For a brief period, I did work on credit derivatives trades that involved signing a non-disclosure agreement, so I have to be careful about precisely what I say here, but I want to take a moment to note what I … Read More
For a brief period, I did work on credit derivatives trades that involved signing a non-disclosure agreement, so I have to be careful about precisely what I say here, but I want to take a moment to note what I think is the most salient feature of the breakdown of the subprime sector that has inundated political as well as financial media recently, and that is that it is entirely a zero-sum game. Every dollar lost by lenders or written down by big dealers selling protection was made by hedge funds and other capital management groups. It's useful, I think, to understand adjustable rate mortgages as mechanisms for redistributing the wealth of dissolute borrowers into the pockets of hedge fund managers, because that, in effect, is what they turned out to be.
Two factors are primarily responsible for the present situation. One is a cultural phenomenon, the apparent inability of contemporary Americans to live within their means — the average personal savings rate has been negative for some years now, meaning that people are not only in debt but digging themselves deeper and deeper — as exemplified by people signing ARMs in spite of the virtual certainty of eventual default, so that they, too, could have million-dollar homes. The other factor is the shockingly short-sighted, arrogant, and frankly obtuse bets that major financial institutions were willing to make.
A credit derivative, to illustrate the second factor, is an agreement among two counterparties to trade values derived from a third party, or reference entity, such that (to take the most common example) one party pays a fixed rate on the total face value of the derivative at regular intervals, and the other is obligated to pay back the entire floating rate of the derivative in case some specified credit event (like default) occurs. If this sounds abstruse, what it amounts to is that it is possible to buy and sell protection against bonds and loan defaulting, without actually holding the bond or loan. What happened is that major Wall Street dealers sold very cheap protection on obviously questionable reference entities, and when ARM holders inevitably defaulted en masse, the protection buyers, mostly hedge funds, reaped the profits.
The common conception of alternative investments is a conception of recondite quantitative strategies rooted in stochastic calculus, but really, you would not have needed much math to discern that high-default risk loans were at high risk of default, and therefore could be very profitable to short. The dealers, meanwhile, seem to have convinced themselves that by packaging non-investment grade securities along with investment grade securities — so-called structured finance products — the risk involved in subprime lending (or selling protection on it) could be mitigated; instead, predictably, subprime mortgages tanked and dragged down better securities with them.
In other words, we are witnessing as a transparent shell game is exposed. Now, it seems, traders are going to try to recoup losses by piling on to misfortune; I suspect that will not end well.