The Greatest Trade Ever (33 page)

Days later, Zafran, Greene’s other broker, also approved Libert to trade with Merrill Lynch. Libert spent about $500,000 to buy CDS protection on BBB-rated slices of the ABX index, just like Greene.

“It was so simple that I thought we were missing something,” Libert recalls. “I figured I didn’t understand the business.”

Once he owned the investment, Libert discovered an odd impulse: He found himself rooting for a rash of home owners to run into problems paying their mortgages, something that would help his trade pay off. The feelings made Libert increasingly uncomfortable. He knew he had no control over whether or not home owners would make good on their mortgage payments, and yet he felt guilty. How could he root against everyday home owners?

As the investments played mind games with Libert, he tried to distract himself from the trade, vowing to check the ABX index only once a day, at the close of trading. It was as if he was trying to control an addiction.

“Greene was looking at it all day long, but I couldn’t take it,” Libert says. “I tried to avoid” watching the fluctuations.

As the ABX rose in the spring and Libert was dealt instant losses, he found himself pulling even harder for mortgage problems to develop. Then, as the subprime market wobbled and he made some gains, Libert felt intense shame about his feelings—while also wondering if he should have bought more protection. It was all too much.

A closet smoker, Libert began bumming cigarettes from his employees and sharing a smoke with some of them in front of their office building in Newton, outside of Boston.

“Michelle, if I was smart, I’d do more of these trades,” he told one colleague on an especially stressful day. She listened sympathetically as her boss shared more of his angst. No one should own the bonds that he was wagering against, she agreed.

But when Libert’s father came by the office to visit, he had a very different take.

“What do you think you’re
doing
??” his father said, heatedly. “This is Wall Street you’re talking about; these guys must know something.”

“Dad, would you own these bonds at these prices?”

“No … but the guys on Wall Street know what they’re doing.”

Greene regularly called Libert, tweaking him for not buying more protection, making him feel even worse.

On the twenty-fifth day of each month, Libert called his brokers to check the latest “remittance” reports that provided a snapshot of how the pools of subprime mortgages were performing and the number of home owners that were delinquent on their loans that month.

For all his attempts to become a dispassionate observer of the housing market, Libert couldn’t wait to get the results.

“Is it in yet? Is it in?” he would ask.

“I needed to see if defaults were escalating. I was hoping, praying, that another hundred thousand people would lose their homes.”

Libert asked others for their opinions on his new investments, trying to find some reassurance that he wasn’t doing anything improper. Rev. Steve Smith, a local minister and good friend, was not pleased.

“You’ve got to stop,” Smith told him. “I can’t believe you’re happy about this.”

“I’m
not
happy. It makes me feel creepy.”

Libert’s wife stepped in, trying to defend him to Smith.

“It’s like being at a craps table. Jeffrey’s just betting on it, he’s not making the loans.”

But Libert was getting excited about the signs of housing problems, the minister retorted.

A few of Libert’s close friends were just as critical. Some called to take him to task, putting Libert on the defensive.

“I didn’t cause it, I didn’t have anything to do with the problems,” he responded to one, as his wife, his moral compass, nodded.

“The friends made me feel guilty,” Libert recalls. “I couldn’t help myself … I was cheering for people to lose their homes.”

Libert called his broker Zafran, to share his feelings and get some support.

“It just gives me the creeps, Alan. I’m betting on people’s misery.”

“I understand,” Zafran responded, sympathetically.

Libert only rarely brought up his conflicted feelings with Greene, though. Greene couldn’t relate to any of it.

“Libert, why are you being so uptight about it?”

“It just gives me the heebie-jeebies.”

“You didn’t cause it!”

“Yeah, I know. But we’re cheering for it.”

When it came to discussing the moral aspects of the trade, it was as if Libert and Greene spoke different languages.

“I didn’t even think about it,” Greene acknowledges. “If more people had been [shorting mortgages] early on, then the pricing of debt would have been higher and things wouldn’t have become so crazy. The world would have been a better place had more people been shorting. We had nothing to do with what happened to home owners.”

Part of Libert agreed with his friend. But he couldn’t shake his qualms. It all left him a miserable ball of nerves.

M
ARIO AND LETICIA MONTES
were the type of home owners Libert was wagering against and the reason he was so torn about his trade.

In mid-2005, the Monteses found a home they loved, a gray stucco bungalow with a hot tub in the backyard in a middle-class neighborhood of Orange County. It cost $567,000. The only catch was they didn’t have money for a down payment and couldn’t afford the home unless they agreed to a mortgage with a low interest rate for the first two years, but one that would then rise, increasing their monthly payments by more than 50 percent. Their mortgage broker assured the Monteses, who earned combined salaries of $90,000, that they’d easily be able to refinance their mortgage before the rate climbed. Sitting around the kitchen table with their two teenage daughters, they decided to cut back on vacations and restaurant outings, and to take the plunge to become home owners.

By the summer of 2007, however, their home had tumbled in value and lenders finally had tightened their standards, making a refinancing impossible. They faced yearly mortgage payments of $50,000, just about their entire take-home salary.

“We have a disaster on our hands,” Mario, a forty-eight-year-old
warehouse manager, told a reporter. Fears of a foreclosure gripped him, he said.

“At this point,” he said at the time, “we really don’t have a plan.”

“Bottom line, it’s our little home,” Leticia told a visitor. “Hopefully, we won’t go down, and if we do, we’re going to go down with a fight.”
¹

B
Y THE SUMMER
, the data was too overwhelming for Libert to ignore. Eight percent of a $1 billion pool of subprime home mortgage loans made in early 2007 already had defaulted—within just six months of being inked. Fifteen percent of them were in default after less than nine months. And the figures were only getting worse! Defaults didn’t necessarily mean losses for the mortgage pools, but if losses in the pool reached 12 percent, or $12 million, even the AA-rated slices of the bonds would be wiped out, Libert knew.

Libert converted all his insurance on BBB-rated bonds to protection for AA-rated slices. Because they were still perceived as being largely safe, the insurance was still inexpensive, allowing Libert to get more bang for his buck. He now owned CDS insurance on $25 of toxic mortgages for each $1 he put down.

“You should really get into the AAs,” Libert told Greene.

Now it was Greene’s turn to feel torn. Should he follow Libert’s lead and roll his own protection into insurance on those AA-rated slices? Greene arranged a phone conversation with analysts from Merrill Lynch and J.P. Morgan. They agreed that CDS contracts protecting AA-rated slices of subprime mortgages were a better bet than Greene’s BBB protection.

Greene bought some protection on the AAs, but soon he became distracted. In late September, he and Mei Sze Chan married at his Beverly Hills mansion, a blowout affair that cost $1 million and was the buzz of the Los Angeles social scene. The guest list included Oliver Stone; Donald Sterling, the owner of the Los Angeles Clippers basketball team; and Robert Shapiro, O.J. Simpson’s attorney. Mike Tyson was Greene’s best man. Chan, wearing a gown of hand-beaded Swarovski crystals, married Greene in a French limestone gazebo.
²
After midnight, the revelers
danced on a revolving dance floor in Greene’s twenty-four-car garage. John Paulson didn’t come, though he sent Greene a gracious card.

But Greene never stayed away from the trade for long. In the middle of the wedding, Greene pulled aside Libert with urgent news: “Your trade is at 89.72 today!”

Libert was shaken. He had bought protection on the ABX index tracking AA subprime mortgages when it was trading at 80. Now it was almost 10 points higher. He had given back half the profits from his BBB trade by shifting into the AA bonds much too early!

Then it dawned on Libert—there was no way Greene could know the price of the index in that kind of detail. Prices were never quoted to the penny. Greene was playing with Libert’s head, preying on his insecurities.

He turned to his wife with a relieved smile.

“What’s he talking about, 89.72??” Libert said. “I’m a schmuck; he’s sticking it to me.”

“He knew I just didn’t have the stomach for the trade,” Libert recalls.

By the end of the summer, Libert set aside his compunctions and made plans to put more money in the investments, convinced that something big was about to happen.

W
ITH EVERY NEW FIGURE
on Greg Lippmann’s computer screen in early 2007 came a single message: Your bonus is soaring!

As the ABX collapsed in February, Lippmann and his team racked up huge gains, thanks to protection they held on about $3 billion of subprime mortgages. One day early that month, they made $20 million, their best day ever. The next day, they did it again! The group followed it up with a still better day. Over one spectacular week, Lippmann’s crew made $100 million of profit. Their Bloomberg terminals became best friends, the next price quote a cause for celebration, the end of the trading day a reason for sorrow.

At first, Lippmann tried to play it cool—his bonus check wouldn’t be
cut until the end of the year and he knew there was a lot of time for the trade to run into potential difficulties. But he couldn’t help feeling relief. Walking with analyst Eugene Xu down a Manhattan street, after meeting a new hedge-fund client, Lippmann turned to his colleague with a look of astonishment.

“It’s really working. Finally.”

Other traders approached Lippmann, asking his advice on their own moves and where he thought the market was going. Colleagues who once snickered at Lippmann now needed his help.

“It’s just starting!” he responded, urging them to get bearish. Many did, buying CDS contracts of their own. Others trimmed their holdings of mortgage-related investments, heeding Lippmann’s advice.

One day, Anshu Jain, Deutsche Bank’s London-based head of global markets, visited the firm’s New York office. He walked over to Lippmann, greeting him with a warm smile, an acknowledgment of his huge gains and rising status at the bank. But Jain wasn’t ready to congratulate Lippmann.

“Do you think you should cover here?” Jain asked. It was a pointed suggestion that Lippmann sell some positions to reap profits.

Lippmann pulled out the latest data on housing, showing Jain how the market was deteriorating.

“No, we have to hold steady,” Lippmann said, according to a nearby trader. “Prices are heading lower.”

Jain didn’t push any further. But with every drop in the ABX, Lippmann received e-mails from superiors and risk specialists at the bank, each urging him to exit positions or at least consider trimming them. Some demanded it. Their message was clear: You better be right or you’ll be blamed if the gains evaporate.

Lippmann couldn’t believe it—the data was getting worse, not better. This was the time to increase the trade, not reduce it!

Didn’t they get it?

As the ABX rebounded in the spring, Lippmann’s mood turned sour. Nonetheless, the rally helped make mortgage protection cheaper, enabling him to generate additional commissions by teaching more hedge
funds to do the trade. And home prices continued to weaken, making Lippmann even more convinced that BBB mortgage bonds were doomed.

Lippmann was less sure about top-rated bond slices, but a conversation with John Paulson persuaded him that even A-rated pieces would run into trouble. Lippmann began urging clients to buy CDS protection on those investments as well.

By then, the various hedge funds that Lippmann had educated about the subprime trade had begun making their investments with various other brokers, quickly spreading word about what Lippmann was advocating around Wall Street. He soon received a phone call from Scott Eichel, his counterpart at Bear Stearns.

“Why are you telling people that things are going to blow up?” Eichel asked him. “Why are you so sure?”

Eichel argued that the trade wouldn’t work because real estate was resilient.

“Dude, when home prices fall, the subprime market is toast,” Lippmann responded.

I
N HIS SANTA MONICA APARTMENT
, Andrew Lahde was staring at the same data that showed housing was deteriorating. February’s panic brought gains to Lahde, as it did to Paulson, Greene, and Lippmann, less than three months after Lahde first bought mortgage protection and launched his hedge fund, Lahde Capital. His firm now was up to about $6 million in assets.

But Lahde was feeling more pressure, not less. The value of his positions had climbed a few hundred thousand dollars, but he hadn’t sold any of them to lock in any of the gains. Instead, his expenses were piling up as he struggled to pay a few staff members. Lahde was making only a few thousand dollars a month from his tiny fund, barely enough to pay the rent. If he ran out of money, he would have to sell his CDS protection, pocket the measly few hundred thousands dollars in profit, and look for a job, once again, watching others profit from the crumbling housing market. That was the last thing he wanted to do.

Lahde had to somehow keep his trade alive and his fund going. He
had to somehow find an investor who believed in him. To cut his expenses, he rarely left his apartment. For lunch, Lahde grabbed a turkey sandwich at a nearby deli. At dinnertime, he cleared paperwork from his desk table and ate tuna fish out of a can.