Here's a Fresh Air interview with Michael Lewis, a very cool author (and former Wall Street alum) who wrote "Moneyball" about the Oakland A's (soon to be a Brad Pitt film) and the book that "The Blindside" film was based on. His theme is writing about innovators who beat the odds to succeed in their trades, much to the disdain of the establishment. His recent book is about a few observant investors who saw through the mortgage-backed securities (MBS) scam and actually made a fortune betting on them to fail. You'd think that these guys were sharks who exploited the system and hoarded secret information from the rest of us. But actually it's not the case. The real "bad guys" were obviously the big Wall Street banks who didn't realize (or didn't admit) that they were trading and peddling in crap securities. The short-sellers we actually doing what the brokers and advisors were supposed to do (and claimed to be doing for their customers): making the best trades possible that would net the most profit under current market conditions. Would you rather risk your money at the blackjack table, or buy an insurance policy that pays you off if another dude loses his money at blackjack?
Some background definitions that you may already know:
Credit default swap (CDS) - Basically insurance on an investment (usually debt/credit based). But the trick is it's off the books - a confidential agreement between two private parties. So say I bought a risky bond, and propose to Goldman Sachs that I will pay them a premium to protect the bond's value. If it defaults, Goldman will pay me my losses. So obviously Goldman wouldn't agree to it unless they thought the chance-cost of default was lower than the premiums I would pay them.
Short-selling - You borrow security X from a third party lender at cost Y, and sell it on the open market immediately, expecting it to go down. Then after it does, X now costs Z. You buy X back at Z in order to repay the lender. So now you've made Y-Z profit (minus transaction fees or whatnot).
http://en.wikipedia.org/wiki/
So the short-sellers did their research and saw the insanity behind the MBS's: bonds made of pools of subprime mortgages where payouts depended on homeowners faithfully maintaining impossible payments. In one example, a couple of "garage hedge-fund managers" gathered up $100k to start short-selling. Their research suggested that Wall Street insurance for unlikely catastrophes was excessively cheap, so it made sense to pay the pocket change and possibly reap huge rewards if a bad event occurred. They grew their seed money to $15M, and then entered the subprime market expecting those bad securities to default. They were soon up to $120M. But they didn't just exploit this discrepancy for personal gain; once they saw that the entire US financial system was basically built like a Ponzi scheme, they contacted the SEC. But as you would expect, they were ignored. In fact, this is the common trend for all the short-sell success stories: after they figured out how to capitalize off this market vulnerability, they alerted the authorities, but to deaf ears. So short of taking out a full-page ad on the NYT, they did their reasonable best to do the right thing, and can't really be faulted for others' stupidity and greed. In fact, many of the short-sellers were terribly distraught over the situation and had poor health during the crisis. It's not like they felt guilty for profiting on other people's foreclosures, but they lost faith in the American financial system and social structure that permitted this scam to materialize. They really feared that the masses would rise up and destroy the elites for perpetrating all this. But unfortunately, we were too gutless and gullible to demand justice.
One way they were guilty by association was their participation in the CDS market. This offshoot market is built on risky MBS's, so they were basically multiplying risk and adding more fuel to the fire. Even though they were betting against others and expecting the MBS's to fail, they contributed to popularizing this exotic trading instrument that created terrible havoc for AIG, Bear Stearns, and others, as we now know. It's like I could buy a gun for home protection and be the perfect poster-boy safe gun owner, but I'm still supporting an industry that is involved with crime and suffering. It's a tough call, but it was legal so they did it to make money. Getting back to the CDS's, they're so dangerous because they're off the books. They don't need to be declared to anyone, so John Q. Public (and the SEC for that matter) have no idea how much CDS business the banks have done with each other, and who owes who how much, but it's clearly in the billions. And as we have seen, this uncertainty caused panic and a loss of trust, which sent share prices plummetting. So the short-sellers also bought CDS's against bank stocks. They knew that some of the Wall Street titans were heavily invested in MBS's, so of course they would fall when their investments did. And they were right.
One of the Wall Street survivors, Goldman, succeeded because they limited their exposure to MBS's, yet pushed MBS's onto their clients, and then placed big side bets on those same MDS's failing (often through CDS's with AIG). It was a real scam job and the perfect hedge: if MBS's go up, they make money on client commission and their own holdings, which will easily cover the meager cost of the CDS premiums. If they go down, AIG covers their losses and so what if their clients get hosed; they're just Guinea pigs. What boggles my mind is that AIG and others were so confident that MBS's were safe that they agreed to insure them so cheaply, and to such a crazy extent that their liability was 20X their total assets. That's like me being so confident that the next roulette spin will be a 00 that I take out a $10M loan on my $500k home to bet on 00. But what was AIG thinking - that they could pull a fast one on Goldman?
The last part of the debacle is the bond-rating agencies (Moody's and S&P). These guys are supposed to be the Yelp that is telling you the best places to spend your money, except that they're financial experts. One problem: they are paid by the banks whose securities they are supposed to objectively evaluate for risk. Apparently Wall Street and Washington are perfectly ok with this, yet it's not like the EPA is funded by Shell and the FDA by Pfizer! One could invest in MBS's in various ways, since an MBS is a collection of low-to-high risk mortgages to spread out exposure. If you want to play it safe, you can buy into the bond at a low interest rate, and get first dibs to the mortgage payments coming in. Those bonds were AAA rated, which is as safe as T-bonds. If you want to gamble for a higher rate of return, you can delay your payout, and possibly reap higher returns if homeowners don't default. But those risky bonds were of course rated worse: BBB barely ahead of junk bonds, and for good reason since a mere 8% default rate of the constituent mortgages would render the bonds worthless. The banks found that no one was buying the BBB bonds, for obvious reasons. So they decided to package a bunch of BBB bonds together, and told the rating agencies that they were safer because again, the volume and geographic diversity of mortgages spread out risk. Somehow Moody's decided to rate 80% of bonds that were collections of BBB crap as AAA, and then they sold better. But all these "bonds of bonds of mortgages" got so damn complicated and inaccurately rated that even the banks themselves didn't know what they were worth and how risky they were. They polished up Yugos, told people they were Porsches, and then when they were flying off the shelves, their greed made them forget what they did and bought them up too.
So Lewis suggests 3 obvious reforms to prevent a future similar crisis: (1) prohibit banks from investing in the same securities that they advise clients on, (2) require CDS's to be transparent and regulated, and (3) prohibit rating agencies taking money from banks. 1 is meant to prevent the Goldman-type conflict of interest. 2 is meant to lift the veil on CDS's so people can better evaluate a bank's health. And 3 is meant to fend off that other conflict of interest and give investors cleaner information. These ideas are already circulating in Congress, but I doubt will make it onto a Senate reform bill. Of course Wall Street are fighting these measures tooth and nail, since they will make it harder for them to make easy money.
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