The $3 Billion Hedge
The Wolf of Wall Street option was a right granted to a specific commodity. One would set a base asset as the standard, determine the expiration date, and then issue a call option or put option based on whether the value of that commodity would rise or fall. A call option was the right to buy at a specific price. For example, if the current price of crude oil was $65 per barrel and one purchased a call option to buy at $80 in three months, but the price rose to $100 after three months, a $20 profit would be made. Because one had taken the risk to secure the right to buy at $80 in advance, the purchase could be made at $80 instead of $100.
The opposite of a call option was a put option. A put option was the right to sell, functioning in reverse of a call option. Using crude oil as an example again, suppose one bought a put option exercisable at $50 in three months. If the price of crude oil fell to $30 per barrel after three months, that would yield a $20 profit. Those without the option would have had to sell at $30, but with the option, they could sell at $50.
However, options were not always good. No one on Wall Street could guarantee an accurate prediction of the price at expiration. The best one could do was set a standard through sharp intuition or precise calculations and constantly monitor while preparing for risks. After all, an option that failed to reach the strike price at expiration held no value whatsoever. In other words, the money invested in the option would simply vanish. Even if the price barely reached the strike at expiration, one still had to pay the option premium separately, so profits and losses had to be calculated including that cost. Therefore, to truly profit from options, investments had to be structured by considering not only the price of the underlying asset at expiration but also the option premium.
Because of these complexities, options were typically used as insurance to hedge risks in large investments or sold midway through the period without waiting until expiration. Aaron Fuld possessed an exceptional eye for discovering subprime mortgage products, but even he was not so detached from common sense. That was why Vincent Greenhill’s proposal had been completely unexpected.
“A put option on subprime mortgage products. It seems President Vincent is quite certain that subprime mortgages will decline?”
“That’s right.”
Vincent nodded firmly at Aaron, showing not a trace of anxiety. Although the negative outlook on subprime mortgages had originated with Yoo Jae-won, Vincent shared the same view. The idea that homeless people could buy homes with unsecured loans was a clear indicator of an overheated market. Moreover, not only Vincent but also ID Investment’s investment analysis team was convinced of the subprime mortgage bubble. The only disagreement was over the timing of the collapse. It was clear the pressure cooker was about to explode, yet some analyses suggested the U.S. economy was so strong that it could last a few more years.
Yoo Jae-won felt the same. From his experience before regression, he knew the subprime mortgage crisis would originally erupt on August 16, 2007. But with so many economic variables having changed significantly, assuming it would happen on the exact same date was risky. There was even a high possibility it could burst earlier amid the current economic boom. Although Yoo Jae-won had not given Vincent an exact date, they shared this sense of unease. Vincent and ID Investment’s analysis team, who trusted Yoo Jae-won’s words enough to believe them even if the sky split in two, concluded they should purchase a massive volume of put options on subprime mortgage investment products.
The problem was that put options on subprime mortgage products did not yet exist. Someone had to issue the options, and currently, no one except ID Investment was predicting the collapse of subprime mortgage products.
“But why come to us specifically?”
“Because Lehman Brothers is the place showing the most optimistic outlook on subprime mortgages, isn’t it? I figured you’d be expecting such high growth rates that issuing put options wouldn’t be much of a burden.”
Aaron nodded at Vincent Greenhill’s words. Indeed, both he and the other executives at Lehman Brothers were positive about subprime mortgages. However, they could not rashly decide to issue put options. It was not because they lacked authority. As CFO, Aaron’s position allowed him to wield power over a wide range of matters, from raising funds for investments to making decisions in investment areas. Rather, the proposal was so tempting that he wondered what kind of trap might be hidden within it.
“Could you give me a moment to think?”
“Take all the time you need.”
With the time granted, Aaron examined Vincent Greenhill with cautious eyes. Without the title of President of ID Investment, he would have looked like an ordinary old man. His once-golden hair had turned completely white, and his clothes and shoes were all plain. The only thing that caught Aaron’s attention was the golden Royal Oak watch on his wrist. It was apparently a long-service award from ID Group—custom-made and impossible to buy even if one wanted to. This allowed Aaron to organize his thoughts to some extent.
“How much of the put option are you planning to purchase? As you know, for Lehman Brothers to move, we need at least ten million dollars…”
“How small-minded. At least a hundred million. No upper limit.”
Vincent countered firmly against Aaron, who had spoken cautiously even about ten million dollars. One hundred million dollars—ten times the amount in a single stroke. And with no upper limit, that meant even a billion dollars would be acceptable. Aaron’s expression changed instantly. Options were, after all, insurance products. Therefore, betting over a hundred million dollars on a single position was extremely rare. That did not mean it never happened, though. In the past, during the Gulf War, ID Investment had made a name for itself with enormous bets on oil futures. The story of taking a massive long position and reaping enormous profits had become a legend on Wall Street. Did the current situation resemble that time? For a moment, suspicion flashed through Aaron’s mind that he and his company might have been too optimistic about subprime mortgages. But that doubt quickly faded. From economic indicators to the daily reports he received, everything looked far too good. Of course, as Vincent said, the scale of subprime mortgages was growing daily, but the housing market rise supporting it remained steady. It would collapse someday, but it did not seem likely to happen anytime soon.
“Hmm, that scale is feasible. However, I cannot decide on this matter alone. I will consult with the executives and get back to you.”
Aaron displayed maximum caution, contrary to his inner thoughts. If he closed this deal alone, he could secure another enormous performance bonus, so he had no intention of sharing it with others. Still, he needed safeguards, and that required time.
“Understood. I’ll wait. But the sooner, the better.”
“Is there a reason it has to be urgent?”
“Haha, if you thought we’d only make this proposal to Lehman Brothers, you’d be disappointed. The same offer will go to AIG, Citigroup, BOA, and Wells Fargo as well.”
The financial institutions Vincent listed were all actively investing in subprime mortgages.
“Ugh.”
Aaron loosened his tightly knotted tie slightly and focused on his thoughts. To him, this deal seemed like the first wrong judgment by Vincent and ID Investment, who had been writing new history on Wall Street. It was like throwing away hundreds of millions of dollars, while for Lehman Brothers, it was nothing short of easy money. Would the other companies not realize this? They had to secure as much as possible before those firms made their moves. Yet he could not flip his earlier words like turning over his palm. At this point, it was a battle of nerves. Aaron maintained his poker face as best he could while seeing Vincent out. He immediately requested an emergency executive meeting and explained Vincent’s put option sales proposal. As expected, Lehman Brothers’ executives all shared Aaron’s view. Some even saw it as a good opportunity to strike back at ID Investment, which had built such a reputation on Wall Street.
The next day, Lehman Brothers contacted Vincent to say preparations for the transaction were complete, and that very day, a massive sum was transferred to Lehman Brothers’ account. The exact amount was a staggering two billion dollars! It was the largest single put option transaction in history. Two billion dollars was immediately transferred from ID Investment’s account to Lehman Brothers’ account, and through the financial network, put options worth the same two billion dollars were registered in ID Investment’s account.
- The options issued by Lehman Brothers expire in October 2006 and can be exercised when the yield on the underlying subprime mortgage-backed securities (CDOs) falls below 3%.
- For every 0.01% decline below the 3% CDO yield benchmark, a profit of ten million dollars is generated. If the yield turns negative, the profit becomes one hundred million dollars per 0.01%.
- AIG and Citigroup each issued options with the same structure worth five hundred million dollars, and negotiations with BOA are ongoing.
“As expected, President Vincent is quite skilled.”
Yoo Jae-won applauded as he read the report. The total scale of put options purchased by ID Investment up to this point was three billion dollars. The largest portion came from Lehman Brothers, and AIG and Citigroup had also failed to resist their greed. Of course, there was risk for Yoo Jae-won as well. If the subprime mortgage crisis did not erupt at the end of 2006 but instead at the original time in August 2007, the three billion dollars currently invested would evaporate. On top of that, ID Investment’s reputation would suffer a major blow. However, it would not be a significant hit to Yoo Jae-won. Among ID Group’s subsidiaries, listed companies from Android to Technology paid regular dividends every year. The notion that IT companies paid meager dividends did not apply to ID Group. The dividend was at least one dollar per share, and for ID Technology, which had hit the jackpot with smartphones, the dividend reached five dollars per share. The cumulative amount received from dividends alone easily exceeded ten billion dollars. Even if ID Investment incurred losses from this put option investment, it was an amount they could easily absorb. Rather, Yoo Jae-won thought it would not be bad even if this put option deal fell through.
“Then we can just buy even more based on 2007.”
Investment firms that earned billions of dollars in a single sitting would surely scale up their next trades several times over. Lehman Brothers had fearlessly gone all in with two billion dollars, while AIG and Citigroup had been slightly more cautious. If these companies saw Lehman Brothers hit the jackpot with put options, they would undoubtedly begin issuing them competitively as well. Conversely, in the unlikely event that ID Investment’s three-billion-dollar warning was taken seriously and they withdrew from subprime mortgages or halted new issuances, that too would be a positive outcome.
The next day.
- ID Investment warns of subprime mortgage overheating.
- Sets up three billion dollars in put options! President Vincent proves it with action.
- While caution against overheating is good, one must also be wary of consumption contraction due to excessive caution.
When Yoo Jae-won returned to his home in San Francisco after crossing the Pacific, news about ID Investment’s bold bet began pouring in. Although the option investment was already a considerable scale, investing a full three billion dollars in put options was an extremely unusual event. Not only financial media but also regular news outlets were buzzing about it. Reactions in the investment market varied. Investment firms with large subprime exposure and big players on Wall Street could not hide their displeasure and wanted to brush the news aside. However, a three-billion-dollar bet was impossible to ignore. Individual investors also disliked it greatly. The heavy selling of put options implied a dark outlook ahead. Moreover, ID Investment had consistently held a negative view on subprime mortgages and had now demonstrated it with action by purchasing three billion dollars’ worth of put options, causing the stock market to trend downward from the opening bell. Without any special developments, the market would likely have closed in the red.
“Hmm? What’s this?”
Just as the stock, bond, futures, and other investment markets had been declining steadily since the opening, a rebound occurred with about twenty minutes left until closing. There was no need to exert effort to find the cause of the rebound. An urgent disclosure had appeared on Yoo Jae-won’s corporate HTS.
- The Federal Reserve decides to cut interest rates.
- Measures for a stable soft landing.
- Caution against excessive concerns in the financial market; inflation concerns are not significant.
The interest rate cut was only 0.25%, not a large reduction. However, the fact that it was a cut rather than a freeze was highly positive for the financial market. The downward trend reversed instantly, and the composite index, after hitting bottom, began rising rapidly.