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create CDOs that Paulson & Co. could essentially bet against.
Paulson’s team would pick a hundred or so mortgage bonds for the CDOs, the
bankers would keep some of the selections and replace others, and then the bankers would take the CDOs to ratings companies to be rated. Paulson would buy CDS insurance on the mortgage debt and the investment banks would find clients with bullish views on mortgages to take the other side of the trades. This way, Paulson could buy protection on $1 billion or so of mortgage debt in one fell swoop.
Paulson and his team were open with the banks they met with to propose the idea.
“We want to ramp it up,” Pellegrini told a group of Bear Stearns bankers, explaining his idea.
Paulson and Pellegrini believed the debt backing the CDOs would blow up. But Pellegrini argued to his boss that they should offer to buy the riskiest slices of these CDOs, the so-called equity pieces that would get hit first if problems resulted. These pieces had such high yields that they could help pay the cost of buying protection on the rest of the CDOs, Pellegrini said, even though the equity slices likely would become worthless over time, as the debt backing the CDO fell in value. And if their analysis proved wrong and the CDOs held up, at least the equity investment would lead to profits, Pellegrini said.
“We’re willing to buy the equity if you allow us to short the rest,” Pellegrini told one banker.
To try to protect themselves, the Paulson team made sure at least one of the CDOs was a “triggerless” deal, or a CDO crafted to be more protective of these equity slices by making other pieces of the CDO more likely to take early hits. Paulson’s goal was to make the equity piece a bit safer, but this step made the other parts of the triggerless CDO even more dangerous for anyone with the gumption to buy them.
He and Paulson didn’t think there was anything wrong with working with various bankers to create more toxic investments. Paulson told his own clients what he was up to and they supported him, considering it an ingenious way to grow the trade by finding more debt to short. After all, those who would buy the pieces of any CDO likely would be hedge funds, banks, pension plans, or other sophisticated investors, not mom-and-pop investors. And if these investors didn’t purchase the newly created CDOs, they’d likely buy another similar product since there were more than $350 billion of CDOs at the time.
The Greatest Trade Ever Page 20
