Part 10 (1/2)

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.

They told us the corporation had taken their top salesmen to the Bahamas on a luxury liner booze cruise. Actually it had been a themed booze cruise, under the banner ”The Best d.a.m.n Mortgage Company. Period.” They'd even hired the railroad station in Barcelona, Spain, for another heavy-drinking junket for top employees. New Century chiefs made huge charitable contributions, and sent one high-flying exec to a Porsche-driving school.

”Guys,” said our new buddy, ”right here you're looking at a new shade of blue chip. That's one of our mottoes.”

You couldn't dislike these New Century heroes. But their knowledge was awfully one-sided. For a start, they knew nothing of Pete Hammack's evidence of heavy stock selling among the company's three founders. Neither did they volunteer anything about some shaky accounting practices, which had caused concern to a Maryland financial research outfit, currently flagging problems with New Century's third-quarter earnings release.

Neither were they aware of the anger of a California lawyer, Alan Ramos, who was plainly infuriated that his client, an elderly lady about to be evicted from her three-bedroom home northwest of Stockton, had been made an enormous ”senior citizen” loan. On checking the doc.u.ments, Mr. Ramos found that her income section had been left blank.

”Blank?” he exclaimed. ”How does it even get past the first person who looks at it?”

Right there I guess we had the New Century way. Its loan originations had been $6.3 billion in the year 2000 and were expected to hit $60 billion this year. This was a corporation that unloaded thousands of mortgages, every month, onto Wall Street mortgage securitization guys who weren't anything like as smart as they should have been.

Dave Gross and I left that bar in mild amazement. That whole group of c.o.c.ky, relatively dumb bodybuilders was so pleased with their lives, so unaware of what could happen, so far behind the advanced thinkers of Wall Street. You know what they say: when it's seven o'clock in New York, it's 1991 in California. Make that 1981.

”There's something really rotten about this place,” I told Dave. ”We're in the Wild West of mortgage lending.”

He said he agreed, and was really shaken by the totally careless way the bodybuilders wrote mortgage agreements, how they could not give a d.a.m.n whether the money was paid back or not. For one bright s.h.i.+ning moment I decided I had seen the light. Because in that restaurant, crammed with self-satisfied know-nothings, we had gazed upon the amoral soul of this housing boom, the crux, the fulcrum, the place where so many dreams would begin, and where surely heartbreak and financial collapse must follow.

We were both struck by the curious remoteness of the guys with whom we had spoken. They acted as though the fortunes of neither the corporation nor the borrowers had anything to do with them. They were like hired guns, oblivious to the fate of their victims or the outfit that had hired them. Both in their own minds and in ours, they were men apart-for slightly different reasons, of course.

Both Grossy and I thought they were a breed, rather than a clan. They were professional salesmen who rode the waves, and when one wave petered out they would find the next one. I thought of that Philadelphia bucket shop, where high-pressure tactics were used to sell penny stocks; they would say anything, promise anything, just to get the sale done.

These guys we'd just left were the same, remote from the reality of what they were doing. They moved in a flock, migrating from one sales scam to another, probably about every five years. And they were good at it. I recognized that much, even though I'd personally have given the b.a.s.t.a.r.ds a run on a vanload of pork chops. Never forget your roots, right?

At this point in August, the New Century stock was at over $40 and rising. It would be pointless trying to persuade the mortgage guys back at the office that this market was surely heading for a very hard brick wall; Dave Sherr and his boys would surely laugh at us, as they had done before. And we flew home that night wondering what the h.e.l.l to do. The fact was, we couldn't find out the volume of subprime that had been sold to Lehman, but we had discovered much about a hardworking, hard-partying culture upon which our corporation's future might depend.

The following day, straight off the red-eye from Los Angeles, we were met at JFK and whisked into the office, where we immediately caucused with Larry and Pete Hammack, both of whom were waiting for us. We already suspected New Century had been taking wild chances with its lending, but now we needed to move fast.

Larry said the $20 puts were 50 cents each for six months, ”let's buy 10,000”-which effectively meant we could make a $500,000 bet that New Century's stock would go below $20 between September and March. This was crazily cheap, we thought, but the market was calm, no volatility. We bought a pile of the puts; we bought the $20s, the $25s, and the $27.50s. Just the $20 puts we purchased made us short a million shares below $20 a share. That's not counting all the other puts we bought. If New Century went down, we'd make close to $30 million. I guess that's why Lehman stood us a couple of nights in the Beverly Wils.h.i.+re.

But on the next day we wanted to up the ante on New Century-short them big-time. And with a position of this size it meant I needed the approval of Rich Gatward. By now I had a solid relations.h.i.+p with the old tiger of the equity trading floor, though we all had to be on our A-game in our dealings with him, and I understood he would not hesitate to bawl out anyone who wasn't. But he and I had developed excellent trust in each other, and he never once turned me down on a well-presented trade, especially against a subprime candidate. He was the toughest, but also the fairest, of the Lehman department heads that I knew. I presented him with our full plan, the complete picture of New Century, along with a sprawl of outstanding spreadsheets compiled by Pete Hammack, who came to the meeting with me. The sheets demonstrated what we could lose and what we might win depending on the price of New Century's stock, from $60 all the way down to $5. I admit I had some trepidation, because we'd been on a clandestine mission and wanted to keep it very quiet. I also had no idea whether Rich had close friends up in the mortgage department. But he never faltered, that fast a.n.a.lytical mind of his slicing up the information we presented.

Finally, after careful study, he said, ”I think you've got something here. And this work is great. Put the trade on, and keep me posted.” Rich was not as bearish about New Century, but he still trusted Larry and me, and he backed us every last inch of the way.

I contacted Susquehanna, an outside broker, the domain of Matt Durso, a good old buddy of Dave Gross. I told him I wanted a menu for 30,000 put contracts on New Century-that's known on Wall Street as a gorilla trade. Big.

”Jesus,” he said, ”what do you guys know?”

”Matt, we've done a ton of research on this,” I told him. ”We don't like the company. And we don't think the dividend's safe. Also, they're registered as a REIT [real estate investment trust], and we think the REITs are vulnerable in a falling housing market.”

I told him we were looking to pay 55 cents per put on one of the options on his menu, and he came back wanting 65 cents. I checked with Larry, who snapped out one of his creeds: ”You limit orders, you limit profits. I don't want to nickel-and-dime. I just want to get it done.”

A limit order is just a way of lowballing, trying to undercut the trader's market, hoping to buy at a lower price. But when the market keeps moving away from your bid, you end up chasing it, like a Bedouin riding his camel toward a mirage. We had no time for that on a trade this hot. So I did that part of the deal and put on a $650,000 initial trade. At the end of the day, in total, we spent $5 million and bought all 30,000 put contracts. G.o.d help Matt Durso, I thought. He and Susquehanna were taking all that risk. Little did I know that in October, New Century would grind ever higher.

We were now in mid-September, and there was developing a feeling of disquiet throughout Wall Street. Yet more evidence was emerging about the stresses on the housing market. And I have to say, our trip to the West Coast was becoming more public than we antic.i.p.ated, and so were the huge short positions.

There was no word from the mortgage guys, at least no formal word, but there was a buzz about the a.s.set-Backed Securities Index, or ABX. That's the index that tracks the prices being asked and paid for the subprime mortgage bonds, the CDOs. The ABX was a system of quivering sensitivity, programmed to practically suffer a thrombosis if those bonds moved a couple of ticks downward.

And what made the situation that fall even more jumpy was that no one could remember the son of a b.i.t.c.h twitching a tendon, never mind moving a muscle. The ABX was static; the mortgage market had been dead calm for years, a graph line unlike any other. There were dead people whose heartbeats were more erratic. The index was as straight as a gun barrel, all through the entire upsurge on the U.S. housing market.

The ABX normally trades at par (100) because it's a measure of the strength and value of mortgage bonds. On Tuesday morning, September 19, the ABX slipped to 9799: the trader, who sets the market, would buy at $97 and sell to you at $99. The ABX had fallen very, very slightly, only three ticks, but in certain places that caused big consternation.

Larry and I went for a drink at a nearby sports bar, Tonic, that evening, and ran into a colleague, Eric Felder, head of our high-grade credit business-that's the traders who deal with investment-grade corporate debt. He knew as much as anyone about Lehman's credit derivative business and was highly respected all over the Street.

Eric was a real up-and-comer, a bull by nature, but as soon as we saw him, he began to tell us he was very bothered by something he had noticed that day. His question was, ”Did you see that move in the ABX today?” We could see the concern on his face. ”It dipped. First sign of volatility I've ever seen on that index. This, guys, is serious. If it drops one more time this week, we better short it. I guess the mortgage guys are still long. And if this keeps up, that's not gonna be good.”

I asked him how this might affect New Century, and he was not optimistic. Larry said immediately he was going to double, maybe triple, our short position against the California brokerage.

The next day the ABX dropped to 9698. I increased the short on New Century yet again. Both Larry McCarthy and I understood why the CDOs were dropping. There were more sellers than buyers, more people watching that ABX, more people paying attention to slight upticks in the default charts, the repossessions, the failures on first-mortgage payments. Maybe there were even people quietly recollecting the words, months ago, of both Alex Kirk and Mike Gelband.

Larry and I did not have all the answers. But we had found out one thing: Lehman had underwritten $101 billion in mortgage-backed securities so far that year, and a whole lot of it was subprime and Alt-A. Holy s.h.i.+t!

By any standards 2006 had been a ride through choppy waters for Lehman, especially with the housing market now s.h.i.+pping water. Short of a miracle, neither of us could see how the mortgage department could come out whole, not with the raft of CDOs they had. For all we knew, the traffic light had already malfunctioned. Which may have been what was causing the ABX to develop a nervous twitch, with everyone lining up to make an exit.

Even the Delta bonds, which seemed like a steady and reasonable bet to increase in value, had suffered a couple of diabolical moments. One of them, back in April, was so dire at the time, I couldn't bring myself to mention it in this narrative, especially as I had made the original market for the bankrupt airline.

Back on April 17, the bonds had rallied to 26 or 27 cents on the dollar. But then things went south, especially Hezbollah's missiles, which started bombarding Israel, and the world oil market, as usual, instantly wet itself. Up went the price of jet fuel. Then the pilots threatened to go on strike. We still had a boatload of the bonds, bought cheaply, but still, $425 million in face-value worth? As the hours ticked away, the strike grew more and more likely. Everyone was saying it was going to happen, and that Delta's entire fleet would be grounded, resulting in zero cash flow and a highly negative balance sheet.

Everyone, that is, except for one person. Jane Castle said, ”The pilots are bluffing. Trust me. And the bonds are still worth fifty-two cents.”

We were close to table max, that is, the maximum amount of money we could put on the table. After that, we couldn't buy another bond, whatever the price. And the market wasn't listening to Jane. The bond price dropped to $23, then $22. And then something truly nerve-wracking broke out.

It was two-thirty on that Monday afternoon when my direct line to the sales desk in our San Francisco office suddenly lit up. John van Oast, our man in command, was on the line with the worst possible news. T. Rowe Price, a huge mutual fund with five thousand employees out of Baltimore, Maryland, wanted to sell their Delta bonds. I knew they might have been holding about $120 million face-value worth of convertibles, and they were one of our biggest customers, with about 20 percent of Delta's entire convertible bond issue. They were a real traditional company, founded in 1937, currently with almost $400 billion under management. T. Rowe Price had to be accommodated.

”Larry,” yelled John from California, ”I got 'em on the wire right now, and they need a bid on Delta convertibles.”

I called back, ”Twenty-one, twenty-two, ten million up!”

”Hold it,” replied John. ”Be right back.”

Seconds later he was on the line again. ”They appreciate the bid, but what they really want is a cleanup bid.”

Jesus Christ. They want to sell them all. The blood drained from my face. I told Larry the state of the battle. I knew he'd go low since we were already near table max.

For a moment there was silence. Then Larry called it: ”Eighteen bid for the lot!”

For the first time in my life I saw a bead of sweat on his brow, and maybe even a slight tremor on his hand as he scribbled down a note.

Van Oast yelled, ”They got a hundred and twenty to go. All I need to hear are the two beautiful words.”

The numbers flashed through my mind: $120 million face value on bonds times 18 cents, that's $21.6 million for cash. Larry nodded curtly. ”You're done!” he replied. And the deal was complete.

Larry, for once, was a bit over his skis. We were about an inch and a half from table max, which meant five bucks was a lot of money to spend. Larry had just spent more than $21 million. Somebody's budget was about to get slammed. ”I'd better go see Gat,” said Larry. ”Jesus Christ!”

Several weeks later I took a call from the head trader at T. Rowe Price, who reminded me, ”I've been in this business a long time. With that airline going down, that was probably the gutsiest call I ever heard. McCarthy?”

”Who the h.e.l.l else?” I replied.

A few days after we had bought all the bonds, the Delta pilots called off the strike, and the price went back up to 2425 cents on the dollar. Gatward was thrilled because Larry, Jane, and I had persuaded him to share the risk, and he'd taken most of it at 18 cents. So far as Jane was concerned, there was no reason to sell any of them. So we all just hung in there with our gigantic load of Delta convertibles, all through the summer of 2006.