Wednesday, March 24, 2010

The Big Short

Micheal Lewis' "Big Short" is out and, as expected, it's a great read. He tells the story of a few traders that saw the insanity of the mortgage bond and CDO markets. Here's a short synopsis before I get to my point, but this book should be mandatory reading for every American, so I don't want to give away too much.
Around 2005, a one-eyed social misfit managing a fund out of Cupertino starts examining the details of mortgage bond issues down to the nitty gritty. He finds that the credit worthiness of the homeowners is so poor in some of these bonds that many of them are certain to default when the 2 year teaser rate expires. He wants to get short so he helps Wall Street adapt credit default swaps, formerly used only on corporate debt, to mortgage backed securities. Some others eventually place the same bet and, of course, they all score when the CMBS market begins to implode in the summer of '07.
Now, to my point. There has been nothing done and nothing is proposed that will stop this from happening again. A lot of people want to ban derivatives. Some want to separate the trading operations from the banking operations. Others think compensation limits will work. None of these will work because loop holes will continue to exist. The disaster occurred because the market was not transparent. Asymetries of information allowed Goldman Sachs to sell a product to one customer for 20 times what it was paying to another customer. That's good for Goldman but bad for their customer and bad for us when we have to bail that customer out. It sucks that Goldman and others (but especially Goldman) have tried to replace brokerage revenues that disappeared from that great information equalizer, the internet, with "trading" profits made from customers intentionally kept in the dark. That's not really trading, it's stealing. In the Chicago exchanges, a meeting of the minds is required for a trade to take place. The market participants don't all have the same information but they do know what prices are trading. The same thing can't trade for 12 cents and $2.50 at the same time, no matter how it's packaged. In negotiating financial reform, Wall Street is extremely focused and financially incentivized to fight efforts at greater transparency and price discovery as opposed to the American taxpayer whose financial incentive, while as great or greater as a whole, is dispersed among millions. Congress needs regulations that moves Wall Street derivative trading onto exchanges. The self regulation from the International Swaps and Derivatives Association is a joke. They don't require margin. They don't settle instruments daily based on quoted, tradable prices. They don't provide common clearing which eliminates third party credit risk and they don't publish intraday prices that lead to market transparency. Any one of these measures would have prevented the growth of CDO's and the CDS' written on them. We probably still would have had a real estate correction but the leverage created by Wall Street would have been much smaller and backed by sufficient capital.

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