All the Devils Are Here [176]
The arrival of this trade may have been the final bit of juice that the market needed to keep from running out of gas. No longer did the underwriter have to find buyers willing to take on the equity risk. Instead, buyers of the equity slice could not have cared less about the risks in that portion of the CDO. If the equity made money, they made money. If the equity lost money, they made even more money. Suddenly, the equity portion was a very easy sell.
This trade gained popularity just when it looked on the ground like the subprime madness was grinding to its inevitable end. Instead, the business kicked into one last crazed frenzy, as subprime originators handed out mortgages to anyone and everyone.
“Equity is the holy grail of CDO placement,” wrote Lang Gibson, the Merrill Lynch CDO researcher. “The compelling economics in the long ABS correlation trade [buying the equity while shorting more senior tranches] will propel the mezz CDO market forward, no matter the evolution of fundamentals in residential mortgage credit, in our view.” Which is exactly what happened.
In January 2007, Tourre sent another e-mail to his girlfriend. “Work,” he wrote, “is still as laborious, it’s bizarre I have the sensation of coming each day to work and reliving the same agony—a little like a bad dream that repeats itself.... When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: ‘Well, what if we created a ‘thing,’ which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows the price?’). It sickens the heart to see it shot down in mid-flight.... It’s a little like Frankenstein turning against his own inventor....”
Of course, the one thing that was neither conceptual nor theoretical was the losses. They were all too real, and in 2007, as winter turned to spring, they were coming.
19
The Gathering Storm
Questions about who owns the risk—it’s spread out all over the world in various formats including repackaging vehicles. Not that obvious to find out who is feeling the pain.
—Dan Sparks e-mail, March 1, 2007
On Friday, March 2, 2007, a man named Ralph Cioffi, who ran two hedge funds at Bear Stearns that had some $20 billion invested in asset-backed securities, held a small, impromptu meeting in his office. Matt Tannin, who managed the two funds with him, was there, as was Steve Van Solkema, a young analyst who worked for the two men and another partner in the funds. They had gathered to discuss the deteriorating market conditions. The week had opened with a drop in the stock market of more than 400 points, the largest one-day decline since the aftermath of 9/11. Cioffi described February as “the most treacherous month ever in the market.” They talked about the plunge in value of the riskier tranches of the ABX index. Even some of the triple-A—the triple-A—were showing a strange wobbliness. That wasn’t supposed to happen—ever. The men were anxious.
On paper, their two hedge funds hadn’t performed that badly: one fund was down a little; the other was up a little. But it had suddenly become difficult to obtain prices on the securities they owned, so they couldn’t be sure what their funds were truly worth. Plus, they’d often told investors that the funds operated like a boring, old-fashioned bank—they were supposed to earn the difference between their cost of funds (a good chunk of which were provided through the repo market) and the yield on the super-safe, mostly triple- and double-A-rated securities that they owned. Investors expected fairly steady, low-risk returns. Any losses, no matter how small, could spook them. The Bear team had made money on short positions they had placed on the ABX, but the volatility was worrisome. Because the higher-rated securities were supposed to be nearly riskless, the Bear Stearns hedge funds were highly leveraged: only about $1.6 billion of the $20 billion was equity. The rest was borrowed. Earlier in February,