All the Devils Are Here [161]
Three firms—Deutsche Bank, Goldman Sachs, and Bear Stearns—led the drive to turn credit default swaps on mortgage-backed securities into easily tradable, standardized instruments. The group, which included Deutsche Bank trader Greg Lippman, Goldman trader Rajiv Kamilla, and Bear trader Todd Kushman, began meeting in February 2005 to figure out what the holders of a short interest should receive, and when they should receive it. Should the protection buyer—as Wall Street called the counterparty on the short side—get his or her money when the mortgage defaulted? When it was ninety days delinquent? The traders decided that the protection buyer should get paid as the mortgage lost value—which would be determined by the Street firm that sold the instrument—in sums that made up for the lost value. They called their concept Pay As You Go, or PAUG. (The correct pronunciation rhymes with “hog,” says one person who was involved.) “To tell the truth, it’s not very glamorous,” Lippman later told Bloomberg reporter Mark Pittman.
In January 2006, an index based on subprime mortgages began trading for the first time. (“THE market event of 1H ’06,” proclaimed a Goldman analyst.) Just as an index like the S&P 500 has five hundred big company stocks, this new index, called the ABX, would list specific tranches of mortgage-backed securities. Once the ABX was up and running, investors could buy or sell contracts linked to the price of mortgage-backed securities, sorted by rating and by year. So, for instance, an investor could short the ABX 06-1 triple-A, meaning a triple-A slice that was originated in the first half of 2006. “Before that, no one ever thought about whether to be long or short mortgages, because everyone was always long and it always worked,” says one trader who was involved.
That wasn’t quite true. The ABX made shorting the mortgage market much easier than it had been before. But even before its creation, a handful of investors—skeptical hedge fund managers, primarily—had sought a way to make a bearish bet on the mortgage market. They had pushed Wall Street firms to sell them customized credit default swaps on specific tranches of mortgage-backed securities. The most famous of these hedge fund managers was John Paulson, who would wind up making $4 billion in 2007 betting against subprime mortgages. He was hardly the only one, though. Michael Burry, a hedge fund manager in California, had become convinced after digging through mountains of paper and actually looking at the underlying loans that the housing market was going to crack. As early as the spring of 2005, he began to enter into trades with Wall Street firms in which he took a short position.
Greg Lippman at Deutsche Bank was one of the few traders operating inside the CDO machine who openly turned against subprime mortgages; indeed, his growing negative view was part of his incentive for getting involved in creating tradable credit default swaps in the first place. Having been, he later said, “balls long in 2005,” he did an about-face when he saw a chart showing that people whose homes had appreciated only slightly were far more likely to default than those whose homes had risen by double digits. Everyone had always thought that unemployment caused mortgage defaults. Lippman realized that the world had changed—now all you’d need was a slowdown in the rate in home appreciation. Lippman would later say that it “takes a certain kind of person to acknowledge that what they spent a lifetime toiling away at doesn’t work anymore.” In the classic fashion of the convert, Lippman became Wall Street’s most enthusiastic salesman for shorting subprime mortgages, making presentations to anyone who would listen. An exuberant, crude man, he had T-shirts