Sinha’s advice was blunt: “It’s time to buy the index,” according to a participant on the call. Based on Bear’s models, “the market has overreacted” to the news from HSBC and New Century. There was nothing fresh out there for investors to react to, Sinha repeated.
Paulson couldn’t believe what he was hearing. During the question-and-answer period, he was tempted to argue with Sinha, but he held back, still unwilling to let others know much about his moves.
Paulson recalls, “[Sinha] said, ‘My duty is to tell people how oversold the market is.’ I had to bite my tongue.”
Sinha blamed the sell-off on selling by inexperienced investors with no background in mortgages. It seemed to be a direct shot at Paulson’s team.
“Almost the entire price movement can be blamed on nothing other than pure sentiment-driven selling,” Sinha continued. “Maybe I’m naive and really I should stop thinking about fundamental valuation in all these markets.”1
To Paulson, Sinha was a hopeless bull. Pellegrini had a less generous appraisal.
“He was full of shit,” Pellegrini says.
Others also came to the defense of subprime mortgages, helping the ABX stage a rebound. At an industry conference in late February at the Roosevelt Hotel in New York, both Cioffi and Ricciardi made comforting comments about the market. Some snickered that Paulson and the other shorts were “tourist investors” who really didn’t understand their market.
Then Sam DeRosa-Farag, the president of New York hedge fund Ore Hill Partners, stood to give an address, urging the crowd of hundreds of fellow investors to step up their buying. Though rough times were ahead, the short-term outlook looked rosy.
“We’re not taking enough risk,” he said. “We are all really a bunch of wimps.”
At his desk, Rosenberg fielded calls from traders passing along gossip about rival funds that were gearing up to buy mortgage investments.
“Cerberus is going to be a buyer,” one trader told Rosenberg, referring to the huge New York hedge fund. “There’s a ton of money on the sidelines.”
Rosenberg turned nervous—perhaps the traders were right about all the money ready to pounce. If Paulson didn’t sell now, it might be too late later.
“I’m hearing about a lot of buyers out there,” Rosenberg told Paulson as he pulled up a chair one morning. Paulson seemed amused by the chatter. Picking up a stack of papers in his hands, he pointed to a figure on one sheet.
“What’s the average home price last month, Brad?”
The point was obvious: Home prices were still too expensive, and finally were falling. Now was not the time to get cold feet.
The ABX kept rallying, though. It rose past 70, hit 75, and rose as high as 77 in mid-May, slicing Paulson’s gains by half. The climb came even after New Century announced that it couldn’t pay its creditors and then filed for bankruptcy protection. The worst seemed over for the mortgage markets.
BEHIND THE REBOUND were investors like John Devaney, who once swore off subprime mortgages but now saw value and rushed to get in. As a teenager, Devaney was thrown out of a boarding school for partying and had had his ups and downs in the wake of his parents’ divorce.
But in 1999, he started a Key Biscayne, Florida–based trading firm, United Capital Markets, which soon became among the largest traders of “asset-backed” bonds—bonds backed by streams of cash from credit cards and leases. While others ran for the hills, Devaney excelled at buying unloved investments, including the debt of mobile-home makers and aircraft leases after the September 11 terror attacks.
By 2007, Devaney boasted of a $250 million fortune. When he wasn’t flying in his Gulfstream jet or sitting around his 16,000-square-foot Victorian mansion in Aspen, Devaney entertained guests on his 140-foot yacht, Positive Carry, named after the bond-market term for borrowing money at a low rate and investing it at higher rates. At conferences, he sponsored performances by comedian Jay Leno and bands such as the Counting Crows and the Doobie Brothers. At a 1970s-themed benefit he sponsored for the local Boys & Girls Club, Devaney made his entrance dressed as a rhinestone-studded Elvis Presley, while his wife, Selene, played a disco diva.
Devaney placed paintings by Renoir, Cézanne, and others on his mansion walls. He donated money to a range of causes, from literacy programs to the Republican Party, becoming a player in the Florida social circuit.
In the financial world, some positively gushed about his trading prowess.
“I don’t think there is anyone in the business who wouldn’t want to be John Devaney,” Mark Adelson, then a senior analyst at Nomura Securities in New York, told the New York Times, “to have the insights and guts to do what he did, as well as the managerial skills, the analytic skills to pull it off.”
By 2006, Devaney had a $600 million hedge fund that was on a roll, scoring heady annual gains of 60 percent. But he resisted purchasing risky mortgage investments, going as far as to tease those doing the buying.
“I personally hate subprime—and I’m kind of hoping the whole thing explodes,” Devaney said on a panel discussion at an industry conference in early 2007.
As investors turned nervous after New Century’s collapse, however, Devaney sensed bargains. Over the spring, he spent about $200 million to buy what he considered to be higher-quality subprime-mortgage investments. Not all subprime mortgages were dangerous, he argued, no matter what investors like Paulson were saying.2
“ ‘Oh! Oh! Another news tidbit of New Century news. Oh, my god!’ ” Devaney said in a mockingly hysterical tone to a reporter, poking fun at the worrywarts.3
• • •
BACK IN JANUARY, at a conference devoted to subprime securities at Las Vegas’s Venetian hotel, Rosenberg was chatting with a banker outside a conference hall when an investor approached and relayed a troubling conversation he had had the previous evening with some Bear Stearns traders.
“It’s not so simple to short mortgages,” one of the Bear Stearns traders allegedly told the investor. “A servicer can just buy mortgages out of a pool, so you guys never will be able to collect” on the insurance contracts.
It turned out that Bear Stearns owned a “servicing” company called EMC Mortgage Corp. that collected the monthly loan payments of home owners. If EMC exchanged poorly performing home loans within a mortgage pool for healthier loans, or added cash to the pool, it could ensure that the pool had sufficient cash flow to pay off all its investors, rendering Paulson’s insurance worthless.
Later at the conference, another bearish investor, Kyle Bass, shared with Pellegrini a similarly ominous comment that he said he had overheard Bear Stearns’ head mortgage trader, Scott Eichel, make in a crowded bar.
Eichel later denied boasting of any such maneuver, saying he was simply warning bearish investors of something they should be wary of. But Pellegrini already was on high alert. For months he had fretted about how the firm’s big gains might be stripped by a player in the market, and he wondered whether investment banks might take steps to bolster pools of mortgages.
“I got concerned because I thought I would have done it myself if I was in Bear Stearns’ shoes,” Pellegrini says.
On a vacation in Jackson Hole with his elder son over Christmas, Pellegrini, atop a ski slope, held a conference call with executives at Markit Group, which developed the ABX index, suggesting that they clarify what would entail manipulation of the index. But they passed the buck to an industry group, the ISDA, that represented traders of these complex market instruments, and the group never addressed Pellegrini’s concerns.
Back in New York, as Rosenberg finished another purchase of mortgage protection, a Bear Stearns trader added an unusual comment: “There’s a document we want to send you.”
Uh-oh, that can’t be good, Rosenberg thought.
Reading it carefully at the fax machine, Rosenberg saw that Bear Stearns was reserving the right to work with EMC to adjust mortgages. Rosenberg immediately showed the document to Pellegrini. Unnerved, he and Rosenberg got on the
phone with Eichel, warning him not to mess with the mortgages.
“A trading desk shouldn’t be telling a servicer what to do,” Pellegrini said flatly.
“But Paolo, we are allowed to,” Eichel replied. “Read the documents.”
A senior trader said Bear Stearns was proposing the new language to ISDA. Adjusting loans that borrowers were having difficulty paying could be effective public relations for Bear Stearns—the firm already had created what it called the EMC Mod Squad, a team working with local community groups to modify the home loans of delinquent borrowers.
Pellegrini and Rosenberg brought the document to Paulson, who seemed just as shaken. He called in Michael Waldorf, a lawyer on Paulson’s team. In most firms, the traders are demonstrative and the lawyers more reserved. It worked in reverse at Paulson & Co. After quickly reading the document, Waldorf, an animated thirty-seven-year-old with close-cropped hair, stormed out of Paulson’s office, his pink hue turning a beet red as he shook with anger.
“They’re going to manipulate the market!” he bellowed. “They could take away” all the firm’s winnings.
Waldorf had spent months watching Paulson and Pellegrini plot their moves; now was his chance to help the big trade.
Waldorf called others betting against subprime mortgages, including Greg Lippmann and Kyle Bass, and then hired former Securities and Exchange Commission chairman Harvey Pitt to spread the word about the alleged threat from Bear Stearns. He and Waldorf held a series of meetings in Washington, D.C., and elsewhere, arguing that EMC could modify all the mortgages it wished—slicing a home owner’s mortgage payments actually might help Paulson because it would reduce the cash coming into mortgage pools. But, they argued, EMC couldn’t discuss its moves with Bear Stearns or switch mortgages just to keep a pool of subprime loans from running into problems.
Pitt and Waldorf seemed to cause enough of a fuss: Bear Stearns soon withdrew its proposal. Paulson had avoided catastrophe. But he was having other difficulties. Each time Rosenberg called a trader to buy protection on subprime mortgages, he seemed to get an expensive price. Now that the market was weaker, the hedge fund would have to pay more, the trader said. But when Paulson’s brokers gave him their daily “marks,” or valuations of the holdings of its portfolio, the prices were much lower, sometimes for the very same investments.
As Rosenberg relayed the various quotes to him, Paulson became increasingly agitated, sometimes picking up the phone to speak with a broker himself.
“Why can’t you give us the same pricing?!” one of the other brokers heard Paulson saying on the phone. “You’re selling to us at ninety-five and we’re buying at seventy-five!”
“Well, we can’t,” the trader replied.
At other times, Paulson was struck by the unrealistically high prices being quoted for slices of CDOs, even though he knew that no one was offering anywhere near those prices. Because the CDOs and other investments weren’t dropping in price, Paulson’s protection wasn’t rising in value, keeping a lid on his returns.
Paulson was uncharacteristically blunt with investors and friends, lambasting Bear Stearns for giving him marks that understated how much his insurance was worth. But he stayed a Bear Stearns client, loyal to his former employer.
The more he thought about it, the more Paulson began to suspect that the brokers weren’t picking on him. Instead, they were relying on faulty models spitting out prices that bore little resemblance to what he was seeing in the market. If they were quoting Paulson prices for toxic investments that were higher than they should be, he knew they must be placing excessive values on similar investments the banks held on their own books. It provided another valuable hint that the banks weren’t nearly as healthy as they seemed.
TWO BIG HEDGE FUNDS operated by Ralph Cioffi soon provided Paulson with more reasons to be suspicious of Bear Stearns’ health. Cioffi’s funds, which held about $2 billion in capital but borrowed so much money that they owned nearly $20 billion of mortgage-related investments, scored early gains in 2007. Cioffi and his partner, Matthew Tannin, owned various slices of CDO positions, including those with the safest ratings, as well as considerable protection on the ABX. So when the ABX dropped, his two big hedge funds rose in value.
Privately, though, Cioffi was beginning to show signs of nervousness.
“I’m fearful of these markets,” Mr. Cioffi wrote in an e-mail to a colleague on March 15, 2007, according to court documents. “Matt … said it’s either a meltdown or the greatest buying opportunity ever. I’m leaning more towards the former.”
In the spring, CDO prices finally began to fall, even as the ABX index snapped back. Cioffi’s funds lost 15 percent or so in March and April, and his lenders became increasingly nervous—withdrawing their lending lines and putting pressure on Cioffi and Tannin.
In late April, Tannin e-mailed his more senior colleague Cioffi that he feared the market for complex bond securities in which they had invested was “toast.” He suggested they discuss the possibility of shutting down the funds, according to the e-mail, which was sent from Mr. Tannin’s private account. The pair decided their caution likely was misplaced, however, and they soon reassured their investors about the health of the funds.
But market conditions turned still worse and they scrambled to sell $8 billion of CDO investments. The air finally was coming out of the CDO market, as investment banks, stuffed with billions of CDO investments of their own from the previous several years’ excesses, dumped their own holdings, pushing prices down.
At first, Bear Stearns’ chief executive, James Cayne, seemed unconcerned about growing problems at his firm’s hedge funds. Bear Stearns’ money wasn’t at stake, he reasoned. Rather, big institutions, wealthy individuals, and lenders, all of whom knew the risks going in, stood to lose their money from their dealings with the funds. Cayne, a gruff seventy-three-year-old former scrap-iron salesman with a penchant for cigars, golf, and cards, took off many Thursday afternoons and Fridays that summer to play golf near his New Jersey vacation home. As prices of various mortgage investments fell further in the summer and the funds ran into more losses, Cayne spent more than a week in Nashville, Tennessee, competing in a bridge tournament, seemingly confident that Cioffi’s funds wouldn’t have much of an impact on Bear Stearns.4
Soon, though, lenders forced Bear Stearns to extend one of the hedge funds’ portfolios $1.6 billion to keep it afloat. A huge red flag had been raised, warning investors to Bear Stearns’ own problems.
By July, the Bear Stearns funds had collapsed, leading to billions of dollars of losses for clients and throwing financial markets into chaos. Investors suddenly shunned mortgages. Brokerage firms could no longer avoid reducing the value of slices of all kinds of CDOs and subprime mortgage bonds, sending the price of all of Paulson’s insurance shooting higher. He now was up more than $4 billion in profits, at least on paper. But until he exited the positions, he had no realized gains.
As investors and banks scrambled to buy protection, Paulson decided it was a good time to sell some of his positions. But Rosenberg, his only bond trader, was with his wife, Lisa, who was in labor with their second son. In a corner of the delivery room of Greenwich Hospital in Connecticut, Rosenberg set up a makeshift office, balancing a laptop atop a wobbly table and pulling up a nearby collapsible chair. He used a cell phone to make some sales for Paulson. Every so often Rosenberg rose to comfort his wife, before returning to his spot in the corner to make yet another trade. Dealing with labor contractions, Lisa watched it all, indulgently.
By 3 p.m., eight hours after going into labor, Lisa’s doctor judged her close to giving birth and had his fill of Rosenberg and his mini-office.
“You’ve gotta get off the phone,” the doctor said to Rosenberg. “It’s time … the baby’s coming!”
Back on Wall Street’s frenzied trading floors, Cioffi wasn’t the only investor buckling. A key New York–based hedge fund operated by Swiss banking giant UBS AG suffered more than $100 million in losses
due to holdings of speculative second mortgages, known as second liens, made by New Century and other lenders. Two months later, UBS removed its chief executive, Peter Wuffli.
A few days later, as the ABX index dropped sharply, Rosenberg turned in his seat, peered into his boss’s office behind him, and called out updates on the market. Paulson was juggling so many pieces of news while trying to run the firm that he appreciated the running commentary.
“John, it’s down two points.”
“Down ten points!”
“Flows are taking the market lower!”
Paulson & Co. was rolling in cash. But Paulson refused to show any excitement, determined to keep his team focused. Some afternoons, he sat in his office, picking at a tossed salad, trying to picture how bad things might get for the markets and the economy. One day, Wong came by with a question. He found Paulson lost in thought, spinning his wedding ring on his desk like a coin, over and over again. After waiting outside Paulson’s office for more than ten minutes, Wong gave up and left.
Quietly, and without clueing in anyone at the firm, Paulson held off-and-on discussions about a potential sale of 10 percent or so of the firm. A number of other hedge funds had sold shares in their companies or pieces of their firms to investors. Paulson worked with a banker to examine a similar move.
In the summer of 2007, Paulson met with two executives with potential interest in buying a piece of Paulson & Co. Throughout the late-afternoon meeting in the company’s conference room, Paulson seemed fidgety, as if he was waiting for an important piece of news. He talked softly and deliberately about the history of his firm and the genesis of the subprime trade. His guests couldn’t figure out why Paulson seemed so unemotional, even as he spoke of the firm’s accomplishments and growth. They wrote it off as an odd character trait.
Paulson’s firm still seemed small to them; the air-conditioning wasn’t working especially well that muggy July day and their seats were uncomfortable. But the investors were impressed by Paulson’s unassuming manner and were intrigued by his subprime trade. Although he seemed nerdy and lacked the swagger of other hedge-fund managers they had met with to discuss similar deals, Paulson’s grasp of the details of his firm’s trades wowed them.
The Greatest Trade Ever Page 23