The Greatest Trade Ever

by Gregory Zuckerman

  By the summer of 2007, however, their home had tumbled in value and lenders finally had tightened their standards, making a refinancing impossible. They faced yearly mortgage payments of $50,000, just about their entire take-home salary.

  “We have a disaster on our hands,” Mario, a forty-eight-year-old warehouse manager, told a reporter. Fears of a foreclosure gripped him, he said.

  “At this point,” he said at the time, “we really don’t have a plan.”

  “Bottom line, it’s our little home,” Leticia told a visitor. “Hopefully, we won’t go down, and if we do, we’re going to go down with a fight.”1

  BY THE SUMMER, the data was too overwhelming for Libert to ignore. Eight percent of a $1 billion pool of subprime home mortgage loans made in early 2007 already had defaulted—within just six months of being inked. Fifteen percent of them were in default after less than nine months. And the figures were only getting worse! Defaults didn’t necessarily mean losses for the mortgage pools, but if losses in the pool reached 12 percent, or $12 million, even the AA-rated slices of the bonds would be wiped out, Libert knew.

  Libert converted all his insurance on BBB-rated bonds to protection for AA-rated slices. Because they were still perceived as being largely safe, the insurance was still inexpensive, allowing Libert to get more bang for his buck. He now owned CDS insurance on $25 of toxic mortgages for each $1 he put down.

  “You should really get into the AAs,” Libert told Greene.

  Now it was Greene’s turn to feel torn. Should he follow Libert’s lead and roll his own protection into insurance on those AA-rated slices? Greene arranged a phone conversation with analysts from Merrill Lynch and J.P. Morgan. They agreed that CDS contracts protecting AA-rated slices of subprime mortgages were a better bet than Greene’s BBB protection.

  Greene bought some protection on the AAs, but soon he became distracted. In late September, he and Mei Sze Chan married at his Beverly Hills mansion, a blowout affair that cost $1 million and was the buzz of the Los Angeles social scene. The guest list included Oliver Stone; Donald Sterling, the owner of the Los Angeles Clippers basketball team; and Robert Shapiro, O.J. Simpson’s attorney. Mike Tyson was Greene’s best man. Chan, wearing a gown of hand-beaded Swarovski crystals, married Greene in a French limestone gazebo.2 After midnight, the revelers danced on a revolving dance floor in Greene’s twenty-four-car garage. John Paulson didn’t come, though he sent Greene a gracious card.

  But Greene never stayed away from the trade for long. In the middle of the wedding, Greene pulled aside Libert with urgent news: “Your trade is at 89.72 today!”

  Libert was shaken. He had bought protection on the ABX index tracking AA subprime mortgages when it was trading at 80. Now it was almost 10 points higher. He had given back half the profits from his BBB trade by shifting into the AA bonds much too early!

  Then it dawned on Libert—there was no way Greene could know the price of the index in that kind of detail. Prices were never quoted to the penny. Greene was playing with Libert’s head, preying on his insecurities.

  He turned to his wife with a relieved smile.

  “What’s he talking about, 89.72??” Libert said. “I’m a schmuck; he’s sticking it to me.”

  “He knew I just didn’t have the stomach for the trade,” Libert recalls.

  By the end of the summer, Libert set aside his compunctions and made plans to put more money in the investments, convinced that something big was about to happen.

  WITH EVERY NEW FIGURE on Greg Lippmann’s computer screen in early 2007 came a single message: Your bonus is soaring!

  As the ABX collapsed in February, Lippmann and his team racked up huge gains, thanks to protection they held on about $3 billion of subprime mortgages. One day early that month, they made $20 million, their best day ever. The next day, they did it again! The group followed it up with a still better day. Over one spectacular week, Lippmann’s crew made $100 million of profit. Their Bloomberg terminals became best friends, the next price quote a cause for celebration, the end of the trading day a reason for sorrow.

  At first, Lippmann tried to play it cool—his bonus check wouldn’t be cut until the end of the year and he knew there was a lot of time for the trade to run into potential difficulties. But he couldn’t help feeling relief. Walking with analyst Eugene Xu down a Manhattan street, after meeting a new hedge-fund client, Lippmann turned to his colleague with a look of astonishment.

  “It’s really working. Finally.”

  Other traders approached Lippmann, asking his advice on their own moves and where he thought the market was going. Colleagues who once snickered at Lippmann now needed his help.

  “It’s just starting!” he responded, urging them to get bearish. Many did, buying CDS contracts of their own. Others trimmed their holdings of mortgage-related investments, heeding Lippmann’s advice.

  One day, Anshu Jain, Deutsche Bank’s London-based head of global markets, visited the firm’s New York office. He walked over to Lippmann, greeting him with a warm smile, an acknowledgment of his huge gains and rising status at the bank. But Jain wasn’t ready to congratulate Lippmann.

  “Do you think you should cover here?” Jain asked. It was a pointed suggestion that Lippmann sell some positions to reap profits.

  Lippmann pulled out the latest data on housing, showing Jain how the market was deteriorating.

  “No, we have to hold steady,” Lippmann said, according to a nearby trader. “Prices are heading lower.”

  Jain didn’t push any further. But with every drop in the ABX, Lippmann received e-mails from superiors and risk specialists at the bank, each urging him to exit positions or at least consider trimming them. Some demanded it. Their message was clear: You better be right or you’ll be blamed if the gains evaporate.

  Lippmann couldn’t believe it—the data was getting worse, not better. This was the time to increase the trade, not reduce it!

  Didn’t they get it?

  As the ABX rebounded in the spring, Lippmann’s mood turned sour. Nonetheless, the rally helped make mortgage protection cheaper, enabling him to generate additional commissions by teaching more hedge funds to do the trade. And home prices continued to weaken, making Lippmann even more convinced that BBB mortgage bonds were doomed.

  Lippmann was less sure about top-rated bond slices, but a conversation with John Paulson persuaded him that even A-rated pieces would run into trouble. Lippmann began urging clients to buy CDS protection on those investments as well.

  By then, the various hedge funds that Lippmann had educated about the subprime trade had begun making their investments with various other brokers, quickly spreading word about what Lippmann was advocating around Wall Street. He soon received a phone call from Scott Eichel, his counterpart at Bear Stearns.

  “Why are you telling people that things are going to blow up?” Eichel asked him. “Why are you so sure?”

  Eichel argued that the trade wouldn’t work because real estate was resilient.

  “Dude, when home prices fall, the subprime market is toast,” Lippmann responded.

  IN HIS SANTA MONICA APARTMENT, Andrew Lahde was staring at the same data that showed housing was deteriorating. February’s panic brought gains to Lahde, as it did to Paulson, Greene, and Lippmann, less than three months after Lahde first bought mortgage protection and launched his hedge fund, Lahde Capital. His firm now was up to about $6 million in assets.

  But Lahde was feeling more pressure, not less. The value of his positions had climbed a few hundred thousand dollars, but he hadn’t sold any of them to lock in any of the gains. Instead, his expenses were piling up as he struggled to pay a few staff members. Lahde was making only a few thousand dollars a month from his tiny fund, barely enough to pay the rent. If he ran out of money, he would have to sell his CDS protection, pocket the measly few hundred thousands dollars in profit, and look for a job, once again, watching others profit from the crumbling housing market. That was the last thing he wanted to do.


  Lahde had to somehow keep his trade alive and his fund going. He had to somehow find an investor who believed in him. To cut his expenses, he rarely left his apartment. For lunch, Lahde grabbed a turkey sandwich at a nearby deli. At dinnertime, he cleared paperwork from his desk table and ate tuna fish out of a can.

  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.

  LAHDE 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.

  13.

  JOHN 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, Prot�
�gé 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.