All the Devils Are Here [160]
On Main Street, the subprime bubble was grinding to a halt. There was going to be a great deal of pain, for both the borrowers and the subprime companies. But Wall Street had one more trick up its sleeve. This was a mechanism created by Wall Street to allow investors to short the housing market similar to the way investors can bet against stocks. It was a natural development—at least from Wall Street’s point of view—but it evolved into one of the most unnatural and destructive financial products that the world has ever seen: the synthetic CDO.
The key ingredient in a synthetic CDO was our old friend the credit default swap. For that matter, the key to shorting the mortgage market was the credit default swap. By 2005, credit default swaps on corporate bonds were ubiquitous, with a notional value of more than $25 trillion. (The notional value of credit default swaps peaked in 2007 at $62 trillion.) They were used by companies to protect against the possibility that another entity it did business with might default. They were used by banks to measure the riskiness of a loan portfolio, because their price reflected the market’s view of risk. And they were used in the mortgage-backed securities area by CDO underwriters to wrap the super-senior tranches. The AIG wrap, you’ll recall, was the key to allowing banks with triple-A tranches on their books to reduce their capital.
In the corporate bond market, traders were using credit default swaps not just as protection against the possibility that a bond they owned might default. They were also using them to make a bet—a bet that a company might default, even when the trader didn’t own the underlying bonds. These credit default swaps had become standardized, meaning that the conditions under which the buyers and sellers got paid were always the same. That’s the way markets tend to evolve: first comes hedging, and then comes speculation. To Wall Street, this is all good, because the more players in the market—whatever their reasons—the more trading there is.
In the mortgage-backed securities market, the credit default swaps that people were using to insure those super-seniors were a kind of short, since the buyer of the protection would be paid off if the super-senior tranches defaulted. But no one thought of them this way—they were focused on the regulatory capital advantages. And they were a customized agreement between two parties, which made them hard to trade, because any buyer would have to understand all the complex terms of the deal.
But why couldn’t you create a standardized credit default swap on mortgage-backed securities? That way, anyone could play. Instead of having to painstakingly scratch out terms with the party on the other side, you could trade these instruments the way people do stocks. That would dramatically expand the market—and all the more so if you also published an index of the prices of mortgage-backed securities. Wall Street likes to say that indices are good because they offer transparency—everyone can see what the prices are—and liquidity, meaning it’s easier to get in and out of trades that are based on a public index. That’s probably true. But it’s also true that indices reduce complexity to the simplicity of a published number, allow investors to think they understand a market when they really don’t, and create a frenzy of trading activity that mainly benefits Wall Street.
Developing a big market of tradable credit default swaps on mortgage-backed securities would have several consequences. It would encourage Wall Street firms that were nervous about having mortgage risk on their own books to stay in the business, because now they could hedge their exposure. It would encourage