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.