The Big Short: Inside the Doomsday Machine (29 page)

Triple-A-rated subprime CDOs, of which there were now hundreds of billions of dollars' worth buried inside various Wall Street firms, and which were assumed to be riskless, were now, according to Greg Lippmann, only worth 70 cents on the dollar. Howie Hubler had the same reaction.
What do you mean seventy? Our model says they are worth ninety-five
, said one of the Morgan Stanley people on the phone call.

Our model says they are worth seventy,
replied one of the Deutsche Bank people.

Well, our model says they are worth ninety-five
, repeated the Morgan Stanley person, and then went on about how the correlation among the thousands of triple-B-rated bonds in his CDOs was very low, and so a few bonds going bad didn't imply they were all worthless.

At which point Greg Lippmann just said,
Dude, fuck your model. I'll make you a market. They are seventy-seventy-seven. You have three choices. You can sell them back to me at seventy. You can buy some more at seventy-seven. Or you can give me my fucking one point two billion dollars.

Morgan Stanley didn't want to buy any more subprime mortgage bonds. Howie Hubler didn't want to buy any more subprime-backed bonds: He'd released his grip on the rope that tethered him to the rising balloon. Yet he didn't want to take a loss, and insisted that, despite his unwillingness to buy more at 77, his triple-A CDOs were still worth 95 cents on the dollar. He simply handed the matter to his superiors, who conferred with their equivalents at Deutsche Bank, and finally agreed to wire over $600 million. The alternative, for Deutsche Bank, was to submit the matter to a panel of three Wall Street banks, randomly selected, to determine what these triple-A CDOs were actually worth. It was a measure of the confusion and delusion on Wall Street that Deutsche Bank didn't care to run that risk.

At any rate, from Deutsche Bank's point of view, the collateral wasn't that big a deal. "When Greg made that call," said a senior Deutsche Bank executive, "it was like last on the list of the things we needed to do to keep our business running. Morgan Stanley had seventy billion dollars in capital. We knew the money was there." There was even some argument inside Deutsche Bank as to whether Lippmann's price was accurate. "It was such a big number," said a person involved in these discussions, "that a lot of people said it couldn't possibly be right. Morgan Stanley couldn't possibly owe us one point two billion dollars."

They did, however. It was the beginning of a slide that would end just a few months later, in a conference call between Morgan Stanley's CEO and Wall Street's analysts. The defaults mounted, the bonds universally crashed, and the CDOs composed of the bonds followed. Several times on the way down, Deutsche Bank offered Morgan Stanley the chance to exit its trade. The first time Greg Lippmann called him, Howie Hubler might have exited his $4 billion trade with Deutsche Bank at a loss of $1.2 billion; the next time Lippmann called, the price of getting out had risen to $1.5 billion. Each time, Howie Hubler, or one of his traders, argued about the price, and declined to exit. "We fought with those cocksuckers all the way down," says one Deutsche Bank trader. And, all the way down, the debt collectors at Deutsche Bank sensed the bond traders at Morgan Stanley misunderstood their own trade. They weren't lying; they genuinely failed to understand the nature of the subprime CDO. The correlation among triple-B-rated subprime bonds was not 30 percent; it was 100 percent. When one collapsed, they all collapsed, because they were all driven by the same broader economic forces. In the end, it made little sense for a CDO to fall from 100 to 95 to 77 to 70 and down to 7. The subprime bonds beneath them were either all bad or all good. The CDOs were worth either zero or 100.

At a price of 7, Greg Lippmann allowed Morgan Stanley to exit a trade it had entered into at roughly 100 cents on the dollar. On the first $4 billion of Howie Hubler's $16 billion folly, the loss came to roughly $3.7 billion. By then Lippmann was no longer speaking to Howie Hubler, because Howie Hubler was no longer employed at Morgan Stanley. "Howie was on this vacation thing for a few weeks," says one member of his group, "and then he never came back." He'd been allowed to resign in October 2007, with many millions of dollars the firm had promised him at the end of 2006, to prevent him from quitting. The total losses he left behind him were reported to the Morgan Stanley board as a bit more than $9 billion: the single largest trading loss in the history of Wall Street. Other firms would lose more, much more; but those losses were typically associated with the generation of subprime mortgage loans. Citigroup and Merrill Lynch and others sat on huge piles of the things when the market crashed, but these were the by-product of their CDO machines. They owned subprime mortgage-backed CDOs less for their own sake than for the fees that their deals would generate once they had sold them. Howie Hubler's loss was the result of a simple bet. Hubler and his traders thought they were smart guys put on earth to exploit the market's stupid inefficiencies. Instead, they simply contributed more inefficiency.

Retiring to New Jersey, with an unlisted number, Howie Hubler took with him the comforting sense that he was not the biggest fool at the table. He might have let go of the balloon rope too late to save Morgan Stanley, but, as he fell to earth, he could look up at the balloon drifting higher in the sky and see Wall Street bodies still dangling from it. In early July, just days before Greg Lippmann had called him to ask for $1.2 billion, Hubler had found a pair of buyers for his triple-A-rated CDOs. The first was the Mizuho Financial Group, a trading arm of Japan's second biggest bank. As a people, the Japanese had been bewildered by these new American financial creations, and steered clear of them. Mizuho Financial Group, for some reason that would remain known only to itself, set itself up as a clever trader of U.S. subprime bonds, and took $1 billion in subprime-backed CDOs off Morgan Stanley's hands.

The other, bigger, buyer was UBS--which took $2 billion in Howie Hubler's triple-A CDOs, along with a couple of hundred million dollars' worth of his short position in triple-B-rated bonds. That is, in July, moments before the market crashed, UBS looked at Howie Hubler's trade and said, "We want some of that, too." Thus Howie Hubler's personal purchase of $16 billion in triple-A-rated CDOs dwindled to something like $13 billion. A few months later, seeking to explain to its shareholders the $37.4 billion it had lost in the U.S. subprime markets, UBS would publish a semi-frank report, in which it revealed that a small group of U.S. bond traders employed by UBS had lobbied hard right up until the end for the bank to buy even more of other Wall Street firms' subprime mortgage bonds. "If people had known about the trade, it would have been open revolt," said one UBS bond trader close to the action. "It was a very controversial trade in UBS. It was kept very, very secret. There were a lot of people, had they known the trade was happening, would have screamed eight ways from Sunday. We took the correlation trade off Howie's hands when everyone knew the correlation was one." (Which is to say, 100 percent.) He further explained that the traders at UBS who executed the trade were motivated mainly by their own models--which, at the moment of the trade, suggested they had turned a profit of $30 million.

On December 19, 2007, Morgan Stanley held a call for investors. The company wanted to explain how a trading loss of $9.2 billion--give or take a few billion--had more than overwhelmed the profits generated by its fifty thousand or so employees. "The results we announced today are embarrassing for me; for our firm," began John Mack. "This was a result of an error in judgment incurred on one desk in our Fixed Income area, and also a failure to manage that risk appropriately.... Virtually all write downs this quarter were the result of trading about [
sic
] a single desk on our mortgage business." The CEO explained that Morgan Stanley had certain "hedges" against its subprime mortgage risk and that "the hedges didn't perform adequately in extraordinary market condition of late October and November." But market conditions in October and November were not extraordinary; in October and November, for the first time, the market began accurately to price subprime mortgage risk. What was extraordinary is what had happened leading up to October and November.

After saying he wanted "to be absolutely clear [that] as head of this firm, I take responsibility for performance," Mack took questions from the bank analysts of other Wall Street firms. It took this group a while to get to the source of embarrassment, but eventually they did. Four analysts elected not to probe Mack too closely about what was almost certainly the single greatest proprietary trading loss in Wall Street history, and then William Tanona, from Goldman Sachs, spoke:

TANONA: A question on the risk again, [which] I know everybody has been dancing around.... Help us understand how this could happen that you could take this large of a loss. I mean, I would imagine that you guys have position limits and risk limits as such. I just--it [bewilders] me to think that you guys could have one desk that could lose $8 billion [
sic
].

JOHN MACK: That's a wrong question.

TANONA: Excuse me?

JOHN MACK: Hello. Hi. And...

TANONA: I missed you...

JOHN MACK: Bill, look, let's be clear. One, this trade was recognized and entered into our accounts. Two, it was entered into our risk management system. It's very simple. When these got, it's simple, it's very painful, so I'm not being glib. When these guys stress loss the scenario on putting on this position, they did not envision...that we could have this degree of default, right. It is fair to say that our risk management division did not stress those losses as well.
*
It's just simple as that. Those are big fat tail risks that caught us hard, right. That's what happened.

TANONA: Okay. Fair enough. I guess the other thing I would question. I am surprised that your trading VaR stayed stable in the quarter given this level of loss, and given that I would suspect that these were trading assets. So can you help me understand why your VaR didn't increase in the quarter dramatically?
⁺

MACK: Bill, I think VaR is a very good representation of liquid trading risk. But in terms of the (inaudible) of that, I am very happy to get back to you on that when we have been out of this, because I can't answer that at the moment.

The meaningless flow of words might have left the audience with the sense that it was incapable of parsing the deep complexity of Morgan Stanley's bond trading business. What the words actually revealed was that the CEO himself didn't really understand the situation. John Mack was widely regarded among his CEO peers as relatively well informed about his bond firm's trading risks. After all, he was himself a former bond trader, and had been brought in to embolden Morgan Stanley's risk-taking culture. Yet not only had he failed to grasp what his traders were up to, back when they were still up to it; he couldn't even fully explain what they had done after they had lost $9 billion.

At length
the moment had come: The last buyer of subprime mortgage risk had stopped buying. On August 1, 2007, shareholders brought their first lawsuit against Bear Stearns in connection with the collapse of its subprime-backed hedge funds. Among its less visible effects was to alarm greatly the three young men at Cornwall Capital who sat on what was for them an enormous pile of credit default swaps purchased mostly from Bear Stearns. Ever since Las Vegas, Charlie Ledley had been unable to shake his sense of the enormity of the events they were living through. Ben Hockett, the only one of the three who had worked inside a big Wall Street firm, also tended to travel very quickly in his mind to some catastrophic endgame. And Jamie Mai just thought a lot of people on Wall Street were scumbags. All three were worried that Bear Stearns might fail and be unable to make good on its gambling debts. "There can come a moment when you can't trade with a Wall Street firm anymore," said Ben, "and it can come like
that.
"

That first week in August, they kicked around and tried to get a feel for the prices of double-A-rated CDOs, which just a few months earlier had been trading at prices that suggested they were essentially riskless. "The underlying bonds were collapsing and all the people we'd dealt with were saying we'll give you two points," said Charlie. Right up through late July, Bear Stearns and Morgan Stanley were saying, in effect, that double-A CDOs were worth 98 cents on the dollar. The argument between Howie Hubler and Greg Lippmann was replaying itself throughout the market.

Cornwall Capital owned credit default swaps on twenty crappy CDOs, but each was crappy in its own special way, and so it was hard to get a read on exactly where they stood. One thing was clear: Their long-shot bet was no longer a long shot. Their Wall Street dealers had always told them that they'd never be able to get out of these obscure credit default swaps on double-A tranches of CDOs, but the market was panicking, and seemed eager to buy insurance on anything related to subprime mortgage bonds. The calculation had changed: For the first time, Cornwall stood to lose quite a bit of money if something happened that caused the market to rebound--if, say, the U.S. government stepped in and guaranteed all the subprime mortgages. And of course if Bear Stearns went down, they'd lose it all. Oddly alert to the possibility of catastrophe, they now felt oddly exposed to one. They rushed to cover themselves--to find some buyer of these strange and newly relevant insurance policies they had accumulated.