The Greatest Trade Ever

by Gregory Zuckerman

  But Pellegrini had nagging concerns that he might be missing something. Was there a way to run his ideas past Cole?

  After the speech, Pellegrini made a beeline to the lectern, grabbing Cole’s attention before other investors had a chance.

  “What will happen when the mortgages reset?” Pellegrini asked, thinking he had found the fatal flaw in Cole’s bullish thesis. “Will there be defaults?”

  Cole seemed remarkably unfazed.

  “No, we’ll just refinance the loans,” he responded, matter-of-factly.

  Cole explained that New Century, like other subprime lenders, earned so much in upfront fees from refinancings that his company was happy to refinance home mortgages before they had a chance to reset at higher interest rates even though it meant lower profits from new, lower-rate loans. That way New Century made sure that borrowers could still make their payments. They could keep refinancing their customers’ loans as long as their underlying properties were worth more than when they took out their original loans, Cole said.

  “Interesting,” Pellegrini replied, meekly.

  The Paulson team’s original thesis, that a spike in interest rates would cause problems for home owners, seemed dead wrong. If rates moved higher, Pellegrini realized, lenders would just bail out borrowers, letting them refinance their homes at lower rates. Given that, a wave of defaults seemed unlikely, at least for homes that had climbed in price.

  Pellegrini had a sinking feeling as he hustled back to the office to tell Paulson.

  It wasn’t the kind of news anyone at Paulson & Co. wanted to hear, and it couldn’t have come at a worse time. The various hedge funds run by the firm gained 5 percent or less in 2005, trailing gains of 9 percent or more for other hedge funds. Chatter on Wall Street was growing that Paulson was falling behind the times.

  “It was very frustrating,” recalls Jim Wong, Paulson’s point man with investors.

  At Concord Management, LLC, an associate, Martin Tornberg, was grilled by the New York firm’s investment chief about Paulson’s disappointing performance.

  “Why are we in this fund?” Tornberg’s boss asked him about one of Paulson’s funds. Tornberg suggested that they give Paulson some more time before pulling out.

  By the end of the year, even friends were asking questions about Paulson’s investing strategy. Visiting Paulson’s office one day in November, Howard Gurvitch, his original investor, suggested that the firm’s subpar performance might be due to the rush of easy money that was chasing every kind of deal, making mergers and other areas more difficult for conservative investors like Paulson.

  “Maybe it’s a new world, John?” Gurvitch asked his old friend, gently.

  Paulson told Gurvitch that he remained confident in his unpopular stance. His challenges soon would grow, however. Unbeknownst to Paulson, a few other investors were coming around to his view on housing and soon would be hot on his heels.

  IN MAY, after Greg Lippmann had helped develop the perfect means to bet against housing, he and his colleagues began racking up commissions trading their new CDS contracts on pools of subprime mortgages. Lippmann, who also operated a trading account for Deutsche Bank, initially joined the pack, selling the CDS contracts to the few bearish investors like Burry in San Jose.

  By June, though, Lippmann’s contrarian instincts had kicked in. He decided to do his own research to make sure the bullish crowd had it right. Lippmann loved to boast about a research analyst at the bank named Eugene Xu, proudly telling colleagues that at just eighteen years of age, the Shanghai native finished second in a national math competition in China. Maybe Xu, who received a doctorate in mathematics from the University of California in Los Angeles, could test the bullish thesis.

  Lippmann asked Xu to dig up as much data as he could about home-mortgage defaults, something Lippmann and most others in the business never thought to examine before, as housing seemed to be on an inexorable climb. Xu split the country into quartiles. He discovered that states with the lowest rates of default, like California, Arizona, and Nevada, also claimed the highest growth in home prices. The quartile with the highest rates of default had the slimmest growth in home prices. Florida and Georgia seemed similar in many ways, but Xu’s numbers showed Florida had a much lower rate of default than its northern neighbor, which seemed due to its soaring home prices.

  The clear relationship between home prices and mortgage defaults didn’t seem to be a recent development, either. Xu found that home prices had been key to loan problems for more than a decade, including during the mini-downturn in real estate in the early 1990s.

  “Holy shit,” Lippmann exclaimed to Xu on Deutsche Bank’s trading floor while reading over his work, “if home prices stop going up, these guys are done.”

  Lippmann’s thesis seemed logical—but at the time it was quite a radical viewpoint. Most economists and traders figured that a range of factors, including interest rates, economic growth, and employment, determined the level of mortgage defaults. Sure, home prices had an impact, and they were bound to plateau at some point. But if the other factors all held up, then default rates shouldn’t climb very much, according to the conventional wisdom.

  Xu’s data clearly showed those other factors didn’t mean nearly as much as home prices. Indeed, California’s employment rate was about the same as a number of states with much higher default rates, but which had more limited gains in home prices. The lesson to Lippmann was that hot real estate areas like California actually were poor credit risks, not good ones. If home prices ever leveled off, defaults would shoot up.

  “Why hasn’t anyone done this research before?” he exclaimed to Xu. A sudden convert, Lippmann wasn’t shy about sharing his views within the bank.

  “These things are gonna blow up!” he bellowed across the trading floor one day, as the other traders shook their heads.

  Lippmann rushed to tell others at the bank, anticipating that they would appreciate his insight. He patiently explained to them that when home prices came back down to earth in California and other raging real estate markets, mortgage defaults and delinquencies would be as high as they were in states like Indiana, where about 6 percent of home owners were delinquent on their home mortgages, double California’s rates.

  His colleagues remained skeptical, however. Even veteran analyst Karen Weaver, who had been warning investors to avoid all kinds of aggressive mortgage-related investments, wasn’t convinced. At weekly meetings, the other Deutsche Bank executives snickered or laughed at Lippmann’s diatribes about the problems ahead.

  “There goes Greg again,” Weaver joked to the group one day. Others began poking fun at Lippmann, sparking a round of laughter.

  “You’ll see; I’ll be right,” Lippmann shot back.

  Some at the bank insisted that Lippmann must be missing something—maybe the explosion in population in California and Florida helped keep defaults low. So Lippmann and Xu went back to their data, controlling for population changes and other factors. But they continued to find that housing prices alone were key to mortgage defaults. Nothing else seemed even close. To Lippmann, it was as if his colleagues and rivals were insisting that the earth was flat.

  “All you need is for California [real estate] prices to start looking like Indiana’s and you get twelve percent defaults, at least,” Lippmann insisted to one colleague. Home prices in Indiana were growing about 5 percent compared with more than 15 percent in California. Lippmann argued that when prices stopped climbing, a rash of problems would result, in even soaring real estate markets.

  By the late fall of 2005, Lippmann was even more convinced of this, but he needed permission from the bank to buy up CDS contracts and lay a big bet against housing. He took a deep breath and proposed to one of his bosses, Rajeev Misra, buying protection on more than $1 billion of risky mortgages.

  “This seems like a great bet,” Lippmann told him, holding twenty pages of documents. “If I’m right, I’ll make a billion dollars for the bank and it will offset losse
s elsewhere; if I’m wrong, it’s going to cost twenty million a year.”

  Lippmann suggested buying CDS protection on the BBB-rated slices of mortgage-bond deals, just as Paulson and Burry were doing. He noted that 80 percent of subprime mortgages adjusted to a higher rate after two years, so his trade wouldn’t last very long—after four years or so, he’d know if it was working or not. The most he could lose the bank if he purchased insurance on $1 billion of BBB bonds was $20 million a year over four years, or $80 million, Lippmann argued. Their trade should be even larger, he argued.

  “If we’re right, we’re looking at a sixfold gain,” he told his superiors. But there wasn’t a six-to-one chance that California real estate would keep going up, because it can’t go up forever, he told them. The bank should take the risk.

  He was showing so much enthusiasm for shorting mortgages that some at the bank thought he might have gone too far. Lippmann’s approach at times seemed unconventional to Deutsche executives, and they weren’t convinced his strategy would work. Grudgingly, however, they assented to his trade, though not in the size he hoped. The Deutsche Bank executives allowed Lippmann to pay $20 million or so a year to buy protection on $1 billion of mortgages. And they told Lippmann to make sure to update them on how the trade was going, keeping the leash tight on the thirty-seven-year-old trader.

  It didn’t help Lippmann’s case that he had antagonized some at Deutsche Bank with his strong opinions and brash trades, resulting in various stories circulating about him. One tale that spread, despite no evidence that it actually took place, concerned the evening Lippmann exited the bank’s building, running late for a business dinner. He couldn’t find a cab. When he saw a long line of employees waiting for Deutsche Bank’s car service, Lippmann went straight to the front of the line and told a woman about to be picked up that he was a senior trader and needed to grab a ride for an important dinner. The woman asked for his name, saying that she’d like to tell people that she’d had the privilege of meeting him. He proudly announced that he was Greg Lippmann, head of asset-backed trading. At that point, the woman said she was the head of human resources and that Lippmann had just taken his last ride in a company car.

  Friends say the story didn’t happen, but that didn’t stop some at the bank from sharing it, a sign of the jealousy and resentment Lippmann had engendered among some at Deutsche Bank.

  Indeed, for all his trading prowess, Lippmann had overlooked the huge personal risks he had assumed in making the most important trade of his life. He already was making several million dollars a year. If he got the subprime trade right, he’d surely make more millions, but it wouldn’t change his life. If Lippmann was wrong, though, he jeopardized his career.

  As mortgage prices moved higher, and the value of his protection dropped almost immediately after he put the trade on, Lippmann’s move seemed especially misguided. When Lippmann told friends what he was up to, they began to worry about him. They warned Lippmann that he risked ruining his reputation at the bank by bucking the rest of the team. A colleague pulled him aside, asking, “Why are you doing this? … If you’re wrong, they’re not going to say thanks for having us buy this fire insurance we didn’t need.”

  But Lippmann and Xu had picked up faint signals that housing already was moderating. Instead of pulling back on his trade, Lippmann was determined to find a way to grow it.

  IF THE NEW CENTURY EXECUTIVE who had spoken with Paolo Pellegrini was right that borrowers would be able to refinance their mortgages and lower their payments, Paulson’s insurance against $1 billion of subprime mortgages and corporate debt was unlikely to be worth much. In fact, while the value of his CDS protection rallied a bit in late 2005, the gains evaporated in early 2006, as some hedge funds sold their own insurance, convinced that housing would keep climbing.

  Sensing a mistake, John Paulson sold his original CDS protection after concluding that it covered mortgages on homes that already had enjoyed so much appreciation that refinancings would be easy. But he continued to feel that the idea behind the trade was a good one. So he traded in his holdings for insurance on more recent subprime home mortgages—homes that wouldn’t have appreciated in price yet, and which couldn’t, therefore, get a refinancing if mortgage rates rose.

  The moves did little for the fund, however.

  “We weren’t getting anywhere,” Paulson recalls.

  He and Pellegrini soon realized that the only likely scenario in which risky mortgages couldn’t be refinanced, and a rash of defaults resulted, was if housing truly was in a bubble that eventually burst. Only then would it be impossible for lenders to bail out overleveraged borrowers by granting them refinancings, they reasoned.

  Until that moment, in early 2006, Paulson’s team hadn’t put much thought or research into whether housing prices were bound to tumble. Sure, they seemed high. But consumers with heavy debt were at risk of missing their mortgage payments if interest rates rose, they figured, even if housing prices didn’t fall.

  Paulson wasn’t even fully aware of how pervasive improper lending practices were until Rosenberg ripped a press release off a printer in January 2006 describing how Ameriquest Mortgage Co., then the largest maker of subprime loans, had agreed to pay $325 million to settle a probe of improper lending practices. The news seemed to startle Paulson.

  “This is horrible,” he told Pellegrini. That kind of aggressive lending was “crazy.”

  Paulson and Pellegrini concluded that the only way their trades would work was if the U.S. real estate market had reached unsustainable levels and began to fall, crippling the ability of borrowers to refinance their loans. The prospect seemed remote to many.

  “At the time, everybody said home prices never had declined on a nationwide basis except during the Great Depression,” Paulson recalls.

  Paulson sent Pellegrini scurrying back to his cubicle to determine how overheated the real estate market was. It was a research project that seemed right up Pellegrini’s alley. In the past, Pellegrini sometimes met criticism for spending too much time delving into an assignment. Paulson sometimes teased Pellegrini, saying that if he had to walk a block from their offices on 57th Street to 58th Street, Pellegrini likely would go across town, up the West Side, back to the East Side, and then downtown, to reach 58th Street. The direct route just didn’t seem his style.

  “Sometimes it’s more fascinating for me to do everything on my own and re-create the wheel,” Pellegrini acknowledges.

  But an in-depth project was exactly what Paulson now wanted of Pellegrini. Each time he discovered new data, Paulson sent him back for more. Paulson asked probing questions: What happens to a home mortgage if there’s a home-equity loan attached to the same house? How closely do mortgage losses track defaults?

  An index produced by the National Association of Realtors showed that home prices had stopped rising in September 2005. But when Pellegrini and a colleague examined an index produced by the Office of Federal Housing Enterprise Oversight, it seemed to show prices were continuing to rise, stirring debate in the firm.

  Paulson seized on signs of a slowdown in home sales. As bond prices raced to record levels in early 2006, Paulson became more concerned and sold all of his firm’s debt holdings, which accounted for 30 percent of its portfolio. But the team still wasn’t sure there was a housing bubble set to pop.

  Then Paulson remembered how his old boss at Boston Consulting Group, Jeff Libert, had demonstrated that housing investments hadn’t been especially attractive after inflation was factored in. So he asked Pellegrini to factor inflation into his calculations. Pellegrini learned to adjust his housing data using a barometer of inflation called the personal consumption expenditures price index. They were getting closer, but an answer wasn’t yet clear.

  Pellegrini would frustrate Paulson and others by sometimes re-creating sets of data that already were available, or getting bogged down in the details of his research. Pellegrini spent hours in Paulson’s office, debating how to deduce a turn in the housing m
arket. Tension between the two ran high and they sometimes clashed.

  To relax, Pellegrini took his sons sailing or to the driving range, among the few moments he wasn’t focused on real estate. Most weekends, he walked through Central Park trying to collect his thoughts and find a better approach to his research.

  Pellegrini’s colleagues still couldn’t quite figure him out or why he was endlessly going over the data, but his ex-wife, Claire Goodman, had a sense of what he was up to.

  “He’s the kind of guy who will work on a problem until he finds what he would call the ‘elegant solution,’ ” she said. “In the Italian culture, there’s a difference between the practical solution and the elegant solution—you can’t just make a couch; it has to be a beautiful couch. He has high standards and will push himself to find not only the practical solution but the elegant solution.”

  Tracking interest rates over the decades, Pellegrini concluded that they had little impact on house prices. That suggested that the Federal Reserve Bank’s previous rate cuts didn’t justify the recent housing surge, despite the arguments of the bulls. But as he reviewed academic and government literature and figures, Pellegrini grew frustrated. He couldn’t quantify how excessive housing prices were or show when a bubble might have started. He couldn’t even prove that the price surge was distinct from historic moves.

  Grasping for new ideas, Pellegrini added a “trend line” to the housing data; the step illustrated very clearly how much prices had surged lately. Pellegrini took a step back to view things over a longer period, ordering up data on real estate all the way back to 1975. Late at night, hunched over his desk in his cubicle, Pellegrini painstakingly tracked annual changes in prices across the country. He then performed a “regression analysis” for the period, to smooth the ups and downs.

  Suddenly, the answer was as plain as the paper in front of him: Housing prices had climbed a puny 1.4 percent annually between 1975 and 2000, after inflation was taken into consideration. But they had soared an average of 7 percent a year over the following five years, until 2005. The upshot: U.S. home prices would have to drop by almost 40 percent to return to their historic trend line. Not only had prices increased like never before, but Pellegrini’s figures showed that each time housing had dropped in the past it fell through the trend line, suggesting that an eventual drop likely would be brutal.