Market Asymmetry

Along with Michael Lewis’ The Big Short, Gregory Zuckerman’s The Greatest Trade Ever shows that at least some investors were aware that the housing bubble of the mid-2000s was likely to collapse, with severe repercussions on the economy. The book (whose alternate subtitle is “How One Man Bet Against the Markets and Made $20 Billion”) focuses on John Paulson, whose Paulson & Company was considered a minor player until he shorted so many mortgage bonds that he made the company $14 billion (plus $4 billion for himself).

Believers in the “efficient market hypothesis” argue that there will always be investors willing to bet on both sides of any market. The resulting prices, they say, represent the most accurate possible evaluations of the true value of any investment. One problem with this hypothesis, Zuckerman shows, is that some investments are asymmetrical, which leads to a bias in the markets.

Investors who think the price of oil is going to go up can buy an oil future, that is, a promise to buy oil (or stock in an oil company) in the future at a price that is set today; they earn a profit if prices rise above the set price. Those who think oil prices are going to go down can short the market by offering to sell the oil (or stock) at a set price in the future; they earn a profit if prices fall below the set price, allowing them to buy oil at the market price and sell it at the set price.

Many investors who looked at the mortgage market in 2004 through 2007 realized that prices were in a bubble and were going to collapse soon. However, there was no way to short a mortgage or even a mortgage bond. But they could buy a credit-default swap (CDS), which was effectively insurance on a mortgage bond. If the bond defaulted, they would collect the value of the mortgages from the insurer.

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“Even the most successful investors shun negative carry; it is like garlic to vampires,” Zuckerman adds in a rather forced effort to be colorful. “Instead, most traders prefer ‘positive’ carry trades, or those where profits are immediate and clear. Banks, for example, borrow money at low interest rates and lend it out at higher rates. A borrow may go belly-up, of course, but on paper the move looks like a winner. There didn’t seem to be a more surefire positive-carry trade than selling insurance on even risky mortgage debt. Insurance companies like American Insurance Group, huge global banks, and countless investors locked in instant gains from the premiums that Paulson and other bears paid for their CDS insurance” (p. 120).

As both Zuckerman and Lewis note, investment houses that tried to short the housing market by buying credit-default swaps caught a lot of flak from their investors. Some who bought CDSs too soon before the collapse ended up going broke paying out the insurance premiums before the market collapsed. Others saw their investors pull their money out, reducing the number of CDSs they could buy. Paulson was lucky that he entered the market just a few months before the collapse and thus earned huge gains without antagonizing many of his investors.

Paulson and the other bears recognized that the ratings agencies had hugely overrated mortgage bonds. One analyst found that default rates were inversely related to the growth in housing prices, with rates being higher in states like Texas (where prices were rising slowly) than California (where prices were rising rapidly). Yet the 10 percent annual price increases in California were simply unsustainable; when they slowed, default rates would rise to levels far greater than assumed by the ratings companies (pp. 100-101).

In other words, prices didn’t even have to fall for some of the mortgage bonds to default; they only had to rise slower. If prices leveled off, even more bonds would default. Some analysts realized that housing markets were more highly correlated than the ratings agencies assumed. For example, many homebuyers took out adjustable-rate mortgages with the expectation that they would refinance before the rates increased–but they might not be able to refinance if increasing default rates led investors to flee the mortgage bond market, thus causing default rates to increase even more. There would be even more defaults when the resulting slowdown in home purchases led prices to fall.

Were it not for the asymmetry in the mortgage bond market, more bears might have entered the market, effectively increasing the price of CDSs and reducing the value of mortgage bonds. This asymmetry was another contributor to the severity of the financial crisis.