Reviewing the Shorts

David Warsh reviews three recent books on the role of credit default swaps in the financial crisis:

• Gillian Tett, Fool’s Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe
• Gregory Zuckerman, The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History
• Michael Lewis, The Big Short: Inside the Doomsday Machine

I enjoyed the first two. Tett tells the story of the rise of the credit default swap, and Zuckerman explains how John Paulson (among others) used them to profit by selling the housing bubble short. Michael Lewis tells the same story, less effectively, and ignores Paulson. I think this is so he can treat those who saw what was happening as weirdos. This may be because, as Warsh point out, Lewis sure considered them so in 2007. As Michael Osinski wrote in Business Week (hat tip to Warsh):

It wasn't until Jan. 31, 2007, that the index of subprime bonds suffered its first ever one-point drop. According to Lewis, that was the day "the market cracked." What Lewis fails to note is that the day prior, Lewis himself had filed a column for Bloomberg News from Davos mocking Nouriel Roubini's warning "that the risk of a crisis happening is rising." Such forecasts of doom came from "people with no talent for risk-taking gather[ed] to imagine what actual risk takers might do," Lewis wrote. The headline described them as "Wimps, Ninnies, and Pointless Skeptics." In The Big Short, Lewis recognizes he was wrong. The ninnies have inherited the earth.

Lewis's book is of course the best read. He is a great writer. But his book seems less like reporting than storytelling. He never questions or analyzes what his heroes tell him. And there ought to be some reward for depth.

I plan to write a longer post comparing Zuckerman and Lewis since they address the same subject but write different books. But for now, Warsh's review is very good.

Naked CDS and Greece

Sam Jones has a nice column on the benefit of naked CDS and the Greek crisis. It is a critique of the argument of Munchau that:

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

Jones shows how hedge funds that were naked CDS are now likely to be buyers of Greek bonds. His argument is twofold:

Firstly, any naked CDS buying – as slated by Mr Münchau – occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks. (Banks, stuffed to the gills with sovereign debt thanks to the ECB, have)

Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe (as Mr Münchau notes, Greece seems content to do this all on its own anyway).

Secondly, and more importantly, however, hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.

In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.

And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.

What I don't understand is why his argument is not even stronger and simpler. Hedge funds buy naked CDS when prices are low speculating that a crisis may occur. When the crisis occurs and spreads rise, the hedge funds sell the swaps to those in dire need -- those who are lenders to Greece.

Indeed, isn't this just like any argument for short selling -- that it is providing more market information about what might happen? Suppose that enough hedge funds bought CDS on Greek debt years ago and that spreads rose significantly then. Lending to Greece would have been reduced and the extent of Greece's debt woes today would be smaller. Wouldn't more naked CDS have been better?

Right On

Felix Salmon had a nice post today about politicians and their nonsense regarding Greece and credit default swaps. Carolyn Maloney, Chair of Joint Economic Committee, is quoted in the FT:

Ms Maloney compared the use of credit default swaps in the Greek situation to the “activities that brought down American International Group”, referring to the US insurer that collapsed and was bailed out in September 2008. “These reports, if true, are a shocking echo of the financial crisis that faced the US in 2008 – whose reverberations are still being felt today, in the worst recession in decades.”

This is nonsense, as Salmon notes. AIG sold CDS and then could not cover claims, Greece is not selling any CDS, it is the subject of insurance. People are buying insurance against their default. The comparison is daft.

Salmon also points to the German financial watchdog which apparently is worried that German bailout funds will go to speculators, even though the speculators seem to be betting on a Greek default. It is crazy.

But as Salmon notes:

it’s all a big Kabuki, wherein anybody bashing banks in general, and Goldman Sachs in particular, gets automatic political brownie points. And there are no points at all, it seems, for basic financial literacy.

More on AIG

The Times of London has an intriguing article on the collapse of AIG. The whole article is interesting, but he most fascinating part concerns an analysis of the valuation of the company back in 2001. The Economist apparently commissioned a study to assess the valuation of AIG.

The research, which took five months, was the work of a team led by Tim Freestone, who is speaking here for the first time. Most analysts are upbeat: their colleagues’ bonuses depend on fees from the company under scrutiny. But Freestone’s firm (now called Crisis Economics) is independent. He judged that AIG was highly overvalued, and he would later realise that its shares were supported by an ability to stifle criticism. In his report for The Economist, however, he was tactful. To justify the share price, he said, “it would have to grow about 63% faster than [its] peers for the next 25 years. If investors believe that AIG can sustain this type of performance for that period of time, then AIG is properly valued”. Any investor who believed that would need to be certified.

The implication is that AIG was seriously over-valued, perhaps even a zombie insurance company. In that context, the excessive risk-taking of the Financial Products Group at AIG, selling vast quantities of credit default swaps might have been an attempt to double up bets.

The conventional explanation for AIG's collapse is that it did not reckon on a perfect storm caused by the collapse of the housing bubble. But this article suggests that perhaps officials knew the risks but were motivated by the need to find profits to support the valuation of the company.

More AIG bailouts

This article by Joe Nocera give the background on the huge losses AIG continues to accrue. Of course, their losses are somebody else's gain. But presumably, even though the banks bought the credit default swaps, these are not enough to cushion the banks. Perhaps it is third parties that are the beneficiaries.

Justin Fox points out that essentially:

AIG got into the business of insuring much of the world's financial system against the consequences of a global financial meltdown. It turned out to be incapable of delivering on that insurance—no private company could deliver on it, which is one reason why AIG's business of selling credit default swaps was a scam. And so government has stepped in as the ultimate insurer.

Credit default swaps that AIG sold were insurance against a financial collapse. But just as a private insurer cannot insure against a flood -- that is why the government provides flood insurance -- a private insurer cannot insure against the whole financial system collapsing. Thus, there should be no shock at taxpayers ending up liable for this mess. The crime is not the bailout, but the fact that AIG managers got rich selling insurance they could not possible back.

Short Sales Ban Ends Tomorrow

The ban on short sales ends tomorrow. Will stocks collapse? Probably not, perhaps the reason why stocks tanked Tuesday was in anticipation of the lifting of the ban. After all, if prices are expected to fall tomorrow nobody will hold them today.

Another interesting date to watch is October 10 (in an earlier post I got the date wrong, October 23 is the date that WAMU bondholders will have their auction. Lehman's auction is in a couple of days, but this just strengthens the point I am making). That is the day that the auction will take place to settle the credit default swaps relating to the Lehman bankruptcy. The amount that is owed in this case could be $400 billion. Fear over how this will play out is just another factor in the general uncertainty over the economy.

Finally, the Fed's announcement that it will purchase commercial paper must reveal that policymakers understand that the credit crisis is really bad. Otherwise they would not have taken this important step. This must have been another shock that hurt markets, but it is good that the Central Bank will take action in this case.