Those Who Beat the Worst Recession in History

“Watch the lenders not the borrowers — borrowers will always be willing to take a great deal for themselves. It’s up to the lenders to show restraint. When they lose it, watch out.”

The worst financial crisis of modern times which took place in 2008 crippled the global economy. It had been the worst global economic crisis since the Great Depression. By early 2009, losses by global banks amounted to $3 trillion while stock market investors had lost more than $30 trillion. The general public suffered a lot. They lost their homes, their jobs and their livelihoods. None of the leaders or experts saw this coming. However there were some people who did. While the whole world as having a big party, some people identified the giant lie at the heart of the economy. A small group of unsung and underdog investors triumphed over the failures of the financial institutions and Wall Street to make the trade of a lifetime and this is how they did it.

Before getting into how these traders made the bet of their lifetime, let us understand a little about how the 2008 financial crisis was caused. Some of the terms which I will be using have been explained below.

1] Bubble — A bubble is an economic cycle (natural fluctuations in the economy) which is characterized by the rapid escalation of asset prices followed by contraction.

2] Mortgage — Mortgage is used either by purchasers of real estate to raise funds to buy real estate, or by existing property owners to raise funds for any purpose, while putting a lien on the property being mortgaged.

3] Mortgage Backed Securities (MBS) — These are a type of asset backed security which are secured by a collection of mortgages. The mortgages are sold to a group of individual (example: investment bank) which packages the loans together and sells it to investors.

4] Subprime Loans — This is a type of loan given by a bank to individuals or institutions who may have trouble maintaining the repayment schedule. These borrowers have low credit ratings. These loans tend to have a higher interest.

5] Collateralized Debt Obligations (CDO) — These are a group of different types of loans (such as mortgages, student loans, car loans, credit card debts, etc) which are packaged by investment banks and sold to investors. These loans are used as collateral. Collateralized Mortgage Obligations (CMO) are a group of mortgages which use Mortgage as collateral.

5] Bonds — A bond is a fixed income investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate.

6] Credit Default Swaps(CDS) — A financial contract whereby a buyer of debt in the form of bonds attempts to eliminate possible loss arising from default by the issuer of the bonds. In simpler terms it is an insurance. If the borrower fails to pay the interest, the lender can insure his debt and make sure he gets paid even in the event of a default by the borrower. This is a type of derivative.

In the traditional way, the borrower would ask the lender for a loan and agree to pay a mortgage on the loan. The lender would be careful as to who he lent his money to because mortgages would take years to get repaid. But in the new system, lenders sold their mortgages to investment banks who combined these mortgages with other loans and created Collateralized Debt Obligations. The investment banks sold these CDOs to investors. The investment banks paid rating agencies to evaluate their CDOs and assign them a rating on various factors. AAA was the highest rating which could be awarded; AAA rating meant that that particular CDO was highly stable and the borrowers would most probably pay off their debt in a timely manner. The rating agencies awarded the AAA rating to many CDOs which made them popular with retirement agencies and pension funds which were only allowed to invest in highly rated securities.

Lewis Ranieri was the man who introduced MBS into in the market in the 1970’s which revolutionized the banking industry. Many mortgages were packaged together and sold to investors. These mortgage bonds were amazingly profitable to the big banks and they made billions and billions of dollars on their fee which they got for selling these. The banks sold these mortgages because then they did not have to worry about the non-payment of mortgages. Also, selling of these mortgages freed up their balance sheet and allowed them to create more of MBS for selling which in turn generated more money for them. Between 2000 and 2003, the number of mortgage loans made each year nearly quadrupled.

Also in the early 2000s there was a tremendous increase in the riskiest loans also known as subprime loans. These subprime loans were combined to create CDOs but these still received AAA ratings by the rating agencies which were paid by the investment banks. The rating agencies didn’t carry a lot of burden because their ratings were only their opinion and they could not be held liable for those ratings. But the problem arose when they started to run out of mortgages to put in these MBS. After all there are only so many homes and so many people with good enough jobs to buy them.

But the banks still did not back off. They wanted to continue their earning spree and so they decided to fill these Mortgage Backed Securities with riskier mortgages or subprime mortgages. The banks actually preferred subprime loans because of their higher rate of interest. This lead to predatory lending (lending in which there are unfair terms imposed on the borrower) which included adjustable rates. Soon anyone could buy a mortgage with minimum or no documentation at all. After sometime when the interest rates increased the borrowers could not pay their mortgages neither could they refinance their homes. This caused a chain reaction which eventually led to the largest financial real estate bubble in history.

DR. MICHAEL BURRY

When Michael Burry was born in 1971, his steel blue eyes seemed crossed in an unusual way which drew the immediate concern of his parents who consulted various doctors and ophthalmologists, who finally diagnosed him with retinoblastoma, which simply meant that Michael would need to wear a glass eye. Well, it wasn’t simple for Burry, who had started facing troubles. He would have intense pain in his socket causing him to leave school. His depth perception was weak and he was often bullied. Burry was an outsider. But this all developed the habit of reading books in Burry. One day while reading the local newspaper, Michael noticed the stock quotations in the business section and asked his father what they were. His father was skeptical of the market but still doused the curiosity of his son. Burry tracked the American Motors shares for over a year getting excited at every rise and fall. Michael became enamored with earning money. He worked odd jobs and started a savings account which he invested in a mutual fund. But unfortunately the funds dropped. This was Burry’s first encounter with the market.

But soon Burry forgot about his financial endeavors and started focusing on school. He got enrolled in the premed courses at UCLA. He felt disconnected from his classmates and faculty members. It was around this time that he rediscovered his passion for stock market. Making a lot of money seemed like the most concrete sign of success. He opened a brokerage account with his summer earnings. Instead of using in his inheritance money to pay off his student loan debts he poured it into the market finding comfort in his profit. He started a website to discuss to discuss stocks and slowly firms started paying him to write. Burry joined residency at Stanford in neurology. On one occasion, Burry had been working so hard studying both for medical school and his personal financial interests that he fell asleep standing up during a complicated surgery and crashed into the oxygen tent that had been built around the patient. As a result, he was thrown out of the operating room by the lead surgeon. At 29, he decided he had had enough of medicine and decided to started his own hedge fund, Scion Capital.

The stocks of telecommunication company WorldCom were soaring which intrigued Burry because it’s competitors profits were quite less. Michael came to the conclusion that WorldCom was fudging it’s accounts and later WorldCom admitted to accounting fraud and filed for bankruptcy. Burry beat himself up for not profiting from this and kept asking himself what could he have done differently. This is when he came across CDS and started researching them. He realized that buying CDS was safer than shorting (betting against) a stock directly. In 2003, Michael bought a house for $3.8 million even though the asking price was $5.4 million. This is when he realized that there may be a housing problem. He delved deeper into the history of housing and why certain neighborhoods decay. He realized that lenders of mortgages didn’t hold on to them anymore but sold them to Wall Street firms who created MBS and sold them to investors. He learnt that each mortgage in a MBS was rated differently (AAA, AA, BBB, BB, and so on). But Michael could not figure out a way to directly bet against the mortgages themselves. He called banks and asked if he could buy CDS on pools of risky mortgages rather than the companies in the mortgage business. The bank said that they might be able to write up a CDS contract but it would take time to work out the complicated language. And it wasn’t the kind of thing Michael could sell to investors. And so Michael had another idea. He called up his broker at Deutsche Bank and told her that he should be their first call when such CDS contracts were standardized because Wall Street loved to roll out new products and protection on toxic mortgages had to be their next trick. Michael knew that this would be his Soros trade.

JOHN PAULSON

John Paulson was a hedge fund manager who took the bus to work he had graduated at the top of his call summa cum laude at both New York University and Harvard Business School. He received early insights into the world of finance from his businessman grandfather. He then learnt at the knees of some of market’s top investors and bankers before launching his own hedge fund. John’s forte was merger arbitrage; which means buying the stock of the company getting acquired and shorting the stocks of the company acquiring. He viewed this as the safest form of investing. Paulson had the ability to explain complex trades in straightforward terms which left some wondering if his strategies were simple. Paulson’s lifestyle had once been much flashier. He used to throw parties and chase the glamour of Wall Street before deciding to get married and settle down and concentrate more on his business. Paulson also began to sense that real estate was getting out of hand when he bought his house for dirt cheap price. Paulson did not have much knowledge about real estate and so he did not give this issue much thought until Paolo Pellegrini, an employee in his fund came up with an idea to buy CDS to protect the fund’s portfolio. Paulson and his team understood little about the world of CDS, beyond a vague understanding. Though CDS contracts had soared in value over the years, it was still a complicated, esoteric world. Paulson was one of those investors who shied away from investing in “derivative” investment because their value depended on some underlying asset. But this was all about to change.

Pellegrini himself had only little knowledge about the world of CDS from his previous jobs. But he was driven. He arranged for various tutorials by different brokerage firms and attended conferences. The firm made their first purchase of CDS on a company MBIA which insured mortgage backed by aggressive loans. They suffered loss but weren’t ready to give up just yet.

Cue Greg Lippmann.

GREG LIPPMANN

Greg Lipmann was a trader at Deutsche Bank. He was a man who never really fit at Wall Street and felt out of place. He was meeting with a few rivals to plot a change in the way debt was traded. He would set the ground work for Burry, Paulson and others to bet against the falling housing market, just like Burry had anticipated. Lippmann called traders from Bear Sterns, Goldman Sachs and a few other firms. They all sat into the night and debated about ideas. Finally, they agreed upon an idea: Create a standardized, easily traded CDS contract to insure mortgage backed securities made up of subprime loans. After a few months they finally introduced a new form of standardized CDS contract that would adjust in price as the underlying mortgages became more or less valuable. The people who were bullish would sell the CDS and pocket money while the bears would buy the CDS contracts. This feat of legal and financial engineering grew the subprime mortgage market by leaps and bounds, a fact that would come back to haunt Wall Street and global economy. Lippmann and the other bankers had no idea about the impact that their change would have. They just wanted another product to sell. In fact, Lippmann’s first move was to sell $400 million of protection on subprime mortgages to a hedge fund. He was oblivious to the impending doom.

THE TRADE

Burry’s trader gave him a call telling him that they were ready to sell those CDS contracts which he wanted. Burry was elated. Burry bought CDS protection on BBB rated mortgage securities. Over the next few months, Burry stepped up his research and researched hundreds of pools of bonds, trying to locate the riskiest of mortgages. He felt that time was running out and other funds would soon realize what was going on. So he wanted to buy as many CDS protections as he could before the price rose. Sometime late in 2005, Burry realized that the first batch of CDS he had bought were not as risky and so he began to isolate mortgage pools in which the buyer had taken two loans, thus making them riskier. He kept buying the insurance which was dirt cheap. He felt like a kid at a candy store who keeps eating up candies as fast as he can (because of the cheap price of candy) before the other kids found out about the markdown. He had insured around $1.3 billion and was paying around $80–90 million as premiums annually. He wanted to buy more CDS but his investors were skeptical of his abilities in the real estate market. They were unhappy. Some investors tried to withdraw their investment. Burry decided to launch a fund to invest in CDS but it was a wild goose chase. He could not secure any funds and the fund closed down.

Paulson, on the urging of Pellegrini had also bought CDS protection. But in early 2006, Paulson sensed a mistake and sold his original CDS protection because it covered mortgages which had already appreciated in value and their refinancing would be easier and so he traded these for CDS on more recent subprime home mortgages. This change did little for the fund though and Paulson and Pellegrini began to get skeptical of their investment. They concluded that the only way their trades would work is if the real estate market reached unsustainable levels and fell, crippling the ability of the borrowers to refinance their loans. Pellegrini decided to get to work. He soon realized that home prices in USA had climbed a puny 1.4% between 1975 and 2000 but they soared over 7% in the next 5 years (after taking inflation into consideration). Home prices would have to fall by 40% to return to their historic trend line. This suggested that an eventual drop in real estate was imminent and brutal. He went to Paulson with these findings. Now they both were confident and bought as may CDS as the fund could. Paulson, just like Burry tried to start a fund to invest in CDS. He had better luck than Burry but could not collect as much as he wanted to. Eventually he invested some of his own money.

Greg Lippmann, the man because of this all this was possible, soon realized what was going on. Eager to get in on the action he told a young, brilliant analyst, Eugene Xu to conduct his own research to test if the bullish market was right. On realizing it wasn’t, he convinced his bosses at Deutsche to invest in CDS. If he would be right, he would make the billions for the bank. The losses could be offset elsewhere. He was allowed to invest in CDS but not as much as he wanted.

One of the main reasons experienced investors weren’t buying CDS was because they were a classic example of negative-carry. In a negative-carry, the investor commits to paying certain premiums in the hopes of untold riches down the line. Also, most of the models on Wall Street suggested that the housing market would never collapse because housing prices would never go negative. And they thought that all the borrowers would pay their mortgages, because who doesn’t. George Soros said that before this crisis he didn’t even know what CDS were and even if he did he would not have invested the Housing market.

By late 2006, housing prices had levelled off. Subprime lenders were failing but still our 3 protagonists weren’t making money. They began to worry. How could the price of the insurance not be affected by the demise of the very thing it insures? This was the question in everyone’s mind. The brokers were telling them that the price of their shorts was still the same. This was bewildering them.

The thing that was happening was that the brokers at investment banks weren’t giving them the proper quotes. The banks had realized what was happening. They knew they screwed up and had to make it right. So they unloaded the toxic CDOs and MBS to unsuspecting clients. Goldman Sachs went a step further. They went behind the back of their clients and shorted those same CDOs and MBS. They acted against the interest of their clients. Goldman bought about $22 billion in CDS from AIG (American International Group) but Goldman realized that AIG itself may go bankrupt and so they went ahead and insured themselves against AIG by paying $150 million. It still went further and started selling CDOs specifically designed so that more money their investors lost, the more money they would make. Later, Goldman had to pay about $5 billion in all forms of settlement. As Al Pacino said in Scarface, “Never get high on your own supply.” Soon Morgan Stanley also joined Goldman. When Paulson had run out of mortgage securities to bet against, he designed more of these with Goldman and Deutsche. All of these securities were highly rated by the rating agencies and they earned millions doing so.

Now the banks would give these traders a proper quote on their shorts because it was in their interest to do so. Burry made $400 million for himself and more than $700 million for his investors. The value of Scion Fund was up 489% since its founding. Paulson made more than $4 billion for himself and around $15 billion for fund. Paulson became “one of the most prominent names in finance” and “a man who made one of the biggest fortunes in Wall Street history.” Lippmann made around $5 billion for Deutsche. At the end of the crisis, the investment banks had to bailed out by the government using tax payer’s money. Around $700–750 billion was used. Lehman Brothers went bankrupt, because someone had to become the scapegoat of the crisis. But after all this was over, the banks continued to function without any significant change. The CEOs still got fat cheques and employees got big bonuses; all at the expense of the tax payer. The Dodd-Frank Act was introduced by the Obama Administration for financial regulation in response to the crisis. But Donald Trump has promised to repeal the act. This is not expected to pass in the Senate.

This was how the greatest trade ever was executed.