Michael Lewis's Complete Guide To Who's Who In The CDO Scandal

Michael Lewis's Complete Guide To Who's Who In The CDO Scandal

via Clusterstock by Courtney Comstock on 4/16/10

The huge SEC case against Goldman and Fabrice Tourre has brought the spotlight back on the mortgage crisis.
Tourre allegedly packaged CDOs filled with very risky mortgage bonds and then marketed them to investors by telling them that Paulson was also long them. He wasn't.
Michael Lewis's book, The Big Short, explains very well what happened during the crisis - who was long, who was short, and how they did it.
Take a quick refresher to remind yourself what exactly happened and you'll better understand the charges against Tourre.

Meet the characters here >

The wanna-be homeowner

The average American cannot afford a house without a mortgage.
So they go to a bank and get a loan. In some cases, it's by talking to someone who works for...

The mortgage originator

This is Mark Ernst, the CEO of Option One, the mortgage originator owned by H&R Block. They made the loans to home owners and sold them to Wall Street.
The company announced a surprising loss in its portfolio of subprime mortgage loans first in June 2006.
After, in a speech about Option One's subprime loan portfolio, he said they had recovered and were expecting a 5% loss rate on its loans from there on out. Someone stood up and basically said, you're completely wrong. He was. He resigned in November 2007.
Information thanks to Michael Lewis' new book, The Big Short.

They ran subprime lending

This is David Wells, who ran subprime lending for a company called Fremont Investment & Loan.
In September 2008, Fremont would announce that 30% of its subprime loans were in default. Its pools of loans would register higher losses than that. Even after Fremont sold the houses it foreclosed upon, it was out nearly half the money it loaned.
Information thanks to Michael Lewis' new book, The Big Short.

The loan buyers

Every bank on Wall Street bought the loans from the mortgage originators, packaged them into bonds, and sometimes repackaged them into CDOs.
Information thanks to Michael Lewis' new book, The Big Short.

The enablers. AKA the rating agencies.

After buying the loans, Wall Street asked the rating agencies to rate them in bundles of bonds.
This Deven Sharma, the President of Standard & Poors, a ratings agency.
Working for him is Ernestine Warner, who is an analyst in the surveillance department at S&P's, which was meant to monitor subprime bonds and downgrade them if the loans that underpinned them went bad. They didn't monitor them because they lacked relevant information about the bonds because, she said, her bank clients, the issuers of the bonds, wouldn't give it to her.
In the end, the ratings agencies, presented with the pile of bonds backed by dubious loans, would pronounce 80% of the bonds in it triple-A. These bonds could then be sold to investors-- pension funds, insurance companies and...
Information thanks to Michael Lewis' new book, The Big Short.

The investor. AKA the loser

John Devaney ran a hedge fund that invested in subprime mortgage bonds, United Capital Markets. He bought the subprime bonds from Wall Street firms.
He wrote in a letter released over the PR Newswire in 2007, "I was long in 2007 and I was wrong."
He had to sell his yacht, his plane, and his Renoir after the market crashed.
Information thanks to Michael Lewis' new book, The Big Short.

The end buyer AKA the sucker

The end buyer of CDOs were CDO managers like Wing Chau, President and founder of Harding Advisory, which would become the world's biggest subprime CDO manager.
It was his job to buy the subprime bonds that served as collateral for CDO investors, like hedge fund manager John Devaney, who we introduced you to in the last slide.
Big investors hired him to vet the bonds. So it was also his job to monitor the hundred or so individual subprime bonds inside each CDO and replace the bad ones, before they went bad, with better ones.
(All by himself, Wing Chau generated vast demand for the riskiest subprime mortgage bonds, for which there had been essentially no demand. This demand led to the supply of new home loans, as material for the bonds.)
Information thanks to Michael Lewis' new book, The Big Short.

The doomsayers. The guys who predicted the crash AKA the winners

Michael Burry
Image: nymag

It was those types of end-buyers we just mentioned that the stars of the subprime mortgage crisis (the best known is John Paulson) bet against.
The first to see what was actually inside these CDOs (the very risky subprime bonds that John Devaney was buying and the CDO manager was "vetting") was this guy, Michael Burry. He saw it in 2005.
Information thanks to Michael Lewis' new book, The Big Short.

Many more followed in his footsteps, like John Paulson

and Kyle Bass

Kyle Bass, John Paulson, Greg Lippman, Steve Eisman, and others joined Burry in "the trade of a lifetime."
Lewis focuses on two guys from Cornwall Capital: Jamie Mai and Charlie Ledley. Before this trade, they were virtually unknown. It was kind of perfect because this trade was virtually unknown in 2006.
Burry, Paulson, Bass, and the guys from Cornwall Capital had to ask Wall Street to let them buy CDOs made up of credit default swaps on those bonds, aka the insurance on CDOs made up of subprime bonds.
Information thanks to Michael Lewis' new book, The Big Short.

Cornwall Capital met David Burt, a guy with great connections on Wall Street

Before meeting David Burt, a consultant, Cornwall Capital had no way to buy insurance on CDOs of subprime bonds in case the loans became worthless. He connected the "garage band" hedge fund with a woman that would sell Cornwall Capital this insurance.
Information thanks to Michael Lewis' new book, The Big Short.

The CDS seller

Image: AP

It was Stacey Strauss' job to find investors who wanted to buy credit default swaps from Morgan Stanley.
The synthetic counterpart to CDOs, packages of subprime mortgage bonds, are CDOs made up of credit default swaps on those bonds.
They are insurance on the subprime bonds incase they become worthless. Cornwall bought this insurance from Morgan Stanley (and others, too).
Information thanks to Michael Lewis' new book, The Big Short.

The doomsayers inside the banks

Then the banks stopped selling insurance on subprime loans and started buying it for themselves (circa 2007).
Andrew Davilman from Goldman Sachs is an example of the people inside the banks who, once they had realized the subprime bonds were worthless, were able to make bets against them (like Michael Burry, Cornwall Capital, and the rest) before the ship went down.
Information thanks to Michael Lewis' new book, The Big Short.

The savior aka TARP

Even though some banks bet against subprime bonds too, it wasn't enough to cover all of their losses.
TARP funds bailed out the banks that were left with tons of unwanted subprime bonds. Most have since paid TARP back.

It is actually much more confusing

Lewis' book provides a more in-depth breakdown of what happened and who was involved.
If you're interested in learning more, you can buy it here.
You should also check out 10 myths about the subprime crisis -->
And our minute-to-minute guide to the SEC's case against Goldman and Fabrice Tourre -->