All the Devils Are Here [162]
Another skeptic was Andrew Redleaf, who ran a big hedge fund in Minneapolis called Whitebox Advisors. His hedge fund traded primarily in what he liked to call “stressed” bonds. (“If a distressed bond has an 80 to 90 percent chance of default, a stressed bond has a 50 percent chance of default,” he explained.) Shaky mortgage bonds were right in his wheelhouse.
A brilliant mathematics student at Yale, Redleaf became an options trader who searched for anomalies between the prices of two different but related securities. By taking advantage of those anomalies, he made money. From a standing start in 1999, Redleaf built Whitebox into a $4 billion hedge fund.
An advocate of the new field of behavioral economics, Redleaf believed that markets were not always rational, that models were not always right, and that Wall Street’s blind adherence to both gave him plenty of opportunity to make money. To him, the mortgage market was as good an example of Wall Street’s shortsightedness as anything you could possibly find. After the crisis, he wrote a book with a Whitebox colleague, Richard Vigilante, entitled Panic, in which he spelled out his philosophy:
This ideology of modern finance replaces the capitalist’s appreciation for free markets as a context for human creativity with the worship of efficient markets as substitutes for that creativity. The capitalist understands free markets as an arena for the contending judgments of free men. The ideologues of modern finance dreamed of efficient markets as a replacement for that judgment and almost as a replacement for the men. The most gloriously efficient of all, supposedly, were modern public securities markets in all their ethereal electronic glory. To these most perfect markets the priesthood of finance attributed powers of calculation and control far exceeding not only the abilities of any human participant in them but the fondest dreams of any Communist commissar pecking away at the next Five Year Plan.
To Redleaf, the cause of the crisis was simple: Wall Street had “substituted elaborate, statistically based insurance schemes that, with the aid of efficient financial markets, were assumed to make old-fashioned credit analysis and human judgment irrelevant.”
Redleaf’s subprime epiphany had come years before, when he listened to a presentation by a New Century executive at an investment conference. He was struck by the fact that 85 percent of New Century’s mortgages were cash-out refinancings. He asked the New Century executive about the default rate for the refinancings as opposed to mortgages that were used to purchase a new home. The man said he didn’t know, but speculated that they probably weren’t any different. This didn’t ring true to Redleaf, whose experience with corporate bonds suggested that defaults were much higher when the debt went to pay off insiders than when it went for general corporate purposes. Cash-out refis struck him as the homeowner’s version of paying off insiders.
Redleaf had another insight. Even back then, he could see that the business model so long touted by the subprime originators made no sense. The companies were saying that they could grow market share, on the one hand, while still using underwriting standards that weeded out borrowers likely to default. “I’ve seen this movie before,” he said. “You can’t have tighter standards and grow share. You can’t even have different standards. In the end, you wind up lending money to people who can’t pay it back, and that isn’t a good business model for a public company.”
Still, Redleaf didn’t immediately act on his insight. “Seeing the New Century guys in 2002 just put the thought in the back of my head,” he said later. He knew it was early in the cycle, and “being early is often the same as being wrong.” Besides, there was no way to short the subprime market except by shorting the mortgage originators themselves, an unappealing prospect given how fast their stocks were climbing.
By 2006, though, the combination of the ABX index and the new credit default