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By Root 322 0

upon the subprime mortgage sprawl, as an ambitious real estate developer might gaze upon Oakland, and found an opportunity to rebrand some of the turf. On Oakland's fringe there was a neighborhood, masquerading as an entirely separate town, called Rockridge. Simply by refusing to be called Oakland, Rockridge enjoyed higher property values. Inside the subprime mortgage market there was now a similar neighborhood known as midprime. Midprime was subprime--and yet somehow, ineffably, not. "It took me a while to figure out that all of this stuff inside the bonds was pretty much exactly the same thing," said Charlie. "The Wall Street firms just got the ratings agencies to accept different names for it so they could make it seem like a diversified pool of assets."

Charlie, Jamie, and Ben entered the subprime mortgage market assuming they wanted to do what Mike Burry and Steve Eisman had already done, and find the very worst subprime bonds to lay bets against. They quickly got up to speed on FICO scores and loan-to-value ratios and silent seconds and the special madness of California and Florida, and the shockingly optimistic structure of the bonds themselves: The triple-B-minus tranche, the bottom floor of the building, required just 7 percent losses in the underlying pool to be worth zero. But then they wound up doing something quite different from--and, ultimately, more profitable than--what everyone else who bet against the subprime mortgage market was doing: They bet against the upper floors--the double-A tranches--of the CDOs.

After the fact, they'd realize they'd had two advantages. The first was that they had stumbled into the market very late, just before its collapse, and after a handful of other money managers. "One of the reasons we could move so fast," said Charlie, "is that we were seeing a lot of compelling analysis that we didn't have to create from scratch." The other advantage was their quixotic approach to financial markets: They were consciously looking for long shots. They were combing the markets for bets whose true odds were 10:1, priced as if the odds were 100:1. "We were looking for nonrecourse leverage," said Charlie. "Leverage means to magnify the effect. You have a crowbar, you take a little bit of pressure, you turn it into a lot of pressure. We were looking to get ourselves into a position where small changes in states of the world created huge changes in values."

Enter the CDO. They may not have known what a CDO was, but their minds were prepared for it, because a small change in the state of the world created a huge change in the value of a CDO. A CDO, in their view, was essentially just a pile of triple-B-rated mortgage bonds. Wall Street firms had conspired with the rating agencies to represent the pile as a diversified collection of assets, but anyone with eyes could see that if one triple-B subprime mortgage went bad, most would go bad, as they were all vulnerable to the same economic forces. Subprime mortgage loans in Florida would default for the same reasons, and at the same time, as subprime mortgage loans in California. And yet fully 80 percent of the CDO composed of nothing but triple-B bonds was rated higher than triple-B: triple-A, double-A, or A. To wipe out any triple-B bond--the ground floor of the building--all that was needed was a 7 percent loss in the underlying pool of home loans. That same 7 percent loss would thus wipe out, entirely, any CDO made up of triple-B bonds, no matter what rating was assigned it. "It took us weeks to really grasp it because it was so weird," said Charlie. "But the more we looked at what a CDO really was, the more we were like, Holy shit, that's just fucking crazy. That's fraud. Maybe you can't prove it in a court of law. But it's fraud."

It was also a stunning opportunity: The market appeared to believe its own lie. It charged a lot less for insurance on a putatively safe double-A-rated slice of a CDO than it did for insurance on the openly risky triple-B-rated bonds. Why pay 2 percent a year to bet directly against triple-B-rated bonds when they