Before long, he began to get calls from concerned clients. They weren’t nearly as skeptical as Burry about real estate; in fact, many were openly dubious about his housing investments. A few advised him to stick with stock investing. What do you know about mortgages? he was asked.
In August 2006, Burry’s brokers called to tell him that someone was buying up every piece of subprime mortgage protection out there, CDS on RMBS (residential mortgage-backed securities), CDS on the ABX, anything and everything. Huge chunks of credit-default swap contracts were flying off the shelf, sometimes more than a billion dollars of protection in a single day. Angela Chang, his broker, told Burry the buying was so lightning-quick and overwhelming, “it was like a drive-by.” Another trader passed on chatter that an investor named John Paulson was doing the buying.
Burry was thrilled. He was sure all the activity would boost the value of his firm’s positions. But Burry’s brokers refused to adjust the value of his investments, making it impossible for him to show any gains. Sometimes, the prices seemed dated or inconsistent. Brokers gave him different prices for the same protection on the very same day. Other times, they wouldn’t update a quote for a full week.
Burry couldn’t believe it—Paulson was buying protection every day, housing prices finally had flattened out, the ABX index was dropping, and shares of home builders were weakening. But Burry was being told by his brokers that the value of his firm’s protection on over $8.5 billion of mortgages and corporate debt was barely budging. Some brokers explained that Burry’s positions didn’t trade frequently, making it hard to prove they had risen in value.
Burry fumed. He started to come home late at night, creeping up the stairs of his luxury home and going straight to bed, to avoid his family. He was afraid his kids might see him bristling with anger.
Fed up, Burry finally decided to pull the mortgage investments out of his hedge fund and place them in a separate account, called a sidepocket. There they’d sit, frozen in price, until Burry was ready to sell them. That way he could place a more exact value on the fund himself and treat his investors more fairly, without relying on quotes from unreliable brokers.
Hours after he announced his move to his investors, however, Burry’s firm was in turmoil. His clients already were skeptical of his housing investments. Now Burry was telling them that they were stuck with the housing protection until he decided it was time to exit. The fine print of his agreements with his investors allowed Burry to undertake this kind of move. But it seemed like a money grab—a heavy-handed way to prevent the investors from fleeing, and to stop the mortgage protection from weighing down his fund.
In October, Joel Greenblatt, Burry’s original supporter, demanded a face-to-face meeting. Several days later, he and his partner, John Petry, flew to San Jose and rented a car to drive to Burry’s office for a late-afternoon sit-down. Months earlier, Greenblatt had told a financial-television network that Burry was among the world’s top investors. But now, as Greenblatt grabbed a seat across from Burry in his small office, he fumed.
Greenblatt told Burry how foolish he was to set up the side account; it was harming Greenblatt’s reputation, as well as his own, he said.
“Cut your losses now,” he told Burry, and advised him to get out of his mortgage positions before clients revolted and his firm was ruined. Greenblatt could barely contain his anger. The trades could be “a zero in the making.”
For Burry, it felt like an uppercut to the jaw. One of Wall Street’s most respected investors—the first to show any faith in him—was ordering him to cut short the biggest trade of his life, one that he had spent more than a year crafting. Like the rest of his investors, Greenblatt and Petry didn’t even bother to try to understand his trade, or to read his letters that mapped it all out, Burry felt. Now, in the first rough period of Burry’s career, they were turning on him.*
Sitting behind his desk, Burry shifted in his seat, growing increasingly uncomfortable under the onslaught. As he listened to Greenblatt and Petry, he realized he might not have enough support to keep his firm going if he held on to the positions and was proved wrong.
Then it dawned on Burry that Greenblatt wasn’t saying anything new. He had no information that in any way negated or changed Burry’s original investing premise.
Looking past his guests through a window just behind their chairs, he could make out the red roof of a condominium, one of countless overpriced units recently erected in an area already teeming with new supply.
If Greenblatt wants proof, he thought, it’s just a rock’s throw away!
Greenblatt was facing his own pressures. His firm, Gotham Capital Management, which made investments but also placed money in various hedge funds for clients, had received withdrawal requests from 20 percent of its investors. If Burry refused to sell investments and hand money back to Greenblatt and Petry, they would be in a bind.
Greenblatt tried to compromise with Burry, suggesting that he cash in some of his trades, rather than freeze them all. But Burry wouldn’t budge.
“I can’t sell any of them,” Burry responded. “The market’s just not functioning properly.”
“You can sell some of them,” Greenblatt responded, his anger rising again. “I know what you’re doing, Michael.”
To Burry, Greenblatt seemed to be suggesting that he was clinging to the trades to avoid handing back cash to his clients. Burry turned livid.
“Look, I’m not going to back down,” Burry told his visitors. He was going to put the mortgage investments in the side account, as planned.
Greenblatt and Petry stormed out of the office, ignoring Burry’s employees on their way to the door. Days later, Greenblatt’s lawyers called Burry, threatening a lawsuit if he went through with his move.
Other investors, angry that Scion now was down about 18 percent on the year, also turned on Burry, withdrawing all the money they could from other accounts at the firm, pulling out $150 million over the next few weeks. A few potential clients, learning about the squabble, suddenly lost interest in Scion.
Burry turned sullen, stress obvious on his face. His wife began to worry about his health.
Late in 2006, Burry felt he had to do something to save his firm and his reputation. So, reluctantly, he began selling some of the CDS insurance, raising money to hand back to disgruntled investors. Over three weeks, he sold almost half of the protection he held on $7 billion of corporate debt of companies like Countrywide, Washington Mutual, AIG, and other financial players that seemed in dangerous positions.
Burry couldn’t have picked a worse time to sell. At that point, Wall Street still held few worries about housing. The protection on $3 billion of debt, which originally cost Burry roughly $15 million or so a year, now cost new buyers only $6 million a year. In selling the insurance, he took a substantial loss. To Burry, it was like giving away a collection of family jewels, accumulated with loving care over two long years.
Money continued to flow out of the fund, though. Burry scrambled to cut his expenses, slashing salaries and firing employees. He flew to Hong Kong to close a small office there.
“Mike, you can’t do this,” a recently hired trader told Burry, his anger growing.
Burry tried to calm him down, explaining that he had no choice. But the trader turned even more agitated.
“You owe me the difference between what I would have made” at his previous job and the severance Burry now was promising. He demanded $5 million.
“I can’t do that,” Burry replied meekly.
His cost-cutting moves destroyed the morale of his remaining employees back in San Jose. In a tailspin, Burry withdrew from his friends, family, and employees. Each morning, Burry walked into his firm and made a beeline to his office, head down, locking the door behind him. He didn’t emerge all day, not even to eat or use the bathroom. His remaining employees, who were still pulling for Burry, turned worried. Sometimes he got to the office so early, and kept the door closed for so long, that when his staff left at the
end of the day, they were unsure if their boss had ever come in. Other times, Burry pounded his fists on his desk, trying to release his tension, as heavy-metal music blasted from nearby speakers.
The growing toll the trade placed on Burry seeped into an unusually frank letter that he sent his clients at the end of 2006: “A money manager does not go from being a near nobody to being nearly universally applauded to being nearly universally vilified without some effect.”
GREG LIPPMANN had convinced his bosses at Deutsche Bank to let him buy protection on about $1 billion of subprime mortgages. But as the trade stalled in the summer of 2006, the Deutsche Bank executives became impatient, expressing doubts about his tactics. They seemed tempted to close Lippmann’s trade.
“Just give me four years,” Lippmann asked Rajeev Misra, his boss. Most subprime borrowers refinanced their mortgage loans after just a few years, Lippmann reminded him, so his trade surely would be over by then. “Give it a chance to work.”
“Show me the research,” Misra responded.
When he did so, Lippmann’s bosses reluctantly gave him a green light to continue with the trade. The regular payments he was making for all the CDS insurance were slowly adding up, so those above him at the bank weren’t thrilled. Yet for all his bluster and self-confidence, Lippmann wasn’t prepared to quit Deutsche and go off on his own. Instead, he had to figure out a way to keep his trade alive and hold on to his job.
Lippmann managed a group that placed bond trades for investors. He realized that if he could convince enough investors to do the same trade he was undertaking, he might be able to rack up sufficient commissions to offset the costs of his bearish housing trade and placate his bosses. And if new investors could be convinced to buy the same CDS contracts that he owned, the price of these investments was bound to climb, which also would help Lippmann.
He traveled uptown to the offices of a hedge fund called Wesley Capital to meet two senior executives, to try to sell them on the idea. At first, they seemed impressed. Then they asked a friend who happened to be in the office, Larry Bernstein, who once managed a powerhouse bond-trading team at Wall Street firm Salomon Brothers, to weigh in on the trade.
Bernstein was dubious. “Coase Law says you’ll be wrong,” he said, dismissively.
The executives looked at each other. Lippmann had no clue what Bernstein was talking about. Neither did the Wesley executives. Coase Law turned out to be an economic theorem—but it didn’t seem to have much to do with the trade. Then the meeting turned contentious. If problems arose, Bernstein argued, the government likely would step in to bail out troubled borrowers. Even if you’re right and the price of the mortgage protection rises, when investors began to sell their insurance, the price would be pushed down, sinking the trade, Bernstein said.
Ultimately Lippmann walked out with nothing.
Jeremy Grantham’s GMO LLC seemed like a certain client. The Boston money-management firm had been cautious about the market for years, and Grantham was among the most vocal doomsayers, writing downbeat op-ed columns for various newspapers warning of “a sensational bust.”
But when GMO executives consulted their resident bond expert, Allen Barlient, he shot down the idea, arguing that most mortgage deals had so much protection that they likely would be fine.
Some investors he met with leveled abuse at Lippmann. “My brother works for Fidelity and he’s buying this stuff,” one said, referring to subprime-related investments. “You’re either an idiot or a liar” trying to wring trading commissions.
Behind his back, some on Wall Street called Lippmann names, such as “Chicken Little” or “Bubble Boy,” chuckling at his quixotic effort. At conferences, some traders teased him, saying “Your crazy trade is losing money.” Others repeated an industry maxim: “A rolling loan gathers no moss.”
Lippmann began avoiding investors with deep knowledge of mortgages or complex bond investments. They understood his maneuver but were lost causes, wed to their markets and reliant on sophisticated models that suggested everything would be fine. Instead, Lippmann asked salesmen at his bank who catered to investors in the stock, junk-bond, and emerging markets worlds if they would help arrange meetings for clients with a potential interest in his idea.
He sometimes stumbled onto tough questions—why were the rates of mortgage delinquencies so different in North Dakota and South Dakota?
“You’re missing it, you have to take a look at employment,” an investor said.
Lippmann was stumped. North and South Dakota sure seemed the same; the fact was that Lippmann didn’t know why the rate of delinquencies was so different. He had never even visited those states. So he and Xu went back to the data. Sure enough, the two states had similar levels of employment and seemed alike in other ways, but home prices were rising much more rapidly in North Dakota, explaining why delinquencies were lower. It confirmed that the biggest factor on default rates was whether or not houses were rising in value. It made Lippmann more certain than ever of his thesis.
Slowly, he began to win converts. A number of investors signed up in London, eager to profit from a U.S. economy they viewed as fragile. It took less than an hour for Lippmann to convince Phil Falcone, a hedge-fund manager in New York, who seized on the limited downside and huge potential windfall of the trade. Falcone didn’t even ask about the technical aspects of the mortgage market. The next day, he called Lippmann’s team to buy insurance on $600 million of subprime mortgages. Later he made even more purchases.
By September, Lippmann had pitched the trade more than a hundred times and had his spiel down pat.
Lippmann won over dozens of investors, and CDS contracts began to fly out the door of Deutsche’s Lower Manhattan office, $1 billion of protection a day. One investor even made a T-shirt that he gave to Lippmann and others saying “I shorted your house,” a joke that seemed amusing at the time.
“What Lippmann did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” says Steve Eisman, a hedge-fund manager. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ ”2
A few hedge funds were such eager converts that they became as evangelical as Lippmann after doing their own research.
“You better get up to speed on the mortgage market … fast,” Alan Fournier, founder of New Jersey hedge fund Pennant Capital, wrote to a journalist in an e-mail in the summer of 2006. “All these crappy loans have been gobbled up by investors and they’re gonna get burned … the credit unwind is really just getting started.”
In all, Lippmann bought insurance on $35 billion of subprime mortgages, keeping about $5 billion of CDS protection for his own firm’s account while selling the rest to eighty or so hedge-fund investors. A few others who already had placed the trade, like John Paulson, compared notes with Lippmann, shared intelligence, and then did some buying through Deutsche. The growing commissions enabled Lippmann to buy even more subprime insurance for his own account.
Nonetheless, by the end of 2006, most of Lippmann’s clients had lost money on the trade. He shared with a friend that his career would be affected if his scheme didn’t work out. Within his bank, Lippmann had become an object of derision. When Paulson’s trader, Brad Rosenberg, called to ask for him, a salesman answering the phone let out a loud laugh: “Why do you want to talk to him? That guy’s crazy!”
Others at Deutsche Bank resented Lippmann. Yes, he was generating commissions, but his trade also was costing the bank about $50 million a year, reducing the firm’s bonus pool, some traders grumbled.
BY LATE 2006, housing prices finally had leveled off. Subprime lenders, including Ownit Mortgage Solutions and Sebring Capital, had begun to fail. John Paulson, Lippmann, Greene, and Burry should have been making oodles of money. But their positions barely nudged higher.
Late one afternoon, following another day of lackluster gains, Paulson picked up the phone to dial Lippmann, his subprime consigliere. To his investors and employees, Paulson
showed absolute faith that the protection his firm owned on $25 billion of subprime mortgages would pay off.
With Lippmann, though, he could share his fears.
“Is there something I’m missing?” Paulson asked Lippmann. “Don’t these people realize this stuff is crap? This is absurd!”
Paulson sounded like he might be wavering, surprising Lippmann.
“Relax, John. The trade will work.”
Lippmann remained cocky because he was on the trading floor, buying and selling mortgage protection all day long. He knew better than almost anyone who the mysterious investors were on the other side of all the trades, a group so eager to sell insurance on all of those risky mortgages. And he knew their time would come to an end.
*Greenblatt says he didn’t disagree with Burry’s housing bet, but he was frustrated with how large it had become, and how many investments Burry had placed in the side account.
9.
Never get high on your own supply.
—Al Pacino in Scarface
A SIMPLE, THREE-LETTERED ACRONYM EXPLAINED WHY PAULSON, Lippmann, Greene, and Burry weren’t making much money in late 2006, even though housing was stalling out and home owners were running into problems: CDO.
A 1980s invention of some of the brightest financial minds, collateralized debt obligations, or CDOs, were investment vehicles that seemed to make the world a safer place—that is, until they fell into the wrong hands, not unlike other weapons of mass destruction.
Mortgage-backed bonds gave investors a claim on the cash flow of a group of mortgage loans; CDOs took it one step further. They were claims on giant pools of all kinds of debt that could include slices of loan and bond payments made by companies and municipalities, and even monthly payments by those leasing aircraft, cars, and mobile homes.
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