The Greatest Trade Ever (16 page)

“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 losses 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.

I
F 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 market. 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.

Pellegrini sat upright, staring at his trend line, amazed at how simple and clear it finally was. When he placed the data on a chart, the visual effect was even more dramatic. The next morning, he raced in to show Paulson.

“This is unbelievable!” Paulson said, unable to take his eyes off the chart. A mischievous smile formed on his face, as if Pellegrini had
shared a secret no one else was privy to. Paulson sat back in his chair and turned to Pellegrini. “This is our bubble! This is proof. Now we can prove it!” Paulson said.

Pellegrini grinned, unable to mask his pride.

The chart was Paulson’s Rosetta stone, the key to making sense of the entire housing market. Years later, he would keep it atop a pile of papers on his desk, showing it off to his clients and updating it each month with new data, like a car collector gently waxing and caressing a prized antique auto. Pellegrini’s masterpiece was a guiding light that told Paulson exactly how overpriced the housing market had become. He no longer needed to guess.

“I still look at it. I love that chart,” Paulson says. “It’s the first key piece of our research. Here was a picture of the bubble!”

To Paulson and Pellegrini, their discovery meant that housing prices were bound to fall, at least at some point, no matter what the moves in unemployment, interest rates, or the economy. And falling prices would put a quick end to all the mortgage refinancing by subprime borrowers, placing them in mortal danger.

Pellegrini’s next assignment was to figure out how to make money from their thesis. The firm had been burned shorting various housing-related companies, so it seemed to make more sense to focus on subprime mortgages themselves. Paulson and Pellegrini remained convinced that CDS contracts provided the best risk-reward proposition for the fund, since they were insurance contracts that required Paulson & Co. to make set, annual payments, limiting any losses.

Looking for help, Pellegrini found Sihan Shu, a young analyst in Lehman Brothers’s mortgage department, who claimed to be just as skeptical about real estate as the Paulson team and was eager to quit his firm to pursue the thesis.

Paulson, wary that Shu wasn’t a true believer in the bear case and was just angling for a lucrative hedge-fund job, tested him in an interview.

“We think these securities are all junk,” Paulson told Shu, referring to bonds backed by subprime mortgages, awaiting his reaction to what was then a radical stance. “They’re going to go to zero.”

Shu passed Paulson’s test with flying colors, sharing overlooked research that Lehman had done showing that even flat home prices would lead to huge losses for many slices of the mortgage bonds. Shu was hired.

Pellegrini and Shu purchased enormous databases tracking the historic performance of more than six million mortgages in various parts of the country, hiring a firm named 1010data to make sense of it all. They crunched the numbers, tinkered with logarithms and logistic functions, and ran different scenarios, trying to figure out what would happen if housing prices stopped rising. Their findings seemed surprising: Even if prices just flatlined, home owners would feel so much financial pressure that it would result in losses of 7 percent of the value of a typical pool of subprime mortgages. And if home prices fell 5 percent, it would lead to losses as high as 17 percent.