By Arnold Kling
Am I too weak to resist financial crisis porn?
The latest example of my shameful indulgence is The Greatest Trade Ever, by Gregory Zuckerman. As with Andrew Ross Sorkin’s Too Big to Fail, I could not put it down. Even though, as with Sorkin, there is essentially no economic analysis.
Zuckerman’s writing has less sizzle and pop than Sorkin’s. In fact, I have this fantasy that Sorkin wrote Too Big to Fail in one continuous manic Kerouacian burst of intensity.
But Zuckerman has something that Sorkin does not have–a portrait of Outsiders, a handful of contrarians, mostly hedge fund traders, who bet against Wall Street right before the housing bubble burst. Zuckerman’s tale is not one of Insiders trying to merge banks and shore up the faltering giants. It is about Outsiders who set out to make a killing, and they did.
In Sorkin’s book, we see Geithner and Paulson going all-out to protect their Insider siblings, raising taxpayer money to pay their gambling debts. Ben Bernanke’s role is to help by promulgating the narrative that this is a Grave Situation that requires Major Efforts to Save the System.
For now, Bernanke’s narrative reigns in the media. However, if history has any justice, that narrative will be replaced by one in which last year’s episode is viewed less as a financial crisis and more as a crisis in Insiders’ status, brought on by their own reckless stupidity.Zuckerman’s characters are people I had never heard of, including John Paulson (no relation to Henry), whose hedge fund reaped the biggest profits from betting against the Insiders, and Michael Burry, a self-taught, Aspergers’-diagnosed money manager. They are by most standards wealthy, but in status terms they are losers, loners, unfit to work at Goldman Sachs. For them, the bet against the housing bubble represents an opportunity for vindication, to overcome years of being held in low regard by Insiders. I identify with them completely, and I root for them with pleasure.
Zuckerman informs us that John Paulson is capable of taking subways and buses. It is almost as if Paulson is determined to differentiate himself from Chauffered America.
Paulson and his friends needed three things: insight, timing, and a trading vehicle. The insight was relatively simple–all they had to do was see that house prices had shot past fundamental values and that any drop in house prices would lead to widespread mortgage defaults. One of my friends saw it, and he made money shorting New Century Financial, a subprime mortgage lender that went bankrupt.
The timing issue comes from the fact that if you are too early, you get wiped out by the last wave of euphoria. That is where the trading vehicle came in. The Outsiders discovered credit default swaps on mortgage securities and on mortgage security tracking indexes. Credit default swaps behave like out-of-the-money put options. If the market rises against you, you can stay solvent a lot longer buying out-of-the-money puts than you can taking a straight short position. Because credit default swaps were esoteric and generally not available to individuals, the Outsiders had an advantage over people like my friend–they could take larger positions at less risk.
As those credit default swaps began to pay off, the Outsiders started asking themselves, “who has been selling us these things?” That is when they figured out that major financial firms would be the next to fall. So they rolled their bets over into bets against AIG, Freddie, Fannie, Bear, Lehman, and so forth.
What Zuckerman enables you to see is the anxiety of someone betting against a bubble when the bubble is still inflating. How long can you hold out? How do you deal with doubt coming from your friends, relatives, and investors? How do you handle your own self-doubt? Above all, how do you deal with the contemptuous laughter of the Insiders? You can see why it takes an Outsider to make this sort of bet and to stick with it. It is, as the saying goes, so much easier to fail conventionally than to succeed unconventionally.
As I was reading, I started to think about my own views that the U.S. is headed toward a sovereign debt crisis. This is clearly an Outsider view. The market for U.S. Treasuries suggests that investors are quite sanguine about those investments. My own portfolio is (for me) precariously skewed toward investments that will pay off under a scenario in which inflation soars.
It was comforting, then, to reach the last page of Zuckerman’s book.
“With all this spending, we’re going to have massive inflation,” [John] Paulson told Hoine, arguing that almost every major currency was at risk, other than the Chinese yuan. “What’s the only asset that will hold value? It’s got to be gold.”
Paulson never had even dabbled in gold, and had no currency experts on his team. Some of his investors were skeptical of his argument, noting a burst of inflation was unlikely with unemployment high, wages stagnant, and businesses running at a fraction of their potential capacity. Other said too many other investors already had flocked to gold…
…but he paid the critics little heed…Betting against the dollar would be his new trade.
One point that I would make is that gold is not the equivalent of a credit default swap. It is not a deep, out-of-the-money option that allows you to make a big killing with little risk. I’m still thinking about the best way to do the trade that will pay off in a sovereign debt crisis. Part of the problem is that you have to hedge against all sorts of economic and political disruption.