All the Devils Are Here [163]
Redleaf and Vigilante would later write that their biggest fear was that the trade would quickly disappear. “The mortgage market was so obviously headed for trouble that by early 2006, when we started shorting mortgage-backed securities, we feared the fun would be over before we were fully invested,” they wrote in Panic. “We needn’t have worried,” they continued. “Rather than the trade vanishing too quickly, we repeatedly found ourselves scratching our heads in disbelief that we could short still more mortgage securities that were obviously going to blow up.” All year long, as the headlines blared about subprime originators running into trouble and with foreclosures rising, Redleaf added to his short position. Every time there was a big piece of news—like the New Century restatement—he expected Wall Street to come to its senses. It didn’t happen. On the contrary: the swaps were so cheap, it was clear Wall Street still didn’t understand the risks it was insuring. The big Wall Street firms continued to view the triple-A tranches as utterly safe; the new ABX index would show them trading at par—that is, 100 percent of their stated value—for at least another year.
After the crisis hit, and writers and journalists began to look back at what had happened in those critical years of 2006 and 2007, a conventional wisdom sprang up according to which only a tiny handful of people had had the insight to realize that subprime mortgages were kegs of dynamite ready to blow. But Redleaf believes that his insight was not nearly as unique as it’s been portrayed in such books as Michael Lewis’s The Big Short or Gregory Zuckerman’s The Greatest Trade Ever, which chronicles John Paulson’s massive bet against the housing market. By Redleaf’s count, there were maybe fifty or so hedge funds that would likely have considered this kind of trade. At least twenty of them, maybe more, were heavily short subprime bonds. “If you look at the disinterested smart players,” he says, “a lot got it.”
Indeed, the market took off. Credit default swaps “grew faster than even we predicted with more than $150B of structured product CDS outstanding at year end ’05 vs. $2B at year end ’04,” Goldman Sachs reported in a presentation in early 2006. But it didn’t take off because Wall Street firms wanted to be on the other side of the bets their smart hedge fund clients were taking. The reason it exploded had to do with one last little wrinkle Wall Street had dreamed up—the one that turned that keg of dynamite into the financial equivalent of a nuclear bomb: the synthetic CDO.
Long before anybody thought to use credit default swaps to short mortgage bonds, Street firms had taken to combining credit default swaps on a variety of corporate bonds and creating CDOs out of them. They were called synthetic CDOs because the CDOs didn’t contain “real” collateral; rather they were based on the performance of existing bonds held by someone else. In Street parlance, they “referenced” the real bonds. The gains and losses would be real enough, but the underlying collateral was at one remove. Unlike a cash CDO that held collateral, and in which all the investors were long and got their payments from the underlying corporate bonds, a synthetic CDO could work only if there were investors on both the long side and the short side of every tranche. To put it another way, each position required two counterparties. Those who were long got cash flows that mimicked those of the underlying bonds, while those who were short paid a fee for the swap protection (which created the cash flows), but got the right to a big payoff