Shorting the Subprime Market

WHEN SOME OF THE MOST INTELLIGENT AND POWERFUL MINDS in the financial world are all doing one thing, it can be very difficult for anyone to do anything else. With fortunes at stake, both personal and financial, going against the trend can sometimes lead to losses totaling in the billions.

If the winds are all blowing in one direction, it takes a brave and confident person to stand against those gusts and forge ahead into a new path. This is what two traders at Goldman Sachs did last year, and their bet paid off. These two traders, with a stronger stomach and a greater appetite for risk than most, went against the common thought on Wall Street and are now being lauded as financial heroes for their efforts.

In early 2006, like almost every other investment bank in the world, Goldman Sachs was exposed greatly to the booming subprime mortgage market. Goldman was doing a lot of business with the mortgage-backed securities that wound up exploding a year later, crippling many of Goldman’s immediate rivals. So why didn’t Goldman suffer the same fate as Merrill Lynch, Bear Stearns or any of the other once-giant investment banks? The answer is quite simple: they took a huge risk.

Michael Swenson, 40, and Josh Birnbaum, 35, with the help of mortgage department head Dan Sparks, 40, were able to convince the higher-ups at Goldman that things would soon come crashing down around them. Swenson and Birnbaum, traders in the firm’s mortgage department, were convinced that the subprime market would fail. Their convictions were not new, but they were in the minority opinion.

As early as December 2006, The New York Times reported on a study that predicted foreclosures for one in every five subprime loans. The report was conducted by the Center for Responsible Lending and was the first of its kind relating to the subprime market. The report stated that about 2.2 million borrowers who took subprime loans from 1998-2006 would be likely to lose their homes.

Swenson echoed the study’s sentiment. In January 2006, the ABX debuted. The ABX, an index of tradable asset-backed securities and credit default swaps, gave investors a chance to gain broad exposure to the subprime market. At the time, Swenson was head of ABS trading at Goldman and participated in a panel discussion at the ASF 2006 conference.

“The market has become big — I mean really big,” Swenson said at the conference.

In late 2005, Swenson convinced Birnbaum to join the structured-products trading group at Goldman. Birnbaum was already a Goldman veteran and had developed a new security that was tied to mortgage rates. Swenson convinced Birnbaum to try trading in the first ABX index. Goldman instantly started making profits with its ABX trades, but Swenson and Birnbaum were forced to use Goldman’s own capital to execute the trades.

Late in 2006, Goldman still had huge exposure to the subprime mortgage market, due to its holdings of CDOs and other securities. David Viniar, Goldman’s CFO, suggested to the group that it adopt an even more bearish look on the subprime market. Swenson and Birnbaum could not agree more and the pair quickly got to work.

Swenson and his group of traders began shorting slices of the ABX. The depression of subprime lending had yet to hit the market and these credit default swaps they were buying were still very cheap. Goldman had a lot of work to do if it wanted to sufficiently hedge its position in the subprime market. Goldman’s exposure was high, and it took a lot of time and even more money to build enough swaps to fully hedge the bets.

Swenson and Birnbaum had bets focused on indexes in the ABX that reflected the riskiest portion of the index. The subsequent weakening of the index was twofold. As predicted in the 2006 study, many subprime loans had begun the foreclosure process. Also working at the same time was an increase in hedging activity involving the ABX index.

As reported as early as September 2006 in the Financial Times, the activity of hedge funds in the U.S. housing market had grown substantially. As a result of the hedging activity, the ABX index began declining. Home prices were falling, and the early signs of a collapse were all presenting themselves. The time to get into this short market was running out.

Luckily for Goldman, Swenson and Birnbaum had begun making their short trades nine months earlier. The appearance of CDOs, which were not as prevalent in the last housing slump, had buoyed the market and kept a bust from appearing. The mortgage shorting market was growing, but it had not yet topped out. Many on Wall Street believed that everything would be fine and that the housing slump would work itself out.

Meanwhile, back at Goldman, people were starting to get nervous. Despite the fact that Swenson and Birnbaum, with the heavy backing of Sparks, seemed to be correct in their bearish look, they were still investing a lot of money — Goldman’s money — in this idea. The idea of a single trader crippling a big company by making a bad decision was not new. We saw it in 1995, when Nicholas Leeson was held responsible for a $1.4 billion loss and the collapse of Barings PLC. As recently as yesterday, a single trader, Jerome Kerviel, 31, was discovered committing massive fraud and losing $7.16 billion for Societe Generale, France’s second largest bank.

Goldman’s chief executive, Lloyd Blankfein, was growing concerned with the amount of risk these two young traders had exposed Goldman to. Along with Goldman’s co-president, Gary Cohn, Blankfein demanded that Swenson’s group cut its risk in half. The position taken by Blankfein should not have been a surprise.

In June 2007, Blankfein, along with Merrill Lynch CEO Stanley O’Neal, spoke about his feelings on the subprime markets at a conference in London.

“It’s reasonably well contained,” O’Neal said at the conference. “There have been no clear signs it’s spilling over into other subsets of the bond market, the fixed-income market, and the credit market.”

Of course, O’Neal was wrong, and it cost him his job. As wrong as O’Neal was, Blankfein echoed his sentiments at the London conference. Swenson and Birnbaum couldn’t have disagreed more. The two believed that the housing markets, along with the credit and other surrounding markets, were still headed for dire areas.

As is usually the case, hindsight can be 20/20. Few were able to predict the fallout of the subprime market before it came. Many smart people thought that subprime lending would be a huge boon to the economy, and they were right.

In fact, Sen. John Kerry of Massachusetts wrote a letter to Freddie Mac and Fannie Mae in 1999. In his letter, the senator urged the two government-backed mortgage institutions to increase their dealings in the subprime industry. Kerry thought it would be a catalyst to help first-time and low-income families become homeowners. Kerry was right, and the boom in housing for Americans who could not afford to own houses unofficially began.

Years later, in December 2007, Kerry, along with several other democrats, signed a letter written by Sen. Chris Dodd and addressed to Fed Chairman Ben Bernanke. Dodd urged the chairman to enact strict controls on lenders who work in the subprime markets. Kerry’s endorsement of this letter says much about the man. Evidently, the senator voted for subprime lending before he voted against it.

Swenson and Birnbaum held fast to their convictions, but alas, the orders from above came down and they got out of their short positions. Believing they had left money on the table, Swenson and Birnbaum continued badgering for the authority to get back in the game. They would eventually get their wish, but not before Goldman started experiencing severe losses.

As the subprime and general housing market continued to shrivel, Goldman realized that it must begin selling off many of its risky CDO holdings. Just like Merrill and Bear Stearns, Goldman was exposed to these poisonous holdings, yet it began selling its shares quickly.

The shorting market had now become harder to break into, but Swenson and Birnbaum returned to the fray and continued their short position on these CDOs. In July 2007, the riskiest part of the ABX index finally succumbed and began to plunge. As Merrill and Bear Stearns were set on a rapid fall from grace, Goldman was covering its losses and raking in profits.

The position of Goldman stayed the same throughout the fall of 2007 as things somehow managed to get even worse. The firm posted record quarterly earnings. Goldman was back in the black, and the smart moves by the guys that got them there were not overlooked. Swenson, Birnbaum and Sparks each received bonuses between $5 and $15 million.

While saving one of the biggest investment banks in the country has earned Swenson and Birnbaum a lot of credit for their investments, they are not alone when it comes to these giant gains in the housing market.

John Paulson, the head of New York hedge fund Paulson & Co., shared a similar belief with Swenson and Birnbaum. Paulson’s hedge fund started two funds in the summer of 2006 that were concentrated solely on expecting a collapse. After his expected collapse arrived, Paulson’s fund garnered some $15 billion in 2007. Paulson’s trade is considered to be one of the biggest single moves in the history of Wall Street.

A lesser-known version of the John Paulson move was the dealings done by Michael J. Burry and his Scion Capital hedge fund. In May 2005, even before Swenson and Birnbaum got to work, Burry made the decision that the housing market was overvalued. He placed a bet that the subprime mortgage market would eventually collapse.

Much like Swenson and Birnbaum, Burry used credit derivatives that were essentially insurance against defaults. He entered into the riskiest parts of subprime mortgages, and at first, his investment appeared foolish.

Through the first nine months of his investment, Scion’s funds were down 16.4%, with most of that loss coming from his credit derivative positions.

Burry made a risky decision and put the poorly performing credit derivative positions in what is known as a side pocket. By doing this, he basically separated these investments from the main fund, whose performance they were seriously injuring. Investors became angry about this, because the side pocket locked up their poorly performing investment into a fund they were unable to exit.

But of course, the market started losing ground and eventually went into a free fall. Burry’s investment paid off, and all those furious investors who were not allowed to leave wound up walking away with huge profits.

Men like Swenson and Birnbaum, Paulson and Burry have one thing in common. They have guts. They had the foresight to see the future before the rest, and they had the courage to stake their reputations, livelihoods and millions of dollars on their gut feeling.

The country, especially the financial sector, is run by some very smart people. Men with high degrees from some of the most prestigious academic institutions in the world are making high-stakes bets with large amounts of money. Even men with these pedigrees can sometimes make mistakes. And a couple of young hotshots toiling on an obscure index can prove that maybe they are the smartest ones of all.

Until next time,
Jamie Ellis
January 25, 2008

The Daily Reckoning