The Rapid Rise and Blistering Fall Of Boaz Weinstein

The WSJ has a long piece on Boaz Weinstein's tenure at Deutsche Bank. Weinstein was DB's "star trader" for a few years—right up until he managed to lose $1.8 billion.

So how did Weinstein lose $1.8 billion? The same way every "star trader" loses a boatload of money: they make a lot of money exploiting arbitrage opportunities in good times, and then lose it all when their market goes berserk in a crisis. Repeat as necessary.

Specifically, Weinstein lost most of the money on basis trades when Lehman collapsed and the corporate bond market froze:

By early 2008, Mr. Weinstein was at the top of his game. He, along with a colleague in London, was overseeing global credit trading for all of Deutsche Bank. His own trading group, Saba, had grown greatly, to roughly $30 billion of positions and $10 billion in capital. And his control also extended to the bank's trading for customers.

Wall Street traders were optimistic in early 2008 that the mortgage crisis was contained, though there were some strains in short-term lending markets, causing corporate-bond prices to decline. On several businesses, such as Ford Motor Co., Lyondell Chemical Co. and General Electric Capital Corp., Mr. Weinstein bought corporate bonds or loans as well as credit-default swaps.

The swaps would pay off if the debt defaulted. And the cost of this protection was less than the income produced by the bonds. Mr. Weinstein believed the debt was cheap relative to the cost of protecting it with swaps.

Corporate bond prices soon rallied, leading to a tidy profit for Mr. Weinstein's group, after the Fed's brokering of a deal for reeling Bear Stearns Cos. stabilized the credit markets. Emboldened, Mr. Weinstein added to his positions in succeeding months. His group entered September in the black for the year, expecting to tack on more gains.

But the simmering financial crisis finally boiled over. The government said early in September that it would take over mortgage giants Freddie Mac and Fannie Mae. And Lehman Brothers Holdings Inc. was teetering. Traders worried about losses they might incur if Lehman failed.
...
The next day it became clear Lehman would fail, and a struggling Merrill Lynch & Co. agreed to sell itself to Bank of America Corp. Within days, the government bailed out another big player in credit derivatives, American International Group Inc.

Brooding in his office overlooking Wall Street, Mr. Weinstein remained outwardly calm as markets went haywire, traders say. The value of his group's holdings of corporate bonds and loans began to slide as other investors, needing to raise money, sold such securities.

At the same time, trading in credit-default swaps was curtailed because market players were concerned about entering trades with banks that potentially could collapse. This left Mr. Weinstein's group increasingly unprotected against losses in corporate bonds and loans, because it used swaps to hedge those positions.

Mr. Weinstein wasn't alone. Similar positions held by banks and hedge funds across Wall Street fell apart amid the seismic dislocations after the Lehman collapse.

As prices of corporate bonds and loans slumped to new lows and stocks plunged too, Mr. Weinstein wanted to buy more swaps to protect his positions, traders say. He told traders that in such a trading environment, "the primary objective is to get as flat as possible to the market" -- not betting on either a rise or a fall -- according to a person familiar with the conversation.

But in contentious conference calls, risk managers at Deutsche Bank told Mr. Weinstein to scale back positions or sell them entirely, traders say. Mr. Weinstein's stock-trading desk was instructed to sell nearly every holding, effectively shutting it down.

I don't think the dislocation in the CDS market after the Lehman collapse was as simple as the WSJ article suggests. It wasn't just that "players were concerned about entering trades with banks that potentially could collapse." That was definitely part of the problem, especially for Merrill.

But as I noted earlier, a big problem was that protection buyers all wanted to lock in their profits when spreads exploded wider (or, alternatively, net protection sellers wanted to cap their losses). And since the dealer banks generally try to run matched books—note that Weinstein's biggest concern in the crisis was getting "as flat as possible to the market"—all the end-users demanding to unwind their CDS trades essentially forced dealers to unwind off-the-run contracts at off-market prices, which is expensive for the dealers and generally requires a sizable upfront payment. It probably didn't help that traders at the dealer banks, being traders, couldn't stop shooting at each other.

As the WSJ article notes, however, the losses on Weinstein's basis trades came predominantly from the corporate bond leg, not the CDS leg. That's what happens when the entire corporate bond market suddenly shuts down, I guess.