Lesson 20: Anatomy of a Recession Part 3: Orchestrated Chaos Section C: Sports-Betting and Game-Rigging
After Paulson and the Democrats took power, 3 things happened that added volatility to the market, made a lot of investment bankers rich, and paved the way for the 2008 elections: 3. The third significant event of 2007 (see Lesson 17) was the creation of the TABX index. To understand its significance, you must first understand the Credit Default Swap (CDS). The CDS is simply a sports bet, except instead of betting that a team will win or lose a game, you bet that someone will default on a loan. It is politely referred to as insurance, and the bets are called premiums. But insurance insures you against the risk of losing something. With the CDS, the only thing you risk losing is the bet. That is because you don't have to own anything or buy anything to place the CDS. You don't have to own the loan or owe the loan. You can just be a spectator. If the loan you're betting on defaults, you collect. The CDS was originally started for insurance purposes. In 1997, they were created by the commercial bank JP Morgan in order to hedge against defaults on the loans they had made. They were, in a way, insuring their own loans. The reason the CDS market degenerated into spectator betting is because it was completely unregulated, which made it better than a casino. Regulation was prevented by the Commodity Futures Modernization Act of 2000, championed by Senator Phil Gramm and signed by President Clinton. A CDS could be written on a napkin; it could be placed on anybody; it could be traded and re-traded. The CDS market became an incestuous orgy, where loan risk was passed around until every major bank was wed to each other like a bizarre harem. By the end of 2007, the CDS market was estimated to be worth 60 trillion dollars, 3 times the value of the stock market. Around 2004, the folks at Dow Jones tried to come up with some standardization of CDS contracts, and an index to guide the price of CDS. But the Dow's index only applied to commercial loans. It took Paulson's pals at Goldman's Sachs to dream up a specialized index just for CDS placed on Mortgage Backed Securities (MBS, see Lesson 17). They did just that in 2006, 6 months before the Senate confirmed Henry Paulson as U.S. Treasurer. Spear-headed by Goldman Sachs executive Brad Levy, the index was called ABX, and it was based on a few securites owned by just 16 investment banks. Because of its narrow focus, it was easy to manipulate. All you had to do was take out a bunch of CDS on a company or two out of the 16. Buying a CDS is betting that something bad will happen. When a bunch of those bets are made, confidence grows that something bad WILL happen. That drives down the ABX, makes it harder for the involved companies to borrow and lend, and the bets become a self-fulfilling prophecy. Then you can go to the stock market and short-sell shares of the company (see Lesson 18). However, that wasn't easy enough (or risky enough). So in 2007, Levy's group created a sub-index of the ABX just for sub-prime MBS. The index was called the TABX. After that, it only took 3 months for Bear Stearns, one of the biggest of the ABX companies, to face bankruptcy. Bear Stearns assets in March 2007 were full of MBS, but even more full of CDS. Over a weekend, in the office of New York Fed president Timothy Geithner, the fate of Bear Stearns was decided by executives from Goldman Sachs and JP Morgan (who invented the CDS), mostly without input from Bear Stearns. The Federal Reserve would loan JP Morgan 30 billion dollars to buy Bear Stearns. This opened the door to the idea of government bailing out private investment banks. Bear Stearns was sold for just $2 per share, less than the value of its office property. It turns out that unregulated gambling wasn't so great after all. At least in a casino, the House has to pay if you win. With the CDS market, the House didn't have enough money to cover the winners. So now you're covering them. You may have heard of this casino: A.I.G.