Tuesday, March 2, 2010

Subprime short, from the beginning

Original posted on FT Alphaville by Tracy Alloway:

Go here for the superb tale of a Milton Friedman-reading , subprime-shorting, one-eyed hedge fund manager, as excerpted by Vanity Fair.

Michael Burry, one of the subjects of Liar’s Poker-playing Michael Lewis’ new book, The Big Short, chronicles the thinking behind Burry’s big US housing bet. According to the book, the man, who founded Scion Capital, was the first to start shorting subprime mortgages via credit default swaps (CDS).

The whole thing is worth reading but the reaction from the investment banks Burry was dealing with at the time is of particular interest, and something that’s already been picked out by the likes of Reuters columnist Felix Salmon.

Here’s a quick summary:

The only problem was that there was no such thing as a credit-default swap on a subprime-mortgage bond, not that he could see. He’d need to prod the big Wall Street firms to create them. But which firms? If he was right and the housing market crashed, these firms in the middle of the market were sure to lose a lot of money. There was no point buying insurance from a bank that went out of business the minute the insurance became valuable. He didn’t even bother calling Bear Stearns and Lehman Brothers, as they were more exposed to the mortgage-bond market than the other firms. Goldman Sachs, Morgan Stanley, Deutsche Bank, Bank of America, UBS, Merrill Lynch, and Citigroup were, to his mind, the most likely to survive a crash. He called them all. Five of them had no idea what he was talking about; two came back and said that, while the market didn’t exist, it might one day. Inside of three years, credit-default swaps on subprime-mortgage bonds would become a trillion-dollar market and precipitate hundreds of billions of losses inside big Wall Street firms. Yet, when Michael Burry pestered the firms in the beginning of 2005, only Deutsche Bank and Goldman Sachs had any real interest in continuing the conversation. No one on Wall Street, as far as he could tell, saw what he was seeing.

Deutsche Bank and Goldman became the first two firms to start selling Burry CDS on subprime asset-back securities, with the hedge funder basically picking and choosing which tranches to insure at will. As Burry puts it, banks like Deutsche “didn’t seem to care” which bonds he wanted to bet against.

Burry made his first CDS-subprime deal in May 2005, buying $60m in insurance from Deutsche. Bank of America and Morgan Stanley soon followed, and by the end of July 2005, Burry had bought insurance on $750m of subprime mortgage-backed securities (MBS).

Perhaps unsurpsingly, Wall Street at this point was watching Burry with complacency, probably even somewhat confused. That attitude began to change from late 2005 onwards:

Oddly, as Mike Burry’s investors grew restive, his Wall Street counterparties took a new and envious interest in what he was up to. In late October 2005, a subprime trader at Goldman Sachs called to ask him why he was buying credit-default swaps on such very specific tranches of subprime-mortgage bonds. The trader let it slip that a number of hedge funds had been calling Goldman to ask “how to do the short housing trade that Scion is doing.” Among those asking about it were people Burry had solicited for Milton’s Opus—people who had initially expressed great interest. “These people by and large did not know anything about how to do the trade and expected Goldman to help them replicate it,” Burry wrote in an e-mail to his C.F.O. “My suspicion is Goldman helped them, though they deny it.” If nothing else, he now understood why he couldn’t raise money for Milton’s Opus. “If I describe it enough it sounds compelling, and people think they can do it for themselves,” he wrote to an e-mail confidant. “If I don’t describe it enough, it sounds scary and binary and I can’t raise the capital.” He had no talent for selling.

Now the subprime-mortgage-bond market appeared to be unraveling. Out of the blue, on November 4, Burry had an e-mail from the head subprime guy at Deutsche Bank, a fellow named Greg Lippmann. As it happened, Deutsche Bank had broken off relations with Mike Burry back in June, after Burry had been, in Deutsche Bank’s view, overly aggressive in his demands for collateral. Now this guy calls and says he’d like to buy back the original six credit-default swaps Scion had bought in May. As the $60 million represented a tiny slice of Burry’s portfolio, and as he didn’t want any more to do with Deutsche Bank than Deutsche Bank wanted to do with him, he sold them back, at a profit. Greg Lippmann wrote back hastily and ungrammatically, “Would you like to give us some other bonds that we can tell you what we will pay you.”

When things really got bad — in early 2007 — there was a step-change:

I[n] the spring of 2007, something changed—though at first it was hard to see what it was. On June 14, the pair of subprime-mortgage-bond hedge funds effectively owned by Bear Stearns were in freefall. In the ensuing two weeks, the publicly traded index of triple-B-rated subprime-mortgage bonds fell by nearly 20 percent. Just then Goldman Sachs appeared to Burry to be experiencing a nervous breakdown. His biggest positions were with Goldman, and Goldman was newly unable, or unwilling, to determine the value of those positions, and so could not say how much collateral should be shifted back and forth. On Friday, June 15, Burry’s Goldman Sachs saleswoman, Veronica Grinstein, vanished. He called and e-mailed her, but she didn’t respond until late the following Monday—to tell him that she was “out for the day.”

“This is a recurrent theme whenever the market moves our way,” wrote Burry. “People get sick, people are off for unspecified reasons.”

On June 20, Grinstein finally returned to tell him that Goldman Sachs had experienced “systems failure.”

That was funny, Burry replied, because Morgan Stanley had said more or less the same thing. And his salesman at Bank of America claimed they’d had a “power outage.”

“I viewed these ‘systems problems’ as excuses for buying time to sort out a mess behind the scenes,” he said. The Goldman saleswoman made a weak effort to claim that, even as the index of subprime-mortgage bonds collapsed, the market for insuring them hadn’t budged. But she did it from her cell phone, rather than the office line. (Grinstein didn’t respond to e-mail and phone requests for comment.)

They were caving. All of them. At the end of every month, for nearly two years, Burry had watched Wall Street traders mark his positions against him. That is, at the end of every month his bets against subprime bonds were mysteriously less valuable. The end of every month also happened to be when Wall Street traders sent their profit-and-loss statements to their managers and risk managers. On June 29, Burry received a note from his Morgan Stanley salesman, Art Ringness, saying that Morgan Stanley now wanted to make sure that “the marks are fair.” The next day, Goldman followed suit. It was the first time in two years that Goldman Sachs had not moved the trade against him at the end of the month. “That was the first time they moved our marks accurately,” he notes, “because they were getting in on the trade themselves.” The market was finally accepting the diagnosis of its own disorder.

Goldman was famously short subprime in 2007, which means if as the story suggests, the bank really did change tact from long to short sometime that year, it did so incredibly fast. The marks referred to are also interesting; Goldman was one of the harshest markers when demanding collateral from AIG, which had written protection on some of the bank’s subprime CDOs.

Clients.

Even Goldman can learn from them.

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