Lately I have been hearing a lot about how Wall Street mortgage market makers who brought the global economies to their knees were “stupid.” MIT Quants, Berkeley physicists, Harvard, Stanford and Wharton MBA’s, we are told, were completely clueless about the upcoming housing collapse. We are supposed to believe that these physics and stochastic calculus majors did not understand that what goes up must come down.
At the 92 Street Y in New York last week, Michael Lewis, the prolific author of “The Big Short” (out in paperback this month), claimed to NPR’s engaging host Ira Glass that most guys on Wall Street did not see the downturn in housing coming. He further declared that only 10-20 people in the whole industry saw the upcoming crisis – the rest are either “fools or crooks.” The handful of credit default swap (CDS) traders aka “short-sellers” in his book are his “heroes.” “I like these guys,” he announced. “I want the reader to like them too.”
Well, we do like them – as much as we can like people who escalated the collapse of the U.S. financial system and were on the receiving end of hundreds of millions of dollars of government bailout monies. Remember AIG? They were one of the losers on the other side of the trades from Lewis’ “heroes.” I guess that means you and I lost that bet.
DealBook writes: We watch these traders “build their credit-default-swap positions. As our guide, Lewis provides the best description to date of the way mortgages, and side bets on the health of those mortgages, turned into gigantic liabilities that sank the mighty insurance group A.I.G.”
How much did A.I.G. cost us? Three hundred billion and counting? Lewis, who has not been in the business of finance for over two decades since his year as a junior salesman on a Eurobond desk, describes a world of glorified avarice that has changed radically in his absence. The Big Short’s accolades for bad behavior are retro-1988, and for all practical purposes so is the book’s theme: greed is good.
How CDS Work
Very briefly, credit default swaps are “quasi-insurance” polices taken out on any financial instrument, in this case: mortgage securities. You buy a mortgage security for your pension fund for say $200m and then “insure” it with a CDS for a fee of $200k annually. If the security defaults (borrowers stop paying their mortgage loans), you get paid by the insurer.
A.I.G. wrote billions of dollars’ worth of these policies. Yet, unlike insurance they had no capital stored away for that rainy day of default. Why? Because they are called “swaps” and the headquarters for these lethal bets was moved to London from Connecticut to circumvent U.S. insurance regulations.
Getting the picture? It gets worse.
“Naked credit default swaps” are swaps held by third parties without any material interest in the underlying security. Translation: You don’t actually have to own the security you are betting against.
Insurance laws developed in England and America in the 18th century. Up until then you could buy insurance on a ship’s cargo that you did not own, sink it and collect on the claim. It was common and legal practice. The law changed in 1746 to include “insurable interest”—meaning you had to actually own the ship, so you would not wish to destroy it.
Before life insurance laws changed, you could purchase a policy on anyone, including complete strangers. Somehow these “insured strangers often wound up murdered.” Ultimately that law was updated to certify that “the purchaser of the policy must have a legitimate interest in the preservation of the insured.” Fancy that.
Naked CDS while common and legal practice, does not mean you are stripped bare; it simply means that you can blow up the world and not take yourself out with it.
Making Heroes of Villains
The Big Short depicts some of the most destructive and self-serving traders in the financial crisis as heroes. They have no insurable interest other than murdering the guy on the other side of the trade.
As Oxford Reviewers Joel Krupa and Braden McDonald explain:
Yet an uncomfortable truth remains; namely, that individuals like The Big Short’s heroes were driving demand for so-called synthetic investments [CDS]. For example, when Eisman unequivocally finds out that he is driving this demand, he tells Lippmann “Whatever that guy [a smug major investment manager named Wing Chau] is buying, I want to short it.”
Eisman’s Harvard law degree helped him understand the credit default contracts he was betting on. If the housing market flattened or declined, he won. Lewis describes Eisman (who along with Deutsche Bank’s Greg Lippman made somewhere between $50m-$100 million each on their shorts) incredibly as: “Wall Street’s first socialist.”
Socialists they are clearly not; capitalists they are in spades. But this is the kind of raw unbridled capitalism that should make us shocked—not awed. At whose expense did they profit?
Other People’s Money
The Naked Capitalist reports: Lewis completely ignores the most vital player, the one who was on the other side of the subprime short bets…The author is remarkably uncurious about who the end investors were for CDOs. Listen up. Who really was on the other side of the shorts’ trades is the important question.
And who were they? Lehman Brothers, Merrill Lynch, Bank of America, Morgan Stanley, Bear Stearns to name a few—the entire mortgage lending and securities market actually. And since we were the ones to pick up the tab for the big boys bad trades— the rest of the America’s working folk were too.
That anyone would describe short-sellers in the post-2008 world as “heroes” is astonishing. Have these guys succeeded in convincing Lewis that there was some sort of noble social contract inherent in their gluttony? After all, they are traders and this is what traders do – make you believe they are on your side until you realize you have been royally screwed.
As Lewis himself described these CDS trades, “It’s like someone buying fire insurance on a house and watching the house burn down.”
Actually that is not the whole picture.
It is like someone buying fire insurance on your house, then supplying the gasoline and matches to set the house on fire—all the while cheering from the sidelines for an arsonist to come along and light the match. There is nothing – absolutely nothing - heroic about credit default swaps or those who traded them. As Lewis admitted publicly last week, credit default swaps should be illegal. Should we celebrate arsonists too?
The Naked Capitalist continues: Eisman recognizes that the subprime market is a disaster waiting to happen, a monstrous fire hazard that, once lit, will engulf the housing market and financial firms. Yet he continues to throw Molotov cocktails at it. Eisman is no noble outsider. He is a willing, knowing co-conspirator. Even worse, he and the other shorts Lewis lionizes didn’t simply set off the global debt conflagration, they made the severity of the crisis vastly worse.
An Old Story
Short-sellers are neither new nor noble. In 1931 Herbert Hoover claimed, “Short-sellers are destroying public confidence…If these gentlemen had any sense of patriotism which outruns immediate profit, they will close up and desist from their manipulations.”
John Paulson, perhaps the biggest short of them all, was embroiled last year in a scandal with Goldman Sachs for his alleged co-creation of toxic CDO debt dubbed Abacus—a portfolio of poorly performing mortgage securities. Goldman sold the securities to investor’s like Germany’s IKB Deutsche Industriebank. Paulson’s hedge fund used CDS positions to bet against IKB and along with Goldman made $1bn on the deal. The SEC sued Goldman claiming the firm deliberately duped its own client. (The case was settled for a $500million fine against Goldman.)
Does that billion dollar scam make Paulson a hero? Perhaps, that is why he is notably absent from the pages of BS, he knows he is no hero—simply a “smart trader” with nerve, luck and the absence of laws on his side.
The international community is no longer giving CDS traders a “free pass.” A movement in the European Union to ban these swaps is underfoot. Germany has already banned “naked CDS” on government securities and France is considering such a move too. The move to ban CDS on residential mortgage securities continues to be hotly debated with the U.S. as one of the ban’s biggest opponents. JPMorgan, Goldman Sachs, and many other U.S. based firms hold large CDS positions. They do have big swinging…lobbyists. Don’t they?
The real truth is that Wall Street pros on both sides of the trades have managed to beat the odds against us all. The losers and winners got their big payoffs directly from our hard-earned cash. In the end, how stupid were any of them when we were the ones to the fall for their high stakes trillion dollar game?
The mortgage market makers on both sides of the bets were neither “fools nor crooks.” (They broke no laws.) They were simply doing what they do—making money anyway they can, no matter who got hurt. We were only the pawns on the chessboard they were moving around.
In the end, the American public was bluffed by the best—a group of smart poker players who pretend to be “stupid” rather than be revealed as indifferent. Perhaps the greatest trade the CDS traders have done yet is to get a well-known journalist with a gift for gab like Lewis to turn their self-interest into honor and greed into genius.
So who are the fools now?
The popularity of the Big Short shows that despite our lessons learned a large group of people who should know better by now do not. We should have learned by the hard knocks we received over the last couple of years that the Big Shorts are not heroes nor do they care if your house burns down. On the contrary, they are rooting for it to happen.
Fortunately in Lewis’ two decade absence, Gordon Gekko has become a major bore as Oliver Stone’s latest box-office flop proves; and profiting at the expense of the innocent in post-financial crisis America is no longer good for those of us on the other side of the trade. In fact, we find it offensive. The fragile economy and desperate struggle of so many Americans to keep their houses from burning down reveals there is no glamour left in greed to the enlightened 21st century mind. Only those stuck in another century will find its destruction admirable.
Lewis is a poetic writer with a wonderful ability to turn straw into gold, dribble into prose, and fiction into fact. If this were a novel, I would recommend it; unfortunately it is not.
©2011 Monika Mitchell, Good Business International, Inc.
Editor’s Note: Credit defaults continue to be traded at high volumes. These opaque derivatives remain dangerous to the financial system and have no discernible value for anyone other than those who trade them. Call to action: Email or call your Senators and Representatives and demand that an exchange be created for these products and that regulations be established for them like every other security. Our fragile economy is still at risk.
Recommended Reading: For more information on these issues read two recent articles by Economist Simon Johnson:
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