Michael Lewis explains CDS

The author of Liar’s Poker has an unparalleled ability to inform and entertain while writing about high finance.  His latest article on Portfolio.com is so good, I wanted to devote a post to it.

Besides being hilarious, Lewis offers particularly clever insight on the role CDS played in blowing up the mortgage market.  Most interesting, to me anyway, is how those shorting the market actually perpetuated its growth.

He follows analyst-turned-investor Steve Eisman, who long knew the structured finance machine on Wall Street was pumping out piles of dogshit securities to sell to investors.  What Eisman could never figure out is why Wall Street would put themselves at such risk.  The answer was they didn’t think they were at risk.  They were selling off most of the toxic securities they manufactured.  Or thought they were.

More interesting is Eisman’s realization that he was actually providing the liquidity necessary to keep the market going.  But I’ll let Lewis describe it:

…Here he’d been making these side bets [buying Credit Default Swaps to short mortgage backed securities and CDOs] with Goldman Sachs and Deutsche Bank…without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for [high yield fixed income product]. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans.

When Alan Greenspan lowered rates to 1% four years ago, everyone started chasing yield. Pension funds, insurers, anyone with a fixed income portfolio trying to maximize returns was buying toxic assets, ignoring the risks and pocketing a few incremental basis points of interest.  Rates were so low on higher quality paper, they created absolutely insatiable demand for the toxic stuff with higher yields.  Wall Street bankers tried to manufacture the stuff as fast as it could.  When bankers couldn’t manufacture enough real mortgage-backed securities—extending actual loans to actual people and then packaging them into securities to be sold to investors—they created “synthetic” MBS by selling the long side of the trade on which guys like Eisman were going short.

Since derivatives like CDS don’t have to be tied to anything real, you can create them out of thin air.  If you have insatiable demand for yield on one side, all the banks needed to do was find someone to take the short side of the same trade.  Every new short position enabled the creation of a new long position.

Fascinating.  An absolutely must-read article.

Posted in banking, credit default swaps |