He modeled every U.S. mortgage by zip code, then bet against housing for 1% a year
By tracing risky loans to the mortgage bundles that funded them, he replaced a costly bet against bank stocks with cheap insurance that paid off when housing cracked.
Joys of Compounding · Chad Cascarilla - Blockchain’s Carpenter - [Joys of Compounding, EP.26]Chad Cascarilla, a former Goldman Sachs analyst running a hedge fund that invested only in financial companies, spent his days inside filings most investors never opened. Banks and lenders had to publish regulatory and securitization reports every month, not just quarterly earnings, and his team at Cedar Hill fed them into spreadsheets until they had modeled every single home loan in the country by zip code.
What he saw did not make sense. Someone was lending $600,000 to buyers with $600,000 houses and no verified income or job. Cascarilla kept asking the simplest question: who is funding these loans?
The answer led him to bundles called securitizations, in which thousands of mortgages were pooled together and sold to investors as bonds. That discovery gave him a cheaper way to bet that housing would collapse. The fund reportedly gained about 200% in 2007, if notes about that year were right.
A normal way to bet against a lender was to short its stock, or borrow shares and sell them hoping to buy them back cheaper. That was brutally expensive, costing 25% to 40% a year in dividends owed and fees to borrow the shares. A newer tool, called a credit default swap, worked more like insurance on those mortgage bundles. You paid a small annual fee, and you collected if the bundle failed.
Cascarilla realized the swap did two things at once. It let Wall Street create more of those risky bundles, because risk could be passed around and priced carelessly, and it also let an outsider bet against the riskiest slice for only about 1% a year. The same invention that fed the irrational lending also made it possible to bet against it.
That math changed everything. For the price of shorting $1 of bank stock, he could place $25 to $40 of bets against the mortgage bundles themselves. He began putting an amount equal to the value of his fund, and then multiples of it, into the trade, and even created separate vehicles just for it.
His investors were alarmed. They told him the trade was too risky and asked what he was doing. Then once the trade started to work, the cheap insurance paid off and the same investors asked a different question: why had he not bought more. As Cascarilla put it, "no good deed goes unpunished."
Questions people ask
What exactly is a credit default swap?
A credit default swap is a contract that works like insurance on a loan or bond. The buyer pays a small annual fee, and if the borrower defaults, the seller has to cover the loss. Investors who do not own the underlying loans can buy swaps purely to profit if the loans fail.
What is a securitization?
Securitization means pooling thousands of individual mortgages together and selling pieces of that pool to investors as bonds. The investors collect the homeowners' monthly payments, and take the losses if homeowners stop paying.
Why did it cost so much to short mortgage stocks directly?
To short a stock you must borrow shares, sell them, and later buy them back. If the stock pays a dividend, you owe it while you wait, and if many people want to borrow a popular or fragile stock, the borrowing fee soars. Those two costs together made betting directly against mortgage lenders cost 25% to 40% a year.