The Weekend That Changed Wall Street

the fallout had been limited to the lenders themselves it might have been contained. But by the time Countrywide was acquired by Bank of America, the worthless mortgage securities bundles were embedded in the system, pulling down some of the giants of investment banking from the United States to Europe and Asia.
The story of the financial industry’s collapse is still being written, but looking back we can pinpoint the warning signs. Nobody was paying attention to the interconnectedness of all the industries. Problems in the housing market were viewed as severe, but people were talking about it as if it were just the health of one industry that was at stake. Not true. The housing market was linked to the investment banks and ultimately to the newly globalized financial system, and when the thread was pulled, everything began to unravel.
Even those in the top echelon of the nation’s economy failed to recognize the looming crisis presented by subprime. Before he stepped down as Fed chairman, Alan Greenspan disputed suggestions of a housing bubble, calling it nothing more than “froth” in certain markets. Ben Bernanke, then chairman of the president’s Council of Economic Advisers and soon to replace Greenspan, told Congress that he believed the boom reflected positive aspects in the economy, like job and housing growth. Neither Greenspan nor Bernanke expressed any real concern that a housing bubble might be growing that could place the economy in peril if it burst.
To be fair, not everyone was swept up in the subprime craze. A small but potent movement was emerging, composed of traders who had no confidence in subprime assets. Leading the charge was John Paulson, a former managing director of Bear Stearns, who in 2006 set up his company, Paulson Credit Opportunities Fund, for the sole purpose of shorting subprime mortgage-backed assets. Paulson was an early predictor that the subprime market would crash. With his colleague, Paolo Pellegrini, he made $2.7 billion in 2007, betting against subprime.
Short selling involves borrowing stock (usually from a brokerage), selling, and then waiting for the price to drop. When (and if) it does, you buy it back at the lower price, replace the stock, and pocket the difference. Short-sellers are rarely looked upon fondly by corporate America—and why would they be? Short-sellers essentially bet against the system. They predict failure, and they earn profits when stocks sink.
A colleague of mine once compared short selling to Pete Rose betting against baseball. Some people believe it is unethical. Short-sellers like Paulson and Pellegrini would argue that they actually perform a valuable service by injecting an honest evaluation of worth into the process. My own view is that there is nothing wrong with short selling. This is what makes a market: a buyer and a seller. Short-sellers do not create a crisis in confidence. It is ludicrous to blame short-sellers, unless they are behaving fraudulently. And I have often seen short-sellers do much more research than “long” analysts. Short selling is just one more strategy, so long as the investor is not spreading false information and creating a run on institutions, the way some Wall Street executives charged during the 2008 period.
Is there a larger obligation—even a patriotic duty—to protect the markets? I have heard people say that short-sellers are abdicating a core responsibility of citizenship. Short-sellers hate being called peddlers of the system’s destruction. In our system, some companies do well and others don’t. You’re allowed to point out the companies you think are on the wrong track, and bet against them.
“You can’t put much blame on short selling for bringing companies down,” a source at the Treasury once told me. “Most of the time when the company fails it’s because the company is inherently a bad company. The short-sellers just saw it early.”
I was interested, though, in what Paulson and Pellegrini saw that others didn’t. In 2010 I asked Pellegrini to describe the reasons for their decision to buck the trend and bet against subprime. He told me that it was not a grand scheme.
“We were only looking for investment opportunities with a lot of upside and little downside,” he said. “And when we first looked at subprime, we made a general observation that there was generally too much leverage in the economy—and, in particular, there was too much leverage with housing.
“We were all familiar with the different mortgages that were being offered, including those we had been exposed to personally, and the subprime just didn’t make any sense. We started investigating that, and since it was so inexpensive to bet against those mortgages, we started doing that, too, in a fairly conservative way. It took time for us to understand all of the intricacies and solve some of the puzzles. For example, why didn’t these mortgages go bad faster? What was propping them up? Asking those questions led us to investigate the housing practices of the lenders with respect to pricing, appraisals, refinancing, and the whole operating philosophy. How could they expect to keep borrowers current despite the fact that the borrowers really didn’t have the wherewithal to pay the mortgages?” It was, I realized, the question too few people were asking—at least not publicly.
It turns out there were plenty of worried faces at the Treasury as early as the summer of 2007. Hank Paulson viewed the freeze of the credit markets with growing alarm. Sure, the stock market was booming, but he could see the underlying paralysis beginning to form. “No one voiced it publicly,” a former Treasury official told me. “But behind the scenes we were thinking that any moment Armageddon was going to happen.”
Bear Stearns, the eighty-five-year-old investment bank, was considered something of a cowboy firm, and that reputation was personified by its seventy-four-year-old, swashbuckling, cigar-chomping leader, Jimmy Cayne. That Cayne was the face of Bear Stearns was galling to some, who found him an indifferent administrator and personally embarrassing. The rap on Cayne was that, in his later years, he preferred playing golf and bridge to running