Korva is a scroll of the internet’s best ideas.
Shorting mortgages for 1% a year
Following the money
Chad Cascarilla, who ran the hedge fund Cedar Hill, followed the money. Someone was funding $600,000 mortgages on $600,000 houses for borrowers with no income or job verification, and that someone turned out to be the securitization market.
Credit default swaps had opened the way to being short a securitization, which had not been possible before. The same swaps let others fund those mortgages and price them irrationally, because synthetic instruments could be created.
The cheapest short
The riskiest slice of a securitization was the cheapest place to be short. Putting the fund's entire value into the trade risked about 1 percent a year, so he started new funds built to do only this.
Investors balked at first and asked why he was buying credit default swaps, which looked risky. He answered by putting the trade in a separate vehicle that contained the risk. Once it started to work, the same investors asked why more of it wasn't in the fund.
How did credit default swaps allow shorting mortgages?
A credit default swap is a contract in which one side pays a regular premium and the other pays out if a specified debt defaults. Standardized contracts for mortgage-backed securities arrived in 2005, when the International Swaps and Derivatives Association published a template for them. That gave investors a way to bet against specific mortgage bonds without owning or borrowing them. The buyer's loss is capped at the premiums paid, unlike a short sale of stock, where losses have no ceiling.
Why does shorting a stock cost so much?
A short seller must borrow shares, and lenders charge a fee that rises when many traders want to bet against the same stock. The short seller also owes the lender any dividends the stock pays. A rising price can trigger margin calls that force the position closed at a loss. Borrow fees on the most crowded shorts have at times exceeded 100 percent annualized.
How did synthetic securities multiply mortgage exposure?
A synthetic collateralized debt obligation is built from credit default swaps rather than actual loans, so it needs no new mortgages to exist. Many such securities could reference the same mortgage bonds, which meant losses on one pool of loans could be counted again and again. The Financial Crisis Inquiry Commission, in its 2011 report, concluded that synthetic CDOs magnified losses from the housing collapse. Total synthetic exposure to a given set of bonds could therefore exceed the value of the bonds themselves.
More from Joys of Compounding
