Paulson Denies Culpability in Crisis, Yet Even Bear Turned Down His Deals

The release of the first batch of FCIC interview reveals interesting finger-pointing among some of the major players. We’ve argued (and in ECONNED, provided a considerable amount of supporting analysis) that the subprime shorts drove the demand for bad mortgages. There is no other explanation for the explosion of demand for “spready,” meaning bad, mortgages that started in the third quarter of 2005. As Tom Adams and I describe in a recent post:

Signs of recklessness were more visible in 2004 and 2005, to the point were Sabeth Siddique of the Federal Reserve Board, who conducted a survey of mortgage loan quality in late 2005, found the results to be “very alarming”.

So why, with the trouble obvious in the 2005 time frame, did the market create even worse loans in late 2005 through the beginning of the meltdown, in mid 2007, even as demand for better mortgage loans was waning? It’s critical to recognize that this is an unheard of pattern. Normally, when interest rates rise (and the Fed had begun tightening), appetite for the weakest loans falls first; the highest quality credits continue to be sought by lenders, albeit on somewhat less favorable terms to the borrowers than before.

In other words: who wanted bad loans?

Had the FCIC report bothered to connect the dots raised by this simple question, it could have actually contributed something.

By blaming regulators (and the rating agencies), the report makes it seem as if it was just about what the lenders could get away with. But that same argument could be applied to any credit market, yet the US mortgage market was rife with remarkably crappy loans. And lenders still would suffer negative consequences for selling a bad product, even if they could get away with it for a while, such as loss of reputation due to inferior deal performance, losses on retained interests, and poor pricing for the drecky mortgages.

Along a similar line, the report notes that bonuses skyrocketed for the industry during the bubble years. Where did this money come from? Why had the mortgage industry never before generated such high compensation?

The obvious answer is that good loans did not generate hugely excessive bonuses, but bad loans did.

What happened is that the benefits for originating bad loans exceeded the cost of these negative consequences – someone was paying enough more for bad loans to overwhelm the normal economic incentives to resist such bad underwriting.

The best example of this is John Paulson, who earned nearly $20 billion for his fund shorting subprime. This amount of money was not ever possible or conceivable in the mortgage business prior to that point. The only way it could occur was through the creation of a tremendous number of bad loans, followed by a bet against them. Betting on good loans could never generate this much gain.

Given the massive amount of money earned by betting on bad loans, the logical next step is to ask, how did such incentives affect and distort the market?…..

You can read the explanation of the mechanisms here.

Yet the narrative of the subprime shorts as good guys still gets undue deference, particularly in the mainstream media. Bloomberg took note of the Paulson version of history in his interview with the FCIC but neglected to consider the account of Scott Eichel, who was head of credit trading at Bear in 2002 and co-head of the mortgage department in 2007.

First the Bloomberg report:

“The Federal Reserve did have oversight for the mortgage area, and there was very little oversight given in the mortgage area,” Paulson said in an October 2010 interview released today by the Financial Crisis Inquiry Commission on its website. “Demanding that proper underwriting guidelines be followed, not allowing ‘no doc’ loans, requiring a down payment, even if it’s just 5 percent,” would have gone a long way toward preventing the crisis…

Paulson said his firm researched the mortgage markets in 2005 and early 2006 and found subprime loans had “no underwriting standards at all.” Mortgages underwritten in 2006 were inferior to those from earlier periods, he said.

“None of this made any sense to us,” Paulson, 55, said, recounting his experience obtaining three mortgages before the housing boom. “When I purchased my home it was very strict underwriting standards. I had to provide two pay stubs, two years tax returns, three months of bank statements, all sorts of credit card information.”

Now consider the Eichel discussion. Bear was far from a paragon of virtue, yet the subprime short strategy did not pass its smell test.

The interview makes clear that when Eichel met with Paulson’s team, they wanted Bear’s help to select the worst possible deals or they would select the worst possible deals.

Eichel said he believed their business was built around the long side of the market: everybody hopes the deal does well. In this case, Paulson was a new type of counterparty that wanted to deal to do poorly.

Eichel rejected the Paulson deals out of hand after the second meeting.

He also discussed the fact that on any synthetic deal, there is a short side but there is also CDO manager who’s job it is to pick the best possible asset, so that’s why Bear was comfortable with such deals. Bear didn’t love synthetic CDOs and did not see them as part of their core business practice. It tended ended to stay with same managers and issuers.

Eichel turned down every short seller who wanted the Paulson type of deal including the Morgan Stanley prop desk and Magnetar.

Note that this ins’t news; the Greg Zuckerberg book, The Greatest Trade Ever, also reported that Bear turned down Paulson down because they had reservations about the propriety of his strategy.

Tom Adams also points out that analyses of this period typically fail to chronicle accurately the deterioration of underwriting standards. One particularly amusing study is by the St. Louis Fed, which argues that subprime lending standards tightened prior to the crisis. The error in its reasoning is in plain view. It notes:

An important feature of the subprime market during 2000-2006 was the significant growth in the proportion of originations with lower documentation and higher loan-to-value ratios (LTV). There is a clear trend of a decline in underwriting standards along these dimensions.

It nevertheless attempts to do a “multidimensional analysis” which evidently gives heavy weight to FICO (how “multidimensional” can an analysis be on a low doc/no doc loan?). As Tom Adams notes:

FICO is not a terribly accurate predictor of performance for a subprime mortgage – FICO scoring only became widespread after 1999 and there was very little analysis available for its long term predictive ability for much larger loan balances than autos or credit cards. However, despite lack of sufficient data, years of true underwriting standards, such as debt to income, LTV, months of reserve, payment stubs and tax returns, were abandoned in favor of using FICO as the underwriting tool. As a note – subprime auto lenders used detailed scorecards for their borrowers, but FICO was not the primary component of their scoring. Other factors were deemed more important. These transactions have held up much better than subprime mortgages and they were on depreciating assets (which is why, of course, lenders had to be more careful).

Also, the authors get the analysis of purchase vs. refinance wrong. With prime mortgages, purchase loans tend to perform better. However, subprime loans were traditionally refinance loans (usually cash out). In the early days, subprime lenders were fairly careful about who they lent to – their target market was people who had been in their homes for at least 5 years, had stable jobs and work history (and were able to document their income with tax returns etc, even if self employed), had equity and had encountered a financial difficulty – thus, the need for more cash. In the mid-2000s, the new target market became first time home buyers who had very little credit history (thus, making FICO score an even worse predictor, since it was based on “thin files”), had no money for down payments (thus, piggy back seconds) and a short job history. Basically, purchases were bad in subprime lending and had generally been avoided in the early days.

Moreover, many lenders gamed labels like subprime and alt A. We had to create our own definitions. Also, many lenders provided poor information regarding documentation – each lender had its own marketing names for their documentation programs,so there was no uniform standard of what “limited documentation” looked like. This also presented an opportunity for lenders to game the system (and lenders like Countrywide were the worst abusers). DTI was also very inconsistent.

This serves to illustrate that many conventional analyses even now tend to miss the dramatic deterioration in underwriting standards. The use of low and no doc loans rose rapidly from 2004 onward, and these pools were particularly favored by the subprime shorts. Moreover, we now know how some aspects of the underwriting were abused, for instance, by the use of inflated appraisals, so analyzing historical data will not provide a full measure of the fall in underwriting standards.

Yet digging into the comfortable narrative of the subprime shorts as heros, or at least harmless, would reveal yet another viper’s nest of bad practices and abuses. The officialdom seems determined to push onward with its “look forward, not back” stance, which means the perps will be able to engage in similar types of looting when the opportunity next presents itself.

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    1. Michel Delving

      Before charging full steam ahead under assumption that these were all “bad loans” from the get go, it is worth taking a look at “bad mortgage servicing”.
      Mortgage servicing fraud was a toxic ingredient in this brew. Ripped off monoliner insurers are now alleging such in litigation. ABACUS 2007-AC1 prospectus contains multiple risk disclosures relating to servicer’s failure to perform. Countrywide and Select Portfolio Servicing serviced 16% of the reference collateral in ABACUS 2007-AC1, both having settled FTC servicing fraud complaints. In addition to C-Wide and SPS, the other 14 servicers in this CDO have long servicing fraud rap sheets as well. What begs to be asked is what did Paulson along with certain prop traders know about ongoing servicer malfeasance? Servicing fraud didn’t happen in a vacuum all by itself. It greatly increased default levels in which subprime shorts profited mightily.

  1. nonclassical understanding is, Bushit Treasury Secretary Henry Paulson went to SEC to DEREGULATE “leverage” in 2005 or 2006. This led to abilities by “investment banks” to BORROW much, much more against collateral=”securitized mortgages”..Lehman at also escalated, provided auspices for Goldman-Sachs driving market the other way.

    I still want to know (I asked Yves on FCIC blog, now mentioned in Frank Rich’s latest Sunday NY TIMES) about “investment banks” secreting away all this bad paper debt, and how they are leaking it slowly out at closer to full value than they could, if it was audited-forced out..

    I know Texas Republi$$K$$an Senator Phil Gramm slid a flyer
    in late Clinton legislation illegalizing bank audits!?!..(Gramm’s wife rewarded with seat on board of Enron)

    1. Yves Smith Post author

      This is the hedge fund manager and famed subprime short John Paulson, not the Treasury Secretary Henry Paulson. The post clearly says “John Paulson”. Henry Paulson was not trying to do trades with Bear in 2005 :-)

      1. moopheus

        Actually, this is only at the end of the lengthy quote of your previous post. It is initially confusing which Paulson is being referred to. It would have been much less so if you’d put the name in the headline.

        1. norcalwindows

          Moo – if you know anything at all about this issue (considering you are on the blog AND making comments, you probably should know H. Paulson had nothing to do with shorting any of the mbs’ vehicles in the oughts, nor did he gain ANY notoriety whatsoever for any major investing gains in shorting said instruments) its pretty clear who Yves is talking about…quit whining and start reading, m’kay?

          1. Cedric Regula

            I’ll weigh in and try and help Yves too. I first got over my Paulson confusion when CNBC made the transition from telling us about stock symbols, then to CDOs and CDSi, to finally trying to spell ABACUS for us but then thankfully
            just aired the congressional hearings.

            Hank did the TARP thing.

  2. Slade Smith

    The flawed logic of the article, summarized by the title, is this: Bear Stearns turned down Paulson’s housing-related deals, therefore Paulson must have culpability in the housing crisis.

    The conclusion does not follow from the premise.

    To claim that Paulson has culpability in the housing crisis, you have to show that what Paulson did was in fact improper, not just that some Bear Stearns person thought it was improper, because they maybe they were wrong– or maybe they didn’t really think it was improper and are just saying so now to make themselves look better in all this. Even if we accept the Bear Stears claims as credible, what Bear Stearns thought of the deals is really irrelevant toward proving the effect those types of deals had toward causing the housing crisis.

    Then you would have to show that whatever improper thing Paulson did, whatever it was, was responsible for increasing the demand for bad loans. You haven’t done that. It takes extraordinary evidence to make that claim, because short selling activity does not usually spur demand on the buy side. In the usual case, short selling itself often tends to have the opposite effect on driving demand for stock. Just look at how elevated levels of short selling affected demand for stock during 2008– buyers were afraid to catch the metaphorical falling knife.

    I followed the link and read the post that purported to provide evidence that Paulson had culpability in generating demand for bad mortgages. But I didn’t read anything which made a coherent case against Paulson.

    So what did Paulson himself do which was improper and how did that improper action create _demand_ for bad loans?

    1. Yves Smith Post author

      The post we linked to makes a very clear case. It describes how the actions of the subprime shorts overrode normal market signals and incentives. I have an even longer and far more detailed case in Ch. 9 of ECONNED, including calculating impact of the one short strategy on the RMBS market. If you don’t get it, quite honestly it’s because you are wedded to some other thesis, not that the case is not well supported. Other readers, including industry participants who were on CDO desks and in risk management positions in dealer banks, have confirmed our interpretation.

      And the Bear data point does provide support. Bear cared about the long investors and recognized the Paulson strategy as destructive to mortgage bond investors. Funny you seem unable to get that.

      1. jake chase

        Your analysis does consistently exonerate institutions on the buy side of these bad mortgages and the CDS contracts constructed around them. I don’t see how the fact that someone wanted CDS protection against a wave of mortgage defaults provided an excuse for the idiots who were selling it in their capacity as managers of other people’s money.

        The oldest truism in the investment game is that more money has been lost chasing yield than at the point of a gun.

        1. Yves Smith Post author


          You’ve clearly never read my analysis. The parties on the other side of these CDO trades were to a significant degree NOT investors. For the AAA tranches was the Eurobanks and some of the US banks, for bonus gaming purposes. For the lower rated tranches, it was other CDOs (a Ponzi), correlation traders (who didn’t care about credit quality) and some isolated chumps (and this isn’t folks like IKB which stuck to AAA but real know nothings, quasi retail investors like Australian town counsels.

          Ex AIG, the monolines, IKB and the Bear hedge funds, there was not much in the way of investors in AAA CDOs post mid 2005. Real “cash” buyers (as in interested in CDOs made of actual bonds) had started to back off from the product in 2004. Had that continued, the subprime party would have ground to a halt. We would have had a S&L level crisis, not a global financial crisis. As we’ve indicated, the largely synthetic CDOs that became widespread in the 2005 onward period had a very limited audience, and mainly NOT investors.

          You complain, yet you fail to present a single fact to rebut the reasoning.

      2. Siggy

        The predicate for the subprime short lies in the perception that easy credit was creating an asset price bubble, namely house prices. Paulson shopped his trade and found GS. Now the subprime short process becomes a self expanding feedback loop and you have the crisis.

        Did Paulson’s short cause the crisis? I think not. I think Pauslon’s short was an expression of the crisis and an affirmation of the fact that gross maleintermediation of credit money was in progress.

        Did Paulson’s short make the crisis worse than it might otherwise have been? Possibly, but, if not Paulson then most assuredly someone else; e.g. Magnetar.

        Are Paulson, etal, responsible for the crisis? Indirectly they are indeed responsible. The larger and critical force was the fact of easy credit money being thrown into a sector. Any seasoned and thoughful entrepreneur would have judged the action of house prices as being unsustainable. The problem for that market participant was to devise a vehicle that would exploit the malallocation of credit money to housing; that is, how do you short house prices?

        The deviousness of the synthetic CDO was a lot like a casino reducing the payoff odds on its slot machines, or maybe adding 000 to the roulette wheel.

        For me the real issue is the tortious, if not fraudulent nature of the marketing of CDO deals. That coupled with the fact that we have so readily accepted the idea that a financial institution can be TBTF. That conceptual acceptance is the most profoundly disturbing aspect of the crisis.

        1. MichaelC

          I think your summary describes why it is so hard for folks to get their head around the key concept that this wasn’t your business as usual short strategy.

          In the normal case you’d short every piece of existing paper that you felt wouuld fail (as Michael Lewis’s heroes did). That was possible through CDS. Normally you would expect that ss the CDS prices increased,the bond prices would drop to reflect their poor quality. That’s the standard arbitrage proces, the key point underlying the efficient markets boosters proof that markets correct on their own.

          As the arbitrage opportunity disappears, demand for new bonds drops, and crappy lending dries up. That was the direction the markets were heading in pre 2006.

          But perversely, increased shorting drove increased lending.
          How is that possible?

          The heretofore normal arbitrage elimination process was broken, because the arbitrage was a regulatory arbitrage (actually a ratings/reality arbitrage) that couldn’t be eliminated till the ratings reflected reality. Absent that correction the new breed of shorts and their enablers (the magnetars, rather than the one-eyed short) were massively incented to create new supply (i.e crappy mortgae origination)to exploit that info asymetry, fob the resulting (highly rated) crap off on investors (or more accurately the “investors’ Yves identifies in her earlier repsonse), and count there winnings.

          The new breed are responsible for toxic phase. The toxic phase led to catastophic collapse. We should be focused primarily on the new breed’s actions. Full stop. Till we do we’re whistling past the graveyard.

          For example people are prohibited from setting up guaranteed to fail listed firms in order to simultaneously short them. (well, except for some of the dot coms perhap and maybe some of the structured deals JPM sold linked to Madoffs funds (felix Salmon has a piece on that).

          That’s would generally be recognized as fraud.


          1. monday1929

            Nicely put. Do you have any opinion on the size of the losses already extant and those to come in the 600 trillion dollars of remaining off-exchange derivatives?

          2. MichaelC

            Apologies for the awful spelling errors (touch screen Blackberry).

            I’d like to add externalities to the list of things to consider as underreported ,if you accept the Paulson/Magentar/+++other Hedge fund ( as described in the FCIC report) impact,

            Servicer volumes (boom+++)
            Fed by : ( see EConned, then ProPublica, then the nose on your face)
            Quality of servicer servicing (——)
            Corruption of fundamental dirt law (——–)
            Basic faith in rule of law (——–!!!)
            Destruction of key middle class asset- today(——–)
            Devastation of the market for that key Middle class asset (—————!)

            They’ve (our children) lost their inheritance (and their parents investment in their education plus their own retirement) to donate to the Paulson, et al (Soros (OMG really??) capriciousness. WTF???!!!

            Externality cost= post baby boomers (and their kid’s) lives will be devoted to rewarding the clever fuckers who willfully absconded with the present value of the next generation’s genius.

            And yet Yves’ team’s outing of the key defect (despite the explosive follow-up by ProPublica (who’ve been curiously quiet post FCIC ) is still ignored.

            Go figure

      3. Slade Smith

        Even if it is true that “Bear cared about the long investors and recognized the Paulson strategy as destructive to mortgage bond investors,” as you say, that’s not the same as somehow enhancing demand for bad mortgages– a very specific claim that you have made against Paulson. I have not read the book, so my apologies if it is all laid out in simple and straightforward terms in Chapter 9, but there’s nothing on the blog that coherently explains how this artificial enhancement of demand was generated by Paulson’s actions.

        I fully recognize that it’s possible that a short-seller, through some deception or manipulation, could manipulate a market higher (in this case by artificially raising demand for bad mortgages) to get a better entry point for a trade or for the purpose of enabling a bigger bet. But even Eichel said that “He [Paulson] had a bearish view and was very open about what he wanted to do, he was more up front than most of them.” So where is Paulson’s manipulation or deception in this?

        It was the dumb longs in the mortgage bond market who were generating the demand for bad mortgages. It was the dumb longs that failed to do their due diligence and notice all the fraud and lax underwriting, or didn’t care because they felt that housing values would continue to rise, keeping defaults rare and not that costly when they occurred. Yes, I’m wedded to that theory.

        Short-selling was inherently hostile to those longs. The appearance of folks like Paulson represented the beginning of the end for the madness. Paulson merely sought out vehicles to short sell in a forthright manner, according to the accounts of people who have no motive to protect him or his reputation, like Eichel. He has no more culpability in the crisis than those who shorted the NASDAQ in 2000 had in the tech “crash”. If anything, folks like Paulson helped pop the bubble before it further got out of hand and led to a worse crash.

        1. Yves Smith Post author

          You admit you haven’t looked at the evidence, yet you continue to cavil. The argument is set forth in the book and to a lesser degree on this blog.

          You have failed to present an alternate explanation. The burden to explain what happened is on you. Tell me why demand for bad mortgages soared, and not just any bad mortgages, but the very worst, as demand for prime was falling? Lew Ranieri has stressed how abnormal this change was, and how dramatic the uptick in demand for bad mortgages was.

          Yet the spreads on the BBB bonds got tighter! The pipeline was screaming for product!

          Traditional buyers were NOT buying this stuff, and certainly not in increased volumes. So who was?

          Every mortgage conference, and I mean EVERY ONE from 2004 onward had a worried panel about subprime. Traditional buyers of cash AAA bonds had started to get jittery. More important, it was necessary to place the lower tranches. The pipeline would shut down if there were no lower tranche buyers, dealers did not want to be stuck with the inventory. AAA buyers looked to lower tranche buyers as canaries in the coalmine. If they started backing off, that was their signal to stop buying. The lower tranche buyers were the ones really at risk.

          And BTW, the AAA bonds through 2004 and even per current ABX spreads, all look to be money good. The only ones that might be impaired is the fourth and fifth (of five) AAA tranches of first half 2006 bonds, which would be second half of 2005 mortgages (second half 2006 and 2007 are another story). So the AAA BOND buyers didn’t get toasted as badly as you imply (they have taken MTM losses because the bonds are no longer AAA). It was the CDO buyers who took it in the chest.

          And you clearly do not have the foggiest idea how CDS and CDOs made of CDS work. This bears no resemblance to shorting stocks. I don’t have a problem with shorting stocks and I do, big time, with CDS.

          1. Karen

            Is everyone guessing who actually bought the mezzanine tranches, and who bought the senior tranches, of the junky CDOs created after 2005 – or are there records that show this information?

            Is there proof (documentary evidence) that John Paulson bought all the mezzanine CDO that he then bought CDS against, so there was no need for a chump long investor to make the deal happen?

            In the SEC’s lawsuit against Goldman Sachs over their Abacus CDO, it appears the junky CDO was sold to a chump German bank, not to John Paulson himself.

            Beyond that one example, I have no knowledge about this. I have the impression that everyone is just guessing, and there are no publicly-accessible records of who actually bought this stuff. Am I right about that, or wrong?

          2. Yves Smith Post author


            Paulson and his aides discussed their subprime short strategy at length to Greg Zuckerberg, and it’s all in his book, even at points down to the prices he was buying the CDS at. The book describes how he approached various firms (Bear included, as separately confirmed by Eichel) that he wanted to create CDOs that were designed to fail. Zuckerberg said he created about $5 billion of CDOs. Some of the CDS he bought were ABX index shorts, but given the size of his positions, he would have blown spreads out if he did much that way. The New York Times has reported that Goldman sold some CDS out of its Abacus program to Paulson. Magentar did not use all the CDS created by its very large program, it’s likely that Paulson picked up some of the CDS they did not take down (note Paulson took down the entire short side of the CDOs he created, Magnetar took down only a portion).

          3. Karen

            Thanks, Yves. If I’m understanding you right, though, John Paulson only bought CDS, not the CDOs he was betting against (and apparently helping to create).

            So we’re back to the question, who bought the junk CDOs, and who was holding them when they went south? Equally important, who sold the CDS to John Paulson and others like him, and why?

            No matter how much John Paulson wanted to make money by betting against CDOs, he couldn’t have made a dime without the willing participation of BOTH the buyers of bad CDOs AND the sellers of CDS on the bad CDOs.

            Seems to me that repairing the system to prevent a repeat performance requires understanding and repairing the motivational environment of those two key players (buyers of junk CDOs and sellers of CDS on the junk CDOs).

            Do you agree?

            Of course, I think it is extremely obvious that CDS should be completely banned. Traditional (well-regulated) bond insurance is the right vehicle for protecting bondholders against bond defaults. There are good reasons insurance is a regulated industry, after all!

          4. Yves Smith Post author


            No Paulson did create CDOs (which were a means for his to get CDS) as well as bought CDS directly. He claims to have invented the synthetic CDO, which is kinda funny (that product already existed in the corporate CDS market, it’s called a CLO, but it is a CDO too. Technically the right name for the CDOs we are discussing here are ABS CDOs, or “asset backed securities” CDOs).

            Paulson and folks like Magnetar would fund the equity of a CDO, which was typically 4-5% of the deal, and then take a much bigger short position than their equity long. You needed to get someone to fund the equity to create a CDO.

          5. Slade Smith


            Why is the burden on me to provide an alternative explanation? I have already provided possible one: namely, that there’s a lot of dumb money out there.

            As support for your position, you say that there were rampant worries about subprime, etc. but the fact is that in every market there are a lot of momentum folks who just follow price action. You’re looking for a logical reason for a pricing phenomenon you observed when there doesn’t necessarily have to be any underlying logical reason for it at all. Heck, the fact that people were clamoring to buy houses at 2005 prices didn’t make a whole lot of sense either, when they could have had the same houses a few years earlier at a fraction of the price.

            You are asking “traditional buyers were NOT buying this stuff, and certainly not in increased volumes. So who was?”… leaving the matter up in the air, as if Paulson perhaps was the buyer, when, as Karen points out below, we know that the buyers who took exposure to the lowest quality mortgages on the other side of Paulson’s trades were, in fact, traditional buyers such as banks.

            You did not include this inconvenient fact in your posts. Why did you not include the fact that, in the trade that we know the most about, the buyer of the exposure to the lowest quality mortgages was a bank, the kind of traditional buyer that you claim was not buying this stuff?

            Why did these traditional buyers place such bets on subprime? Presumably, they believed that the risks in the housing market were overstated and that the investments they made would rise in value, or they were engaged in some sort of hedging strategy. Perhaps they were deceived by those that sold the investment to them, as they have claimed. Does it really have to be any more complicated than that?

            Also, from my understanding, the synthetic CDOs were based on existing mortgages and did not require issuance of new bad mortgages. So how exactly did that part of Paulson’s strategy increase the market’s appetitie for bad mortgages?

          6. Karen

            Agreed, the CDO deals couldn’t have happened without someone buying the equity tranche. According to Satyajit Das’s book, “Traders, Guns and Money,” that was usually the investment bank that created the CDO, and was considered a cost of doing business which offset some percent of the fees they charged. I’m sure if John Paulson bought the equity instead, the investment bank might have been willing to do deals with somewhat slimmer fees than it would otherwise have demanded.

            But the CDO deals couldn’t have happened without buyers for the other 90-95% of the deal.

            As I understand it, buyers of ALL tranches are hurt if the courts determine there are no actual mortgages in the trusts. None of the buyers appears to have checked that the terms of their contracts were adhered to and the mortgages were properly transferred into the trusts in a bankruptcy-remote and tax-advantaged manner. Who were these buyers, and why were they so careless?

        2. Deus-DJ

          Slade…let me lay it out for you as Yves mentioned in ECONNED. If you want an explanation in a few sentences, then I have it for you. CDO’s are made of tranches. These CDO’s cannot be created if the riskiest portion of them(the equity tranche) is not bought by someone. Remember that.

          So why would someone be willing to buy that tranche that would almost surely lose money? Well…look at Magnetar…look at Paulson. How did they make their money? They bought the equity portion…which allowed the entire structure to be created. They then shorted whatever portion of the structure that they wanted, which made them much more money than the pennies they were throwing at buying the equity tranche. So what Paulson did was create more of these CDO’s(synthetic I believe) so that he was allowed to short something and make a lot of money.

          And blaming investors for something as fraudulent as this is idiocy. It’s a shame you weren’t one of the losers too…I’d like you to make as boastful a statement then. And you very well could have been, so don’t go there pal.

          1. Slade Smith

            Dues-DJ, you say “look at Magnetar…look at Paulson. How did they make their money? They bought the equity portion…which allowed the entire structure to be created. They then shorted whatever portion of the structure that they wanted, which made them much more money than the pennies they were throwing at buying the equity tranche.”

            Either other reputable sources I am reading are wrong, or you are wrong about the nature of Paulson’s deals. Paulson, according to the reports I am reading, was not engaged in transactions as you allege.

            Felix Salmon, for instance, wrote:

            “…if Magnetar really just wanted to go short subprime securities, it could have done so Paulson-style, without taking on the equity tranche at all.”


            Paulson != Magnetar. Do you have evidence that Paulson did what you claim he did?

  3. attempter

    It’s impossible that anyone within the MBS system didn’t know (or know in the sense of willfully avoiding full knowledge) all about the poor quality of these loans, that the bubble built upon them would certainly burst, and therefore that the MBS were fraudulent. (That’s just the fraud in the quality of the loans, which is in addition to the trust conveyance fraud.)

    So the only question is to what extent this criminal enterprise was fully planned out going back to the 90s, or to what extent the crimes were improvised and piled atop one another. It looks like the Paulson types were late-stage parasites on the whole venture (Goldman did the same thing; we see how they judged the top of the market better than Bear, though no doubt this shorting also helped bring about this topping), once the bubble’s collapse became imminent.

    One thing that’s beyond dispute is that the whole thing was set up for criminal purposes, to maximize fraudulent extractions in whatever way possible.

  4. bob

    Paulson sat down at a casino table that he knew was fixed, in his favor, and bet more than the casino could payout.

    How is this smart? How is it ethical when done with OPM?

    1. Daniel Plainview

      I don’t mind laymen asking questions or getting involved in the discussion, that’s very healthy, but let’s try to get our analogies straight here.

      It’s more like John Paulson saw a lot of crazy gamblers losing money at the casino, knew the crazy gamblers couldn’t make collateral as they doubled their bets, and bet that very soon the Casino would go bankrupt when the large number of crazy gamblers didn’t pay up. Some might say John Paulson was recruiting/scouting crazy gamblers to come in off the street into the casino

      Then in August 2009 after making hundreds of millions off the bankruptcies of the casinos, he bought some of those casinos at “discounted” (so he apparently believes) prices. Never let it be said Hebrews aren’t intelligent as hell (I’d say clever, sharp, or sly but then the “anti-Semite” screamers start coming in). John Paulson is Hebrew and educated in Hebrew schools.

      Make sure you take notes from here on.

        1. Daniel Plainview

          Jack Rip—
          You know sir I wouldn’t feel the need to answer annoying gnats like yourself if it wasn’t for to set the record straight. That fact is if someone in our society makes jokes about Irish people’s tendency to drink everyone chuckles it off and doesn’t make a second thought. But if someone compliments the intelligence of Hebrews, people like you and some Hebrews get excited because someone just sneezed in the same room you inhabit. Or maybe it just makes you feel “holier than thou”. I can’t explain where idiocy comes from. The FACT is in every country and in nearly every walk of life Jews rise to the top. If by RECOGNIZING THAT FACT that means I am an “anti-Semite” then take off the dunce cap you’re wearing, scribble “anti-Semite” on it and I’ll wear it.

          How John Paulson USES that intelligence, I’ll let OTHERS decide if that deters or reinforces existing stereotypes.

          1. offended jew


            I am deeply offended that you are allowing your comment section to be taken over by anti-semites. I do not think it is right to blame the Jews for this financial crisis. In fact they have no responsibility. If I had to choose one person the most responsible, it will be George Bush. Does that mean Christians evangelicans are responsible?

          2. Deus-DJ

            Dear Offended Jew:

            You would only flame the fans of “jews control everything” if Yves were to listen to you. Mr. Plainview’s views would thus become filled with more vitriol(if you want to call it that) towards your kind. Thus the proper response was to have said nothing and allowed this guy to say what he wants. To suggest this board is being filled with anti semites as a result of 1 poster is an insult to the moderator. The poster in question also was not suggesting that Jews caused the crisis…I mean seriously?

            In essence, I say to you: shut up crybaby.

          3. formais

            looking at the ownership of Magnetar, and the fact that Paulson and Soros are Jews, its kinda funny that offended Jew would state flat-out that:
            “I do not think it is right to blame the Jews for this financial crisis. In fact they have no responsibility. ”

            How can he make such an obviously false statement.

      1. bob

        I prefer the simple, accurate analogy that I made.

        Occam’s razor. No need for notes or racism, crooks are crooks.

        People like you who come out of nowhere, spouting opinion designed to redirect the discussion only helps TPTB.

        I will note, however, that you are part of the problem, and will take that knowledge forward.

  5. Daniel Plianview

    I like to give you a hard time sometimes, but this is one of your better posts. Here is one thing I would like to have your opinion on Yves (if you have given it before and I missed it, please excuse the hassle). It has been insinuated by more than one financial media outlet (I think left and right) that Mr. Philip Angelides was in WAAAAAAAAAAAAAAAAAAY over his head on this and did not have the credentials or knowledge base to do his job as Head of FCIC. And of course, if someone with the proper knowledge base HAD headed the FCIC it might have actually proved much more constructive.

    YVES—Do you share this view on Mr. Angelides???

    1. Yves Smith Post author

      I have not met Angelides, but your view comes pretty close to conventional wisdom. Even at the time the FCIC was established, he was seen as being not up to the task. His appointment as chief, and the composition of the commissioners generally (a dearth of hands on banking, and more important, credit market experience) was seen as a sign that the FCIC was set up to fail.

      He may have done better than expected, but that is still far short of what was called for. But the limited budget and unrealistic timetable were further huge obstacles.

      1. Daniel Plainview

        Speaking frankly YVES, for me the real kicker was when they put Peter Wallison on the FCIC panel. That’s where I knew the fix was in on the whole thing. Peter Wallison is a sham in my book. During C-Span coverage C-Span went from a camera shot of Warren Buffet directly to a camera shot of Peter Wallison and I wondered to myself at the time if in the history of recorded television there had ever been a larger drop off in IQ in succeeding camera shots of two people.

    2. attempter

      Any reasonably intelligent person who’s put even a modest effort into learning about all this can understand it perfectly well.

      So while I can believe Angelides is intellectually mediocre, still it’s not his intellect which was in question here. It was his integrity. His political courage and sense of morality. That’s what’s lacking even among the allegedly best intellects.

      I think we’ve had more than enough of the idea that we need to “understand” the intricacies here. These criminals on this panel understood the only thing they needed to understand: That they were supposed to whitewash the banks.

      The notion that there’s complexity and nuance involved in any of this is just meant to misdirect us into an infinite hall of mirrors and distract us from the overwhelming fact of history’s worst robbery.

  6. Superduperdave

    Yves, I second the first comment: You are a treasure.

    Even were your analysis somehow proved to be flawed, the ultimate explanation has to start by showing that this time it really was different, that the economic logic was turned on its head, i.e., that underwriting standards got WORSE as conditions deteriorated. Blaming it on Freddie, Fannie, the Fed or the SEC doesn’t do it.

  7. rps

    I believe that Dr. Michael Burry of Scion Capital was the visionary not Paulson. Vanity Fair’s Betting on the Blind Side details Burry buying credit-default swaps on very specific tranches of subprime-mortgage bonds. “The only problem was that there was no such thing as a credit-default swap on a subprime-mortgage bond, not that he could see. He’d need to prod the big Wall Street firms to create them.” May 19, 2005, Mike Burry did his first subprime-mortgage deals prior to Gregg Lippman and Paulson.

    “As often as not, he(Burry) turned up what he called “ick” investments. In October 2001 he explained the concept in his letter to investors: “Ick investing means taking a special analytical interest in stocks that inspire a first reaction of ‘ick.’”

    1. Yves Smith Post author

      Burry was small scale and did not create CDOs, nor did he go around recruiting other shorts (Paulson per Zuckerberg told Soros about his trade, and Soros did a few billion).

      But Burry was remarkably uninquisitive about who was on the other side of his trade. The other small fund Lewis mentions (I forget their name, but they also tried alerting the SEC) actually did get worried if their bets would be any good an trying to figure out who their counterparties were.

  8. KenG

    Of course Bear turned down Paulson and every other short seller, they only drank their own kool-aid. They were so incredibly greedy that they kept wanting to buy bad mortgages, and would not want anyone to create any doubts about the safety of those mortgages and CDOs.

    I remember asking financial advisers in 2004 and 2005 how I could invest in something that would make money when millions of people defaulted on mortgages, because it seemed obvious to me that it was inevitable. Nobody told me about credit default swaps or any other way to bet on defaults, but had I known, I would have made the same bets. The fact that these short instruments were still available, let alone even more so than in 2005, in 2007, amazes me.

    What I would like to know is how did Paulson get people to continue to buy those obviously worthless CDOs? He was able to raise tens of billions of $$ betting on defaults, so obviously people were aware of those bets, and still continued to go long on insanely/incompetently/greedily/grossly negligently granted mortgages.

    1. KevinNYC

      Ken, individuals generally can’t buy credit default swaps. They are derivatives You need to have a special license to do it.

      Burry represented a fund, so he was able to get one, but it took some wrangling I believe. In Zuckerman’s book, he mentions a guy in LA who owned several hundred million in real estate was able to get one too. Burry actually tried to buy CDS on subprime mortgages before Wall Street was selling it. Eventually Wall Street created a standard contract for these.

  9. Birch

    This John Paulson thing reminds me of the old Mel Brooks movie The Producers. The technical details may be new, but the strategy is basically the same. Disgusting.

    BTW, what does FICO stand for?

    1. Obsvr-1

      Fair Isaac Corporation (NYSE: FICO) is a public company that provides analytics and decision making services—including credit scoring—intended to help financial services companies make complex, high-volume decisions

  10. Obsvr-1

    The only way that Paulson and others that used the “I select them to fail” then short them is corruption run amok on a scale that makes the mafia envious. He should be disgorged of the ill gotten gains and having lunch with Madoff.

    The single case that exposed this heist, the GS ($550m fine) ABACUS deal stinks so bad of fraud, but no real justice is done.

    If the masses could take the time to review all of the content, documents, interviews and public testimony there would be much more outrage and calls for prosecutorial action. But the brain washing from MSM continues to highlight Obama’s fairy tales, and Chief Cheerleader Geithner trumpeting the success of TARP in saving the economy from the abyss and “we actually are making a profit” meme. The greatest success of TARP for the administration is in covering up the Truth.

    Yves thanks for keeping this alive.

  11. Schofield

    For God’s sake. Why are some people failing to make the connection that you can’t earn big by shorting mortgage loans unless there’s a lot of manufactured “guaranteed to fail” mortgage loan product. So why wouldn’t there be a response to this type of market demand? Heck there’s a lot of demand for firework product that will blow itself up on the 4th July.

  12. Slade Smith

    By extension of your logic, the shorts who made a fortune after the tech bubble popped couldn’t have done so without “manufacturing” guaranteed-to-fail dot-coms like Webvan and Also, in order to “ear big,” shorts would have had to artificially generate demand for IPOs for these kinds of junk companies so that new stock would be created to be shorted.

    Of course that theory would require a suspension of the laws of supply and demand and a willful blindness to what actually occurred. Hard as it is to believe, there really was genuine demand for the shares of those junk companies that, if you truly looked at their business plans, were “guaranteed to fail.”

    Similarly, hard as it is to believe, there really was demand for exposure to even the “worst” mortgages in 2005 and even 2006. Why? Because lots of people believed that house prices would continue to rise. As long as house prices rose, they theorized, even most of the worst credit risks with the junkiest mortgages would make good on their mortgage, because they wouldn’t want to lose their newly generated equity, and, at worst, they would be able to refinance. If house prices had continued to rise, the riskiest bets– the bets on the worst mortgages– would have paid off the most.

    So, you’re just not correct. To earn big, it was only necessary that there exist bad mortgage loans and a means to short them. Both in theory and in fact, bad mortgages did not have to be “manufactred” by the shorts for shorts to make money, so long as there was demand for the bad mortgages, which, as I have said above, I believe there was. In Paulson’s case in particular, in the trades that he’s gotten the most criticism over, we *know* there was demand for even the worst stuff because we know the buyers by name, thanks to lawsuits.

  13. Schofield

    Why does this have to be an either/or explanation for the reason for the demand for crappy mortgages? Why can’t it be twin or both? Or more precisely two forms of faith operating. One that the market will continue to inflate and the other it will start to deflate with re-setting interest rates followed by a cumulative bursting of the bubble. The result two faiths merged under one bond with the first faith artificially reinforced by the bond rating tagged to it.

    1. Slade Smith

      There doesn’t have to be an either/or explanation, but that doesn’t mean we should accept an explanation that doesn’t make much sense and has little evidence to back it up.

      In this case, Yves has presented a claim that:

      1.) runs counter to natural supply and demand tendencies (shorting normally creates supply and discourages demand, but Yves claims just the opposite happened here);

      2.) is not supported by evidence– for instance, no evidence showing how Paulson “created” bad loans is given; we are just supposed to accept that he did, because he “wanted” them;

      3.) is not only not supported by evidence, but is directly contradicted by evidence– for instance, the claim that there were no traditional investors looking for exposure to “bad” mortgages is contradicted by hard evidence;

      4.) is reliant on heavily circumstantial evidence, such as perceived anomalies in market pricing, rather than hard evidence of specific actions on Paulson’s part.

      To her credit I suppose, Yves replies to critics in the comments, but her replies to me here, which can be boiled down to “I’m the expert and you’re clueless” and “buy my book for the proof” is pretty unresponsive to my criticisms in this case. The claim that Paulson has culpability for demand for bad mortgages is here, so the evidence supporting the claim should be here.

  14. Schofield

    Essentially as I see it Yves Smith’s argument is that the FCIC failed to understand that the financial industry trades on trust but betrayed that trust by going short whilst they were pretending to go long. She has tried to make the case that in going short a demand for crappy mortgages was generated in order to take a place on either side of the shorter’s bet and this should result in further investigation. You I accept argue that she needs to present better evidence for her case which I see as really also supporting her argument for further investigation. It’s important to investigate because you will either confirm Karl Marx’s complaint that the world is worse for allowing a system where “Roving Cavalier’s of Credit” roam the planet when they should be caged or you put the complaint to bed. Personally I think 60% of us had a loving childhood and the other 40% didn’t so any result will be close.

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