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”
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 that 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.