However, at least one banker smelled trouble and rejected the idea. Paulson didn’t come out and say it, but the banker suspected that Paulson would push for combustible mortgages and debt to go into any CDO, making it more likely that it would go up in flames. Some of those likely to buy the CDO slices were endowments and pension plans, not just deep-pocketed hedge funds, adding to the wariness.
Scott Eichel, a senior Bear Stearns trader, was among those at the investment bank who sat through a meeting with Paulson but later turned down the idea. He worried that Paulson would want especially ugly mortgages for the CDOs, like a bettor asking a football owner to bench a star quarterback to improve the odds of his wager against the team. Either way, he felt it would look improper.
“On the one hand, we’d be selling the deals” to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Eichel told a colleague; on the other, Bear Stearns would be helping Paulson wager against the deals.
“We had three meetings with John, we were working on a trade together,” says Eichel. “He had a bearish view and was very open about what he wanted to do, he was more up front than most of them.
“But it didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side,” Eichel says.
For his part, Paulson says that investment banks like Bear Stearns didn’t need to worry about including only risky debt for the CDOs because “it was a negotiation; we threw out some names, they threw out some names, but the bankers ultimately picked the collateral. We didn’t create any securities, we never sold the securities to investors.… We always thought they were bad loans.”
Besides, every time he bought subprime-mortgage protection, someone had to be found to sell it to him, Paulson notes, so these big CDOs were no different.
Indeed, other bankers, including those at Deutsche Bank and Goldman Sachs, didn’t see anything wrong with Paulson’s request and agreed to work with his team. Paulson & Co. eventually bet against a handful of CDOs with a value of about $5 billion.
Paulson didn’t sell any of these products to investors. Some investors were even consulted as the mortgage debt was picked for the CDOs to make sure it would appeal to them. And these deals were among the easiest for an investor to analyze, if they so chose, because they were “unmanaged” CDOs, or those in which the collateral was chosen at the outset and not adjusted later on like other CDOs. It wasn’t his fault that others were willing to roll the dice.
A few other hedge funds also worked with banks to create CDOs of their own that these funds could short—so Paulson wasn’t doing anything new. Nor did Paulson’s moves create more troubled mortgages or saddle borrowers with additional losses—the deals were CDOs composed of CDS contracts, rather than actual mortgage bonds.
“We provided the collateral” for the CDOs, Paulson acknowledges. “But the deals weren’t created for us, we just facilitated it; we proposed recent vintages of mortgages” to the banks.
But some investors later would complain that they wouldn’t have purchased the CDO investments had they known that some of the collateral behind them was chosen by Paulson and that he would be shorting it. Others argued that Paulson’s actions indirectly led to more dangerous CDO investments, resulting in billions of dollars of additional losses for those who owned the CDO slices when the market finally cratered.
In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out.
They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. “But we still didn’t know.”
10.
ANDREW LAHDE WAS OUT OF WORK IN THE SUMMER OF 2006, HE had little left in his savings account, and he was stuck in a cramped one-bedroom, rent-controlled apartment. But Lahde was convinced he had at least one thing of value: a trade that was sure to make him a fortune. He just couldn’t get anyone to believe in him.
The thirty-five-year-old had been let go by Los Angeles investment firm Dalton Capital after a series of clashes with his boss and an abrupt shuttering of the hedge fund that Lahde was working on. He wasn’t very concerned, at least initially. Young traders were launching hedge funds with ease, from coast to coast. Lahde figured he’d just do the same. But investors turned him down cold. The only nibbles came from those offering very little money but demanding a huge chunk of his new firm. That was something Lahde wouldn’t consider, though in truth his firm amounted to little more than a glass desk and a simple chair in his Santa Monica living room, as well as an unyielding conviction that the housing market was about to crater.
It didn’t help that Lahde looked more like a chilled-out surfer than a budding hedge-fund titan. Six-foot-two with tousled blond hair, chiseled features, and sleepy, deep-blue eyes, Lahde seemed to have just rolled out of bed, more than a bit upset at having been awoken. He didn’t seem comfortable around people, fidgeting in his seat during most meetings, and the slow, deliberate tone of his voice was so deep and muted, it sometimes was hard to make out what he was saying.
Lahde’s mother, Bonnie, back home in Michigan, kept calling, badgering him to find a real job. His best friend, Will, insisted that his trade idea wouldn’t pan out because the Fed and the government would ensure that housing held up, at least through the 2008 elections. It had been years since Lahde cared very much about the opinions of family members and friends, but their lack of confidence grated on him. It’s not like he didn’t at least apply for some jobs at nearby firms, but they didn’t pan out, partly because Lahde, brimming with a confidence not yet reflected in his résumé, was uninterested in junior positions.
“Dude, I stopped looking for a job, full on,” he told Will after one more irritating call.
Lahde’s deep suspicions and bitter resentments always lay just below the surface. He grew up in a religious home, the son of a mechanical engineer and a physician’s assistant, in the mostly white, wealthy Detroit suburb of Rochester, Michigan, Madonna’s hometown.
His father, Frank, worked for Ford Motor Company and then for various auto suppliers in the area, but he was occasionally out of work as the industry’s troubles grew. Nonetheless, the Lahde family stretched their finances to buy a 2,000-square-foot home, among the smallest in the neighborhood, adding to the tension in the home. Sundays were spent at St. John, a local Lutheran church, and all three of the Lahde boys attended the church’s school from fourth to eighth grades.
But at fourteen, Lahde, hoping to generate some cash for himself amid the family’s strain, began selling marijuana to wealthier kids in town, after starting with fireworks sales. Once, when he was caught dealing pot, Lahde argued to his parents that alcohol was a gateway drug and a far greater evil than cannabis.
“I figured out that the only way to have security was to have a business with good cash flow, or to be wealthy enough so you didn’t have to work,” Lahde recalls.
At Michigan State, where Lahde majored in finance and graduated with honors, he began subscribing to The Wall Street Journal, impressed with stories of traders making millions. Math courses came easily to Lahde, though he had little patience for much else. After college, and a few years making less than $30,000 a year as a broker at TD Waterhouse, Lahde was rejected by every business school he applied to. It happened again, a year later—Stanford University, the University of Chicago, the Wharton School, and Yale University all turned him down. Finally, he gained acceptance to UCLA’s Anderson School of Management, the last student taken off their waiting list.
At UCLA, Lahde bristled at his more privileged classmates, some of whom graduated from prep schools and Ivy League universities but didn’t seem especially bright to him. When he told them that he had graduated from Michigan State, rather than its more prestigious rival, the University of Michigan, he felt they looked down on him. Things didn’t go any more smoothly inside the classroom. Lahde almost was kicked out after receiv
ing an F in a Human Resources class. He blamed the grade on his repeated challenges to the professor’s weak arguments during class discussions. The F drove Lahde nuts because he was paying his own way at the expensive school, draining savings from his earlier jobs and extracurricular activities while many classmates were enjoying a free ride courtesy of their families.
“He almost took away everything I had worked for,” Lahde recalls, referring to his professor.
Placed on probation after the failing grade, Lahde graduated in 2002 to a discouraging job market. In his spare time during business school, he had taken courses to become a chartered financial analyst, helping to distinguish him in the market. Through a UCLA contact, Lahde landed a job at Roth Capital, a third-tier investment bank in nearby Newport Beach known for raising money for small, usually obscure companies. He was miserable from day one, itching to invest money rather than sell securities to investors. But Lahde quickly found his niche, picking a number of winning stocks for clients and learning to pitch the firm’s various products.
In the fall of 2004, Lahde latched on as an analyst at Dalton. Steve Persky, the owner of the growing, $1 billion hedge fund on Wilshire Boulevard in Los Angeles, judged Lahde the hungriest of the job candidates he met. But Lahde soon began to clash with his demanding boss, unhappy when Persky publicly criticized employees in regular group meetings when they overlooked details in their work. On the other hand, Lahde’s work impressed Persky, who named his firm after the prestigious New York prep school he had attended. But Lahde rankled his boss by overdramatizing investment opportunities, sometimes calling a promising company “another Microsoft,” while referring to a problematic company as “the next Enron.”
At the time, both Persky and Lahde were novices when it came to real estate. When he first joined Dalton, Lahde told his boss that he was thinking about buying a $600,000 condominium by paying $30,000, or 5 percent of the price, as a down payment. Persky seemed shocked.
“Are you serious, that’s all they want?” Persky said.
“Yeah, that’s the standard,” Lahde replied. “I think I can even get a mortgage with no down payment at all.”
One day, after Persky’s wife told him that she wanted to start investing in the white-hot Los Angeles real estate market, despite the fact that she had no background in the business, Persky began to get concerned. Weeks later, he read a negative article in Barron’s magazine about a big subprime-mortgage lender in nearby Orange County called New Century Financial and asked Lahde to check it out.
Lahde had a vague awareness of the company from his time at Roth Capital and spoke with an old friend who was still an analyst at the firm, Rich Eckert, who had a “Buy” rating on New Century’s shares. But Lahde had been developing his own misgivings about housing and had recently convinced his parents to sell their second home, on a lake in Michigan. Lahde spent weeks studying New Century, quickly realizing the company had little cash of its own—only by selling its mortgages to Wall Street banks to be used in mortgage pools could New Century get the financing to make new loan commitments. If that securitization market ever disappeared, Lahde figured, New Century’s business would disintegrate.
Lahde dug into the world of securitizations, telling Persky that it didn’t seem like many slices of the mortgage pools would hold up if borrowers ran into problems. Even if housing prices just flattened out, the riskiest slices of the pools could be in trouble, because home owners wouldn’t be able to refinance their mortgages.
Lahde walked into Persky’s office one day and said the firm should short “the entire Orange County,” where real estate development and aggressive lending were running rampant. It was Lahde’s usual hyperbole, and obviously impossible, but Persky fully agreed with his sentiment. Betting against shares of New Century seemed to be the next best thing, though Lahde warned Persky that it might take a year or two before things slowed and the trade worked.
By early 2005, New Century was Dalton’s biggest short position; it soon would be joined by fellow subprime lender Accredited Home Lenders. Lahde and Persky visited another Orange County financial company, Downey Savings and Loan, and were amazed to realize that so much of their business was extending so-called option ARM loans, or loans that allowed borrowers to make monthly payments that didn’t even cover the interest cost of the loan. They quickly began to short Downey as well.
But the stocks kept climbing throughout 2005, as respected hedge-fund investor David Einhorn established a big position in New Century and then joined the company’s board of directors. Adding salt to Dalton’s wounds, New Century paid its shareholders a hefty annual dividend that amounted to 13 percent of the value of its shares. By shorting, or borrowing and selling the shares, Dalton had to pay that dividend to the investors it had borrowed from, adding to the firm’s losses.
But Dalton wouldn’t give up, adding to its bearish positions in 2005 and into 2006, even buying CDS insurance contracts on a number of housing players and mortgage-related debt. The losses piled up, month after month. With each bad day, and each furious call from his investors, Persky became more frustrated.
“I was doing what I thought was prudent, but my performance was modest, and many of my investors had short leashes,” Persky says.
Tempers simmered, and the bickering between Persky and Lahde escalated. When Persky criticized Lahde, who was on edge because his recommendations were losing money for the firm and his bonus was in jeopardy, he often fired back at his boss, even in public meetings. By April 2006, Persky had had enough. He began to sell all the fund’s bearish housing bets, handing cash back to his clients, even though he remained convinced a real estate collapse was inevitable. He just couldn’t take it anymore. The decision shocked Lahde, as did Persky’s subsequent decision to fire him and give him just three months’ severance pay, or about $30,000.
Lahde remained convinced that housing was set to crack. New Century and other lenders were starting to come under pressure because as interest rates rose, their borrowing costs were approaching those of the loans they were making to customers, crimping profits. It was a sure sign that their business couldn’t last.
His unpleasant experience at Dalton weighed on Lahde. As he gazed out his window at the beach next to his apartment, he was tempted to give up on the financial business, find a girl, and go on a long vacation. But Lahde figured that if he could set up a hedge fund of his own dedicated to wagering against real estate, the payoff could be huge.
“It was always going to be a two-year thing,” Lahde says. “I knew they couldn’t hold it together longer than that.”
He set up Lahde Capital in his 800-square-foot apartment, angling his chair to get a good view of the blue water glistening just a few hundred yards away. Some days the weather was so warm that Lahde took a break from his steamy apartment, which lacked central air-conditioning, to jump in the nearby Pacific Ocean.
All summer, the sun shone brightly outside the apartment while darkness grew within. Lahde was sure that housing was on its last legs, but he worried that all kinds of financial firms would be devastated by the fallout. The way he viewed it, he was about to get on a surfboard ahead of a tsunami. The wave would be huge but it could turn out at the last second, knocking him cold before he reached shore.
To avoid that, Lahde decided to buy only CDS protection on the ABX index of subprime residential mortgages, rather than on various MBS pools like other bearish investors. He figured the ABX was more actively traded and would be easier to exit on a dime when things surely crumbled.
In truth, Lahde didn’t really know much about the ins and outs of trading CDS contracts. At Dalton, he had focused on New Century and other lenders. Persky didn’t let him tackle the firm’s CDS moves. So Lahde asked advice from the few traders he knew who were willing to spare him some time.
Lahde began to pitch potential investors on his two-year strategy of betting against risky mortgages, asking for minimum investments of $5 million, aiming to start with at least $100 million. Bu
t every meeting was another strikeout. No one was interested in Lahde or his bearish arguments. Pressure grew; Lahde felt he had only several weeks to place his trades before it all unraveled.
In a desperate moment, Lahde even tried Persky, who also turned him down. Lahde began leaving his tie and suit at home, wearing a polo shirt to meetings with investors, and adopting a jaded attitude; it was as if he had given up.
“Andrew’s not a perfect guy to persuade you to invest,” says Dr. Norman Zada, one of those who received a call from Lahde asking for an investment. Zada, founder of Perfect 10, an adult magazine featuring women willing to pose nude but unwilling to undertake cosmetic surgery, ignored Lahde’s entreaties for months before finally giving him some cash. “He’s a youngster and a little strange … and he seems sort of nervous around people.”
At first, Lahde couldn’t convince brokers to enter into ISDA (International Swaps and Derivatives Association) agreements with him and serve as counterparties to his new firm, making it impossible for Lahde to buy the CDS contracts he so coveted. The brokers said his firm was too small. Lahde didn’t even have much of his own money to invest, compounding matters. He was worth only about $150,000 and needed most of it to pay the firm’s bills, not to mention his own living expenses.
After weeks of frustration, Lahde sweet-talked brokers at Lehman Brothers and Bear Stearns into considering selling him CDS contracts, telling them that big money was on the way and soon he’d be managing $100 million or more. They were skeptical but began working on complicated trading agreements just in case the money came through.
By November, Lahde had managed to raise $2 million from a few investors, but he was exhausted from the chase, and it didn’t seem like he’d be able to turn up other investors. Holding his breath, he asked the Bear Stearns and Lehman brokers if he could begin putting his trades on with the money he already had. He reminded them that his firm was sure to grow quickly and pointed out how much work they’d already done on the complex agreements. Why put it all to waste, Lahde argued.
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