Odd Lots - Episode 16: Making Money When Everyone Else is Losing Theirs

Episode Date: February 22, 2016

Everybody knows by now that a handful of hedge funders made a fortune by betting against housing before the market crashed back in 2008. But, people who bought at the bottom, when everyone else was panicking, also did extremely well. In the latest episode of Odd Lots we speak with Bloomberg Alastair Marsh, who discovered two traders who won big time by buying the most toxic assets in the world during the depths of the panic in early 2009.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Hello and welcome to the latest edition of the Odd Lots podcast. I'm Joe Wisenthal, managing editor at Bloomberg Market. My co-host Tracy Alloway is away again this week, but fortunately she is going to be back next week. But since she's out, we're doing another special episode or unusual episode I want to talk to one of my colleagues here at Bloomberg who wrote a fantastic news story that I absolutely love entitled The Big Long, Making a Killing in a Market, everyone left for dead. It's about the people who made a fortune by going long, risky assets down at the worst part during the worst period of the financial crisis. this. So essentially the opposite of the big short. So without further ado, I want to get right into it. I'm here with Alistair Marsh, who wrote this story. Alistair, thank you very much for joining us. Thanks having me on. Let's give the quick roundup. What's your story about? Who are

these investors who were bold enough to go along very risky assets right at the bottom of January 2009? Who were they and what was their bet? Sure. Well, they were trading assetback security for a UK bank called H-Boss. H-Boss has a very interesting history in the UK. In fact, one of the most controversial ones, you might say. It ultimately collapsed back in the end of 2008. It had a government bailout. It had a secret cash infusion from the central bank

and ultimately was taken over by Lloyd's Bank. So while all this was happening in the background, you had these two traders at H-Boss called Milan Patel and Richard Paddle. who had spent the last 10 years or so trading ABS every day. And when the crisis hit... So ABS, the asset-backed securities, and these were the securities that were tied to mortgages mostly that everybody has come to know and understand

were sort of a key variable in the financial crisis. Exactly. Yeah, these were typically backed by... So these were bonds backed by mortgages in the UK, typically. and they were trading these for 10 years or so. For most of that time, these were considered a relatively vanilla product. Most of them were rated AAA. It all seemed like a good and safest houses, so to speak, kind of bet. The title of your story is called The Big Long, obviously a reference to the Big Short.

So explain what they did in this trade and how it was sort of the mirror opposite of the Big Short trade. Sure, well, there's many kind of parallels to the Big Short. Effectively, the Big Short was saying that the housing market is going to collapse, and these subprime mortgage bonds are priced at crazy levels that don't imply that collapse. Well, they had the opposite view that in the UK, the housing market was not going to collapse, and that the mortgage bonds in the UK implied that the mortgage market had collapsed or was about to, and they believed it wasn't. And they believed that the same kind of mass foreclosures that we saw in the U.S.

or the same spike in mortgage years wasn't going to happen in the UK. And obviously they ultimately turned out to be correct. So anyone who's seen the movie or read the book The Big Short knows that it wasn't just enough to have a negative view on housing or asset values, but that these trades were not trivial to exercise. They were complicated to structure. In the case of the story you reported on, there were difficulties and complications in executing the opposite trade. What did they have to do to express their view on these assets? Sure. Well, the biggest difference between the two, leaving aside one was short and one was long,

was that under short bets, these were mainly institutional investors, hedge funds and others trying to do this. But the big long, these guys, whilst they were traders by profession, they worked for a bank, Actually, they put up their own money. Ultimately, they were retail investors. And so they had to first get compliance from the bank. They managed to get this. What's quite interesting, and I've had feedback from a number of people in the Asabak Securities Market here in the UK who were quite indignant that these guys were able to do this,

because they, whilst working at various other banks, wished that they had the opportunity they were permitted to do so as well. But anyway, they had to ask compliance, they managed to get that, and then they had to go to the retail broker and say, I want to buy ABS, please. And the retail broker would say, you want to buy what? Typically, they're... Right, these are retail brokers that are typically used to selling vanilla bonds and stocks, right? They're not asset-backed securities or this sort of more complicated stuff that institutional traders trade, right? Exactly, yeah. It'd be the kind of thing like I want to buy BP shares or I want to sell Berkeley shares, please.

So asking for triple B granite bonds, for example, which is what their best trade was, was virtually unheard of. And they had to explain to the, basically they called a call center in Glasgow. For some reason in the UK, most of our call center operators are based in Scotland because there's something to do with a Scottish accent that's kind of soothing or something like that. Is that true? Is that really a thing? That's really a thing, yeah. Call up most banks, switchboards, etc. It's always in Scotland. Anyway, so they call Glasgow. They're on the phone for two hours. And they have to explain not only what they want, what it is, how it works, but also kind of where they can get it. And in some cases, who to call to get it. So for the ABS, because they're sitting at the Bloomberg, they have all the contacts in the market. They know that, for example, Morgan Stanley has got these bonds, or they know that Credit Suisse has got those bonds.

So they'd say, call this guy at Morgan Stanley, please, and get me these bonds. So basically, they're doing the job for the retail. I love this. It's quite hilarious. Because they're institutional traders, they know everything there is to know about what they're trading. But because they, for this weird quirk, were forced to go through a retail brokerage to make these purchases. They had to sit there on the phone and walk the broker through the trade. Exactly.

So Milan Patel said that he would, while sitting at his desk, be on hold or be listening to the Beethoven symphony and then in the background whilst the call center person tried to work out what it was and how to how to get hold of it. But ultimately these retail brokers were able to do the mechanics of buying these assets and getting them into their accounts? Ultimately, yes, but it was very painful. It was worth it, but it was very painful. Now, do the stories of these two traders, Patel and Pathel,

Do they sort of undermine a common argument? I mean, the view is, I think, in popular culture and probably expressed by the books and movies, that the people trading these assets had no idea what they were trading. They had no idea what was in them. Everyone on Wall Street was kind of stupid. And there were only a few smart people. But does their experience show that actually a lot of the traders really did understand them and were at least more aware of what was in these assets than popular people?

than popular culture is depicted? Well, they certainly knew them, and there's no... Basically, the way they explain it is that they were trading for 10 years. They knew the names of the bonds. They knew how they were structured. They knew where to buy them, who to sell them to. So they knew the market like the back of their hand, and it kind of stands to reason that the same thing would be true of other traders or other institutions.

Now, that's not to say that they weren't kind of egregious... things done in various times and various places. But it stands to reason that people who trade these products every day, and these are not simple products, they're very complicated. That's why it took them so long to get it through their brokers. They should know the risk. They should know what's backing them. They should know what the mortgages are like.

They should know the chances of, you know, the arrears history. They should know that stuff. But it does seem like the way people talk about this period always is a very black. black or white. There's the few people that were warning, and then all of the other people were sheep and not paying attention to the risks at all. And it sounds like it's not quite that simple. Yeah, that's true. And actually, I think in some of the pages of the big short, actually, it implies that some of the guys at the investment banks did know what they were doing. They were just hoping that the merry-go-round would go on for a little bit longer than it did.

But they knew what was in there. Of course, one of the things that makes the Big Short such a compelling story, it's just the jaw-dropping returns that those traders got and the amount of money they made. Talk to me about how well these two traders did. Well, they didn't do anything on the scale of the Big Short. They didn't become billionaires. They didn't become billionaires, no. I think, well, they were, they didn't disclose fully.

numbers. We had to do some calculations here, but we estimated that Patel made about 1.2 million pounds, which is not bad return. He put forward, we reckon about 450,000 pounds. Their best return was 800% on bonds called granite. These were sort of controversial and central to the whole thing. Tell us about the granite bonds. Well, Granite were backed by mortgages from a UK bank called Northern Rock. And Northern Rock is probably the closest thing we had in the UK to subprime. The bank basically massively over-leveraged. Well, it had a huge residential mortgage-backed securities program,

which was called Granite, and allowed it to fund 50 billion pounds worth of mortgage lending. Ultimately, it succumbed to the first bank run in the UK in 140 years. So I remember the scenes of watching people queuing. being outside of Northern Rock branches on the high streets of various towns across the UK. That is almost as iconic as the images of the Lehman Brothers Bankers leaving the building with their crates and so on. So Northern Rock is a very kind of controversial and institution, and it was bailed out by the UK government. But granite bonds, because they were sold, I mean, without going to all the technicalities of securitization,

they were sold by a separate vehicle that continued. to exist once Northern Rock didn't. In the story, you quote, Paddle is saying, quote, there was a concern in the market that the UK government would rip it up. What did that mean, that they would theoretically pay nothing in the end? Yeah. Well, they bought these bonds, so they were initially sold at 100 pence on the pound. They bought them at 8 pence.

So 92% discount. Yeah. Now, that was for the riskiest bonds, the ones. that were first in line to take losses. But even so, that's kind of a huge decline. Yes. And the view was simply that basically it was down to political risk, that the UK government, having taken over the institution,

I don't think we'd had a nationalization like that in, well, in anyone's memory, what's going to happen? This is unprecedented. Are they just going to say, do you know what, we're not paying those bonds back? This bank doesn't have enough money. We're not going to pay. Why did they feel confident that the government would not rip up those bonds? Well, they didn't actually.

But basically their view was that mathematically it worked out that they should at least get their money back. So they bought it eight pence on the pound. And I think the way they described it to me was that it would take about two years. for the granite structure to be unwound, as in it's quite a complicated structure and lots of mortgages behind it and so on. It would take about two years in their calculations to unwind. And in that period, they should have two years of 5% coupons,

so 10%. So they should get 10 back, having put 8 in. So that was their very kind of basic bet. Obviously, they then had a huge, huge price rally, so that's where the huge returns came from. But at that point, they were just thinking... Yeah, so you have this chart, that obviously the listeners to the podcast can't see, but I'm looking at it right now,

and it shows that they bought in around 8 and then they sold around 60. But actually, the bonds continued to rally. There was a little bit of volatility, but they actually rallied much more even after they sold them. Yeah, that's right. And I did ask them, why didn't you try to hold on? Because actually, they were redeemed in January and December so that they don't exist anymore. and they were paid back at par, so at 100. Let's just pause right there, how unbelievable that is.

We all remember these bonds, these first in line losses from 2008 and 2009. I don't even think that got much attention that in 2015, they had essentially recovered 100% of their value, not that they recovered some, but virtually the entire thing. I think that part is almost entirely unknown to people. Yeah, it's pretty unbelievable. really. But they said, or Patel specifically said that his style of investing is not to try to to time the top and not to try to hold on for the last 20% or so. But having gone from 8 to 70 or 60,

he thought, do you know what, that's a pretty good return. I'll take that. And actually, at the time they sold out, which was about 2010, 2011, it wasn't clear at all that the UK government was going to sell them. That's why they were redeemed because the government sold them. But it wasn't clear at all that that was going to happen at that point. Yeah, so no reason to get greedy. Eight to 60 is a pretty nice return, isn't it? Indeed, yeah. Let's look big picture for a second. You know, one thing I'm always curious about is the sort of psychology of trading, making a bed or making a trade that's the exact opposite of how the market sees. Like, basically having the guts to make a call that's different from what everyone around you is calling for.

And it seems to me that bears, there are always bears. There are always people who think the world is coming to an end. They're always people who are predicting doom. And that's sort of accepted. People just accept that there's going to be negative people out there. But in a way, optimism in the face of panic actually strikes me as much more brave. because no one likes to hear someone called a permable or people mock the bulls. People have an intellectual respect for negative people.

How does that, what's your view on that? Do you think that this view that they expressed was particularly brave and gutsy given the prevailing negative sentiment at the time? I think it was, and especially when you think about the very place where they were sitting, when they put these trades on or when they first asked for permission to do it, that was in January 2009. And it was that month that the takeover of H-Boss actually happened. So they'd had in, you know, a few months earlier, Lehman had gone down.

Then H-Boss itself had had a 20 billion pound bailout from the government. It had a central bank, well, additional top-up from the central bank. And so with all that background for them to be sort of bullish, for lack of a better way of putting, it is quite remarkable. But what's also interesting about these guys is that they're not particularly, particularly, they're not how you might think or a caricature of a bond trader. They're not kind of gregarious types or brash. They're both quite quiet and quite thoughtful.

And actually, Milan in particular was very interesting because he started investing in bank bonds, not ABS, even though he traded ABS for a living. He first started investing in bank bonds. And he told me, having not known this market that well, he spent his e-basket. evenings for about a month or so reading through bond prospectuses. So this is just like Michael Burry. Yeah, so it's like someone who's actually willing to dive into all the paperwork to really figure out what's in there. And how did you find this story, just as a reporter? It was quite fun finding them, actually. I spent quite a bit of time in 2015 reporting on the sale of Granite.

The UK government announced it was going to sell. At the time, it was 13 billion pounds, and it was the biggest ever sale of assets from the UK government. And because, Because Granite was such a well-known series of bonds, I wanted to investigate and actually managed to break some news on who was bidding for them, who wanted to buy them. In the end, it was Cerberus who won. But as part of that, I kept hearing about these mystical traders, or the mythical, I should say, traders who bought Granite at the bottom. I guess there had to be someone, right?

Yeah, well, one whimsical hedge fund manager told me that it was Harold Hinesight who bought the bonds at the bottom. But I actually wanted to find out who did, particularly when in December the first bonds started to be redeemed and they were paid back at par, at 100, which to me thought, if you bought at the bottom and got 100 back, that's amazing. And so I kind of made it a bit of a mission to find out who bought them. and through asking various contacts in the market, I came across Richard Paddle, and he was kind enough to speak to me and tell me the tale, and it was fascinating, and then Milan also. So, yeah, it was a really interesting investigative process, and looking back at the crisis, well, the UK's experience of the crisis, is really interesting. Are there others that you think probably you haven't found?

Well, there's others I know of, but I haven't necessarily included in the piece. There were some others who did it with them at H-Boss. I mean, Milan and Richard were effectively the brains of the trade, but there were other traders that got in on various purchases with them. We also know of a few other hedge funds and one particular large US investment bank that shall remain unnamed, I guess, that also got in on the trade. But they were doing it not for themselves, of their own personal money, but for either the prop desk or for the hedge fund.

So looking ahead to today, are there always these types of stories in the market, people finding assets with extreme dislocations, or is this really the type of thing that when there's a huge crisis or a huge bubble, yes, you find them, but most of the time people can't really be expected to find these extraordinary dislocations? I think you could probably argue,

that both ways actually. I mean, Richard Paddle said something very interesting that he reckons that every 10 years, or approximately every 10 years, there's some big market event that happens, whether it would be the dot-com bubble bursting, whether it be the Asian financial crisis, whether it be EM debt in Russia, for example. And this time around, he said, well, this, in, so in the 2008, 2009, it was in the ABS market, Aspect Securities market. And since he was trading that market, he was in the perfect position to profit from it. Now, following his logic, then, you know, in a few years' time, we should see something else, something similar. And perhaps some people might say, oh, that's bank bonds, or maybe that's high yield,

or some people might even say that's ETFs. So I'm sure that there are going to be more of these type of scenarios. I guess you just need to be in the right place at the right time. I really know that market. Well, Alistair, thank you very much for joining us. I'm looking forward to in a few years you reporting on who made the big money in 2015 and 2016. I'm sure you'll find them, and I really appreciate you coming on the Odd Lots podcast. Thank you very much. Thank you.

And thank you very much for joining us on the Odd Lots podcast. I'm Joe Wisenthal. You can follow me on Twitter at the stalwart, and you should follow Alistair too because he'll be turning up the next great. the next great scoop. He's on Twitter at at Elister J. Marsh. And we'll be back here next week. We at Bloomberg are proud of our new and growing slate of original content podcasts. They include benchmark, a jargon-free dive into the stories that drive the global economy. It's hosted by Tori Stillwell, Aki Ito, and Dan Moss. Odd Lots, hosted by Joe Wisenthall and Tracy Allaway, takes you on a not-so-random walk through hot topics and markets, finance, and economics. And each week,

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