How You Bet Against the Housing Market Before It Fell
A handful of investors profited enormously from the 2008 collapse. The instrument that let them do it, and the reason it took years to pay off, is more interesting than the personalities.
The Problem With Shorting a Bond
Shorting a stock is straightforward. You borrow shares, sell them, and buy them back later. Bonds are harder. Mortgage backed securities in particular traded infrequently and in large sizes, so borrowing them to short was impractical.
The solution was the credit default swap. A CDS is a contract where one party pays a regular premium and the other agrees to compensate them if a specified security defaults. Functionally it is insurance on a bond.
The Feature That Mattered
The critical detail is that you did not need to own the bond to buy protection on it. That converts an insurance contract into a directional bet.
Buying fire insurance on a house you do not own would be absurd, and in insurance it is prohibited precisely because it creates an incentive for arson. In credit derivatives it was permitted. Investors who believed subprime mortgage bonds would default could buy protection on them, paying a modest annual premium against a very large payout if they were right.
Because protection could be bought without owning the underlying bond, the amount of exposure created could exceed the amount of actual debt. The bet was larger than the thing being bet on.
The Asymmetry
The trade was attractive because the payoff was extremely skewed. Premiums on securities rated highly were small, because the market considered default remote. If the bonds performed, the buyer lost only the accumulated premiums. If they defaulted, the payout was many multiples of that.
That is the structure of an option, and it is why so few people needed to be right for the payoff to be enormous.
Why Being Right Early Nearly Failed
The part most often skipped is how painful the position was to hold. The investors who identified the problem were early by a considerable margin, and the premiums had to be paid the entire time.
Worse, as long as the bonds continued performing, the market value of the protection fell. Funds holding these positions faced mounting paper losses and had to explain to investors why they were paying steadily for a bet that appeared to be losing. Several faced redemption demands that would have forced them to close positions before the payoff arrived.
This is the recurring lesson about the difference between a correct analysis and a profitable trade. Solvency has to outlast the market's willingness to disagree with you, and that is a funding question rather than an analytical one.
Who Was on the Other Side
Someone sold all that protection. Much of it was written by insurers and bank trading desks who treated the premiums as nearly free income, reasoning that highly rated mortgage securities essentially never defaulted.
Selling protection on a rare event is profitable almost every year and catastrophic in the one year it is not. It is the same structure as selling deeply out of the money options, and it accumulates small steady gains against an enormous concentrated loss. Firms that had written vast amounts of it required rescue when the payouts came due simultaneously.
The Bottom Line
Credit default swaps let investors short bonds they could not borrow, and let others sell disaster insurance without holding reserves against it. The winning trade required being right and, harder, staying funded long enough to collect.