The Greatest Trade Ever (30 page)

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.

T
WO 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.

About an hour into the meeting, Rosenberg gently knocked on the door, interrupting the group. Entering the room, he leaned into Paulson’s ear, whispering something. Paulson immediately rose, apologized, and stepped out, leaving his guests staring at an array of Snapple iced teas.

Ten minutes later, Paulson returned, appearing much more upbeat, almost jovial. A wide, Cheshire grin streaked his face. Something had happened in those few minutes away from the room; the more they watched Paulson, the more it seemed he was holding a secret that he was dying to share.

Finally, one of Paulson’s guests asked if he was needed elsewhere and whether they should reschedule the meeting for a more suitable time.

Paulson finally blurted out what was on his mind: “We just got our marks for the day. We made a billion dollars today.”

The investors were stunned. They had never heard of such a quick profit and didn’t know what to say. In that instant, they knew they could no longer afford to buy a piece of Paulson & Co. Rising to leave a few minutes later, they shook hands and asked Paulson how much further his trade could go.

“I think they’ll all go to zero,” referring to the value of subprime home mortgages. “But I think I may need to get out of the positions” ahead of time, to try to ensure a profit. “That’s the trick,” Paulson told them.

I
T WAS THIS VERY ISSUE
that caused a growing rift with some of Paulson’s investors, and even Pellegrini.

Most of his clients were thrilled with the sudden gains. But some were worried. Just as Paulson would look foolish if he built up huge gains only to fritter it away, many of these investors would be embarrassed if they stuck with Paulson and the profits later vanished. Investors in Paulson’s other funds, which also owned some of his CDS mortgage protection, were especially on edge. They didn’t have much experience with these kinds of derivatives, or those kinds of fast returns, and it was making them nervous.