The Greatest Trade Ever (24 page)

Luckily for Paulson & Co., the exchange for insurance on the latest mortgages proved relatively painless because the ABX index tracking the most recent mortgages remained around 100, close to the level where it began trading, reflecting continuing enthusiasm for housing. Because the index was so high, the cost of the CDS contracts on the mortgages remained cheap. Paulson had dodged a bullet.

O
UT ON THE WEST COAST
, Jeff Greene was experiencing more serious setbacks. He had placed his own trades a few months before Paulson launched his fund. As the market continued to rally in the
summer of 2006 and the cost of mortgage protection fell further, it caused Greene deeper losses than Paulson was experiencing. By the summer, Greene was down about $5 million.

He ached to reach out to his old friend, to discuss the market and ask whether he should hold on to his trades. And Greene still remained interested in Paulson’s fund. But Greene’s account was down so much, he was even less eager to exit his trades and lock in the losses. He knew he had to confess to Paulson that he had kept his investments, despite Paulson’s demand that he sell them.

Sitting in his Malibu home, the wind chimes playing a gentle tune, Greene booted up his computer and wrote a new e-mail to Paulson. When he had finished, he took a deep breath and pressed the send button. In his e-mail, Greene had written that he was looking forward to getting together when he was back on the East Coast. He asked if he could still invest in Paulson’s fund. Then Greene casually mentioned that he still held his own subprime trades.

Greene quickly got a sense of Paulson’s reaction: He was livid.

“I don’t want you in my fund,” Paulson fired back in an e-mail. “You’re not an honorable person.”

Paulson stormed out of his office to alert his staff not to have anything more to do with Greene.

A few days later, Paulson called Jeffrey Tarrant, sounding hurt: “You build a relationship with someone and this is what happens?”

“We really could have used Greene’s money at the time,” Paulson said later, explaining why he felt so betrayed. “And he said he unwound the trade after I asked him to and he didn’t.”

Greene felt some regret over his actions, and his friend’s reaction. But a part of him also wondered what the big deal was. Paulson had given him dozens of investment tips over the years. He had acted on most of them. And Paulson had told dozens of investors about the trade; he already owned billions of insurance protection. Surely the word was out.
It’s not like it’s a secret
, he thought to himself.

“He never told me ‘Don’t do it,’ ” Greene says.

For Greene, the dustup was a downer, especially since few of his other friends managed to find brokers willing to place the trades for them.

“It was lonely,” Greene says.

Greene never did see Paulson on his trip back east. Well after midnight on a warm Saturday night, he anchored off Sag Harbor to check out another party. There, at the back of a room crowded with people, Greene met an attractive woman, Mei Sze Chan, a Chinese refugee from Malaysia who had grown up in Australia. Like Greene, Chan was in the real estate business and was a fixture in the late-night scene, sometimes attending a half-dozen parties a night in the Hamptons or New York. The thirty-two-year-old also had begun to wonder whether she would ever find Mr. Right.

Greene and Chan hit it off. She touched his shoulder. He held her hand. Then they found a quiet spot in the back of the room and began to discuss mortgages.
¹

A few months later they were engaged.

Greene was less successful with his short trade, however, and his frustrations began to boil over. Every day at 11 a.m., soon after rolling out of bed, he called his broker, Alan Zafran, to ask, “What’s the pricing today?”

Most mornings Zafran came back with data showing that Greene’s protection was worth less than the day before. Demand for subprime mortgages was growing, not shrinking, Zafran told him.

“It doesn’t make any sense to me,” Greene responded one morning. “It just doesn’t make any sense.”

Zafran visited Greene’s Hollywood Hills home to go over the results of the trade, and they pored over a giant spreadsheet of figures together.

Soon Greene’s calls to Zafran became more heated. Greene couldn’t even get a quote on his investments without asking a bond dealer for an estimate, feeding his frustrations. He also couldn’t figure out why the insurance wasn’t rising in price, even as housing seemed to falter. The Merrill traders seemed reluctant to lower the value on all those subprime mortgages, he decided.

“How can you justify this price?!” Greene asked at a rapid-fire clip, his voice rising with anger. “It doesn’t make any sense to me. Does it make sense to you!? Call me back!”

After Greene read a newspaper article about growing difficulties at
Countrywide Financial, he called Zafran, who patched in a Merrill executive in New York, Cliff Lanier.

“I
have
to be in the money, right?” Greene said, bitterly.

Lanier retrieved a fresh quote for Greene from a trader, along with an update on the market: The ABX index tracking subprime mortgages indeed was falling. But Greene held insurance on a range of mortgage bonds, not just the ABX, and those positions showed even more losses for Greene.

“Come on!!” Greene responded. “Countrywide’s on the front page of the paper. I don’t understand it!”

With each call, he noticed that the quotes were getting a little better. That pleased him, but it also sowed suspicions about how Merrill was coming up with its quotes. The Merrill team said it was merely passing along the latest quotes.

Greene had spent millions investing in an obscure, opaque market. Now, as housing was slipping, his mortgage insurance wasn’t budging. He couldn’t even be sure what they were worth.

“I don’t understand it, Alan. Explain it to me,” Greene pleaded to Zafran.

M
ICHAEL BURRY
was under even more pressure. He’d become bearish on housing a full year ahead of Paulson & Co., buying protection against mortgage securities and financial firms when no one else wanted it. But by mid-2006, his investments, too, were falling in value. And unlike the previous year, Burry couldn’t find many winners with his stock picks to offset the losses. His trade was dealing his fund its worst setback ever.

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.