Making a profit on the crashing market

This is the third in a five-part series on the subprime mortgage crisis.

J. Kyle Bass, a hedge fund manager from Dallas, strode into a New York conference room in August 2006 to pitch his theory about a looming housing market meltdown to senior executives of a Wall Street investment bank.

Home prices had been on a five-year tear, rising more than 10 percent annually. Bass conceived a hedge fund that bet on a crash for residential real estate by trading securities based on subprime mortgages to the least credit-worthy borrowers. The investment bank, which Bass declines to identify, owned billions of dollars in mortgage-backed securities.

"Interesting presentation," Bass says the firm's chief risk officer said into his ear, his arm draped across Bass' shoulders. "God, I hope you're wrong."

Within six months, Bass was right. Delinquencies of home loans made to people with poor credit reached record levels, and prices for the securities backed by these subprime mortgages plunged. The world's biggest financial institutions would write off more than $80 billion in subprime losses, while Bass, his allies and a handful of Wall Street proprietary trading desks racked up billions in profits.

Bass and investors like him saw opportunity in a range of new investment tools that banks created to sell subprime securities worldwide. These included mortgage bond derivatives, contracts whose values are derived from packages of home loans and are used to hedge risk or for speculation. The vehicles allowed hedge funds such as Bass' to bet against particular pools of mortgages.

The new subprime derivatives, which amplified the risks of the underlying mortgages, were sold to banks and institutional investors. When borrowers started to default on high-yield, high-risk subprime mortgages by the thousands, the values of these leveraged securities plunged.

An index designed to be a proxy for the lowest investment-grade subprime mortgage bonds sold in the second half of 2005 -- the ABX-HE-BBB-06-01 -- traded as high as 102.19 cents on the dollar when it started in January 2006 and today trades at about 30 cents on the dollar.

Bass, a former salesman for Bear Stearns Cos. and Legg Mason Inc., had struck out on his own in early 2006. He started Hayman Capital Partners, specializing in corporate turnarounds, restructurings and mortgages. Bass isn't related to Texas billionaire Robert Bass.

Bass named Hayman for the private island off Australia where he spent his honeymoon. He drove a $200,000 500-horsepower Porsche Ruf RTurbo with a built-in race-car-style crash cage.

A former competitive diver who had put himself through Texas Christian University in Fort Worth partly on an athletic scholarship, Bass was about to take his most ambitious plunge yet: betting home values would decline for the first time since the Great Depression.

"We were saying that there were going to be $1 trillion in loans in trouble," Bass says. "That had really never happened before. You had to have an imagination to believe us."

Other early converts were Mark Hart of Corriente Capital Management in Fort Worth, Texas, and Alan Fournier of Pennant Capital in Chatham, N.J.

On the other side of their trades would be investors chasing the high yields from securities based on subprime loans. This group included Wall Street firms, German and Japanese banks and U.S. and foreign pension funds. They were reassured by the securities' investment-grade ratings, even as foreclosures started in some parts of the U.S.

To learn about the contracts, Bass visited Wall Street trading desks and mortgage servicers. He met with housing lenders and hedge fund analysts. He read Yale professor Frank Fabozzi's book on mortgage-backed securities, "Collateralized Debt Obligations: Structures and Analysis." Twice.

Bass and Fournier hired private detectives, searched news reports, asked Wall Street underwriters which mortgage companies' loans were at risk of default and called those lenders directly. Bass turned up the California mortgage lender Quick Loan Funding and its proprietor, Daniel Sadek.

The hedge fund traders learned from a news account that Sadek was dating a soap opera actress, Nadia Bjorlin, and using profits from his mortgage company to fund a movie about car racing, in which she starred.

"When they started catapulting Porsche Carrera GTs and he says, 'What the hell, what are a couple of cars being thrown around?' I'm thinking, 'That's the guy you want to bet against,' " Bass says.

Bass called Quick Loan Funding directly. He says he got on the phone with a senior loan officer, identified himself and said he was interested in the mortgage business. As Bass tells it, the conversation sealed his determination to short Quick Loan's mortgages.

For his part, Sadek says he was never told that hedge funds had asked how his firm did business. He disputes Bass' characterization of Quick Loan's mortgages.

"If my loans were so bad, why did Wall Street keep buying them to securitize?" Sadek says.

One of Bass' first investors was Aaron Kozmetsky, a Dallas investor. Kozmetsky's grandfather, George Kozmetsky, was one of the founders of Teledyne Technologies Inc.

"It was the first time he's said: 'Drop what you're doing. You need to meet with me on this. Make time for me,' " Kozmetsky says. Kozmetsky invested more than $1 million.

Bass and Fournier focused on single-name mortgage bond derivatives to be more certain that their bets were right. Both bought only securities rated BBB and BBB-, rather than AAA rated securities, expecting them to pay off more quickly.

As Bass and Fournier executed their trades in August and September 2006, foreclosures were beginning to spread across the U.S.

"This is the fat pitch," Bass says. "This is the once-in-a-lifetime, low-risk, incredibly high-reward scenario where we're going to be right."

THURSDAY: Moody's, S&P stoke the demand for mortgage-based securities.