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The Moral Compass Missing From The Greatest Trade Ever

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John Paulson was dissatisfied. The marketplace had not satiated his appetite for placing bets against subprime mortgage securities.  So he cooked up a scheme to issue billions more in new securities designed by him to fail. The scheme worked, and his hedge fund earned billions.

The most interesting part of The Greatest Trade Ever, by Wall Street Journal reporter Gregory Zuckerman, describes Paulson’s plan to give irrational exuberance an extra boost.  It’s one thing to trade against the value of securities that have already been issued.  That’s what the free market is all about. But it’s quite another thing to direct your banks to originate new securitizations for no legitimate business purpose. No wonder Paulson slammed the book for  “numerous inaccuracies” without citing specifics. 

Here’s how Zuckerman recounts the scheme, which was initiated by Paulson and one of his fund managers, Paolo Pellegrini:

Paulson and Pellegrini were eager to find ways to expand their wager against risky mortgages.  Accumulating it in the market sometimes proved to be a slow process. So they made appointments with bankers at Bear Stearns, Deutsche Bank and Goldman Sachs, and other banks to ask if they would create CDOs that Paulson & Co. could essentially bet against.

More specifically, Paulson asked his investment banks to create new issues of repackaged subprime mortgage securities, known as collateralized debt obligations, or CDOs, so that they could be sold to some suckers at close to par.  That way, Paulson’s hedge fund could approach some other sucker who would sell an insurance policy, or credit default swap, on the newly minted CDOs.  Bear, Deutsche and Goldman knew perfectly well what Paulson’s motivation was. He made no secret of his belief that the CDOs’ subordinate claims on the mortgage collateral were close to worthless. By the time others have figured out the fatal flaws in these securities, which had been ignored by the  rating agencies, Paulson could collect up to $5 billion.

Paulson not only initiated these transactions, he also specified the terms he wanted, identifying which mortgages would be stuffed into the CDOs, and how the CDOs should be structured. Within the overall framework set by Paulson’s team, banks and investors were allowed to do some minor tweaking. Zuckerman writes:  

Paulson’s team would pick a hundred or so mortgage bonds for the CDOs, the bankers would keep some of the selections and replace others, and then the bankers would take the CDOs to the ratings companies to be rated…To try and protect themselves, the Paulson team made sure that at least one of the CDOs was a “triggerless” deal, or a CDO crafted to be more protective of [the] equity slices by making other pieces of the CDO [which Paulson had bet against] more likely to take early hits.  Paulson’s goal was to make the equity piece at bit safer, but this step made the other parts of the triggerless CDO even more dangerous for anyone who had the gumption to buy them.

Prior to 2006, there were not many opportunities for naked short selling on subprime securitizations. But in January of that year, investment banks launched a new product, which enabled Paulson to place those bets on a large scale. The ABX index, a sort of Dow Jones Average of subprime mortgage securities, facilitated benchmarking the price of credit default swaps. But it appears that Paulson made much more money by betting against the newly issued CDOs.

Here’s how Trader Daily reported it:

Paulson and Pellegrini then skinned the subprime cat two ways, via an ABX index position and by shorting individual CDO names. Their real score came through the second approach, which involved a huge purchase of credit default swaps tied to certain handpicked CDOs;Paulson homed in on the most troubled mortgage pools, regardless of rating-agency or Wall Street assurances. The value of the CDS instruments he amassed went through the roof when the CDOs’ value plummeted as subprime borrowers, many with adjustable-rate hikes kicking in, began to default. [Emphasis added.]

Among the banks that Paulson had approached, Bear Stearns saw the deal for the sham that it was, and refused to play along. Trader Scott Eichel said that, “it didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass.  We didn’t think we could sell deals that someone was shorting on the other side.”

Paulson felt unburdened by any moral compass. Though he had made clear that the CDOs should be stuffed with only risky slices of debt, Paulson accepted no personal responsibility, claiming “it was a negotiation; we threw out some names, they threw out some names, but the bankers ultimately picked the collateral. We didn’t create the securities, we never sold the securities to investors…” 

Again, we are not talking about the supply and demand in a transparent market. The banks were not responding to the demand for financing these mortgages, which had already been placed into securitizations. Nor were the banks responding to investor demand for repackaged versions of the once-sold securitizations. Paulson asked his banks to artificially inflate the supply. “We want to ramp it up,” Pellegrini told Bear Stearns. Nobody could make the pretense that he was acting in good faith.

The Greatest Trade Ever doesn’t dwell on the legal and moral implications of Paulson’s collaboration with the investment banks.  The book, which devotes no more than three pages to the scheme, remains sketchy about a lot of details. (Who issued the CDOs? What were their names? Who sold the credit default swaps?) This may make for a breezier narrative, but it points to the inherent limitations of books that recount private conversations. Sources like Paulson are clearly selective and self-serving in their recitation of facts. I wonder if any of Zuckerman’s sources was candid about the real reason Paulson was able to get so rich so fast: The utter lack of transparency in the markets for private label mortgage securitizations and credit default swaps.  The most important part of the story was what no one was talking about.

The other part of the story that no one was talking about was an open secret: Everyone knew that subprime lenders aided and abetted mortgage fraud. To my knowledge, the only investment banker who wrote candidly about the subject was Joseph Tibman, who was at Lehman when it collapsed, and wrote The Murder of Lehman Brothers: An Insider’s Look at the Global MeltdownTibman, who clearly has great affection for his old firm, recounted how in 2000, Lehman was tainted because of its financing arrangements with a sleazy subprime lender called First Alliance. The New York Times and 20/20 did a joint expose of First Alliance’s shady practices, and internal documents showed that Lehman knew exactly what was going on. First Alliance was a “financial sweatshop,” where you checked your “ethics at the door,” to promote “high pressure sales for people…in a weak state.” At the time, the head of Lehman’s commitment committee was an executive named Allan Kaplan, who had been with the firm for more than 30 years and was known as “the conscience of Lehman.” Kaplan had opposed the financing of First Alliance on the basis of his moral compass. After the scandal, his decisions on the committee, at least with regard to ethical concerns, were never challenged.

Kaplan’s style was antithetical to that of Dick Fuld, Lehman’s CEO.  Tibman recounts a story where Fuld, then a young fixed income trader, rushed into Kaplan’s office insisting that he needed an immediate approval of his trade. Kaplan, of the old school, said he would approve the deal when his desk was clear.  Fuld pushed off the papers on Kaplan’s desk and told Kaplan his desk was clear.  Kaplan died in 2003, and afterwards, there were fewer restraints on Fuld’s bullying style for pushing deals through. Coincidentally, subprime securitizations took off in a big way the next year.  Tibman believes that as much as anything, what killed Lehman was Fuld's emasculation of the risk management function, which served as a moral compass.