Times has this nice story of how Wall Street giants like Goldman Sachs placed unusually heavy bets against mortgage securities (shorting them), even as it was packaging and peddling securities based on them, like Synthetic Collateralized Debt Obligations (CDOs), to its clients.
CDOs are made up of credit default swaps (CDS) that insure against default of mortgage bonds (as against the bonds themselves in case of normal CDOs). Sellers of CDS would receive regular payments as long as the underlying mortgage securities stayed healthy. Sellers in turn sold them off to Wall Street investment banks, who packaged them off as synthetic CDOs to their large clients. The proprietary trading desk of these firms then bet against the mortgage bonds by themselves purchasing insurance in the form of CDS and paying premiums for it. When the mortgages sour, the investors lost the right to their investments even as the swaps pay out to those who bet against them. Exercise the swaps, liquidate the short positions on these bonds by market purchases, and book handsome windfall profits! In other words, your clients pay you for losing their investments!!
Unlike conventional CDOs, where investors took losses only under extreme credit events, when the underlying mortgages defaulted or their issuers went bankrupt, the synthetic CDO holders would have to make payments to short sellers under less onerous outcomes, or 'triggers' like a ratings downgrade on a bond. This meant that anyone who bet against such CDOs could collect on the bet more easily. Regulations were progressively gamed to favor those betting against these CDOs.
At the peak of the sub-prime mortgage bubble, even as its trading and portfolio management arm was selling synthetic CDOs to unsuspecting clients, carried away by the "irrational exuberance" of the boom, the proprietary trading desks (which uses its own capital) of firms like Goldman Sachs were betting against the same underlying instruments by shorting them. When the bubble burst, the investors were left holding suckers while Goldman made windfall gains on its bets.
Goldman's version of such mortgage linked securities, whose underlying was not the mortgage bonds but the related CDS's, were called Abacus. The NYT story nicely captures how Goldman's traders were aggressively selling Abacus, trying to make its assets more attractive than they actually were, without encouraging their clients to hedge agianst these instruments going bad.
In effect, these firms were simultaneously selling securities to customers and shorting them because they believed they were going to default - "buy protection against an event that you have a hand in causing". Incidentally, worried about a housing bubble, Goldman Sachs had decided in December 2006 to change the firm’s overall stance on the mortgage market, from positive to negative, though it did not disclose that publicly. One of the sources of the Times report put such instruments in perspective,
"When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson".
From John Cassidy's excellent chronicle of the sub-prime crisis.
"CDS aren't really swaps at all, they should be called credit insurance contracts... In 1997, a group of math whizzes in Morgan's derivatives department took $9.7 bn in loans that it had issued to about 300 corporations, placed them in a SIV, and distributed tranches of the SPV to investors. This sounds like routine securitization, but it came with a twist. The investors - insurance companies and other banks, mainly - didn't get to own the loans, which remained on Morgan's books; they merely agreed to take on the risk of Morgan's borrowers defaulting.
In return, Morgan agreed to pay them what were effectively insurance premiums. As long as the borrowers kept making their interest and principal payments, the investors would receive a steady stream of income - some $700 m a year in total. But if some of the borrowers defaulted, the owners of the SPV stood to make up the full value of the loans. These mutual obligations were defined in legal agreements, which were called CDS.
The deal accomplished several things : it removed $9.7 bn in credit risks from Morgan's balance sheet, freeing up capital the firmm could use elsewhere; it transferred these risks to other financial institutions that had more of an appetite for them; and it created securities that could be traded, this allowing investors to get exposure to an asset class - bank loans - that they had previously been excluded from."
It is widely acknowledged that unregulated, over-the-counter (OTC) derivatives like an option to buy a stock in the future at a fixed price set today and credit-default swaps (a form of insurance against the future default of a bond) played a critical role in the sub-prime bubble. Now Goldman's CEO Lloyd Blankfein has himself acknowledged the need to regulate them by standardizing the contracts and making them trade in exchanges.
William Cohan has a nice account of how Goldman Sachs made massive money by betting against the sub-prime mortgages, while AIG lost money betting against sub-prime mortgages falling.
Update 2 (6/11/2011)
Citigroup sold securities to investors and then turned around and shorted these same securities. The bank not only believed the securities would decline in value, but it actually spent its own money to make money off the terrible product it had sold to customers. The transaction involved a $1 billion portfolio of mortgage-related investments, many of which were handpicked for the portfolio by Citigroup without telling investors of its role or that it had made bets that the investments would fall in value. Bruce Judson has call it a classic swindle.
The SEC recently announced a $285 million dollar civil settlement with Citigroup involving both compensating the victims and penalizing the firm.
The unfortunate aspect of this settlement was the relatively light nature of the punishment given to Citigroup despite this malafide transaction being clearly established. The $95 mn fine is a relative pittance for Citigroup, whose Q3 2011 profits are estimated to be $3.8 bn. As Judson writes, "these settlements have become simply a "cost of doing business" for our increasingly monopolized financial sector and are unlikely to impact its behavior".