Subprime Securities shorting Market Began as
`Group of 5' Over Chinese
Greg
Lippman, head of Deutsche Bank AG's mortgage traders, is shown in this undated
handout photograph. Source: Deutsche Bank via Bloomberg News.
By Mark Pittman found at
bloomberg.com Dec. 17, 2007
The host was Greg Lippmann, then 36, a fast-talking Deutsche Bank AG trader
who aspired to make mortgage securities as big a cash cow for Wall Street as the
$12 trillion corporate credit market.
His allies included 34-year-old Rajiv Kamilla, a trader at Goldman Sachs
Group Inc. with a background in nuclear physics, and 32-year-old Todd Kushman,
who led a contingent from Bear Stearns Cos. Representatives from Citigroup Inc.
and JPMorgan Chase & Co. were also invited. Almost 50 traders and lawyers
showed up for the first meeting at Deutsche Bank's Wall Street office to help
set the trading rules and design the new product.
``To tell you the truth, it's not very glamorous,'' Lippmann says. ``Just a
bunch of guys eating Chinese discussing legal arcana.''
Those meetings of the ``group of five,'' as the traders called themselves,
became a turning point in the history of Wall Street and the global economy.
The new standardized contracts they created would allow firms to protect
themselves from the risks of subprime mortgages, enable speculators to bet
against the U.S. housing market, and help meet demand from institutional
investors for the high yields of loans to homeowners with poor credit.
Credit Boom Turns Bust
The tools also magnified losses so much that a small number of defaulting
subprime borrowers could devastate securities held by banks and pension funds
globally, freeze corporate lending, and bring the world's credit markets to a
standstill.
For a while, the subprime boom enriched investment bankers, lenders, brokers,
investors, realtors and credit-rating companies. It allowed hundreds of
thousands of Americans to buy homes they never believed they could afford.
It later became clear that these homeowners couldn't keep up with their
payments. Defaults on subprime mortgages have so far produced about $80 billion
in losses on securities backed by them. The market for the instruments is so
opaque that many firms still aren't sure how much they've lost.
Chief executives at Citigroup, Merrill Lynch & Co. and UBS AG were
replaced. To forestall a housing-led recession, the Federal Reserve has cut its
benchmark rate three times since August and is injecting as much as $40 billion
into the credit system to encourage banks to lend to each other.
`You Can't Wait' for subprime loans
This is the story of how Wall Street transmitted the practices of southern
California's go-go lending industry and the inflated U.S. real estate market to
the global financial system:
-- In Orange County, California, a mortgage lender named Daniel Sadek was
among those who took notice of the increase in Wall Street's appetite for
subprime loans. He turned the staff at his firm, Quick Loan Funding, into a
subprime mortgage factory. ``You can't wait,'' said his ads, aimed at high-risk
borrowers. ``We won't let you.''
-- In Dallas, a hedge-fund manager named Kyle Bass taught himself to use the
contracts pioneered by Lippmann's group, then went looking for mortgage-backed
securities to bet against. He found them in instruments based on loans Sadek
made.
-- In New York, the ratings companies Standard & Poor's, Moody's
Investors Service and Fitch Ratings put their stamp of approval on securities
backed by loans to people who couldn't afford them. They used historical data to
grade the securities and didn't adjust quickly enough for the widespread
weakening of criteria used to qualify high-risk borrowers. Among the securities
on which they bestowed investment-grade ratings: those backed by Sadek's loans.
`Robert Parker of Raw Fish'
Lippmann was a Wall Street renaissance man, with a strong appetite for sushi
and an online restaurant guide so comprehensive one blogger labeled him ``the
Robert Parker of raw fish.'' He opened the kitchen of the $2.3-million Manhattan
loft he lived in then, complete with six burners, two grills and 20- foot
island, to an Italian cooking class.
The goal of Lippmann's group on that winter evening in 2005: to design a new
financial product that would standardize mortgage-backed securities, including
those based on high-yield subprime loans, paving the way for their rapid growth.
Of the firms participating that night, Lippmann's Deutsche Bank is based in
Frankfurt, UBS in Zurich and the others in New York.
In February 2005, pension funds, banks and hedge funds owned fixed-income
securities that were earning returns close to historic lows. AAA-rated
securities based on home loans offered yields averaging a full percentage point
higher than 10-year Treasuries at the time, according to Merrill.
Lure of Subprime
The trouble was that most creditworthy borrowers had already refinanced their
houses at 2003's record-low mortgage rates. To meet demand for mortgage-backed
securities, Wall Street had to find a new source of loans. Those still available
mainly involved subprime borrowers, who paid higher rates because they were seen
as credit risks.
While the group of five banks had packaged billions of dollars in subprime-based
securities, in February 2005 none was among the leaders in the home-equity bond
business. Countrywide Securities, RBS Greenwich Capital Markets, Lehman Brothers
Holdings Inc., Credit Suisse Group and Morgan Stanley dominated the industry.
The banks wanted more mortgage-backed securities to sell to clients. Creating
a standardized ``synthetic'' instrument, or derivative, would leverage small
numbers of subprime mortgages into bigger securities. In this way, the firms
could produce enough to meet global demand.
Building the Rocket
``We called up the guys we felt like we knew and could work with,'' Lippmann
says.
Deutsche Bank sprang for the take-out food, and traders and lawyers sat down
to design a new product and create what would soon become one of the hottest
capital markets in the world.
The meetings were monthly, beginning at 5 p.m., after the trading day, and
lasted more than three hours each.
``In the beginning, everybody brought their lawyer,'' says Lippmann.
Eventually, the Chinese food was replaced with deli fare because some
participants complained it wasn't kosher.
The group sought to bring ``transparency,'' or openness, and ``liquidity,''
or trading volume sufficient to ensure ease of buying and selling, to the
mortgage market.
The most important issues centered on how to account for the eccentricities
of mortgage bonds, perhaps the most difficult-to-value securities on Wall
Street. Unlike corporate bonds, home loans can be paid back at any time.
Mortgage `Pay as You Go'
Traditionally, the best mortgage traders have been those who can read
macro-economic trends to guess when homeowners will pre-pay their loans. Until
recently, early repayment was perceived as the biggest risk faced by Wall
Street's mortgage desks.
One concern with creating a standardized contract for mortgage-backed
securities was that it was difficult to agree on a simple method of determining
how market-changing events affected the values of the complicated, layered
instruments.
To deal with the complexity, the group of five decided to install a
``pay-as-you-go'' system. When something happened affecting the cash flows
underlying the security, the seller would have to make cash payments to the
buyer immediately, and vice versa.
ISDA Steps In
As the group nailed down the details, the International Swaps and Derivatives
Association, which sets trading terms for dealers, arranged conference calls
including more of Wall Street.
To this point, some of the biggest mortgage underwriters -- Lehman Brothers,
Merrill, Bank of America Corp. and Morgan Stanley -- hadn't been included in the
negotiations. These firms heard about the talks and demanded to be let in.
On the conference calls, which included the market leaders, things got testy.
One point in dispute was whether the contract should be traded on the basis of
price or yield.
``Some of those points of detail were getting a little heated on the calls,
and it was just thought it would be better to have a meeting face to face to
move beyond those points,'' says Edward Murray, a London-based partner of the
international law firm of Allen & Overy who was the chairman of the meeting
and the outside counsel for ISDA. ``To be frank, the dealers that were not in
the group of five were not that happy that there was a group of five.''
ISDA sought to resolve the differences by calling a sit- down meeting at its
New York headquarters. Over coffee and pastries, Murray faced a crowd of dozens
of traders and lawyers. Kamilla and Kushman acted as discussion leaders.
`Talk Was Very Firm'
``Rajiv would say something, and I'd be absolutely convinced about what he
said,'' Murray says. ``And then Todd would say, `Well, I don't agree.' And I
would be absolutely convinced about what Todd said. And then Rajiv would say
`Well, the reason you're wrong is' and so on, et cetera.'' Kamilla and Kushman
declined to discuss the negotiations.
Michael Edman, one of Morgan Stanley's representatives at the ISDA
conference, was less chipper, Murray says.
``Arms folded, frown on his face, I'm not sure that's exactly true, but he
wasn't in a happy-go-lucky mood,'' Murray says. ``There wasn't any shouting or
anything, but the talk was very firm.'' Edman, who no longer works for Morgan
Stanley, declined to comment.
By June, the differences were sorted out, the new contract was endorsed, and
banks that hadn't been party to the group of five negotiations signed on. The
banks would go on to create similar derivative contracts to trade securities
backed by loans for commercial buildings and collateralized debt obligations, or
CDOs, which are securities backed by various kinds of debt.
Creation of ABX-HE Index
Another necessary step was to create an index to represent the market and
help hedge general market exposure. It was called the ABX-HE and would be
similar to the indexes traders use for baskets of stocks. This, participants
believed, would add to the market's liquidity, or depth, by attracting more
trading.
By September 2005, some within Deutsche Bank were beginning to worry about
defaults on subprime mortgages and how that might affect the securities based on
them. A team of Deutsche Bank analysts that month warned of growing subprime
market risks.
The ABX-HE index started trading on Jan. 19, 2006. At 8 a.m. on the first
day, John Kane of Sorin Capital started phoning dealers. Kane, then 27, was a
trader at Sorin, which runs hedge funds that invest in mortgages and other
securities.
His auto mechanic, in describing the debt burden he was carrying to own a
home, had planted the idea in Kane's mind that the housing market might be in
trouble. Kane thought it through, ran an analysis on available data, and decided
to wager against, or ``short,'' subprime. To do that, he turned to the portion
of the ABX index dealing with the lowest investment-grade subprime securities.
Investors Go Short
The trouble was that quotes from brokers selling the ABX were already
dropping, an indication that a number of investors wanted to do the same thing.
``All the other dealers were already scared'' and dropping their bids, Kane
said while on a panel at a November industry conference. ``All but Goldman. So I
bought from them.''
On its first day, the index traded more than $5 billion. The cost of wagering
against the securities was rising, a sign that traders saw an increased chance
of default. An early warning was visible to anyone who knew where to look.
The new derivatives were a hit among the group of five's customers -- the
banks and other institutional investors that bought them to lock in high yields.
In the months to come, Deutsche Bank and at least one other member of the
group of five, Goldman Sachs, began using subprime derivative contracts to bet
the other way and guard against the possibility that subprime mortgages might
default.
Lippmann Explains
For Lippmann's part, he says, it wasn't that he had ``any secret knowledge''
of the damaging events that were about to unfold in the U.S housing market.
Rather, he says, he thought the risks of a downturn were significant enough to
justify the millions of dollars it would cost to ``short,'' or wager against,
subprime securities.
He says he told his bosses: ``If we're right, we're looking at a sixfold
gain. And since a housing market slowdown is not as big a long shot as that, we
should take the risk.''
Lippman disputes that the derivatives the group of five helped create --
which banks packaged into CDOs -- caused the subprime crisis.
``The problems in subprime are what they are and derivatives did not cause
them,'' Lippmann says. ``Derivatives enabled more CDOs to be created and the
stakes to be bigger. But the transparency made people realize the problem
faster.''
Others see things differently. Derivatives, or ``synthetics,'' are ``like
wearing a seatbelt that allows you to drive faster,'' says Rod Dubitsky,
director of asset-backed research for Credit Suisse. ``The total dollar amount
of losses, all these losses you're seeing, are from synthetics. No question, it
changed the game dramatically.''
(TOMORROW: A California lender heeds Wall Street's call.)
To contact the reporter on this story: Mark Pittman in New York at mpittman@bloomberg.net
Last Updated: December 17, 2007
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