Diary of a Very Bad Year Chapter 1 - When Subprime Was Just a Weird Word

This is part of my series retelling Diary of a Very Bad Year. Today we’re covering Chapter I.

The backstory

Before the interview starts, the book gives you context on how we got here. And it’s a story about cheap money and bad decisions stacking on top of each other.

After the dot-com crash in 2000 and 9/11, the Federal Reserve cut interest rates to basically nothing. By mid-2003, rates hit 1 percent. Saving money paid you almost zero. Getting a loan was dirt cheap. And the government was pushing hard for more people to own homes.

There’s a global piece too. China was booming, paying workers very little and parking profits in US Treasury bonds and stocks. All that Chinese money flowing into America made borrowing even cheaper. Low interest rates plus a flood of foreign cash, and it all poured into housing.

Wall Street saw an opportunity. Banks figured out how to take all these mortgages, good and bad, bundle them into bonds, and sell them off. Houses kept going up in value, so everybody felt safe. In Florida, speculators were buying unbuilt condos and flipping them online before construction even started.

Then in mid-2005, home prices started falling. By July 2007, two Bear Stearns hedge funds deep in mortgage-backed securities collapsed. Bush held a press conference saying the subprime problem was “modest.” A reporter asked about overexposed banks. Bush blinked, said “Thank you!” and walked away.

A month later, Gessen sat down with HFM in a Brooklyn coffee shop. That’s where Chapter I begins.

September 30, 2007

The Dow was at 13,895. Unemployment was 4.7 percent. There were 243,947 foreclosure filings the previous month. On the surface, things still looked okay.

Gessen opens with a dramatic question: “Is America now a Third World country?” HFM shuts that down immediately. No. The dollar is weak, but currencies move in cycles. People love to extrapolate. The dollar is down today, so everyone assumes it’s going to zero. But that’s not how currencies work.

Currency crosses and the herd

HFM tells a story about a dinner at the beginning of 2005 where a bunch of prominent investors were basically competing to see who could be most bearish on the dollar. One guy says the euro is going to $1.45. The next guy says $1.60. Then someone else says $1.75. It was a bidding war for pessimism.

Here’s the thing. If everyone at the table already hates the dollar, they’ve already bet against it. So who’s left to actually push it lower? HFM went home and reversed all his dollar-bearish positions. Not because he had a strong view on the dollar, but because when everyone is on one side of a trade, that itself is a risk.

He brings up Julian Robertson, a legendary investor who shorted the yen in the late 1990s. Japan’s economy was a mess. Everything pointed to a weaker yen. But during the 1998 crisis, the yen strengthened 10 to 15 percent. Robertson got destroyed. The logic was perfect. The trade was a disaster.

HFM’s lesson: even when the facts are on your side, currency trades can kill you. The other side is governments with infinite money and political motivations that have nothing to do with profit.

Black box trading

Then HFM gets into something wild. That summer, a bunch of quantitative trading funds blew up. These are what people call “black box” systems. Physicists and statisticians build computer models that trade thousands of stocks automatically. No human is clicking buy or sell. The computer runs everything.

The problem? All these black boxes were built by people who learned from the same four or five pioneers. So they all had basically the same DNA. Same models, same positions. Long the same stocks, short the same stocks.

When a few funds got hit with losses and started reducing risk, their black boxes began unwinding positions. That triggered losses for other black boxes. Those funds turned down their systems too. It became an avalanche. HFM’s own black box had a “ten-sigma event,” something that statistically should never happen. But as he jokes, “that’s the first time that’s happened in three months.”

It’s like an ecosystem with no biodiversity. When everyone trades the same way, markets become fragile.

How mortgage sausage gets made

The core of the chapter is HFM explaining how subprime mortgages actually turned into a crisis. And the key idea is separation of knowledge from risk.

Here’s how it worked. Mortgage originators made loans to people. Then they sold those loans to hedge funds or banks. Those buyers packaged the loans into CDOs (collateralized debt obligations), sliced them into layers from safe (triple-A rated) to risky (equity), and sold the safe pieces to investors worldwide. The hedge funds kept the riskiest piece.

The buyers of triple-A paper trusted Moody’s rating. Triple-A meant safe. Money-good. You’ll get your principal back. So they didn’t dig into what was backing these bonds. No budget to hire analysts to check mortgage pools. They just bought anything stamped triple-A.

But here’s the thing. The demand for this paper was so huge that it flipped normal finance upside down. Usually you find a good investment first, then look for funding. Instead, the hunger for CDO paper was actually creating the mortgages. There was a machine that needed to be fed. So loans got pushed out the door to anyone who would sign.

The mortgage originator in Stockton, California knew they just lent half a million dollars to someone making $50,000 a year. But the person holding the risk was five steps removed and had no idea.

HFM’s own fund was in this business too. They created CDOs, sold the senior paper, kept the equity. That equity is now worth “pretty much zero.” The person who ran that part of the business? Already fired.

The expert who missed the big picture

This is the part of the chapter that stuck with me most.

The guy who got fired was a genuine mortgage expert. Fifteen years in the business. He could pick good mortgage pools from bad ones better than almost anyone. Their CDO paper performed better than the industry average.

But he was a true believer. He thought subprime lending was opening up home ownership. People said in 2003 that credit quality was getting worse, and those mortgages performed fine. So he had data to back up his optimism.

Meanwhile, other people at the firm who were not mortgage experts saw the obvious signs. Forests of cranes in Florida. Friends lying about primary residences to get loans. No-doc mortgage ads on TV. Guys at bars bragging about flipping houses. They said, “This is a bubble. We should be short.”

But the expert said no. You have anecdotes? I have data. I see the remittance reports. I know the details.

In normal times, the expert wins that argument. But this was a paradigm shift. The expert was buried in the trees and couldn’t see the forest. The people with broader vision could see the whole thing was insane.

HFM sums it up perfectly. Making money in finance is about catching paradigm shifts. And the people most likely to catch them are not specialists trained in one way of thinking. It’s people with broader experience who can step back and see the bigger picture.

The expert? He now has plenty of time to think about the big picture.

Previous: Introduction

Next up: Chapter II - The Death of Bear Stearns, where things start getting really scary.