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March 14, 2010
David Warsh, Proprietor


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How We Got the Bad News

“Differences of opinion is what makes horse races.” So my algebra teacher would taunt us, deliberately ungrammatical, standing at the blackboard, chalk in hand, touting the virtues of proof. Differences of opinion make markets, too – especially speculative financial markets. No matter how complicated the transaction might be, its essence boils down to a buyer who thinks he knows more than the seller, and vice versa. Keep that in mind when thinking about credit default swaps.

For of all the financial instruments that have tumbled from the cornucopia of modern finance – options, futures, forwards, repos, swaps, synthetics, exotics – the CDS market may be the one most worth knowing something about. Credit default swaps played a major role in precipitating the subprime mortgage meltdown in 2008. Last week they were in the news again, following the Greek sovereign debt crisis, with the leaders of Germany and France calling for a ban on their speculative trading. How you feel about credit default swaps is a pretty good litmus test for how you feel about financial innovation in general.

As it happens, three books about the CDS market have appeared recently, each of them in the form known in the trade as a “character-driven narrative” (meaning that they have been written to read like novels), two of them by newspaper reporters and the third by a well-known magazine writer. Together they form a triptych that reveals a great deal about the process of financial innovation – and only slightly less about the news business. But few who are not duty-bound will read all three.

Gillian Tett, of the Financial Times, was the first to market. 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 is an origin story wrapped in a morality tale. It has much in common with Tracy Kidder’s The Soul of a New Machine, which introduced readers to real-time computers in the 1980s, or G. Pascal Zachary’s Showstopper, which did the same for operating system software in the 1990s. Tett explains how a handful of innovative thinkers, led by a pair of attractive expatriate Brits, were charged with finding new ways to make J.P. Morgan grow its commercial lending business.

Peter Hancock, Blythe Masters and their colleagues came up with a product that is part insurance, part speculative vehicle, and built a market for it – beginning with a transaction in which the European Bank for Reconstruction and Development in 1994 contracted for a modest sum to assume the risk that Exxon wouldn’t repay a $4.8 billion line of credit it had borrowed from Morgan in order to pay the fine for its Exxon Valdez oil spill. Fat chance of that! EBRD made a small but tidy profit, Morgan got the risk off its books and was able to make more loans. From these blue-chip beginnings, a major market was born. Morgan did the hard work, standardizing contracts, persuading regulators of the legitimacy of the transaction, explaining the utility of its new product to customers. Before long Morgan’s competitors were writing CDS insurance on every kind of credit imaginable – including subprime mortgages. Along the way, Tett explains clearly the various other concepts necessary to understand what happened next – value-at-risk accounting, structured investment vehicles, collateralized debt obligations, the ABX bond index, and so on

Who wanted to buy? That’s where Gregory Zuckerman comes in. Zuckerman, who writes the Heard on the Street column for The Wall Street Journal, is author of The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, an astonishingly interesting story about how a low-compression good-time Charlie smartened up, got married, and struck it rich – very rich. Paulson had finished first in his class at Harvard Business School, but after nearly twenty years in merger arbitrage he had never made a killing. Early in the book he asks his chief analyst, Paolo Pellegrini, is there a bubble we can short? Not only was there one – the housing frenzy – but the perfect vehicle for shorting it had just been invented and was very poorly understood. Shorting stocks – betting that they will fall – was dangerous, because if they went up instead, he could lose an essentially uncapped amount of money. Buying CDS insurance was much less risky: all he stood to lose was the annual premium he paid, and the upside was enormous. Zuckerman’s book is the story of how Paulson and a handful of others figured out how to bet against the housing bubble, with varying degrees of success. It was Paulson who did it best, earning $15 billion dollars for his firm, and more than $4 billon for himself, in a single year.

More vivid if less clear is Michael Lewis, best-selling author of Liar’s Poker and The Blind Side, who is surely the best storyteller in the business. The Big Short: Inside the Doomsday Machine tells the same story as does Zuckerman, but he does it without Paulson. Instead Lewis elevates a one-eyed physician-turned-hedge-fund operator named Michael Burry to a starring role, along with stock analyst turned hedge-fund manager Steve Eisman and a handful of others who discovered credit default swaps and used them to bet against the housing marker. Burry plays a subordinate role in Zuckerman’s account, because he gets the timing of his trade wrong. Such is the joy in Lewis’s telling of the story that it doesn’t matter – hubris is everywhere. The book ends with an account of lunch with John Gutfreund, for whom Lewis worked twenty years before when Gutfreund, as head of Salomon Brothers, was the most powerful man on Wall Street.

The point is credit default swaps turned out to be an excellent vehicle for a ventilating a difference of opinion – not about a horse race, but about the housing bubble and the subprime mortgage bender that fueled it. They are how we got the bad news, once mortgage defaults began to rise and, if they had been more familiar and better understood, might have communicated the bad news earlier, perhaps even soon enough to prevent the meltdown that ensued. Gillian Tett has a short-seller in her book, Andrew Feldstein, but he is there mainly to give advice to regulators, who try to do their job but fail. (This is, in fact, the way regulation has always worked, when it has worked: the best guys in the market educating regulators in market practices.). Certainly Tett chose the right regulators, Gerald Corrigan and Timothy Geithner, both former presidents of the Federal Reserve Bank of New York, and William White and Claudio Borio, economists at the Bank for International Settlements, in Basel.

But she was writing a morality tale. Early on she sets up Mark Brickell, of J.P. Morgan, as the fall guy, a Hayek-quoting free-market extremist who asserts that “markets can correct excess better than any government.” He becomes head of the International Swaps and Derivatives Association, successfully lobbies against regulation, and as late as the spring of 2008 is seen to be arguing that “market discipline has guided the derivatives business better than regulation has steered housing finance.” The Zuckerman and Lewis books bear him out, up to a point. Credit default swaps were essentially prediction markets. They gave force to those differences of opinion. (As Warren Buffett puts it at one point in Michael Lewis’s book, “Writing a check separates a commitment from a conversation.”) Angry bears had no more powerful means of raising an alarm than the traditional Cassandra tools: planted newspaper stories and phone calls to regulators.

All three books show the limitations of the character-driven narrative, which inevitably leads authors to focus on one set of players at the expense of others. Thus Tett, despite her scorn for the ease with which lobbyists tipped over regulators, has nothing to say about the Robert Rubin-Lawrence Summers Treasury Department, which in 1998 so effectively throttled efforts by the Commodity Futures Trading Commission to rein in the growth of derivatives. Zuckerman has almost nothing to say about J.P. Morgan’s success in backing away from the CDS debacle, at one point painting Jamie Dimon, the trader who as chief executive kept J.P. Morgan Chase out of the mire, as a glad-hander who understood little about credit default swaps. And Lewis not only fails to weave Paulson into his tale, but passes up the even more illuminating ending to his book proposed last week by Michael Osinski in Business Week:

Even when default rates initially started rising, bond prices held firm. It wasn’t until January 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.

But life is not fair. The film rights to The Big Short have already been sold to Paramount, with Brad Pitt producing. As if he knew he was bound to be eclipsed, Paulson permitted Zuckerman to begin The Greatest Trade Ever with a photograph of his subject, the hedge fund proprietor, no longer just another merger arb, looking as thoroughly relaxed and happy as a man can be. Tett is headed for New York, as managing editor of the Financial Times US edition. Take your pick of these three quite different books, depending on your tastes. There will, of course, be more.

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