A Darwinian Crisis
(or Doing God's Work
or "Say it ain't so, Joe")

Books like Andrew Ross Sorkin's "Too Big to Fail," Gregory Zuckerman's "The Greatest Trade Ever," and Michael Lewis's "The Big Short" present narratives where smart, talented and virtuous bankers and financiers prevail against the mob during the recent clusterfuck. (The authors still agree common sense reforms are needed of course.)

Joe Nocera however provides an analysis of a different kind of Darwinian moment:

Remember in the months leading up to the crisis, when the Federal Reserve chairman, Ben Bernanke, and Henry Paulson Jr., then the Treasury secretary, were assuring everyone that the "subprime problem" could be contained? In truth, if the only problem had been the actual mortgage bonds themselves, they might have been right. At the peak there were well over $1 trillion in subprime and Alt-A mortgages that were securitized on Wall Street. That’s a lot, to be sure -- but it was a finite number. You could have only as much exposure as there were bonds in existence.

The introduction of synthetic C.D.O.’s changed all that. Unlike a "normal" collateralized debt obligation, which contained the bonds themselves, the synthetic version contained credit-default swaps -- derivatives that "referenced" a particular group of mortgage bonds. Once synthetic C.D.O.’s became popular, Wall Street no longer needed to feed the beast with new subprime loans. It could make an infinite number of bets on the bonds that already existed.

And why did synthetic C.D.O.’s become popular? One reason was that the subprime companies were starting to run out of risky borrowers to make bad loans to -- and hitting a brick wall. New Century, a big subprime originator, went bankrupt in early April 2007, for instance. Yet three weeks later, the Goldman synthetic C.D.O. deal, called Abacus 2007-ACI, went through, because it was betting on subprime mortgage bonds that already existed rather than bundling new ones. It didn’t even have to go to the trouble of repackaging old C.D.O. tranches into new C.D.O.’s, which was also a common practice. (Goldman has vehemently denied any allegations of wrongdoing, pointing out that it lost $90 million on the particular Abacus deal that is the subject of the S.E.C. complaint.)

The second reason, though, is that synthetic C.D.O.’s gave people like John Paulson a way to short the subprime market. Mr. Paulson’s bet against the subprime market, which famously reaped the firm billions in profits, was the subject of a recent book, "The Greatest Trade Ever." Boy, I’ll say.

Both Gregory Zuckerman, the author of that book, and Michael Lewis, who wrote the current best seller "The Big Short," make it clear that the heroes of their narratives -- the handful of people who had figured out that subprime mortgages were a looming disaster -- were pushing Wall Street hard to give them a way to short the market. Maybe synthetic C.D.O.’s would have been created even without their urging, but it seems a little unlikely. They were the driving forces. (emphasis added)

 Reminds me of some lines James Diedrick wrote about Martin Amis's novel London Fields.

This exhaustion extends right down to the low comedy of Keith's petty criminality. Consider this description of what he and his cohorts discover when they enter a house they intend to rob: "it was all burgled out. Indeed, burgling, when viewed in Darwinian terms, was clearly approaching a crisis. Burglars were finding that almost everywhere had been burgled" (248).

Nocera makes an excellent point at the end of his piece:

In its filing on Thursday, the S.E.C. charged that Goldman never told investors of Mr. Paulson’s involvement. "Credit derivative technology helped people disguise what they were doing," said Janet Tavakoli, the president of Tavakoli Structured Finance, and an early critics of many of the structures that have now come under scrutiny.

There appear to be other examples of this, as well. Last week, Pro Publica, the nonprofit investigative journalism outfit, reported how a big Chicago hedge fund, Magnetar, helped put together some synthetic C.D.O.’s -- precisely so that it could bet against them. In his book, Mr. Zuckerman seems to have stumbled onto Abacus and similar deals. One banker, he writes, "suspected that Paulson would push for combustible mortgages and debt to go into any C.D.O., making it more likely that it would go up in flames." Which is precisely what the S.E.C. is claiming. But in his quest to lionize his central character, Mr. Zuckerman rushes past what by all rights should have been the most shocking revelation in his book.

Mr. Lewis, for his part, recounts a dinner, late in the game, in which one of his heroes, Steve Eisman, is seated next to a man who is taking the long position on many of the C.D.O.’s he is shorting. They get to talking, and the man says to Mr. Eisman: "I love guys like you who short my market. Without you, I don’t have anything to buy." He adds, "The more excited that you get that you’re right, the more trades you’ll do, the more product for me."

As a reader, it is hard not to love that moment, rich as it is in irony and foreboding. The guy on the long side -- who was making investments that the housing and mortgage markets would remain strong -- is an obvious fool; Mr. Eisman, on the short side the trade, is clearly going to be vindicated. (And, by Mr. Lewis’s account, Mr. Eisman never "helped" a Wall Street firm pick the bonds for the C.D.O.’s he was shorting, the way the S.E.C. says Mr. Paulson did.)

But on second reading, the passage isn’t quite so funny. The people on the short side of those trades were truly savvy investors, who, unlike so many others, did their homework and had insights that made them a great deal of money. But the rise of synthetic C.D.O.’s that they pushed for -- and their ability to use credit-default swaps to short subprime mortgage bonds -- took an already bad situation and made it worse.

And here we are now, all of us, paying the price.

Emphasis added. How did the savvy speculators make it worse? By encouraging enormous, over-leveraged bets by people who were - by design - in the dark about the fact that the "smart money" was betting against them. The game was fixed in other words.