Playing to lose

(H/t E)

The author of Liar's Poker has written another scathing apprasal of Wall Street and the current economic disaster. He adds another interesting piece of the subprime puzzle.

He does it by following the story of one Steve Eisman.

By way of introduction, here's Eisman's partner Daniel Moses describing him:

He put a fine point on the absurdity they saw everywhere around them. “Steve’s fun to take to any Wall Street meeting,” Daniel says. “Because he’ll say ‘Explain that to me’ 30 different times. Or ‘Could you explain that more, in English?’ Because once you do that, there’s a few things you learn. For a start, you figure out if they even know what they’re talking about. And a lot of times, they don’t!”

So Eisman's out in inevstment land - he's made his bones dealing with subprime lenders and other financial bottom feeders - and starts noticing things that are a bit odd:

At the end of 2004, Eisman, Moses, and Daniel shared a sense that unhealthy things were going on in the U.S. housing market: Lots of firms were lending money to people who shouldn’t have been borrowing it. They thought Alan Greenspan’s decision after the internet bust to lower interest rates to 1 percent was a travesty that would lead to some terrible day of reckoning. Neither of these insights was entirely original. Ivy Zelman, at the time the housing-market analyst at Credit Suisse, had seen the bubble forming very early on. There’s a simple measure of sanity in housing prices: the ratio of median home price to income. Historically, it runs around 3 to 1; by late 2004, it had risen nationally to 4 to 1. “All these people were saying it was nearly as high in some other countries,” Zelman says. “But the problem wasn’t just that it was 4 to 1. In Los Angeles, it was 10 to 1, and in Miami, 8.5 to 1. And then you coupled that with the buyers. They weren’t real buyers. They were speculators.”

and then:

By the spring of 2005, [Eisman's employer] FrontPoint was fairly convinced that something was very screwed up not merely in a handful of companies but in the financial underpinnings of the entire U.S. mortgage market. In 2000, there had been $130 billion in subprime mortgage lending, with $55 billion of that repackaged as mortgage bonds. But in 2005, there was $625 billion in subprime mortgage loans, $507 billion of which found its way into mortgage bonds. Eisman couldn’t understand who was making all these loans or why.

and then:

Enter Greg Lippman, a mortgage-bond trader at Deutsche Bank. He arrived at FrontPoint bearing a 66-page presentation that described a better way for the fund to put its view of both Wall Street and the U.S. housing market into action. The smart trade, Lippman argued, was to sell short not New Century’s stock but its bonds that were backed by the subprime loans it had made. Eisman hadn’t known this was even possible—because until recently, it hadn’t been. But Lippman, along with traders at other Wall Street investment banks, had created a way to short the subprime bond market with precision.

What he's talking about is the Credit Default Swap.

The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. “What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” Eisman says. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’ 

CDS means you pay less, and get paid more to bet against bonds you think are going to fail.

They can even be your own bonds, or bonds you helped set up.

While I'm sure this is an oversimplified scenario - variations of this undoubtedly are possible:

• Firm A presses Mortgage broker to bundle as many loans as possible into Mortgage Backed Security X
• Firm A then buys MBS X and bundles it into Collateralized Debt Obligation Y
• Firm A then sells CDO Y to as many people as it can
• Firm A then buys Credit Default Swap ZZ on its own CDO
• Firm A then buys Credit Default Swap ZA on its own CDO
• Firm A then buys Credit Default Swap ZB on its own CDO
• Firm A then buys Credit Default Swap ZC on its own CDO

Now, Firm A is on the hook for the value of CDO Y once, but is insured against its value four times over.

CDO Y is worth 5 billion dollars and if it fails Firm A loses up to 5 billion. But if it does fail, Firm A gets paid up to 20 billion dollars.

Money for losing. The triumph of capitalism.

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