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January 22, 2010

Book review: The Greatest Trade Ever

The Greatest Trade Ever'The case of the journalist who didn't bark.'
would be a good subtitle for this review. In a minute I'll explain why.

Gregory Zuckerman has produced an eminently readable story about the Wall Street winners and losers in the financing of the recent housing bubble. All the main characters are introduced with a thumbnail biographical sketch many of which could have been shorter in Agatha Christie style. But then, Agatha Christie's players are stereotypes while Zuckerman's traders are all unique. It is not easy to write a thriller when the audience knows the ending beforehand, all the more merit for Zuckerman.

The plot is as follows: The government wants more people to own their homes. Interest rates and credit standards are lowered making it possible for more people to buy homes they could not normally afford. Securitizing allows banks and other lenders to package the mortgages into bonds that are sold to fixed income investors all over the world. The conventional wisdom is that houses never lose their value, always appreciate and that securitizing, by spreading the risk reduces it. A few smart people believe the conventional wisdom is wrong and search for ways to "short" the mortgage backed bonds. John Paulson succeeds beyond his wildest dreams while others do less well. Banks and their customers suffer heavy losses many going bankrupt.

Besides the fast moving story, the two elements I enjoyed most were, first, the description of the research, a.k.a. due diligence in the investing world, performed by John Paulson and Paolo Pellegrini. Performance on Wall Street is seldom a matter of luck but rather a question of patient and acute research as the basis of well planned trading campaigns. And, second, the detailed explanation of the various derivative instruments that were used in the financing of the housing bubble. Nowhere had I found as clear and complete an explanation of the financial derivative instruments used in the housing bubble as that provided by Zuckerman.

What is missing is the rest of the story and the moral of the story. While they are not part of the book review proper, I believe it is the most important and least understood part of the story.

On Wall St. when you like an investment you buy it or "go long." If you think the investment is a looser, you "go short." As Zuckerman explains in the book, to short a security you have to borrow it from someone who owns it and then sell it. If the security drops in price, you buy it back cheaper, pocket the difference and return the security to its proper owner. Although many people think this is a terrible thing to do, un-American and all that, it is perfectly legal because the buyer is getting what he is paying for. The problem for Paulson and the others was that there is no way to short a house or a mortgage. They did short the banks and builders they figured would be the losers but this was small potatoes. They had to find a way to short the mortgage backed bonds.

The latter part of the 20th Century saw an explosion of financial innovation. One was the so called "Credit Default Swap," CDS for short, a form of credit insurance. Investopedia states: "The risk of default is transferred from the holder of the fixed income security to the seller of the swap." The key words are the risk is transferred, that is the essence of insurance. You cannot buy insurance where you have nothing at risk. You cannot insure your neighbor's Rolls Royce because you don't have an "Insurable Interest" in it unless you lent him money to buy the thing, for example.

The CDS was designed to insure certain forms of credit, for example bonds. If the creditor defaults, the seller of the CDS, the insurer, makes the holder of the bond whole. But what if you don't have such a bond? The insurance industry cannot sell you the insurance. But the Credit Default Swaps were not managed under insurance regulations. To collect the premium, the issuers were willing to sell the Credit Default Swaps to anyone whether they had an Insurable Interest or not. And there lies part of the problem. A million dollar bond might be insured by one hundred people but only one of them had the Insurable Interest. This is no longer insurance, it is a casino, very much like a roulette table where lots of people can make bets without having an Insurable Interest. Had the rules and regulations of insurance applied, John Paulson and the others would not have been able to bet against the mortgage industry.

The other part of the problem is that the issuers of the Credit Default Swaps miscalculated the risk involved. The miscalculation stems in part from using the wrong probabilities as explained by Nassim Nicholas Taleb in The Black Swan and in part from the belief that the housing bubble would never end. The result of the miscalculation was that the sellers charged too little for the insurance and when the bubble burst they did not have sufficient reserves to pay off the "insurance." Because they sold the Credit Default Swaps to anyone, they amplified the damage when the housing bubble burst. This was one of the negative unexpected consequences of not limiting insurance to parties with an Insurable Interest. The banks such as Bear Stearns that kept to much of these CDSs went belly up as well as many hedge and retirement funds that bought them.

Gregory Zuckerman never mentioned the issue of Insurable Interest. Why not? I would suspect that being an expert financial writer, he would know about Insurable Interest, maybe not. Maybe he figured that his job was reporting, not judging, fair enough. But the fact remains that had the insurance not been sold willy-nilly to anyone willing and able to pay for it, "The Greatest Trade Ever" would not have happened for him to write about.

Be that as it may, I hope the regulators impose insurance rules on the sale of Credit Default Swaps.

Denny Schlesinger

The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History by Gregory Zuckerman

The Black Swan: The Impact of the Highly Improbable by Nassim Nicholas Taleb

Time to Rethink the Doctrine of Insurable Interest in Light of CDS by David Merkel

Investopedia: Credit Default Swap "A swap designed to transfer the credit exposure of fixed income products between parties."

TheFreeDictionary: Insurable Interest "A right, benefit, or advantage arising out of property that is of such nature that it may properly be indemnified."

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