The beginnings of a meltdown: Traders saw a cash cow in mortgage derivates

This is the first in a five-part series about the subprime mortgage crisis.

Representatives of five of Wall Street's dominant investment banks gathered around a blond-wood conference table on a February night almost three years ago. Their talks over take-out Chinese food led to the perfect formula for a U.S. housing collapse.

The host was Greg Lippmann, then 36, a fast-talking Deutsche Bank AG trader who aspired to make mortgage securities as big a cash cow for Wall Street as the $12 trillion corporate credit market.

His allies included 34-year-old Rajiv Kamilla, a trader at Goldman Sachs Group Inc. with a background in nuclear physics, and 32-year-old Todd Kushman, who led a contingent from Bear Stearns Cos. Representatives from Citigroup Inc. and JPMorgan Chase & Co. also were invited. Almost 50 traders and lawyers showed up for the first meeting at Deutsche Bank's Wall Street office to help set the trading rules and design the new product.

"To tell you the truth, it's not very glamorous," Lippmann says. "Just a bunch of guys eating Chinese discussing legal arcana."

Those meetings of the "group of five," as the traders called themselves, became a turning point in the history of Wall Street and the global economy.

Magnifying losses

The new standardized contracts they created would allow firms to protect themselves from the risks of subprime mortgages, enable speculators to bet against the U.S. housing market, and help meet demand from institutional investors for the high yields of loans to homeowners with poor credit.

The tools also magnified losses so much that a small number of defaulting subprime borrowers could devastate securities held by banks and pension funds globally, freeze corporate lending and bring the world's credit markets to a standstill.

For a while, the subprime boom enriched investment bankers, lenders, brokers, investors, real estate agents and credit-rating companies. It allowed hundreds of thousands of Americans to buy homes they never believed they could afford.

It later became clear that those homeowners couldn't keep up with their payments. Defaults on subprime mortgages have so far produced about $80 billion in losses on securities backed by them. The market for the instruments is so opaque that many firms still aren't sure how much they've lost.

Go-go lending

Chief executives at Citigroup, Merrill Lynch & Co. and UBS AG were replaced. To forestall a housing-led recession, the Federal Reserve has cut its benchmark rate three times since August and is injecting as much as $40 billion into the credit system to encourage banks to lend to each other.

This is the story of how Wall Street transmitted the practices of Southern California's go-go lending industry and the inflated U.S. real estate market to the global financial system.

Lippmann was a Wall Street Renaissance man, with a strong appetite for sushi and an online restaurant guide so comprehensive one blogger labeled him "the Robert Parker of raw fish." He opened the kitchen of the $2.3 million Manhattan loft he lived in then, complete with six burners, two grills and 20-foot island, to an Italian cooking class.

The goal of Lippmann's group on that winter evening in 2005: to design a new financial product that would standardize mortgage-backed securities, including those based on high-yield subprime loans, paving the way for their rapid growth. Of the firms participating that night, Lippmann's Deutsche Bank is based in Frankfurt, UBS in Zurich and the others in New York.

In February 2005, pension funds, banks and hedge funds owned fixed-income securities that were earning returns close to historic lows. AAA-rated securities based on home loans offered yields averaging a full percentage point higher than 10-year Treasuries at the time, according to Merrill.

The trouble was that most creditworthy borrowers had already refinanced their houses at 2003's record-low mortgage rates. To meet demand for mortgage-backed securities, Wall Street had to find a new source of loans. Those still available mainly involved subprime borrowers, who paid higher rates because they were seen as credit risks.

More securities

The banks wanted more mortgage-backed securities to sell to clients. Creating a standardized "synthetic" instrument, or derivative, would leverage small numbers of subprime mortgages into bigger securities. In that way, the firms could produce enough to meet global demand.

Deutsche Bank sprang for the take-out food, and traders and lawyers sat down to design a new product and create what would soon become one of the hottest capital markets in the world.

The meetings were monthly, beginning at 5 p.m., and lasted more than three hours each. By June, the differences were sorted out, the new contract was endorsed, and banks that hadn't been party to the group of five negotiations signed on.

Another necessary step was to create an index to represent the market and help hedge general market exposure. It was called the ABX-HE and would be similar to the indexes traders use for baskets of stocks. This, participants believed, would add to the market's liquidity, or depth, by attracting more trading.

The ABX-HE index started trading on Jan. 19, 2006, with a volume of more than $5 billion. The cost of wagering against the securities was rising, a sign that traders saw an increased chance of default. An early warning was visible to anyone who knew where to look.

In the months to come, Deutsche Bank and at least one other member of the group of five, Goldman Sachs, began using subprime derivative contracts to bet the other way and guard against the possibility that subprime mortgages might default.

For Lippmann's part, he says he thought the risks of a downturn were significant enough to justify the millions of dollars it would cost to "short," or wager against, subprime securities. He says he told his bosses: "If we're right, we're looking at a sixfold gain. And since a housing market slowdown is not as big a long shot as that, we should take the risk."

'Seat belt'

Lippmann disputes that the derivatives the group of five helped create -- which banks packaged into collateralized debt obligations, or CDOs -- caused the current subprime crisis.

"The problems in subprime are what they are and derivatives did not cause them," Lippmann says. "Derivatives enabled more CDOs to be created and the stakes to be bigger. But the transparency made people realize the problem faster."

Others see things quite differently.

Derivatives, or "synthetics," are "like wearing a seat belt that allows you to drive faster," says Rod Dubitsky, director of asset-backed research for Credit Suisse. "The total dollar amount of losses, all these losses you're seeing, are from synthetics. No question, it changed the game dramatically."

TUESDAY: The story of Daniel Sadek and his subprime mortgage company, Quick Loan Funding Corp.