KEY POINTS:
Representatives of five of Wall St's dominant investment banks gathered around a blond wood conference table on a February night almost three years ago.
Their talks over Chinese takeaways led to the perfect formula for a United States housing collapse.
The host was Greg Lippmann, then 36, a fast-talking Deutsche Bank AG trader who aspired to make mortgage securities as big a cash cow for Wall St as the US$12 trillion ($15.58 trillion) corporate credit market.
His allies included 34-year-old Rajiv Kamilla, a trader at Goldman Sachs Group with a background in nuclear physics, and Todd Kushman, 32, who led a contingent from Bear Stearns. Representatives from Citigroup and JPMorgan Chase were also invited.
Almost 50 traders and lawyers showed up for the first meeting at Deutsche Bank's Wall St office to help to set the trading rules and design the new product.
"To tell you the truth, it's not very glamorous," Lippmann says. "Just a bunch of guys eating Chinese discussing legal arcana."
Those meetings of the "group of five", as the traders called themselves, became a turning point in the history of Wall St and the global economy.
The new standardised contracts they created would allow firms to protect themselves from the risks of sub-prime mortgages, enable speculators to bet against the US housing market, and help to meet demand from institutional investors for the high yields of loans to homeowners with poor credit.
The tools also magnified losses so much that a small number of defaulting sub-prime borrowers could devastate securities held by banks and pension funds globally, freeze corporate lending, and bring the world's credit markets to a standstill.
For a while, the sub-prime boom enriched investment bankers, lenders, brokers, investors, realtors and credit-rating companies. It allowed hundreds of thousands of Americans to buy homes they never believed they could afford.
It later became clear that these homeowners couldn't keep up with their payments. Defaults on sub-prime mortgages have so far produced about US$80 billion in losses on securities backed by them. The market for the instruments is so opaque that many firms still aren't sure how much they've lost.
Chief executives at Citigroup, Merrill Lynch and UBS AG were replaced. To forestall a housing-led recession, the Federal Reserve has cut its benchmark rate three times since August and is injecting as much as US$40 billion into the credit system to encourage banks to lend to each other.
This is the story of how Wall St transmitted the practices of southern California's go-go lending industry and the inflated US real estate market to the global financial system:
* In Orange County, California, a mortgage lender named Daniel Sadek was among those who took notice of the increase in Wall St's appetite for sub-prime loans. He turned the staff at his firm, Quick Loan Funding, into a sub-prime mortgage factory. "You can't wait," said his ads, aimed at high-risk borrowers. "We won't let you."
* In Dallas, a hedge-fund manager named Kyle Bass taught himself to use the contracts pioneered by Lippmann's group, then went looking for mortgage-backed securities to bet against. He found them in instruments based on loans Sadek made.
* In New York, the ratings companies Standard & Poor's, Moody's Investors Service and Fitch Ratings put their stamp of approval on securities backed by loans to people who couldn't afford them. They used historical data to grade the securities and didn't adjust quickly enough for the widespread weakening of criteria used to qualify high-risk borrowers. Among the securities on which they bestowed investment-grade ratings: those backed by Sadek's loans.
Lippmann was a Wall St renaissance man, with a strong appetite for sushi and an online restaurant guide so comprehensive one blogger labelled him "the Robert Parker of raw fish". He opened the kitchen of the US$2.3-million Manhattan loft he lived in then to an Italian cooking class.
The goal of Lippmann's group that evening in 2005: to design a new financial product that would standardise mortgage-backed securities, including those based on high-yield sub-prime loans, paving the way for their rapid growth. Of the firms involved that night, Lippmann's Deutsche Bank is based in Frankfurt, UBS in Zurich and the others in New York.
In February 2005, pension funds, banks and hedge funds owned fixed-income securities that were earning returns close to historic lows. AAA-rated securities based on home loans offered yields averaging a full percentage point higher than 10-year Treasuries at the time, says Merrill.
The trouble was that most creditworthy borrowers had already refinanced their houses at 2003's record-low mortgage rates. To meet demand for mortgage-backed securities, Wall St had to find a new source of loans. Those still available mainly involved sub-prime borrowers, who paid higher rates because they were seen as credit risks.
While the group of five banks had packaged billions of dollars in sub-prime-based securities, in February 2005 none was among the leaders in the home-equity bond business. Countrywide Securities, RBS Greenwich Capital Markets, Lehman Brothers Holdings, Credit Suisse Group and Morgan Stanley dominated the industry.
The banks wanted more mortgage-backed securities to sell to clients. Creating a standardised "synthetic" instrument, or derivative, would leverage small numbers of sub-prime mortgages into bigger securities. In this way, the firms could produce enough to meet global demand.
"We called up the guys we felt like we knew and could work with," Lippmann says.
So the traders and lawyers sat down to design a new product and create what would soon become one of the world's hottest capital markets.
The meetings were monthly, at 5pm, and lasted three hours or more.
"In the beginning, everybody brought their lawyer," says Lippmann.
The group sought to bring "transparency", or openness, and "liquidity", or trading volume sufficient to ensure ease of buying and selling, to the mortgage market.
The most important issues centred on how to account for the eccentricities of mortgage bonds, perhaps the hardest Wall St securities to value. Unlike corporate bonds, home loans can be paid back at any time.
Traditionally, the best mortgage traders have been those who can read macroeconomic trends to guess when homeowners will prepay their loans. Until recently, early repayment was perceived as the biggest risk faced by Wall St's mortgage desks.
One concern with creating a standardised contract for mortgage-backed securities was that it was difficult to agree on a simple method of determining how market-changing events affected the values of the complicated, layered instruments.
To deal with the complexity, the group of five decided on a "pay-as-you-go" system. When something happened affecting the cash flows underlying the security, the seller would have to make cash payments to the buyer immediately, and vice versa.
As the group nailed down the details, the International Swaps and Derivatives Association, which sets trading terms for dealers, arranged conference calls that included more of Wall St.
To this point, some of the biggest mortgage underwriters - Lehman Brothers, Merrill, Bank of America Corp. and Morgan Stanley - hadn't been included in the negotiations. These firms heard about the talks and demanded to be let in.
On the conference calls, which included the market leaders, things got testy. One point in dispute was whether the contract should be traded on the basis of price or yield.
"Some of those points of detail were getting a little heated on the calls, and it was just thought it would be better to have a meeting face to face to move beyond those points," says Edward Murray, a London-based partner of the international law firm of Allen & Overy who was the chairman of the meeting and the outside counsel for ISDA. "To be frank, the dealers that were not in the group of five were not that happy that there was a group of five."
ISDA sought to resolve the differences by calling a sit-down meeting at its New York headquarters.
"Rajiv would say something, and I'd be absolutely convinced about what he said," Murray says. "And then Todd would say, 'Well, I don't agree.' And I would be absolutely convinced about what Todd said. And then Rajiv would say, 'Well, the reason you're wrong is' and so on."
Kamilla and Kushman declined to discuss the negotiations.
Michael Edman, one of Morgan Stanley's representatives at the ISDA conference, was less chipper, Murray says. "Arms folded, frown on his face ... There wasn't any shouting or anything, but the talk was very firm."
Edman, no longer at Morgan Stanley, declined to comment.
By June, the differences were sorted out, the new contract was endorsed, and banks that hadn't been party to the group of five negotiations signed on. The banks would go on to create similar derivative contracts to trade securities backed by loans for commercial buildings and collateralised debt obligations, or CDOs, which are securities backed by various kinds of debt.
Another necessary step was to create an index to represent the market and help to hedge general market exposure. It was called the ABX-HE and would be similar to the indexes traders use for baskets of stocks. This, participants believed, would add to the market's liquidity, or depth, by attracting more trading.
By September 2005, some within Deutsche Bank were beginning to worry about defaults on sub-prime mortgages and how that might affect the securities based on them. Deutsche Bank analysts warned of growing sub-prime market risks.
The ABX-HE index started trading on January 19, 2006. At 8am on the first day, John Kane of Sorin Capital started phoning dealers. Kane, then 27, was a trader at Sorin, which runs hedge funds that invest in mortgages and other securities.
His car mechanic, in describing the debt burden he was carrying to own a home, had planted the idea in Kane's mind that the housing market might be in trouble. Kane thought it through, ran an analysis on available data, and decided to wager against, or "short," sub-prime. To do that, he turned to the portion of the ABX index dealing with the lowest investment-grade sub-prime securities.
The trouble was that quotes from brokers selling the ABX were already dropping, indicating several investors wanted to do the same thing.
"All the other dealers were already scared" and dropping their bids, Kane said in November. "All but Goldman. So I bought from them."
On its first day, the index traded more than US$5 billion.
The cost of wagering against the securities was rising. An early warning was visible to anyone who knew where to look.
The new derivatives were a hit among the group of five's customers - the banks and other institutional investors that bought them to lock in high yields.
In the months to come, Deutsche Bank and at least one other member of the group of five, Goldman Sachs, began using sub-prime derivative contracts to bet the other way and guard against the possibility that sub-prime mortgages might default.
Lippmann says he didn't have "any secret knowledge" of the damaging events about to unfold in the US housing market. Rather, he says, he thought the risks of a downturn were significant enough to justify the millions of dollars it would cost to "short" sub-prime securities.
He says he told his bosses: "If we're right, we're looking at a sixfold gain. And since a housing market slowdown is not as big a long shot as that, we should take the risk."
Lippmann disputes that the derivatives the group of five helped to create - which banks packaged into CDOs - caused the sub-prime crisis.
"Derivatives enabled more CDOs to be created and the stakes to be bigger. But the transparency made people realise the problem faster."
Others see things differently. Rod Dubitsky, director of asset-backed research for Credit Suisse, says derivatives are "like wearing a seatbelt that allows you to drive faster ... No question, it changed the game dramatically".
High stakes game of home loan finance
One week in 2002, Daniel Sadek was US$6000 ($7800) short of covering the payroll for his new sub-prime mortgage company, Quick Loan Funding Corporation. So he flew to Las Vegas and put a US$5000 chip on the blackjack table.
"I could have borrowed the money, I suppose," Sadek says.
That wouldn't have been his style. With his shoulder-length hair and beard, torn jeans and T-shirts with slogans such as "Where is God?" Sadek looked more like a guitarist for Guns N'Roses than a mortgage banker.
Sadek says he was dealt a jack, then an ace. Blackjack. He would make payroll. Quick Loan Funding, based in Costa Mesa, California, would survive and, for a while, prosper as one of 1300 mortgage lenders in the state vying to satisfy Wall Street's thirst for sub-prime debt.
As home prices rose and hunger for high-yield investments grew, Sadek found his niche, pushing mortgages to borrowers with poor credit. Such sub-prime home loans grew to US$600 billion, or 21 per cent, of all US mortgages last year from US$160 billion, or 7 per cent, in 2001, according to Inside Mortgage Finance, an industry newsletter. Banks drove that growth because they could bundle sub-prime loans into securities, parts of which paid interest as much as 3 percentage points higher than 10-year Treasury notes.
"I never made a loan that Wall Street wouldn't buy," Sadek says. He worked hard to build the business, he says, and the company did nothing illegal.
In 2005 and 2006, New York bankers expanded the market for mortgage-backed securities by creating new sub-prime derivatives contracts.
The derivatives allowed Wall Street firms to sell more sub-prime securities and offered a new way to bet against the US housing market. Investors from Germany to Japan poured about US$1.2 trillion into mortgage-backed securities in those two years, according to Global Insight, an investment research firm in Waltham, Massachusetts.
Now the US economy is paying the bill for that easy credit. Nearly one in six sub-prime borrowers has missed a monthly payment, sending home prices to their first annual decline since the Great Depression.
The Federal Reserve cut its main interest rate three times to fend off recession, and Wall Street firms that posted record profits for the last three years have written down more than a combined $80 billion on sub-prime-related losses.
Sadek, now 39, got into the lending business in 2002, just as home prices were in the early stages of a record five-year surge.
Staked by banks including Citigroup, Sadek and others in his industry tripled the sub-prime market in five years.
"I was working every day, all day, from dusk to dusk," says Sadek, who pumped gas and sold cars before creating Quick Loan Funding. "I slept in my office sometimes. I worked about 80 or 90 hours a week."
- Bloomberg
