The Big Short: Chapter Summary (Chapter 9)
If you can imagine a football player from New Jersey turned bond trader, then you can imagine Howie Hubler. For the most part, Hubler was Morgan Stanley’s equivalent of Greg Lippmann in function. His strong points seemed to run along the lines of a combination of brute force and luck: he substituted bullying for intellectual argument, and as long as the bond market did well, Hubler did well. In 2004, the bond market had been doing well for ten years, so as the person in charge of asset-backed trading, which included subprime mortgages, Hubler looked good.
Credit default swap solves the subprime bond demand issue--Morgan Stanley was one of the first to use what had originally been corporate financial instruments as a way of repackaging consumer loans. According to Lewis, the company invented the credit default swap in response to the speed with which Hubler’s subprime mortgage bond group was creating new bonds. This sometimes meant keeping the loans around for months, until they could be packaged into bonds. That, in turn, meant that loan prices could fall in the meantime. The idea behind the credit default swap, assuming Morgan Stanley could have the loans insured, was to remove that risk. They were never intended for a broader market or even to be known or understood outside a limited circle of financial experts.
Hubler’s group steals the quant’s idea--With the subprime situation turning sour, both Morgan Stanley’s quants (intelligentsia) and Hubler were looking for ways to short the market. According to Lewis’s story, the quant who invented “all this stuff” (in the words of a Morgan Stanley saleswoman) had the original idea of creating and managing a small separate group—an idea that Hubler’s group stole along with the creation of the new instrument, which they attributed to Mike Edman, one of Hubler’s traders.
Fraudulent “bespoke” credit default swaps--What set this particular version of credit default swaps apart was that, unlike the later, standardized versions of subprime loan credit default swaps, these were rigged to prevent the loan pool shrinkage that would inevitably occur when homeowners repaid their loans through mortgage refinancing. They did this by providing a clause in the fine print that limited Morgan Stanley’s insurance purchases to the original loan, which was the riskiest; yet somehow they managed to simultaneously guarantee a non-shrinking bet, even if a portion of it had been repaid. What this meant was that no matter what happened in the market, Morgan Stanley was sure to gain as long as Hubler and his traders could fool enough people into thinking that taking the other side of the trade was a good idea. It was not, of course. Lewis describes it as being the equivalent of buying insurance on a home that was slated for the wrecking ball.
Within a few months, Hubler had amassed a $2-billion portfolio of these dubious credit default swaps (called “bespoke” in financial jargon, which means that they were nonstandard and customized for a specific purpose) by luring enough customers who were either unwilling to or incapable of investigating the details. German institutional investors seemed particularly susceptible, which ties back in with Lippmann’s “Düsseldorf” responses to FrontPoint’s queries about who was buying this garbage. Fortunately, just a few months later, Michael Burry expressed an interest in purchasing standardized credit default swaps, the details of which were subsequently hashed out by several traders from the different investment banks, including Greg Lippmann and (apparently against his will) Mike Edman. Standardization did not bode well for Hubler’s group, which would now lose its illegitimate advantage.
In the meantime, though, Hubler’s group was one of the most profitable at Morgan Stanley as they neared $1 billion in profits in 2006. Hubler himself was at the top of the list of bond traders, earning $25 million, but that was no longer enough for him. It was peanuts compared to the billions the hedge funds were making. To keep him and his group from leaving, Morgan Stanley upgraded Hubler’s group to what they named the Global Proprietary Credit Group. It would be known as the company’s top-rated group and was intended to produce twice the profits of the previous group, a large amount of which would personally go to Howie and his traders.
Together with the supposed cream of Morgan Stanley’s traders, Hubler now moved from the second to the tenth floor, where his group presumably separated itself from Morgan Stanley’s ordinary, customer-driven trading activities. This was important (at least, in theory, as there was some doubt as to the actual effectiveness of the separation), since their own proprietary interests could easily be construed as conflicting with the customers’.
Although Hubler was certain that the group’s credit default swap position would soon pay $2 billion in profits, he still had the problem that the $200 million they were paying per year to maintain their position was making it difficult to generate the $2 billion they were expected to bring in annually. His solution was to generate his own premiums by selling $16 billion in credit default swaps. The reason he had to sell $16 billion worth was because he was trading swaps on triple-A-rated subprime CDOs, which yielded only one-tenth of the dollar amount of the riskier triple-B-rated premiums. Luckily, the other major investment banks were happy to comply.
To Lewis, those two facts—Hubler’s sale and Wall Street’s response—were clear evidence that the subprime mortgage bond market was delusional. In a footnote, Lewis explains that owning a financial instrument and selling a credit default swap on it are both effectively the same thing in terms of risk. Lewis seems to be saying that Hubler was now insuring $16 billion worth of garbage in the form of triple-B-rated bonds (under the guise of triple-A-rated CDOs) that would go completely bad, although Hubler was mistakenly betting that some of them wouldn’t.
One of the things that facilitated such incidents as Hubler’s major self-deception was the fact the rating agencies that decided that the prices of the bonds underpinning the CDO were correlated by roughly only 30 percent. In practice, that meant that there was little relationship between their price movements. That was what Hubler was counting on, except that the rating agencies were in error. They had been persuaded by the Wall Street firms—including Morgan Stanley—to approach corporate and consumer loans in the same manner, although the problem with consumer loans (other than the obvious instability of the subprime market) was that there was next to no background on them. Rather than viewing this as a potential red flag and area for further investigation, both the rating agencies and the trading firms conveniently chose to ignore it. Everyone—with the exception of the astute few, like Greg Lippmann, who did his best to dissuade Deutsche Bank from trading with Hubler—seemed equally convinced that the trades they were making were risk-free.
The helium-balloon metaphor--Lewis gives a metaphorical description of the subprime mortgage market in the first half of 2007, beginning in February, as he likens it to a huge helium balloon that, by virtue of its sheer size and weight, was destined to lift with it all who held onto it. He relates how the big Wall Street firms let go one by one. In some cases, as with Bear Stearns, they were compelled to do so by the force of events. By contrast, Goldman Sachs would reverse its position and bet against the subprime mortgage market.
Hubler’s canceled sale to Bear Stearns--In April of the same year, before the Bear Stearns disaster, New Century, the major American subprime mortgage lender, went bankrupt. Lewis thinks that Hubler that may have gotten cold feet about his $16 billion bet, because he started negotiations shortly after that to sell $6 billion of his CDOs to the Bear Stearns hedge fund. Ralph Cioffi, who ran the fund, wanted a higher yield, so Hubler called off the deal—a move that later caused Morgan Stanley to lose almost $6 billion instead of the several tens of millions they would have had to pay Bear Stearns. The official story is that Hubler and Zoe Cruz, the president of Morgan Stanley, discussed and decided the issue together. Unofficially, the facts vary according to different sources close to Hubler and Cruz, but the more plausible argument was that Hubler either didn’t understand or didn’t sufficiently explain the risk involved in owning triple-A-rated CDOs. One thing is certain: John Mack, the firm’s CEO, never intervened or even discussed the situation with Hubler.
Greed and fear take over--A month or so later, Hubler began complaining that the terms of his contract with Morgan Stanley were not being fulfilled. He was referring to the firm’s promise to give him 50 percent ownership of his trading group as an independent money management company. So to prevent their star trader from quitting, Morgan Stanley increased the profits Hubler and his group would be earning, and Hubler managed to extract a significant increase over the $25 million he had earned in the previous year.
Morgan Stanley’s risk department wakes up--In June 2007, Morgan Stanley’s risk department finally caught up with Hubler and his group. The so-called stress tests they had performed so far had at most tested for losses of 6 percent. But the risk analysts now wanted information on more extreme scenarios—10 percent instead of 6 percent. Angry and upset, Hubler’s group strongly resisted, claiming that losses as high as 10 percent couldn’t possibly happen (according to Lewis, the loan pools from their trades lost up to four times as much). When the group finally came out with the new projections, their figures showed a $2.7 billion loss on 10 percent loan pool losses—nearly three times the reversal of their previously projected profit of $1 billion. They still tried to protest that such losses would never happen in reality, but by now the risk department had lost faith in their statements and was taking a closer, more critical look. From what they could see, Hubler’s traders didn’t know what they were doing.
Deutsche Bank calls to collect--In July, Deutsche Bank, in the person of Greg Lippmann, called Morgan Stanley to inform them that they owed them $1.2 billion. According to Lippmann, the triple-A-rated CDOs that Morgan Stanley had sold Deutsche Bank several months earlier had dropped to 70 cents. Hubler and others at Morgan Stanley protested that they should be at 95 cents on the dollar according to their model. This went back and forth until Lippmann finally debunked their model and gave them an ultimatum. The debate was given to the upper management of both firms, who agreed on a payment of $600 million to Deutsche Bank rather than submitting the matter to a jury of three other Wall Street banks. According to Lewis, Deutsche Bank’s perception that there was any risk of not receiving what was owed them was a mark of the level of confusion that reigned on Wall Street at the time.
Morgan Stanley refuses offers for a way out--The subprime situation continued to worsen. The constant increase in defaulting loans resulted in the failure of both the bonds and the CDOs that contained them. Several times, Deutsche Bank offered Morgan Stanley a way out, and several times, they refused. Morgan Stanley could have chosen to minimize its losses at between $1.2 and $1.5 billion, but its traders apparently didn’t understand their own trade well enough to make the right moves. They failed to recognize that triple-B-rated bonds were 100 percent correlated, not 30 percent. Their fates were not loosely but inextricably connected, which meant that they would all fall together, like dominoes.
As Lewis says, Burry could not have timed it better. The U.S. subprime asset market, whose losses would be estimated at roughly one trillion by the IMF (International Monetary Fund), was close to having run its course. With the buyers all gone, all of Wall Street—in fact, most of Western high finance—was stuck in a fatal predicament with no way out.