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David's Macro Blog

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Tag: Credit Default Swaps

When did Wall Street become the dumb money?

Why did traders who lost on their bets still earn millions (sometimes tens of millions) in income?

Author Micheal Lewis (Liars Poker, Moneyball, The Blind Side) explains the answers to both of these questions in his best-selling book, The Big Short. He writes so that even his mother could understand the intricacies of the financial system that the wrecked the global economy for the next decade.

The most remarkable thing to me is that individual traders on BOTH sides of the bet (for or against subprime mortgages) got rich while their firms collapsed and taxpayers got the bill.

Watch the C-SPAN interview with Michael Lewis below:

My Favorite Quotes

That the Wall Street firms had become the dumb money at the poker table. Somehow these firms, which used to be the smart money… When I left Soloman Brothers, the last thing you wanted to do if you were an investor, was be on the other side of one of Soloman Brothers trades. There was some zero-sum bet to be made with Soloman Brothers, you did not make it because you were sure to lose money. And what had happened was somehow the firms had become, had turned stupid as institutions, they’d become the dumb money. That made me curious. Something big had changed. The natural question was, who was the smart money? That led me to my characters because they were the smart money.

They didn’t know their own balance sheets. He doesn’t persuasively know his own business.

The whole financial system is organized around a bet.

The minute that the Wall Street firms were in the business of harvesting middle class and lower middle class Americans for their home equity value (via sub-prime loans) and making loans to them against it, there was a natural risk of abuse because just generally in financial transactions people are bewildered.

There were lots of cases where the nature of the loan was sort of disguised from the person who was borrowing the money. Teaser rates should be criminal. You essentially talk someone into taking a loan out that has an artificially low rate for the first couple of years so it looks very tempting. Then it skyrockets after two years.

There were 3 trillion dollars of loans there were dubious [referring to sub prime and alt-A]

But then seeing this explosion of lending again in this beast he (Steven Eisman) thought he slayed back in the 90’s, the sub-prime mortgage lending business and he says this is all going to blow up again, this is going to end badly because I know how this business is done. It’s a sinister business.

Interviewer: “So the $180 billion taxpayers dollars that went to AIG then went to Goldman Sachs (and other Wall Street firms) to pay off bets?”

ML: “Yes, yes, yes – for bets”

Interviewer: “Why did Hank Paulson and Ben Bernanke want to pay off the gambling debts of AIG?”

ML: “Because all the other Wall Street firms were on the other side of (AIG’s) bets and if AIG didn’t pay off then those firms would have experienced losses. For example Goldman Sachs lost on its bet to Michael Burry, but they thought they were just brokering the bet between Michael Burry and AIG so they paid off Michael Burry and they are out of pocket. They want to get paid by AIG, or they have a $13 billion loss. Paulson and Bernanke are thinking, if we don’t make the Wall Street firms whole, they will collapse, the market is not going to believe they’ll survive. And they would have all collapsed.”

Interviewer: “Who got hurt?”

ML: “Not the Wall Street firms. The rest of the country got hurt by what the Wall Street firms had been doing the last five years, generating this frenzy of finance where finance shouldn’t have happened.”

This was to me, my revelation. First, that the financial system had organized itself around this bet. And second, no matter which side of this bet you were on, you STILL got rich personally. Your institution might have lost huge sums of money, but you yourself got rich.

The only social purpose I had in writing the book was, I thought if I could explain this to people, they’d be outraged. And they need to know.

Derivatives are meant to redistribute the risk in an intelligent way.

None of those people in Davos made a lot of money betting against the subprime mortgage market. If they really understood it, that’s what they would have done.

Michael Lewis on his personal profession of book writing:

The interesting thing that I do is learn about something and communicating it in words.

Notes

Credit Default Swaps is the mechanism created in 2005 to bet against the subprime mortgage market. CDS is like an insurance policy and costs a couple percent per year.

CDS quickly became a way to bet against mortgages, instead of just an insurance policy against your own bonds defaulting.

Subprime mortgage bonds are pools of loans. Most were betting the bonds would pay off, just a few were betting against it – they were the smart money who ran the numbers, not just looking for commissions and transaction fees.

The unit selling most of the CDS was AIG FP (AIG financial products group). They used AIG’s AAA rating to sell insurance but reserved no capital against losses.

Humor only works when there is truth embedded within it.  This works because while it is humorous, the truth is evident.

“You want the truth? You can’t handle the truth. Son, we live in a country with an investment gap. And that gap needs to be filled by men with money. Who’s gonna do it? You? You, Middle Class Consumer? Goldman Sachs has a greater responsibility than you can possibly fathom. You weep for Lehman and you curse derivatives. You have that luxury. You have the luxury of not knowing what we know: that Lehman’s death, while tragic, probably saved the financial system. And that Goldman’s existence, while grotesque and incomprehensible to you, saves pension funds. You don’t want the truth. Because deep down, in places you don’t talk about at parties, you want us to fill that investment gap. You need us to fill that gap.

We use words like credit default swaps, collateralized debt obligation, and securitization? We use these words as the backbone of a life spent investing in something. You use ’em as a punchline. We have neither the time nor the inclination to explain ourselves to a commoner who rises and sleeps under the blanket of the very credit we provide, and then questions the manner in which we provide it! We’d rather you just said thank you and paid your taxes on time. Otherwise, we suggest you get an account and start trading. Either way, we don’t give a damn what you think you’re entitled to!”

Source: StatsGuy – Baseline Scenario.

Warren Buffett calls derivatives “financial weapons of mass destruction.”  Do you believe him?

Derivatives are financial instruments whose prices are derived from underlying assets.  One example would be a futures contract between a farmer and a food processor.  In this case the underlying asset is the grain harvested by the farmer and the derivative is the contract to deliver that grain at a specified price, time, and location.

This all sounds reasonable enough.  So why would Warren Buffett call derivatives “financial weapons of mass destruction”?

What if a Wall Street trader could make financial bets that rewarded the trader with bonuses and the firm with earnings all without setting aside capital or assets to cover that bet?  How many of those bets would you make?  How many would you make when you get immediately rewarded for wins and little or no apparent penalty for losses in the unforeseeable future?  Finally, how many would you make when your expert with a PhD from MIT says his mathematical model shows those bets are risk free?

Now that you’ve thought about those questions, watch this video from Khan Academy regarding Credit Default Swaps (CDS).   Listen for the part about a cascading failure which starts in one location and ripples through the whole system, ultimately destroying everything that looked seemingly safe and sound.

Khan Academy – Credit Default Swaps 2