Howie Hubler was a former Morgan Stanley bond trader who became infamous for his role in the single largest trading loss in Wall Street history. His actions directly resulted in the loss of roughly $9 billion during the 2007–08 financial crisis after he purchased risky subprime mortgages in the U.S., but to offset the risk on these trades he also sold insurance on AAA-rated mortgages that market analysts considered to be less risky, but turned out to be worthless which resulted in a massive net loss in total.
Hubler joined Morgan Stanley in the late 1990s and worked in the investment bank’s Fixed Income Division as a bond trader. The former college American football player had a reputation amongst colleagues as a hothead and a bully who responded to criticism with aggression.
The types of securities Hubler traded are known as structured products and comprised a significant amount of mortgage backed securities (MBS). Mortgage backed securities are financial instruments that are made up of residential mortgages of various credit ratings.
Many of the loans contained in these batches of mortgages were ‘subprime’, meaning they were made to people that are less credit worthy borrowers. At this point, (the mid 2000’s) mortgage lending had become quite lax and financial companies were offering mortgages to people that in reality were in no position to buy houses and some of these were known as NINJA loans, which is an acronym for No Income No Job.
The general theory was that if a large number of these mortgages were grouped together into bundles, the risk contained in individual subprime loans would be counter-balanced by the overall diversity of the portfolio which would provide a net positive return.
Once the mortgages were granted to homeowners, most financial companies would then sell them off to be resold to investors such as pension funds and life insurance companies. The majority of loan originators therefore didn’t keep the loans on their books and as a result didn’t bear any risk if the mortgages were ever to default, as the risk was passed on to investors. When this happens, the overall credit quality suffers because mortgage lenders are less-inclined to show restraint in who they offer mortgages to and it was this easily obtainable credit that fuelled the mid noughties housing bubble.
In his book The Big Short, Michael Lewis described Mortgage Backed Security trading as a low stakes poker game that was rigged in the favour of the traders. As long as there was demand for the products, aided by risk-free stamps of approval from the credit rating agencies, the MBS machine was able to keep running and as a result it became extremely profitable.
Hubler and his team were generating hundreds of millions of dollars in profits for Morgan Stanley using these methods and by 2006, he and his group of 8 bond traders accounted for about 20% of Morgan Stanley’s profits by their own estimates.
During the relatively short period between buying the risky mortgages from the mortgage originators and selling them off to investors as Mortgage Backed Securities (MBS), Hubler and his team were exposed to the risk that the loans could go bad. Subsequently, an instrument known as a credit default swap (CDS) was created to offset the risky loans they were wholesaling.
A CDS is a sort of insurance policy on an MBS in case it defaults and much like insurance, a premium has to be paid annually to ensure ‘coverage’. Hubler and his team therefore saw the warning signs and cleverly bought some of this protection on the riskier portions of MBS.
The blunder occurred when Hubler and his team attempted to fund the purchase of the CDS by selling credit default swaps on their triple-A rated MBS. So basically they were acting like an insurance company on their good quality mortgage loans and receiving premiums in return for a potential pay out if any of them defaulted. Because the good quality MBS were ‘safer,’ the premiums earned on them were lower, so therefore to cover the cost of buying CDS cover for the sub-prime loans, more of the good loans had to have CDS sold against them and by January 2007, Hubler had sold credit default swaps on $16 billion worth of triple-A rated securities.
By mid 2007, the mortgage market had begun to unravel as the credit crunch kicked in. New Century, which was the largest subprime lender in the U.S. at the time, had filed for bankruptcy and eventually the triple-A securities collapsed along with riskier BBB loans.
MBS that were previously priced at 100 were now trading at 7.6 and this cast a dark shadow over the credit rating system used at Standard & Poor’s and Moody’s.
Since Hubler had disproportionately sold more insurance on the AAA MBS than he had bought for the sub-prime MBS, he was obliged to pay out more than he received as a result of the triple A’s unexpected collapse.
Morgan Stanley therefore accrued losses of $9 billion as a result of Hubler’s blunder, which is 12 times the amount lost by the rogue trades that Nick Leeson made to cause the collapse of Barings bank.
If such a loss had occurred at other financial institutions, it is unlikely they would have been able to survive but Morgan Stanley at the time held $70 billion in capital so the losses represented about 13% of the bank’s worth – an amount that was devastating but would not result in its demise.
What went wrong?
Hubler’s $16 billion liabilities on AAA loans were amassed because the securities were considered risk-free due to their rating. They were effectively treated like government bonds so when they came in they didn’t cause any alarm. Of course, they would go on to lose 93% of their value, but Morgan Stanley’s risk management system used a backward looking process that assessed historical volatility to predict future risk. As the housing market had never experienced anything like the problems it suffered in 2007 since the Great Depression, it was generally assumed that everything would be fine.
In our opinion, Morgan Stanley shouldn’t be too down hearted about losing $9 billion simply because Mr. Hubler was over-confident about the safety of triple A mortgage loans. Our publisher Darcus White recently sold his house to purchase some Chinese cryptocurrency in the same week they were banned by the Chinese government – whilst the house was worth nowhere near $9 billion, it certainly constituted a damn sight more than 13% of his total net worth that can never be recovered!