Confidence Game - Christine Richard [92]
The entire investment team was about to get a lesson on just what was going on in the subprime world. In April, Boaz Weinstein, the head of credit trading at Deutsche Bank, called Ackman to set up a meeting. He wanted to bring along Greg Lippman, a trader with the German bank, who helped to create the ABX Index, a benchmark for the performance of various securities backed by subprime mortgages. Among those who helped Lippman create the index, which would become a gauge for the market’s fear of subprime, was Rajiv Kamilla, a Goldman Sachs trader with a background in nuclear physics.
The idea behind the ABX Index was to create reference points that could be used as a proxy for the state of the mortgage market. The ABX was actually a series of indexes. Each index averaged prices on a basket of credit-default-swap contracts written on 20 mortgage-backed securities, all originated around the same time and with the same credit rating.
Lippman had come to pitch Pershing Square on betting against the BBB-rated ABX index. Spreads on these mortgage-backed bonds had widened in recent months, but there was more to come, Lippman said. That was because spreads on these bonds had been kept artificially low. The buyers of the securities had been mainly CDO managers—and they’d been overpaying, Lippman said. In some ways, that was not surprising because the same banks that were underwriting the mortgage securities were underwriting the CDOs. There was no real third-party investor involved in the market. As subprime losses worsened, there was potential for “devastation of the sector,” according to the presentation.
The trade wasn’t the type of investment Pershing typically put on, McGuire remembers. Ackman liked to take positions in large, publicly traded companies that he believed were under- or overvalued by the market. Deutsche Bank’s trade, using credit-default swaps to bet on the rising risk premiums on an index of asset-backed securities, was esoteric and seemed initially like “a bunch of witchcraft,” McGuire says. “Looking back, it was the playbook for everything that was going to happen [in the subprime crisis].”
It was stunning how vulnerable BBB-rated mortgage bonds—considered safe, investment-grade securities—were to losses. It would take only a minor downturn for the securities to be wiped out. And the housing market was headed for more than a minor downturn. Housing prices had surged for years, mortgage loans had become more aggressive, and borrowers had put down less money. The strong housing market kept default levels in check. But if home prices were to lose their momentum, there would be huge problems, Lippman explained.
In a good housing market, losses on subprime-mortgage pools were typically about 6 percent. Deutsche Bank’s models predicted that if home-price appreciation slowed to 4 percent a year, losses on subprime-mortgage pools would jump to nearly 8 percent. That would be enough to wipe out most bonds rated BBB-. If home prices remained flat, then the next level, the BBB-rated bonds, would be wiped out. If home prices actually fell, higher-rated bonds would be in jeopardy.
Pershing didn’t put on the trade Lippman pitched, but the presentation affirmed Ackman’s view that Pershing should be shorting not just MBIA but also the other bond insurers, including Ambac Financial Group and Security Capital Assurance. On the surface, the bond insurers appeared well insulated. They hadn’t guaranteed BBB-rated subprime mortgage- backed bonds. But they had guaranteed something called mezzanine CDOs. These securities were backed by mortgage bonds rated A and BBB, levels in between the AAA-rated front row and the B-rated bleacher seats.
If Lippman’s projections were right and it took only a small drop in home prices to wipe out BBB-rated securities, then the bond insurers were in deep trouble. MBIA and Ambac may have insured only the AAA-rated parts of the mezzanine CDOs, but if the securities backing those CDOs were worthless, there was no hiding in the highest-rated tranche. By shorting the bond insurers,