A Colossal Failure Of Common Sense Part 9

In one small sense they were right, because it was certainly beyond Christine's grasp that anyone in their right mind could possibly lend GM several billion dollars to go on losing it and almost certainly never pay it back, and we all agreed with her. Wrong Wrong. In this market there were banks that would continue to loan cash to Detroit's version of the t.i.tanic t.i.tanic, even as the icy waters of debt and failure came splas.h.i.+ng over the bow.

GM could roll the debt in the short-term commercial paper market, meaning the carmaker could take out a thirty-day loan and pay it back by borrowing the money from someone else. There were still many banks that would lend to General Motors for thirty days, since death did not seem imminent. But the big picture, moving the loan from one bank to another, would in the end turn out to be a lunatic game of Russian roulette, because someone somewhere was likely not to get paid. In the current climate of hyperliquidity though, all this was disregarded, and the show rolled on.

Rick Wagoner, CEO since 2000, the tall former Duke University basketball player, strived valiantly to hold the place together. He created an enormous layoff plan to get rid of workers the corporation did not need, paying them $100,000 to go, up to ten thousand people. It probably was not going to solve the gargantuan problem he had inherited from GM policies of long ago, but it sent precisely the right signal to Wall Street: that here was a CEO who would do whatever it took to pull the corporation into shape. That was one of the reasons the stock kept edging up despite everything.

Another was the instinct of most Americans that General Motors ought not to go bankrupt. That may be irrational, and it may be softhearted. But there is a place in American hearts for the corporation that was the global leader in auto sales for seventy-seven years. It was the largest company in the world for an extended time, and it stood for everything that made the United States great. It was an industrial giant glowering on the banks of the Detroit River beneath the Stars and Stripes, a symbol of world power, U.S. know-how, engineering, and excellence. It was the biggest, the towering Goliath of the auto industry. Most people would feel a tinge of sadness if GM went under, because it wasn't just a car company, it was a part of America's soul, a breath of times past, proud and significant times-times that, I hope, will come again.

A very large section of the American public did not want GM to go down. Perhaps that's where Christine and the rest of us misjudged it. Not everything has to do with money.

I am keenly aware of the pure pain-in-the-a.s.s quality of Wall Street's acronyms. RMBS, CDO, CLO, SIV, LBO, MBS, SEC, NINJA, and on and on. But right now I must return to a subject we touched upon only briefly-the credit default swap, or CDS. In the merry month of May 2006, Wall Street took hold of this gambling concept and decided to transform itself into something between a Las Vegas casino and an off-track betting parlor. You'll recall, I hope, the fancy-free nature of the CDS, which was nothing more than a bet on the total demise of a company, financial inst.i.tution, or people defaulting on their mortgages. It was disguised as insurance, which is of course just a euphemism for bookmaking. Insurance companies are bookmakers in pinstripes: am keenly aware of the pure pain-in-the-a.s.s quality of Wall Street's acronyms. RMBS, CDO, CLO, SIV, LBO, MBS, SEC, NINJA, and on and on. But right now I must return to a subject we touched upon only briefly-the credit default swap, or CDS. In the merry month of May 2006, Wall Street took hold of this gambling concept and decided to transform itself into something between a Las Vegas casino and an off-track betting parlor. You'll recall, I hope, the fancy-free nature of the CDS, which was nothing more than a bet on the total demise of a company, financial inst.i.tution, or people defaulting on their mortgages. It was disguised as insurance, which is of course just a euphemism for bookmaking. Insurance companies are bookmakers in pinstripes: We'll offer you hundred-to-one odds your house won't burn down-a $3,000 premium against a $300,000 payout We'll offer you hundred-to-one odds your house won't burn down-a $3,000 premium against a $300,000 payout. Like an insurer, a real bookmaker carefully balances the odds, taking in hundreds of bets, balancing his book to cope with the unhappy circ.u.mstance when the favorite wins, trying to ensure that the other bets amply cover his risk. Naturally, this occasionally fails, and a horse everyone has backed wins at tight odds. But this time-honored system, perfected down the centuries by the oddsmakers, does not fail often. Wall Street, however, which has zero experience at balancing such a book, did not take these rudimentary precautions.

And that brings us directly to May 2006, when a kind of gambling fever hit the hub of America's financial industry. The CDS became the flavor of the month. I'll just refresh your memory on how it works.

Say a major pension fund loans General Motors $1 billion at 13 percent. The pension fund contacts Lehman or one of the other big investment houses and says, "Will you insure my billion-dollar bond in return for 8 percent of the loan amount each year as a premium? That's $80 million a year for you, and all the risk." But what is the risk? Will GM go bust and default totally on that billion-dollar bond? Highly unlikely in May 2006, with GM stock up at over $30. So Lehman agrees to shoulder the risk and prepares to collect the $80 million a year. But it does not stop there. Lehman contacts Morgan Stanley to do what bookmakers call "laying off." Lehman offers to transfer 90 percent of the risk, $900 million, for a premium of $72 million per year. Morgan Stanley thinks the CDS is sound and accepts, leaving Lehman with an income of $8 million a year, and the risk of the remaining 10 percent of the billion, or $100 million.

You might describe this as like running in front of a 100-mph express train to pick up $50. Some may think this a harsh simile, but the fact remains that you make all this bulls.h.i.+t profit, and the very first day one of your counterparties goes down, you lose the whole lot, everything you thought you made. Still, at this point nothing had gone down, and despite our warnings, the CDS market, certainly inside Lehman, had become the coolest, most fas.h.i.+onable trading Wall Street had to offer. No one had been asked to pay out a ma.s.sive loss. At least, not yet.

But Lehman's CDS group did not worry too much about the potential losses. They had enormous trading fees on the lucrative spreads in this less transparent over-the-counter market. But they also saw that millions of dollars a year, and thought if we could collect little more than a hundred of those bets, we'd earn a billion dollars a year with no outlay, no need to purchase the bonds or anything else. We just collect that huge income stream. The downside, a payout of more than $10 billion if the market went south, did not appear to trouble anyone.

And there were seventeen other Wall Street banks that thought precisely the same, including Bear Stearns, Wachovia, Bank of America, Citigroup, Goldman Sachs, Morgan Stanley, Merrill Lynch, and Credit Suisse. In 2006 the total notional value of the CDS market hit $26 trillion $26 trillion, up from $800 million in 2001. That $26 trillion represented an eye-popping eight times eight times the amount of the underlying bonds. Deep down I knew this was a truly lousy idea. Where does it all stop-$600 trillion, $900 trillion? the amount of the underlying bonds. Deep down I knew this was a truly lousy idea. Where does it all stop-$600 trillion, $900 trillion?

And therein rested the charm/terror of the CDS, depending on your point of view. There was no limit to the amount you could sell. It was nothing like regular bond trading, where the limit was the number of bonds issued by the parent corporation. The credit default swap, the wager on success or failure, was endless. You could sell as many as you liked, because the CDS was not attached to anything. It was just out there in the ether. And no one owned anything. The only real cash flying around emanated from the original loan, the coupon paid by the corporation. The rest was a kind of phantom.

"It's f.u.c.king voodoo," said Larry at one memorable meeting, referring to the gigantic risks. "There's young traders in this organization who never even saw a grizzly bear up close and personal. And they're just printing money against the risk of some kind of ephemeral catastrophe that may or may not happen. What do we do if it does?" So far as Larry could see, we were just trading CDSs, which are IOUs or bets between dozens of Wall Street counterparties. He was a cla.s.sic old-school realist, a cash bond trader, accustomed to the sale of bonds in exchange for a cash payment. Like several of our group members, he could sense something really odd about a world that was being built on side bets about the viability of corporations, where no one owned anything, where the risk was vague but nonetheless real.

We all had an uneasy feeling. The same group of people who were so jumpy over the shaky mortgages were just as jumpy over the CDSs. Because we were all far more grounded in reality, we found it impossible to ignore the risks inherent in these modern forms of hypertrading, where rules were bent and tried-and-true methods went straight out the window.

So far as we were concerned, risk was an absolute. At some point in the argument, the degree degree of risk becomes irrelevant: either there's risk or there isn't. And in this case, however remote it may have seemed, there was risk. I agree it may have seemed a bit far out from where we all stood right then. But when you get slammed by a friggin' rogue comet from outer s.p.a.ce, no one gives a rat's a.s.s how far it traveled. And the risks to the financial system from the explosion of CDS contracts were a lot more likely to rear their ugly head than a comet hitting Earth. of risk becomes irrelevant: either there's risk or there isn't. And in this case, however remote it may have seemed, there was risk. I agree it may have seemed a bit far out from where we all stood right then. But when you get slammed by a friggin' rogue comet from outer s.p.a.ce, no one gives a rat's a.s.s how far it traveled. And the risks to the financial system from the explosion of CDS contracts were a lot more likely to rear their ugly head than a comet hitting Earth.

There were risk meetings when Larry would ask disarmingly "What's going to happen to all the profits built into your trading ledgers when your counterparty is not there on the other side of your trades?" There were, of course, no answers. The bigger problem was that no one wanted to search for answers. The CDS profits were great; what else could matter? So Lehman just went right ahead and kept selling the CDSs as if we were just printing more stock certificates. No one really paused to consider that if a regular stock trader had ever done that, without asking permission from the princ.i.p.al corporation, that trader would have been led away directly to the slammer. And the record keeping was close to impossible to keep up with. Some firms, Lehman included, were months behind. To make matters worse, Lehman had to buy boatloads of CDs to protect themselves when they sold too much, leaving us exposed to yet another counterparty.

The whole environment was innately illegal gambling, and the law had always made it clear you could not gamble on stocks or bonds unless you owned them. A rash of Wall Street betting parlors did spring up in the early years of the twentieth century, but they were closed down by the feds. In fact, this government precaution began at the end of the eighteenth century, when "insurance" betting parlors began to spring up in seaports like New Bedford, Nantucket, New York, and Boston. People were actually placing wagers on whether or not s.h.i.+ps would return from their voyage. And with this there came rumors of diabolical dishonesty, of s.h.i.+ps being sunk in order for friends of the crew to collect the "insurance." Plainly, this could not be tolerated, and for two centuries this kind of wagering by people who had no connection with the princ.i.p.al was outlawed. Not until 2000, with the Commodities Futures Modernization Act, did Congress, in its wisdom, legalize the process, with some kind of special dispensation for Wall Street to bet and take bets on the success or failure of a stock, a bond, or its components.

And now there was rocket fuel driving the market to stratospheric heights-the trillions of dollars in side bets on those mortgage securities and corporations, the CDSs. By 2006 well over half of CDS bets outstanding were pure speculation by people who did not even hold the underlying corporate bond. They were essentially private insurance contracts that paid off if the investment went sour. But now it was not necessary to own the investment to collect the insurance. These were the beginnings of casino capitalism. The irony was that it was no longer insurance. It had nothing to do with insurance. It was a bet. And not many proper bookmakers would have taken it.

Even bookmakers in Las Vegas are regulated. But this booming marketplace for CDSs was not regulated. The corporate bond market is regulated by the TRACE system, options are regulated by the Chicago Board Options Exchange, and stocks are regulated by the SEC. But the CDS boys could do anything they pleased. They traded over the counter, which was invisible. There was no central exchange, only private bets between parties, and these bets were dominating the most virulent part of Wall Street in the year 2006. There were no SEC limitations-possibly because the SEC really didn't understand the risks involved.

And, in a way, we on the third floor had to let them all get on with it, and look after our own very substantial corner of the Lehman operation, trading and earning, always searching for the weak link in the mortgage and home building market that would guide us to major short positions, and try to save Lehman from a real estate Armageddon we alone believed might be around the corner.

It was Larry and Mike's firm belief that the U.S. housing market could darn near take us down. Ma.s.sive shorts the other way could provide a lot of help toward rescuing us on the other side. But it would have been a h.e.l.l of a lot better if we somehow could have stopped these lunatics from betting the farm on poor people making their mortgage payments.

I look back at the hours and hours Peter Hammack and I spent poring over charts, trying to spot the flaws in the balance sheets of some of the biggest brokerage houses in the country. My number one target remained the LA-based New Century, with its 222 branch offices and 47,000 salesmen, the bodybuilders.

I sensed rather than saw the tiniest trend, so small that no one else, except Peter, would have given it a second thought. But then no one else was looking for the same things we were. The first inkling we had that all was not well came when Peter somehow gained access to a database and unearthed the thirty-day and sixty-day mortgage delinquency numbers. Both of them showed a slight uptick. Hmmm Hmmm. Then we came across an ad from NovaStar Financial, the huge Kansas Citybased specialists in "nonconforming residential loans" (that is, loans to guys who haven't got any bread). The ad was offering a program to help borrowers get a job.

"What d'you think about that?" I asked Pete.

"f.u.c.king weird" was his reply.

We checked NovaStar's numbers, and during the process ran into a small announcement that a very key executive had recently quit. To me, that's always like a red flag to a bull. Even more important was the volume of mortgages-just a little off, not much, but sufficient to raise our antennae. They were still lending $20 billion a month nationally, but their earnings were slightly off too, and there was a small blip in the credit lines of the new homeowners.

And then there was the Lehman June 12, 2006, second-quarter conference call at which we invited anyone in the business to call in and question executives on certain aspects of our operation. Shareholders and a.n.a.lysts were also free to come on the line and ask about anything that was bothering them. On this particular day, during a mortgage-related discussion, we had a question from Guy Moszkowski, a Merrill Lynch a.n.a.lyst. His query was made in the soft, polite manner that a.n.a.lysts are inclined to adopt when they're going in hard. He asked, "Maybe you can give us a little more color on volumes and revenues on the mortgage origination side and how you are dealing with the slowdown that we've been seeing." He was making a request that even I had not heard before, and I worked there.

There was a brief silence before the chief administrative officer, David Goldfarb, stepped up to the plate on behalf of Lehman Brothers to reply to Guy's question. It was not what you might describe as a perfectly straightforward answer. Indeed, David's opening sentence was as close to unadulterated gibberish as anything I've ever heard: "You know, again, our mortgage platform in the U.S. as well as in Europe and Asia is predicated on a diversified set of products and a diversified set of regions, and with that diversification it has led to, you know, resiliency overall. As Chris [Chris O'Meara, the recently appointed CFO of Lehman] mentioned in his formal remarks, the overall securitization volume is slightly down; however, there was a slight mix s.h.i.+ft this quarter, more going toward Europe; our small lending platform basically had a couple of large securitizations."

Note the words that mattered: "the overall securitization volume is slightly down." Because they really did admit that this enormous U.S. real estate market might already have peaked. Some way or another, the volume of people grabbing onto those tricky mortgages was down, despite all the efforts of the bodybuilders. The question was, was this just a slowdown or were we heading for a crash? What did that lower volume of mortgages really mean? And can you believe that there were people in this firm discussing the possibility of buying New Century when we already owned two large mortgage brokerage houses, Aurora and BNC?

I leave it to David Goldfarb, still valiantly going forward on the phone: "So, broadly," he said, "there are certain pockets that continue to have less volume. We have built very much of a variable cost base around the business, and certainly we basically have our infrastructure tied very much to a variable platform, and as we believe volume gets reduced so does our cost base."

On reflection, I'll take a shot at explaining it myself. For some reason a whole lot of people declined the tricky mortgages. It could be market saturation; with 47,000 salesmen, New Century alone must have banged on the door of every potential buyer in the free world. In addition, by this point there had to be hedge funds that were in CDOs up to their eyeb.a.l.l.s, with billions invested on behalf of their clients. However, I believed the biggest danger to the market was the bush telegraph of the poor-families and friends pa.s.sing along hair-raising tales of people's mortgage payments ripping upward as much as threefold as the interest rate resets kicked in.

They say that in the book business, the finest advertis.e.m.e.nt of all is word of mouth. My instinct was telling me that the resets had scared the life out of a lot of people who were stuck with payments they could never afford. That kind of really G.o.d-awful news, and especially when it involves repossessions and defaults, is apt to zip around the NINJA community real quick.

For all of us, these disparate facts, none of them of magnetic importance, added up to the very first suspicions of a trend-one that involved the possible crash of the mortgage market. We had taken a penetrating look at the risk factor that most people seemed happy just to ignore. And according to Larry, the real culprits in Lehman Brothers were the guys who would not recognize risk if it walked up and bit them in the a.s.s. This was the risk management department, a group of quasi-a.n.a.lysts whose sole job was to a.s.sess where we were vulnerable in our trading and holdings.

I have to say, they drove McCarthy nuts for several reasons. But the main one was their a.s.sertion that our Delta position was somehow lethal and kept each and every one of them awake at night to the detriment of wives, families, and sundry pets. They were forever calling nervously, checking, worried we had overstepped the mark, with $180 million of the firm's cash exposed against Delta bonds worth up to $600 million in face value. Remember, we had bought most of them below 18 cents on the dollar, and Jane currently had a satellite picture of lines of gleaming Delta-owned Boeing pa.s.senger jets parked in the desert. Delta, of course, was still flying, and had a cash flow. Jane's opinion remained intact: we'd stolen those bonds.

This was not precisely how the risk management guys saw it. And they never stopped griping and moaning about the way Alex, Larry, Gatward, Sch.e.l.l, Beggans, and I had so recklessly committed the firm to the bankrupt southern airline named after the delta of the mighty Mississippi.

On the other hand, risk management seemed thrilled to bits about the $10+ billion subprime CDO securitization position held by the mortgage guys up on the fourth floor. The risk department viewed that as far less harrowing than our Delta bond position, despite the fact that those CDOs were entirely dependent on the financial capabilities of some of the least capable people in the West: Kmart checkout staff who'd claimed a comfortable income of $250,000 a year on their application for a no-doc mortgage to buy a house out there in the asparagus fields. One month, in fact, we logged five times the volume of worried phone calls from the risk managers than did the mortgage guys, with whom we did a comparison.

But who could blame them? The CDOs were considered the same as government bonds, AAA, by the most prestigious ratings agencies in the United States. In contrast, we were foolishly invested in some bankrupt air transportation company whose pilots were about to go on strike.

Risk managers in Lehman Brothers were guided, advised, regulated, trapped, imprisoned, and threatened on pain of torture and death by a tyrant who stood in their back office with a bullwhip and branding irons. His name was VaR. His strength was beyond that of a normal man; he could terrify legions and lay down the law in a manner that made empires shudder. VaR had a brain the size of a caraway seed and the imagination of a parsnip. The acronym that provides his name comes from value at risk value at risk, a technique used to estimate the probability of portfolio losses based on the statistical a.n.a.lysis of historical price trends and volatilities. It measures the worst expected loss under normal market conditions over a specific time interval at a given confidence level. Which means it measures both fear and optimism.

In this particular instance, VaR knew that the market had no problem with the confidence level of those who bought CDOs. There was as yet no volatility in this market. There had not been any volatility for years. It was a calm, tranquil place, like Nantucket Sound on a still and windless August morning, without even the wash of the pa.s.sing Martha's Vineyard ferry.

The one great flaw with VaR was its insistence on putting heavy emphasis on recent volatility. This meant that if a security did not have a history of volatility, it would irrevocably be marked as riskless despite the fact that it currently gazed into the abyss. VaR was a prisoner of its own guidelines.

And like all systems that place too much faith in a philosophy, especially one as widely used on a global scale as VaR, it ends up with too much power and influence. It ended up ruling the department it was supposed to a.s.sist, because at Lehman no one wanted to be the renegade who stepped over the sacred VaR guidelines. Should there be a disaster, there could be only one scapegoat: the man who kicked over the traces and failed to obey the tried-and-true rules of VaR. Therefore, right or wrong, VaR was obeyed.

In our case its flawed reasoning was obvious. The CDOs were fine because they fell within the no-volatility rules, they were AAA-rated, and there had never been a default. But Delta was another story: much lower-rated because of the bankruptcy, a shaky history with the unions, operational problems because of the rise of jet fuels, undercutting by no-frills rivals, and a questionable future. When the risk management guys ran Delta through the computer program, the d.a.m.n thing nearly blew up. Result: love CDOs, hate Delta. Verdict: VaR was a bonehead. It's just a G.o.dd.a.m.ned machine. And it's only as good as the information it's given. You cannot implicitly rely on it. And our risk management guys never should have idly switched off their own brains and paid attention only to the friggin' robot.

Still, that stupid piece of equipment, with its blinking lights, colored screens, and softly lit keyboard, was not the only brain around Lehman that was ignoring all of us. Someone should have given the son of a b.i.t.c.h a kick in the b.u.t.t and told it our Delta bonds were worth a thousand of those collateralized debt obligations on a risk-reward basis. My department had a total risk of $180 million on the Delta bonds, with an upside of up to $600 million in the bond's face value. The mortgage guys were sitting on more than $10 billion of subprime; their only upside was the income from the mortgages, with billions on the downside.

The deepest irony was that our group was more worried about the real estate market than the mortgage department was. One evening, Alex Kirk and I went for a drink after work, down to n.o.bu 57, New York's fabled celebrity j.a.panese sus.h.i.+ restaurant on West 57th Street between Fifth and Sixth Avenues. And right there I asked him if he could give me a little guidance about the size of Lehman's exposure to a possible subprime default. I knew it was privileged information, and I knew it might be very difficult for Alex to confide even in me, one of his right-hand men. But I needed to know. And he knew I needed to know.

He was about as cagey as I'd ever seen him. "You know I can't go there," he said. "But I understand why you're asking. You want to know how big to short on the other side, just in case we might need a rescue operation?"

"Correct," I said. But I could not pry the information out of him.

"I just wish I could get a handle on the size of the problem," I told him, and he nodded very seriously. He knew. If ever anyone knew, it was Alex. h.e.l.l, he and Mike Gelband were the first ones in the entire corporation to call the problem of the steroid-boosted property market.

But Lehman, like all investment banks, was a real black box, with its secrets and its untold revelations. Alex hinted to me that we had his total support in our endeavors to balance the property books.

"You mean you won't object to us shorting those big mortgage brokerages and mortgage insurers in a major way?"

"That, Larry," he said, "sounds like a very sensible idea."

I mention that incident only to ill.u.s.trate the depth of our anxiety. The problem was constantly on our minds. As.h.i.+sh Shah, Larry McCarthy, and I were always talking about it. And we finally evolved a plan in which David Gross ("Grossy"), one of the top convertible bond salesmen on our floor and a very good friend, would come with me on a trip to the West Coast. Its purpose would be twofold. First, visit with several important clients to discuss airline bonds, one of my princ.i.p.al areas of trading responsibility. The second-and perhaps more important-would be to do some high-quality professional spying. The name's Bond, Larry Bond.

We had to be extremely careful, because on no account did we want the mortgage department-or anyone else, for that matter-to find out what we were doing. We just wanted to make a discreet trip out west and try to take the pulse of places like New Century and the rest, out there in the world headquarters of the bodybuilders. Grossy and I were going behind enemy lines, and we could not afford to have the tough-minded head of our mortgage securitization business, Dave Sherr, made aware of our presence in the cradle of the CDOs in Orange County.

The fortyish Sherr was a property bull. It was he who had opened the attack on our group at a meeting when he declared we did not understand the workings of that market. It was he who was ready with the instant retort that the U.S. housing market had never gone down more than 5 percent in any year since the Great Depression. He was a well-educated graduate of Babson College, the business school out in leafy Wellesley Ma.s.sachusetts, due west of downtown Boston. The global head of every aspect of Lehman's mortgage securitization business had an ill-disguised dislike of our ideas about his bailiwick. His belief in the everlasting validity of the CDOs was inviolable. Secretly we planned our trip. We first flew to Chicago where we would entertain clients for a couple of days. Dave Gross would be a key man here, since he was a salesman and knew them all personally. We made a point of allowing this trip to the Midwest to be well known inside the building. But only Larry McCarthy, Pete Sch.e.l.lbach, and Pete Hammack knew where we were really going.

For the first two days of the trip we entertained our clients out there by Lake Michigan, advising every last one of them to get in and short New Century, NovaStar, and an outfit called Accredited Home Lenders. We both explained there were small but significant signs that this housing market might have peaked or, worse yet, might crash. I told them how some of the cleverest people at Lehman Brothers were extremely concerned that the roof might fall in on the biggest mortgage brokers.

I know that many of them took our advice, mostly because any Lehman trader commands great respect beyond Wall Street, but also because our trip was a very warm, sociable time. We took two clients out to Cog Hill Country Club, west of the city, and played a memorable round on Course Four, the tigerish Dubsdread, where great professional and amateur champions.h.i.+ps have been held.

Dubsdread is 6,940 yards long with tight tree-lined fairways. Tiger Woods had recently fought his way around there to win his third straight Western Open. I've mentioned that I'm a lifelong golfer and the son of a very fine amateur player. But it still gives me a huge thrill to follow in the footsteps of the immortals. I guess it's similar to standing on Wimbledon's Centre Court, in center field at Yankee Stadium, or down on the hardwood at Madison Square Garden. But there's nothing like standing in solitude on a world-cla.s.s golf course and knowing that great champions also stood here, with the same thoughts running through their minds: a slight fade into the green ... stay left of the bunkers ... is this club long enough? a slight fade into the green ... stay left of the bunkers ... is this club long enough?

For every reasonably accomplished player, the ghosts of golf's legends are always present. And at places like Cog Hill you just knew they were all once here: Sam and Ben, Arnie and Jack, Gary and Tom, as well as the sweet-swinging Tiger himself. And I'll tell you one secret: when I hit the sloping green at the par-five six-hundred-yard ninth with a drive and a three-wood, h.e.l.l, I thought I was was Tiger. Darn near filed an entry for the 2007 U.S. Open Champions.h.i.+p at Oakmont. Tiger. Darn near filed an entry for the 2007 U.S. Open Champions.h.i.+p at Oakmont.

In the end I shot 75. But Grossy and I made some good friends, and the following evening we flew west to Los Angeles. No one met us, and we rented a car, then drove to the Beverly Wils.h.i.+re Hotel, checked in, and had dinner with two very big clients, hedge fund managers who had bought a lot of product through Lehman. Again we gave the warning about the housing market, and again we advised on some serious short positions against New Century, NovaStar, and Accredited Home Lenders.

At seven o'clock the following morning we received a scary signal from a retail equity broker from the Cape, Jack Corbett, who called the hotel to let me know that Accredited had ma.s.sively missed their second-quarter earnings target. Jack was a good old buddy from Falmouth High, and he knew I was interested in the subject. Interested? My annual bonus was locked up in a corporation that was up to its eyes in CDOs, so many we weren't even allowed to know the number.

However, Peter Sch.e.l.lbach and I had shorted Accredited in a major way, so we weren't unduly troubled when the stock crashed 15 percent that day. In fact, we each made over $2 million profit that day for the firm. It was our first subprime trade, and it felt good. This was the first tangible evidence that we were correct in our a.s.sessment of the mortgage market, and that Dave Sherr and his band of subprime securitization brothers might be on borrowed time.

I wondered if Dave Sherr was still so utterly certain we had no idea what we were talking about. There was no sense of triumph. We just wanted them to come to their senses, to listen to the biggest brains in the company: Alex, Mike, Larry, As.h.i.+sh, and, I suppose, the rest of us.

The tumultuous events of that early morning immediately instilled a charge of urgency into our mission. What if all these brokerage guys started missing their earnings? What if we could not stop Lehman from buying New Century? What if we could not get big enough short positions to counteract the problem?

I called Larry, who'd already heard about Accredited, and he thought Grossy and I had better get right down to the sprawling headquarters of New Century and try to get some solid information from someone-G.o.d knows who, because we couldn't just walk in and demand facts. That much was obvious.

We saddled up our hired Buick and picked up Route 405, running southeast for almost 50 miles, following the coastline toward San Diego. It was still quite early in the morning when we arrived, and we decided to take a scenic side trip down to Lake Forest, ten miles beyond Irvine, and take a look at the West Coast HQ of the Lehman subsidiary Aurora. There was not much to see, but it sure looked like a prosperous operation. So we turned around and headed back to Irvine, first of all scouting around the headquarters of BNC, our other subsidiary-another campus that looked suspiciously like a billion dollars.

But we pressed on to our objective, the giant mortgage factory in this manicured section of outer Los Angeles. We knew this would not be a simple reconnaissance mission, taking a look and moving on. We needed to go undercover, find somewhere to make contact with the enemy, and then make some serious a.s.sessments, validate the dangers.

We drove down typical California upper-middle-cla.s.s streets, following our map and keeping an eye on the GPS system. It was pretty easy to find. In fact, the world headquarters of New Century seemed to pervade the entire area, as if the expensive shops, bars, and restaurants were all somehow a part of this grinding coast-to-coast money machine with a sales force that seemed like the size of the U.S. Army.

Finally we located it and pulled up outside its impressive front entrance, with its perfectly clipped lawns. New Century stood back, a palace of black gla.s.s-at least I guess it looked like a palace to its employees. To us, Wall Street special agents with a jaundiced eye, it looked like the Lubyanka-that's the Moscow headquarters of the old KGB.

We eased forward, making a quick recon of the front parking area. For a split second I couldn't work out whether this was a mortgage brokerage or a Ferrari dealers.h.i.+p. But I definitely never before saw one single spot on G.o.d's green earth with that many top-of-the-line automobiles parked shoulder to shoulder. Alongside the Ferraris, we saw two low-slung 160-mph Lotus sports cars from England. We saw brand-new Jaguars and the most opulent BMWs. Mercedeses were two for a penny. We even saw a dark blue Bentley.

And walking with the merest suggestion of a swagger, across the immaculately paved driveway, were two unmistakable salesmen-flat-top haircuts, two-piece suits that fit slightly too tight, gold earrings, leather briefcases with gold fittings. They climbed into a metallic blue Jaguar that started with a throaty, confident growl.

Grossy burst out laughing. "Holy s.h.i.+t!" he said. "Did you just see those two lugheads? Are we in the wrong business?"

8.

The Mortgage Bonanza Blows Out These were people who, in the five thousand years of recorded human house construction, never would have been granted a mortgage to purchase even a dwelling of mud, reeds, or palm leaves. And they were very, very frightened.

WE DID NOT linger very long outside the New Century parking lot. We drove maybe half a mile back toward the freeway and parked on a side street. We then walked back to New Century and took a long look around the outside of the building. linger very long outside the New Century parking lot. We drove maybe half a mile back toward the freeway and parked on a side street. We then walked back to New Century and took a long look around the outside of the building.

There was plainly no point in even contemplating entering, since we had no appointment and in any event had no right to be snooping around asking questions. It would have taken someone mere moments to call the mortgage department back in New York and demand to know who the h.e.l.l we were and what we wanted, at which time the game would be up and Dave Sherr would want some embarra.s.sing answers.

"We'd never get in there," said Dave Gross. "Not under any guise."

"I wouldn't be absolutely sure about that," I replied. "Gimme a couple of big pizza boxes, I'll be through that door and in the president's office in about three minutes-'Brad Morrice insisted, real hot with extra cheese.'"

Grossy looked at me, plainly considering whether I'd completely lost it. I decided not to elaborate on my misspent youth, and instead outlined our strategy. We needed a restaurant close to the building, where we could locate a few bodybuilders on their break.

We found a place that was almost perfect-snazzy, pricey lunch, nice bar, expensive decor, glamorous waitresses-just a few hundred yards from the New Century building, and made it our HQ for a couple of hours. Sitting at a corner table, we a.s.sessed the events of the last few days.

First off, Merrill Lynch, according to a fast phone call from As.h.i.+sh, now had $50 billion worth of CDOs filled with mortgages on their books-a whole ma.s.s of subprime, scads of them from California, some of them probably sold from this very restaurant. Grossy reminded me of Pete Hammack's very last words before we left: "If, in just one month, New Century cannot move those subprime mortgages out into the market, they're dead. Their balance sheet could not stand it." Pete meant not just New Century but all of us. No one can afford to hold on to the scalding hot potato of subprime mortgages that cannot be sold. "Larry," he'd told me, "this market right now is like a line of traffic, with everyone moving up to the head of the line and waiting for the green light-get the CDOs sold and keep going forward." In Pete's opinion, if that traffic light malfunctioned, and the first two vehicles were somehow stuck, everyone else would back up. There would be a whole line with nothing moving, all jammed up, and the carnage would be indescribable.

New Century was selling $5 billion worth of mortgages every month, and David Einhorn, the founder and president of the multibillion-dollar hedge fund Greenlight Capital, had just joined its board of directors. He's probably the smartest short-seller on Wall Street, maybe the world. So what was he doing on the board of this New Century outfit, with its billion-dollar headquarters and lugheads riding around in brand-new Jaguars? His presence on the board gave me pause. Could we all be wrong? Did they really have a golden business, upright and aboveboard? Could Alex, Mike, and Larry all be completely wrong in their a.s.sessments? This was, after all, the second-largest subprime lender in the nation.

The thoughts were racing through my mind. And I guess my expression betrayed my concerns, but Dave, one of our best bond salesmen, did not share them. "Listen," he said, "New Century had a real shake-up couple of months ago, new CEO, this guy Brad Morrice. And quite frankly, I don't care whether David Einhorn is on the board or not. I don't care who the h.e.l.l's on the board.

"But I do know one thing-we both saw those doc.u.ments Pete pulled on the New Century's mortgage portfolio, and they showed nothing less than a factory, thousands and thousands of those mortgages, subprime up a hundred percent in 2004, a hundred percent in 2005, and G.o.d knows how much in 2006. And now we got signs the housing market might be heading south. Finally."

Worse yet, the interest rate resets were about to kick in. We'd seen the doc.u.ments. Hundreds of thousands of poor people were about to see their monthly payments rocket up from $800 to possibly $2,400 a month, maybe more. It had to be a house of cards, because these people could not afford that much. Suddenly my cert.i.tude was restored and I knew that Pete Hammack's traffic jam would ultimately start right here. Maybe not for a while, but the traffic lights that would stop turning green were just outside this restaurant door, on the grounds of New Century.

By now it was around twelve-thirty and the bodybuilders were coming in for lunch. You could not miss them, with their slick hair, toned muscles, and tight-fitting s.h.i.+rts. You could smell them as well, expensive cologne in the middle of the day, reeking of success, and so c.o.c.ky. Our waitress told us she'd just been given a $100 tip for three plates of pasta.

You could tell everyone was doing great. They were confident, slightly too loud, with a brashness common among people who are paid huge amounts of money for tasks that require no real brilliance. These guys were pleased with themselves, pleased to be talking about sport, girls, or automobiles. The stock market could have fallen and not raised a flicker in this particular chophouse.

We finished our lunch and moved into the bar, where I could see two or three bodybuilders having a beer. We easily fell into conversation, and they were happy to chat to a couple of vacationing Wall Street guys. They told us that mortgage brokerage was the greatest business on earth. Bar none. They were all earning between $300,000 and $600,000.

We mentioned there were rumors back on the Street that this booming real estate market might be turning. There were small but clear signs, the market had flattened and would probably fall. But they dismissed the possibility out of hand: That's no problem, just a blip-don't worry about it That's no problem, just a blip-don't worry about it.

They were like peac.o.c.ks, bragging about their huge salaries, New Century's enormous share of the market, how so much money was being made every day, every week. They cheerfully confirmed they were all on double commission: Takes a tough man to sell this stuff, and New Century is prepared to pay well for the best Takes a tough man to sell this stuff, and New Century is prepared to pay well for the best.

I asked them if they gave much thought to the possibilities of defaults when the resets began. They dismissed this with even more panache. Not our concern, pal. Our job is to sell the mortgage policy. Period. Right after that it's someone else's problem Not our concern, pal. Our job is to sell the mortgage policy. Period. Right after that it's someone else's problem.

I asked, did they think some of the less wealthy guys would still be able to afford the reset payments? Hope so, otherwise it's back to the ghetto, right? Hope so, otherwise it's back to the ghetto, right?

Was proof of income or a.s.sets needed before the mortgage is granted? h.e.l.l, no. They just need to state their income. No docs. That's why we work here h.e.l.l, no. They just need to state their income. No docs. That's why we work here.

You guys ever worried some of these no-doc borrowers might just take the money and run, without making payments? I just told you, it's not our problem. We're salesmen. New Century makes it easy for us I just told you, it's not our problem. We're salesmen. New Century makes it easy for us.

They all knew one of the big attractions of New Century stock was the 10 percent dividend it paid. The stock was held up by that. It was one of the highest dividends on the New York Stock Exchange, and it was quite obviously too good to be true. If the market went down and that dividend had to be cut back, the stock would have to crash. Anyone could see that, but it did not faze the bodybuilders. Look, man, right here we got a great company and we're killing them out there in the market. Let's just fly with it. Three of our top guys have made $74 million over four years, with cash and stock. That's a goal for all of us. And New Century's gonna make that possible. Universal home owners.h.i.+p, right? That's our target. New Century for the new century. You gotta love it Look, man, right here we got a great company and we're killing them out there in the market. Let's just fly with it. Three of our top guys have made $74 million over four years, with cash and stock. That's a goal for all of us. And New Century's gonna make that possible. Universal home owners.h.i.+p, right? That's our target. New Century for the new century. You gotta love it.