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Cashing in on Subprime

The subprime crisis in the housing market has led to a financial crisis and fears of a recession. If only someone could have predicted it. Someone did. His name is Kyle Bass, and he made about half a billion dollars from it.
By Craig Hanley |
SHORT-SELLER’S STORY: Bass was called before Congress to explain the origins of a global financial crisis.
photography by Dan Sellers

Asky-blue canvas hangs in the reception area at Hayman Capital Partners LP, a hedge fund with offices on Cole Avenue, near the Quadrangle. In the painting, a giant dollar sign towers over smaller symbols of the franc, yen, and British pound sterling. After soaking up buoyant art like that, it’s a bit disconcerting to hear how the firm’s 38-year-old founder responds to a question about the future of the U.S. economy. J. Kyle Bass sits at his desk and gamely tries to Google up a helpful definition of “economic depression.” Nothing he finds is very enlightening; just the usual generic descriptions of a prolonged recession. Nor has any similar research during the past few months given him a clear conceptual framework of the grim phenomenon that he considers likely.

He wants to make it clear that he is not by nature “a doom and gloomer,” but Bass has studied the housing market long enough to understand the full consequences of its implosion. The first $400 billion of bad loans that the banks had to write off was nothing. The real pain will set in as $27 trillion worth of U.S. homes lose enormous value, taking a possible $6 trillion out of consumer pockets. Bass says the downward super-cycle will dwarf the S&L crisis and the California slump of the ’90s. He has grown accustomed to people reacting to this prognosis with denial.

“Everywhere we went to raise money for our enterprise, people would say, ‘Oh, we completely agree with you, but it’s not going to happen here because of this, this, this, and this,’ ” he says. “Not just Dallas, everywhere I went. Portland, Seattle, Chicago.”

That denial cost more than one investor candidate a lot of money. By forecasting the mortgage market crash last year, Bass and his two Subprime Credit Strategies Funds parlayed $110 million into $700 million, a coup that cast him as a rare success story at the center of a global financial crisis. While most hedge funds operate as stealth cults, Bass’ recent celebrity has included several prominent media profiles and appearances before Congress and the American Enterprise Institute. And now money men who shunned his housing market predictions are much more interested in his future bets these days.

No relation to Fort Worth’s Bass family, he was born in Miami, where his charismatic father managed the Fontainebleau Hotel before taking over the Dallas Convention and Visitors Bureau. He went to TCU on a diving and academic scholarship and eventually secured a berth at Bear Stearns’ brokerage firm, which focused on event-driven special situations. It also specialized in short-selling, or betting that the value of certain stocks would fall. The Dallas office did a lot of original research, and Bass became senior managing director at 28. Then he ran the local office of Legg Mason, where he paid close attention to the housing industry and indulged his obsession with risk-taking after hours. In 2002, he raced a $200,000 RUF Porsche RTurbo from Manhattan to Los Angeles in a road rally called the Gumball 3000. Ignoring posted speed limits everywhere and using a helicopter spotter at one point, he won the event’s “Hottest Wheels” award for hitting 208 mph on a stretch of Nevada highway. Then, after saving $33 million, he launched Hayman Capital in February 2006 as a global special situation fund.

By then, Bass had noticed a brewing storm of fraud and free speculation in the U.S. mortgage marketplace. Unscrupulous home loan originators—paid on the volume, not the quality, of their loans—were putting people in houses they couldn’t afford without even asking to see W-2s. The loans were shabby, but their high interest rates generated good profits. So investment banks were buying the loans and bundling them into securities called collateralized debt obligations, or CDOs, that they could then sell to other banks and institutional investors, with the help of credit rating agencies—Moody’s, Standard & Poor’s, etc.—that made money by giving the CDOs their blessing as safe, solid investments. Then along came the “synthetic” CDOs, a derivatives instrument that essentially sold insurance against mortgage defaults to other CDOs.

If it sounds complicated, it is. Think of it this way: firms were making bets on other firms’ bets, to the tune of billions of dollars. Everyone was betting that each other’s bets would pay off. And the entire arcane system depended on a mechanic earning $40,000 a year keeping up with the mortgage payments on a $400,000 house. Today, a growing number of investigations are looking into possible crimes at various levels of the food chain.

Bass and his team did months of detective work to figure out which CDOs were underpinned by the shabbiest mortgages. He focussed on a California shop called Quick Loan Funding, founded in 2002 by a former car salesman named Daniel Sadek. Quick Loan’s ad campaign read: “You can’t wait! We won’t let you!” Sadek’s subprime loans made him rich enough that he could bankroll a $35 million film for his actress fianceé.  Beginning in August and September of 2006, Bass used the leveraging power of derivatives to short-sell about $4 billion of subprime securities to the synthetic CDO market. By December 2007, a wave of foreclosures swept the nation, and Bass was introduced on Bloomberg TV as a man who had just made a fortune “basically betting against the subprime borrower.”

Bass says that’s the wrong way to understand his role in the market. “We’re not profiting off other people’s demise,” he says. “What we did is we made a very simple bet, and that very simple bet is that synthetic-CDO managers were over-levered, and they had no idea what they owned. It was two professional investors that made these bets. An individual can’t come in and make these bets.”

Behind the story of Hayman’s splendid killing lurks the tale of a scam to neutralize the bets that Bass and other short-sellers had put in play. The intrigue got started in Las Vegas in January 2007, at the American Securitization Forum. Many of the attendees were the CDO managers Bass had bet against just months earlier, and he showed up to glean whatever competitive intelligence might be available. Understandably, he was vexed to learn that Bear Stearns, caught in a huge way on the wrong side of the mortgage market, was trying to weasel out of its bet. Bass says that Bear Stearns and its West Coast client Pimco were discussing “a kind of racketeering” scheme to pay off bad mortgage loans early, a move that would cause the short-sellers to lose their money.

To help thwart the plot, Hayman joined forces with New York-based Paulson & Co., another hedge fund aggressively shorting subprime CDOs. John Paulson had every reason to defend the bets that would swell his funds by $15 billion as the year progressed. Paulson’s personal take, according to the Wall Street Journal, would eventually amount to somewhere between $3 billion and $4 billion, reportedly the biggest one-year pot ever scraped off Wall Street’s table.

A pressure group was created—the Asset Backed Securities Credit Derivatives Users Association, or ACDUA. Bloomberg reported that about 10 hedge funds had joined by May, when the association petitioned the SEC to uphold its anti-manipulation provisions. The maneuver backed Bear Stearns down, arguably a good instance of counterparty surveillance enabling the market to police itself.

But an exemplar of transparency the ACDUA is not. Three of the five directors are from Paulson, two from Bass’ group. Asked to name some other members, Bass says he’s unsure about the rules and suggests a call to Paulson legal counsel Renata Holt. Holt says, “We had a memo to the bylaws that no membership information could be disclosed.” Asked why, she replies, “Specifically, to keep people like you from calling up and asking.” Paulson’s PR chief, Michael Waldorf, the executive director the ACDUA, describes it as a perfectly normal business organization but can’t think of a similar entity. Finally, he offers this: “It’s like five guys in an association who get together to play poker and talk about issues.” Bass describes membership today as a huge investor base, “pretty much everybody who trades derivatives.” But he says the ACDUA, which has no mission statement, isn’t doing much now because it fixed the problem it was formed to solve. Limited to these facts, anybody might conclude that there are major hedge funds out there—funds that might invest money for, say, a prestigious university—that simply do not want to admit they made a ton of money off the surge in foreclosures.

Hayman Capital, on the other hand, went very public with its position. As a man who does not own a voter registration card and who has never voted in an election—a man who admits that he doesn’t even read the local newspaper—Bass concedes that it was a bit incongruous for him to volunteer for an active policy role. But as a fiduciary, he says he felt compelled to share his insights on an economic issue that affects him, his investors, and every person in the country.

Some of his investors know people in the White House, and his colleague Richard Howard helped run logistics for the last Bush-Cheney campaign. (Howard is the son of the former conservative prime minister of Australia.) Bass told Howard they needed to go to Washington and meet with the Speaker of the House and with the House Financial Services and Senate Banking committees.

“So I went up there and met with everyone,” Bass says. “I met with the White House. I met with Treasury, with Democrats, Republicans, staffers on both sides. Because the only way to solve this problem—or let’s say shorten the wavelength of this Darwinian flush, in my opinion—is to allow bankruptcy. Or allow mortgage loans to be crammed down in bankruptcy, basically make them unsecured.”

He says that two major emergency bills—the Miller bill in the House and the Durbin bill in the Senate—contain many of the suggestions that he offered the politicians. In an interesting parallel, when Paulson & Co. donated $15 million to a consumer rights group that supports the same “cramdown” legislation, a BusinessWeek article noted that passage could result in a windfall for the hedge fund’s bearish mortgage bets. And banking industry lobbyists allege that a wave of cramdowns will depress bank stocks, another boon for people inclined to short them. Recently, Hayman Capital has been shorting bank stocks, but he insists that the main reason he’s pushing for bankruptcy reform is to help ward off the big “d” word he’s been pondering a lot lately.

After his first trip to Washington, Bass was invited to testify before a House subcommittee investigating the agencies that rate U.S. securities. Initially, he didn’t want to testify, because a person in the financial industry can make a fair number of enemies when he breaks the code of silence. But Bass felt someone had to call out the ratings agencies for rubber-stamping the dicey CDO investment vehicles. So in September 2007, while cameras rolled, he sat at a long table in a chamber of the Rayburn Building, dissecting the agencies’ sloppy valuation models and blaming their conflicts of interest for undermining the integrity of the financial system. Seated beside him, witnesses from Moody’s and Standard & Poor’s spun the story their own way.

When the subcommittee members had to leave the room for a vote, the witnesses relaxed. Michael Kanef, head of Moody’s asset-backed finance group, walked over to Bass and introduced himself. According to Bass, Kanef pointed to the door and said, “I can’t tell them [the subcommittee] this, but investors need to do their own work. We’re just a point of reference. We have freedom of speech. We’re just basically the press. But I can’t tell Congress that.”

According to Bass, Kanef said something else he found enlightening. “He says, ‘You realize that no one has ever sued us for anything that we’ve put together.’ And I said, ‘I know exactly where you’re going to get sued. I can tell you which CDO you’re going to get sued for.’ And he backed away and said, ‘I don’t want to know! Don’t tell me! Don’t tell me!’ ”

Standing behind Kanef, Moody’s legal team suddenly found their cell phones lighting up—warnings from those who’d been listening to the testimony online that their client’s chatter was still being webcast. A lawyer grabbed Kanef’s arm, spun him around, and said, “Your mike is on. Get out of here!”

So Bass never got to warn Moody’s about the “Dead President” CDOs, a series of investment vehicles concocted by the property group at one of America’s largest financial services firms—though Bass declines to name the firm. Each CDO was named for a deceased U.S. commander in chief, and they were all doomed to fail. Like a two-headed coin, a Dead President gave little chance to whoever bet “tails” on the other end of the transaction. Moody’s approved them anyway, because the agency wasn’t astute enough to spot the tricks hidden in various provisions. (For history buffs, the most devious Dead President CDO, according to Bass, was called “Buchanan.”) Bass calls the whole caper a billion-dollar fraud, as yet unpublicized.

“It was bad, but it’s so complex that you couldn’t possibly write about it,” Bass says. “The Journal couldn’t even write about it. That’s how complex it is. It would take teams of lawyers reading indentures, complex flow charts. And then people would look at you with cross-eyes, even if you understood it all. They’d go like, ‘Yeah, well, I don’t see it.’ ”

As he talks, every 10 seconds or so Bass’ own eyes dart reflexively to the monitor on his desk. The constantly refreshing numbers on the screen represent $4 billion in market positions that he manages in his own funds or under contract for others. He squints at the numbers the way a bomb squad officer might regard an abandoned suitcase.

Hayman Woods LLC is his newly formed partnership with Jonas Woods, the former Hillwood CEO responsible for the Victory development. For the next three years, the team will focus on buying distressed real estate in markets like Southern California, Florida, Phoenix, and Las Vegas. They want it understood that this is not a vulture fund, just a way to return capital and vision to a market that badly needs both. Bass also plans to keep scrutinizing residential mortgage bonds, as many sound ones have been tossed out with the bad. He’s moving heavily into municipal bonds, too. If homes really do depreciate dramatically, city tax bases will shrivel. In that eventuality—call it a depression—intensive credit analysis will be needed to figure out which cities will weather the crisis and which ones won’t.

“Do you think the city of Dallas can dial its budget back?” the betting man asks. “Do you think any city could?”

Craig Hanley is a contributing editor to D Magazine. Write to [email protected].

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