Michael Lewis, author of the Wall Street memoir Liar’s Poker, tells the story of some hedge fund guys who saw the handwriting on the subprime mortgage bond wall in time to bet on the side of reality, and how the investment banks even helped them place those bets.
Thereâ€™s a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1. â€œAll these people were saying it was nearly as high in some other countries,â€ Zelman (housing-market analyst at Credit Suisse), says. â€œBut the problem wasnâ€™t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They werenâ€™t real buyers. They were speculators.â€…
By the spring of 2005, FrontPoint was fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds. But in 2005, there was $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds. Eisman couldnâ€™t understand who was making all these loans or why. He had a from-the-ground-up understanding of both the U.S. housing market and Wall Street. But heâ€™d spent his life in the stock market, and it was clear that the stock market was, in this story, largely irrelevant. â€œWhat most people donâ€™t realize is that the fixed-income world dwarfs the equity world,â€ he says. â€œThe equity world is like a fucking zit compared with the bond market.â€ He shorted companies that originated subprime loans, like New Century and Indy Mac, and companies that built the houses bought with the loans, such as Toll Brothers. Smart as these trades proved to be, they werenâ€™t entirely satisfying. These companies paid high dividends, and their shares were often expensive to borrow; selling them short was a costly proposition.
Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Centuryâ€™s stock but its bonds that were backed by the subprime loans it had made. Eisman hadnâ€™t known this was even possibleâ€”because until recently, it hadnâ€™t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision. …
The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.
The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. â€œWhat Lippman did, to his credit, was he came around several times to me and said, â€˜Short this market,â€™â€‰â€ Eisman says. â€œIn my entire life, I never saw a sell-side guy come in and say, â€˜Short my market.â€™â€ …
Here heâ€™d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There werenâ€™t enough Americans with shitty credit taking out loans to satisfy investorsâ€™ appetite for the end product. The firms used Eismanâ€™s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesnâ€™t create a second Peyton Manning to inflate the leagueâ€™s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. â€œThey werenâ€™t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldnâ€™t afford,â€ Eisman says. â€œThey were creating them out of whole cloth. One hundred times over! Thatâ€™s why the losses are so much greater than the loans. But thatâ€™s when I realized they needed us to keep the machine running. I was like, This is allowed?â€
Essentially, it was in nobody’s interest, except for FrontPoint Partners, of course, to look at the subprime lending business realistically. So no one did.
Read the whole thing.
Hat tip to Karen l. Myers.