The Big Short_ Inside the Doomsday Machine - Michael Lewis [98]
One risk of betting against subprime loans was that, as long as house prices kept rising, borrowers were able to refinance, and pay off their old loans. The pool of loans on which you've bought insurance shrinks, and the amount of your insurance shrinks with it. Edman's credit default swap solved this problem with some fine print in its contracts, which specified that Morgan Stanley was buying insurance on the last outstanding loan in the pool. Morgan Stanley was making a bet not on the entire pool of subprime home loans but on the few loans in the pool least likely to be repaid. The size of the bet, however, remained the same as if no loan in the pool was ever repaid. They had bought flood insurance that, if a drop of water so much as grazed any part of the house, paid them the value of the entire house.
Thus designed, Morgan Stanley's new bespoke credit default swap was virtually certain one day to pay off. For it to pay off in full required losses in the pool of only 4 percent, which pools of subprime mortgage loans experienced in good times. The only problem, from the point of view of Howie Hubler's traders, was finding a Morgan Stanley customer stupid enough to take the other side of the bet--that is, to get the customer to sell Morgan Stanley what amounted to home insurance on a house designated for demolition. "They found one client to take the long side of the triple-B tranche of some piece of shit," says one of their former colleagues, which is a complicated way of saying that they found a mark. A fool. A customer to be taken advantage of. "That's how it starts--it drives Howie's first trade."
By early 2005 Howie Hubler had found a sufficient number of fools in the market to acquire 2 billion dollars' worth of these bespoke credit default swaps. From the point of view of the fools, the credit default swaps Howie Hubler was looking to buy must have looked like free money: Morgan Stanley would pay them 2.5 percent a year over the risk-free rate to own, in effect, investment-grade (triple-B-rated) asset-backed bonds. The idea appealed especially to German institutional investors, who either failed to read the fine print or took the ratings at face value.
By the spring of 2005, Howie Hubler and his traders believed, with reason, that these diabolical insurance policies they'd created were dead certain to pay off. They wanted more of them. It was now, however, that Michael Burry began to agitate to buy standardized credit default swaps. Greg Lippmann at Deutsche Bank, a pair of traders at Goldman Sachs, and a few others came together to hammer out the details of the contract. Mike Edman at Morgan Stanley was dragged kicking and screaming into their discussion, for the moment credit default swaps on subprime mortgage bonds were openly traded and standardized, Howie Hubler's group would lose their ability to peddle their murkier, more private version.
It's now April 2006, and the subprime mortgage bond machine is roaring. Howie Hubler is Morgan Stanley's star bond trader, and his group of eight traders is generating, by their estimate, around 20 percent of Morgan Stanley's profits. Their profits have risen from roughly $400 million in 2004 to $700 million in 2005, on their way to $1 billion in 2006. Hubler will be paid $25 million at the end of the year, but he's no longer happy working as an ordinary bond trader. The best and the brightest Wall Street traders are quitting their big firms to work at hedge funds, where they can make not tens but hundreds of millions. Collecting nickels and dimes from the trades of unthinking investors felt beneath the dignity of a big-time Wall Street bond trader. "Howie thought the customer business was stupid," says one of several traders closest to Hubler. "It was what he'd