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THE MADNESS
ket. In fact, on one side of tens of billions of dollars worth of synthetic CDOs were in-
vestors taking short positions. The purchasers of credit default swaps illustrate the im-
pact of derivatives in introducing new risks and leverage into the system. Although
these investors profited spectacularly from the housing crisis, they never made a single
subprime loan or bought an actual mortgage. In other words, they were not purchasing
insurance against anything they owned. Instead, they merely made side bets on the
risks undertaken by others. Paulson told the FCIC that his research indicated that if
home prices remained flat, losses would wipe out the BBB-rated tranches; meanwhile,
at the time he could purchase default swap protection on them very cheaply.
On the other side of the zero-sum game were often the major U.S. financial insti-
tutions that would eventually be battered. Burry acknowledged to the FCIC, “There
is an argument to be made that you shouldn’t allow what I did.” But the problem, he
said, was not the short positions he was taking; it was the risks that others were ac-
cepting. “When I did the shorts, the whole time I was putting on the positions . . .
there were people on the other side that were just eating them up. I think it’s a catas-
trophe and I think it was preventable.”
Credit default swaps greased the CDO machine in several ways. First, they al-
lowed CDO managers to create synthetic and hybrid CDOs more quickly than they
could create cash CDOs. Second, they enabled investors in the CDOs (including the
originating banks, such as Citigroup and Merrill) to transfer the risk of default to the
issuer of the credit default swap (such as AIG and other insurance companies). Third,
they made correlation trading possible. As the FCIC survey revealed, most hedge
fund purchases of equity and other junior tranches of mortgage-backed securities
and CDOs were done as part of complex trading strategies. As a result, credit de-
fault swaps were critical to facilitate demand from hedge funds for the equity or other
junior tranches of mortgage-backed securities and CDOs. Finally, they allowed spec-
ulators to make bets for or against the housing market without putting up much cash.
On the other hand, it can be argued that credit default swaps helped end the hous-
ing and mortgage-backed securities bubble. Because CDO arrangers could more eas-
ily buy mortgage exposure for their CDOs through credit default swaps than through
actual mortgage-backed securities, demand for credit default swaps may in fact have
reduced the need to originate high-yield mortgages. In addition, some market partic-
ipants have contended that without the ability to short the housing market via credit
default swaps, the bubble would have lasted longer. As we will see, the declines in the
ABX index in late would be one of the first harbingers of market turmoil. “Once
[pessimists] can, in effect, sell short via the CDS, prices must reflect their views and
not just the views of the leveraged optimists,” John Geanakoplos, a Yale economics
professor and a partner in the hedge fund Ellington Capital Management, which
both invested in and managed CDOs, told the FCIC.
CITIGROUP: “I DO NOT BELIEVE WE WERE POWERLESS”
While the hedge funds were betting against the housing market in and ,
Citigroup’s CDO desk was pushing more money to the center of the table.
