The Problem with Shorting the Mortgage Market

Recently I've read praise of the folks who shorted (bet against) the mortgage market from some unexpected corners, including Dean Baker at Beat the Press. The basic argument is that by shorting mortgage-related securities (subprime, CDOs, etc), these investors were sending important signals to the market that these assets were overvalued. Baker says that though they were obviously profit-driven, these short sellers were "performing a valuable public service" and that they were "pushing down the price of these assets towards their true level." I think Baker is mistaken for a few reasons.

First of all, there is a lot of evidence to suggest that the development of instruments used to short the subprime/CDO market actually fueled the further expansion of the market, rather than slow it down. Asset-backed credit default swaps, which weren't even invented until 2005, offered investors the chance to hedge their bets in the market - which pushed them to make even larger investments in these ill-fated securities. From a Bloomberg article on the "Group of Five" that developed the derivatives, by Mark Pittman:

Derivatives, or "synthetics," are "like wearing a seatbelt that allows you to drive faster," says Rod Dubitsky, director of asset-backed research for Credit Suisse. "The total dollar amount of losses, all these losses you're seeing, are from synthetics. No question, it changed the game dramatically."

Synthetics are CDOs composed entirely of credit default swaps. As we have seen, the safety net turned out to be pretty flimsy. The Dow Jones article trumpeting the invention of the asset-backed credit default swap in January 2005 ran under the headline "New Derivatives Could Boost Asset-Backed Secondary Market" (not available online), and said that these instruments would give the market "a shot in the arm" by allowing investors to "express a negative view."

Notice that in this graph, CDO issuance -- and the appetite for CDOs actually fueled the subprime lending boom to a large extent -- gets a dramatic boost in late 2005 and 2006. Coincidence?

So the opportunity to short subprime doesn't appear to have put the brakes on the market, or depress the prices of these mortgage-related assets, for a good long while -- quite the opposite, in fact. Perhaps the development of the short end of the subprime/mortgage market actually allowed the bubble to inflate further, even as the housing bubble was bursting in mid-2005, and then come to a more dramatic halt in mid-2007.

But what about the investors who did develop large net short positions in this market? Were they sending important signals to the market? Were they pushing prices back down to realistic levels? Not until things got way out of hand, it seems.

Take the example of the hedge fund Magnetar, covered a a couple months ago in the Wall Street Journal. Magnetar profited from the subprime debacle through a clever shorting strategy that actually seems to have temporarily inflated the value of the securities it was shorting.

The fund served as the lynchpin investor for CDO issuances, meaning that it agreed to buy the very worst tranches of these issuances, the slices that paid the highest interest rates and were most likely to default. It then shorted the more senior tranches of these issuances, in a gamble that these tranches weren't worth close to what they were going for. The moniker "lynchpin" speaks for itself -- without this crucial investor, who was actually maintaining a net short position, these CDOs might not have even been possible (that would have been a good thing). Ironically, the lynchpin turned out to be the exact opposite, the CDO came apart, and Magnetar made lots of money.

It was in the interests of investors shorting the mortgage markets that the market continue to inflate as they developed massive short positions. For one thing, as long as everyone thinks it's still a good idea to go long subprime, then it's much cheaper to short subprime. That is, the price of insuring against losses in the market is quite low, because everyone is eager to buy up CDOs and the high prices mask the high risk of foreclosure/default. Also, the bigger the bubble, the bigger the crash, and the more to gain from a short position down the road.

That's why you didn't see many investors making public pronouncements about the housing bubble while they were developing the short positions. Was Goldman Sachs out there in late 2006 and the first half of 2007 saying things were bad in the subprime market, and that they were unwinding their positions and going short subprime? Of course not (the opposite, in fact). They needed to be able to sell off their bad positions to unsuspecting investors and find sellers of bond insurance that didn't understand the risks in play.

Then there is the fact that the market for asset-backed credit default swaps is free of regulation and little understood, even when held up to the low standards of our financial markets, which have been undergoing deregulation for thirty years now. The transparency and pricing mechanisms that are present in other markets simply weren't there for mortgage-related securities, and this carries a number of consequences for the free flow of information that would tip off other investors. Also, who really knew how to short mortgage-related securities until very recently? Only a select group of investors even knew how to build these positions, and they exploited this special knowledge to their benefit.

So in my opinion, shorting this market was less a public service than just one more way Wall Street figured out how to rip off Main Street.

Meanwhile, Baker made an astute observation yesterday that Clinton has suggested two of the worst people imaginable to head a commission investigating what went wrong in the financial markets.