You’ve heard of The Big Short. Here’s the big long

▶ How two traders made a killing on mort­gage bonds left for dead ▶ “Ninety-five per­cent of the stuff I wanted to buy they had not heard of”

Bloomberg Businessweek (North America) - - News - �Alas­tair Marsh

You’ve heard of “the big short”—the epic bet against mort­gage bonds made by a small group of pre­scient hedge fund man­agers be­fore the 2008 crash. Mi­lan Pa­tel and Richard Pad­dle made their own ex­tra­or­di­nary mort­gage bond trade. Call it the big long.

In Jan­uary 2009, as the fi­nan­cial cri­sis raged, Pa­tel, Pad­dle, and a hand­ful of col­leagues at the U.K. bank HBOS de­cided to put up their own money to buy com­plex in­vest­ments ev­ery­one else was dump­ing. By the time they sold, they’d racked up re­turns of as much as 800 per­cent.

The twist is that much of what they were buy­ing—as­set-backed se­cu­ri­ties (ABS) linked to mort­gages—was the kind of pa­per they’d loaded onto the books of their em­ployer. Those pur­chases helped sink HBOS, an in­sti­tu­tion that traced its roots to the 17th cen­tury.

“Some­thing big hap­pens ev­ery decade,” says Pad­dle, 44, who’s worked in the City of Lon­don for his 23-year ca­reer. “This was hap­pen­ing in my mar­ket in some­thing I knew in in­tri­cate de­tail. That’s a once-in-al­ife­time op­por­tu­nity.”

In any mar­ket de­cline (surely in­clud­ing the cur­rent one), lu­cra­tive bar­gains even­tu­ally emerge. The story of Pad­dle and Pa­tel’s trade shows those deals aren’t al­ways easy to take ad­van­tage of. Find­ing the nerve is one prob­lem; an­other is find­ing the money. The trades may also re­quire spe­cial­ized knowl­edge, mainly pos­sessed by the very peo­ple and in­sti­tu­tions most caught up in the panic.

“Af­ter sub­prime blew up, ev­ery­one said as­set-backed se­cu­ri­ties have to go,” says Pa­trick Janssen, an ABS money man­ager at Pru­den­tial’s M&G unit. “Those that were able to tune out that ad­vice and make their own de­ci­sions did very well.”

In the early days of 2009, HBOS was on life sup­port. The bank, formed by the 2001 merger of Hal­i­fax and the Bank of Scot­land, es­tab­lished in 1695, had re­ceived a se­cret Bank of Eng­land cash infusion and a £20.5 bil­lion ($29.3 bil­lion) tax­payer bailout. The govern­ment had ar­ranged for a takeover by what be­came Lloyds Bank­ing Group.

Pa­tel and Pad­dle were in traders’ pur­ga­tory, still col­lect­ing pay­checks but pre­vented from buy­ing any­thing for the bank. “I would think, ‘What am I do­ing? I’m re­gress­ing,’ ” says Pa­tel, 42. The men spent their days cal­cu­lat­ing the per­for­mance of the bank’s as­set­backed port­fo­lio, fore­cast­ing how deep losses could be, and pre­par­ing re­ports.

As they dug through spread­sheets and bond doc­u­ments, they found se­cu­ri­ties at prices that seemed far below their value. The pair rea­soned that the U.K. hous­ing mar­ket would avoid the level of de­faults that had ham­mered the U.S. There was money to be made. But Pa­tel and Pad­dle wouldn’t be buy­ing for their em­ployer. In­vest­ing up to £50,000 at a time, they bought sep­a­rately, to­gether, and in groups with two or three HBOS col­leagues. They bought dis­tressed as­set-backed se­cu­ri­ties, typ­i­cally se­cured by U.K. mort­gages, and bank bonds.

Their most prof­itable trade in­volved bonds se­cured by mort­gages made by North­ern Rock, which in 2007 needed a U.K. govern­ment res­cue af­ter suc­cumb­ing to the first bank run in the coun­try in 140 years. The se­cu­ri­ties, known as Gran­ite, col­lapsed af­ter the bank was na­tion­al­ized. Pad­dle re­calls that the mar­ket was wor­ried the govern­ment would “rip it up,” mean­ing bond in­vestors would get paid less than ex­pected. The pair bought Gran­ite bonds for less than 10 per­cent of their orig­i­nal sale price.

The duo in­vested about £8,000 each on that trade and pock­eted about £70,000 when they sold the bonds about two years later, a re­turn of about 800 per­cent. Gran­ite bonds were re­deemed in De­cem­ber and Jan­uary af­ter the govern­ment sold the un­der­ly­ing mort­gages.

Pad­dle joined HBOS in 1998, where he had been re­spon­si­ble for man­ag­ing the ma­jor­ity of as­sets meant to be quickly sold for cash. Pa­tel was a se­nior credit trader. The two men were in­stru­men­tal in the growth of Grampian Fund­ing, an HBOS in­vest­ment ve­hi­cle thatt is­sued short­term notes to buy longer-term ABS. Like many bank op­er­a­tions that re­lied on short-term fund­ing, Grampian ran into trou­ble in Au­gust 2007 when the mort­gage rout in the U.S. spread to Europe and made banks and in­vestors less will­ing to lend.

The rapid growth of Grampian and other as­set-backed debt in­vest­ments that Pad­dle and Pa­tel man­aged mir­rored the ag­gres­sive ex­pan­sion of HBOS. In seven years, its as­sets more than dou­bled, to £630.9 bil­lion.

That ex­pan­sion was the un­do­ing of HBOS, as growth in lend­ing out­paced that in de­posits, a U.K. par­lia­men­tary com­mis­sion con­cluded in 2013. Last year, U.K. reg­u­la­tors said HBOS failed be­cause it was un­able to bor­row money to fund it­self af­ter in­vestors ques­tioned its sol­vency. They also said the growth of Grampian con­trib­uted to the strain.

“Peo­ple knew that there was mas­sive liq­uid­ity risk” at the bank, says Paul Moore, HBOS’S for­mer head of risk, who says he was fired for his warn­ings about in­ap­pro­pri­ate sales of in­sur­ance and bond prod­ucts. The bank “just car­ried on to­wards disas­ter.”

In Jan­uary 2009, the month Pad­dle and Pa­tel of­fi­cially be­came em­ploy­ees of Lloyds, they sought per­mis­sion from the com­pli­ance depart­ment to buy as­set-backed bonds on their own. That’s stan­dard pro­ce­dure for money man­agers want­ing to in­vest their own cash. It was the first of many hur­dles.

The ABS mar­ket is all but im­pen­e­tra­ble for in­di­vid­u­als, with many bonds trad­ing in de­nom­i­na­tions of $100,000. When the mar­ket col­lapsed, ac­cess be­came eas­ier. With prices at around 10¢ on the dol­lar, the thresh­old to buy dropped to $10,000.

The next hur­dle was ex­e­cu­tion. It took as long as two hours for Pa­tel to ex­plain to the anony­mous cal­lcen­ter op­er­a­tive at his bro­ker what he wanted to buy and how to find it. “Ninety-five per­cent of the stuff I wanted to buy they had not heard of,” he says. “It was very painful.”

Pad­dle in­vested about £300,000 in bank debt and ABS, av­er­ag­ing re­turns of roughly 150 per­cent, while Pa­tel put in about £350,000 and av­er­aged 350 per­cent, they say. Pad­dle made roughly £450,000, and Pa­tel earned about £1.2 mil­lion. Both men made the ma­jor­ity of their in­vest­ments us­ing their pen­sion funds, mean­ing they can’t ac­cess most of their gains un­til they re­tire. Pad­dle says his prof­its helped off­set the hit he took on HBOS shares. Pa­tel’s gains ex­ceeded his stock losses.

Pad­dle left Lloyds in Septem­ber 2009. Un­able to find an­other se­nior bank­ing role in the ABS mar­ket, he be­came a fi­nan­cial ad­viser. Pa­tel, who also left in 2009, went on to co-in­vest in an In­dian startup that makes pre­ci­sion com­po­nents for min­ing. He’s now seek­ing to re­turn to the mar­ket.

The bot­tom line Who was able to spot bar­gains in toxic mort­gages? Traders at a bank with its own mort­gage trou­bles.

Low set the auc­tion high for a Basquiat

when he paid $48.8 mil­lion for

Dust­heads in 2013. He still owns it.

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