The Big Bluff: Wall Street Traders Burn Down The House

The Big Bluff: Wall Street Traders Burn Down The House

 Readers Note:

GoodB Executive Director Monika Mitchell will be on writing sabbatical until March to finish her new manuscript on The World of Wall Street Finance  due out in ebook in June and print in Fall 2011.


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’saccolades 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.

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Monika Mitchell

Executive Director

Good Business International, Inc.

Economy of Trust Blog