Rarely do I find myself starting a book I can’t put down. Such a book is The Big Short, by Michael Lewis. In it, Lewis, author of Liar’s Poker and The Blind Side, tells the story of a handful of young hedge fund operators who realized the folly of the burgeoning subprime mortgage security industry in the years leading up to 2007, and found ways to “short” the housing market.
Going “short” on an investment means betting its value will decline. Traditionally, one did this by borrowing another person’s shares of a given stock and selling them. If the price went down, the investor would buy back the shares at the lower price and return them to the lender, pocketing the difference between the selling price and the subsequent purchase price.
Shorting a mortgage is essentially impossible. And shorting a security like a Ginnie Mae (Government National Mortgage Association) backed by a large pool of mortgages is likewise impossible.
All that changed with the development of the “credit default swap” in the early 1990s. In a credit default swap, one party seeks to protect itself from the risk that an issuer of debt might default (that is, fail to pay its debts when due). That credit risk is “swapped” from the purchaser to the seller in exchange for an annual fee.
If that description of a credit default swap sounds like an insurance policy, that’s because it is an insurance policy—plain and simple. Despite, or perhaps because of, their name, credit default swaps haven’t been treated as insurance products. They’re not covered by state insurance regulations, and their issuers (sellers) aren’t required to maintain adequate reserves to assure their ability to pay claims as ordinary insurance companies would.
In the early 2000s, investment banks like Goldman Sachs began repackaging lower-quality mortgages into more complex securities. As Lewis explains in his book, a large pool of subprime mortgages would be divided into “tranches.” Those who bought the lowest-rated tranches were like purchasers of the lower floors of an apartment building—if a flood came, the owner of the ground floor would sustain all the damage. If the flood was more severe, then the second floor owner would bear the damage, and so on.
What made the whole system work was the rating agencies like Standard & Poor’s and Moody’s, which rated the top 80 percent of the subprime mortgage tranches as AAA, equivalent to the creditworthiness of U.S. Treasury securities. According to the agencies’ computer models, the flood waters would never reach above the second floor. In fact, because of the complexity and obscurity of ownership of these repackaged mortgage securities, and because lots of subprime mortgages began defaulting at the same time due to widespread economic conditions, the value of the supposedly safe tranches collapsed before the water even reached the second floor.
The problem was made worse when the lower tranches of the mortgage-backed securities were repackaged again into “collateralized debt obligations” (“CDOs”), where once again the top 80 percent of the tranches were rated AAA. By such alchemy, the worst mortgages were transmuted into gold.
Those few investors chronicled in The Big Short, who saw the danger, profited mightily by buying credit default swaps on these mortgage-backed securities and CDOs for their hedge funds. And those firms that issued those swaps, like AIG, failed big time. In essence, the credit default swap market, obscured from view of the ordinary investing public, became a giant casino in which massive bets were placed on the housing market that all came due when housing prices failed to continue the rapid ascent that underlay the assumptions in the rating agencies’ models.
Not widely appreciated in the subprime mortgage-credit default swap debacle is the fact that one could purchase credit insurance even if one did not own the underlying debt security. Viewed as insurance, it’s easy to understand the problem this creates. Imagine if you could buy life insurance on someone you didn’t like very much. And so could anyone else. What’s the chance that one or more of the policyholders would contract for a hit on the insured?
This problem was recognized long ago in the insurance industry, leading to the requirement that the purchaser of a life insurance policy have an “insurable interest” in the insured. Typically, an insurable interest is limited to those persons and entities that ordinarily are expected to have a strong desire to keep the insured alive, such as a spouse or business partner.
With no requirement for an insurable interest, those hedge funds that wished to bet on a decline in housing prices had every incentive to see the subprime mortgage backed securities fail, a phenomenon documented in Lewis’ book. Indeed, the Securities and Exchange Commission has now sued Goldman Sachs, alleging it cooperated with John Paulson, the hedge fund manager rumored to have made billions in the collapse of the subprime mortgage market, in arranging to put mortgages destined to fail into securities sold to investors.
Requiring an insurable interest to get paid on a credit default swap seems like a simple way to avoid future similar abuses. But given that Congress (Democrats and Republicans alike) are dominated by the big Wall Street firms and their myriad lobbyists and large campaign funding machine, don’t expect such a simple regulatory approach to be adopted anytime soon.
