KEY POINTS:
J. Kyle Bass, a hedge fund manager from Dallas, strode into a New York conference room in August 2006 to pitch his theory about a looming housing market meltdown to senior executives of a Wall St investment bank.
Home prices had been in a five-year boom, rising more than 10 per cent annually. Bass conceived a hedge fund that bet on a crash for residential real estate by trading securities based on sub-prime mortgages to the least creditworthy borrowers. The investment bank, which Bass declines to identify, owned billions of dollars in mortgage-backed securities.
"Interesting presentation," Bass says the firm's chief risk officer said into his ear, his arm draped across Bass' shoulders.
"God, I hope you're wrong."
Within six months, Bass was right. Delinquencies of home loans made to people with poor credit reached record levels, and prices for the securities backed by these sub-prime mortgages plunged. The world's biggest financial institutions would write off more than US$80 billion ($103 billion) in sub-prime losses, while Bass, his allies and a handful of Wall St proprietary trading desks racked up billions in profits.
Bass and investors like him saw opportunity in a range of new investment tools that banks created to sell sub-prime securities worldwide. These included mortgage bond derivatives, contracts whose values are derived from packages of home loans and are used to hedge risk or for speculation. The vehicles allowed hedge funds like Bass' to bet against particular pools of mortgages.
The new sub-prime derivatives amplified the risks of the underlying mortgages, and now investors are reaping the consequences.
Bass, a former salesman for Bear Stearns and Legg Mason, had struck out on his own in early 2006. He started Hayman Capital Partners, specialising in corporate turnarounds, restructurings and mortgages.
He drove a US$200,000 500-horsepower Porsche Ruf RTurbo with a built-in racecar-style crash cage.
A former competitive diver who had put himself through Texas Christian University in Fort Worth partly on an athletic scholarship, Bass was about to take his most ambitious plunge yet: betting home values would decline for the first time since the Great Depression.
"We were saying that there were going to be US$1 trillion in loans in trouble," Bass says. "That had really never happened before. You had to have an imagination to believe us."
Other early converts were Mark Hart of Corriente Capital Management in Fort Worth, Texas, and Alan Fournier of Pennant Capital in Chatham, New Jersey. In his earlier sales jobs, Bass had sold securities to Fournier. Now the two joined forces to research bad loans.
On the other side of their trades would be investors chasing the high yields from securities based on sub-prime loans. This group included Wall St firms, German and Japanese banks and US and foreign pension funds. They were reassured by the securities' investment-grade ratings, even as foreclosures started in some parts of the US. The traditional way for a speculator to wager against, or short, the housing market was to sell the stocks of major home-building companies with borrowed money and repurchase them for a lower price if the shares fell.
Bass had tried that strategy in the past and found there were limits on its effectiveness, he says. There was always a danger that a leveraged buyout firm would bid for the home-building company and cause the stock to rise, which would cost anyone shorting the stock money.
The new, standardised mortgage bond derivative contracts created a strategy with less risk and greater profit potential.
To learn about the contracts, Bass visited Wall St trading desks and mortgage servicers. He met housing lenders and hedge fund analysts. He read Yale Professor Frank Fabozzi's book on mortgage-backed securities, Collateralised Debt Obligations: Structures and Analysis. Twice. "What I didn't understand was the synthetic marketplace," Bass says.
"When someone explained to me that it was a synthetic CDO that takes the other side of my trade, it took me a month to understand what the hell was going on." Bass and Fournier hired private detectives, searched news reports, asked Wall St underwriters which mortgage companies' loans were at risk of default and called those lenders directly.
In this blizzard of research, Bass turned up the California mortgage lender Quick Loan Funding and its proprietor, Daniel Sadek.
The hedge fund traders learned from a news account that Sadek was dating a soap opera actress, Nadia Bjorlin, and using profits from his mortgage company to fund a movie about car racing, in which she starred.
"When they started catapulting Porsche Carrera GTs and he says, 'What the hell, what are a couple of cars being thrown around?' I'm thinking, 'That's the guy you want to bet against'," Bass says.
Bass called Quick Loan Funding directly. He says he got on the phone with a senior loan officer, identified himself and said he was interested in the mortgage business. As Bass tells it, the conversation sealed his determination to short Quick Loan's mortgages.
Armed with their understanding of the loans they wanted to short and a plan for doing so, Bass, Fournier and Hart hit the road, making pitches to potential investors that the market was about to collapse.
"My biggest fear was that it was going to happen before I could get the money," Bass says.
One of Bass' first investors was Aaron Kozmetsky, a Dallas investor with whom he already had a business relationship.
While Kozmetsky had invested in almost every venture Bass had ever offered, this time Bass put a note of urgency into his pitch.
"It was the first time he's said, 'Drop what you're doing. You need to meet with me on this. Make time for me'," Kozmetsky says. Kozmetsky invested more than US$1 million.
Bass and Fournier focused on single-name mortgage bond derivatives to be more certain that their bets were right. Both bought only securities rated BBB and BBB-, rather than AAA rated securities, expecting them to pay off more quickly.
Bass says he raised about US$110 million and used the leveraging effect of derivatives to sell short about US$1.2 billion of sub-prime securities.
Two-thirds of it was based on BBB rated mortgage instruments, some involving Sadek's loans. One was Nomura Home Equity Loan 2006-HE2 M8, an instrument based 37 per cent on loans issued by Quick Loan Funding.
The remaining third of Bass' investment involved securities rated one grade lower, BBB-, some also incorporating Quick Loan Funding mortgages.
As Bass and Fournier executed their trades in August and September 2006, foreclosures were beginning to spread across the US.
"This is the fat pitch," Bass says. "This is the once-in-a-lifetime, low-risk, incredibly high-reward scenario where we're going to be right."
In January, Bass decided he needed "to meet the enemy" by going to the American Securitisation Forum convention in Las Vegas and listening to presentations from managers of the synthetic collateralised debt obligations that took the other side of his trades. "I came away relieved," Bass says. "They said, 'We know what we're doing. We've been doing it for 10 years. Our models are robust'."
In May, two independent researchers, Joshua Rosner of Graham Fisher & Co and Joseph Mason of Drexel University, concluded in an 84-page study that the US ratings companies Standard & Poor's, Moody's and Fitch had been wrong to bless billions of dollars of mortgage securities with AAA and BBB ratings.
After a May 3 presentation at the Hudson Institute in Washington, Rosner stood on K Street and lit up an American Spirit cigarette.
"The ratings are just wrong," Rosner says. "Completely wrong."
For Bass and Fournier, it was validation of their trading strategy. As investors worldwide began to panic, Bass and Fournier watched the values of their short positions soar.
- BLOOMBERG
