These smart people collected large amounts of mortgage bonds from the market and then found insurance companies.
To put it simply, it is a bet on whether house prices will fall.
If house prices fall to a certain point, the insurance company will need to pay compensation, otherwise it will receive a considerable premium.
Except for a very small number of people, people at that time generally did not believe that housing prices would fall, which gave short sellers room to operate.
It was at this time that Su Nuan arranged for Ji Mo to start shorting the housing market.
Ji Mo received Su Nuan's proposal and raised questions.
"Ms. Su, subprime mortgage bonds can only be bought, not shorted."
"I know you found Deutsche Bank to customize a credit default swap (CDS). CDS is real estate default insurance. You bought $50 billion worth of CDS on six subprime mortgage bonds. If mortgage payments are defaulted and house prices fall, causing the value of subprime mortgage bonds to drop, the bank will pay us huge compensation. If the subprime mortgage bonds are not in trouble, we only need to pay the insurance premium every year. The premium rates are 0.2% for AAA, 0.5% for A, and 2% for AAA."
"You'll find that CDS is a great short-selling tool. Traditional short selling requires you to buy the underlying asset, but CDS doesn't. If you buy a stock to short it and it rises 50%, you'll lose 50%. But with CDS, the premium won't change regardless of how much the underlying asset rises. This is a guaranteed win for us."
"But, Ms. Su, would Deutsche Bank be stupid enough to sign a contract with us?"
"Yes. Although housing prices in Country A are showing a downward trend, the decline is not significant. They are still much higher than the original market conditions. Most people don't believe that there will be any problems with housing prices and subprime mortgages. They just think we are crazy and are giving them a free insurance premium every year. After that, you just need to find one bank after another to customize CDS."
"Okay, Miss Su."
"Ji Mo, we can do CDS like this in the early stages, but it's not perfect because this type of CDS is not tradable."
"So what should we do next?"
"They developed a tradable CDS whose price fluctuated with the price of subprime mortgage bonds. If the value of subprime mortgage bonds rose, the value of the CDS would fall, and those who were bullish on the housing market would sell it, while those who were bearish on the housing market would buy it. If house prices fell and subprime mortgages defaulted, many people would rush to buy the CDS in order to earn the huge premiums, causing its price to skyrocket."
"Ms. Su, the risk of doing this is too great."
"Don't worry. I've researched the data. Since the second-home policy was opened, the probability of defaulting on a loan for those whose home values have increased by 1-5% is four times higher than for those whose home values have increased by more than 10%. This means that housing prices don't even need to fall. As long as the rapid growth stops, a large number of people in Country A will stop repaying their loans."
"If the interest rates on $738 billion of balloon loans go from 5% to 10-10.5%, and the Fed has already started raising rates, those rates will get even higher. So, shorting the housing market is a surefire way to go."
“Okay, I know what to do next.”
After Ji Mo hung up the phone, he began to arrange the things that Su Nuan had asked him to do. In addition to buying CDS from major banks, he was also preparing CDS that could be traded.
As time passed, the ABX index, a barometer of the subprime mortgage market, remained around 100. The ABX, determined by major banks based on six months of market data, can be considered the Dow Jones Industrial Average for the subprime mortgage market. Despite falling house prices and rising default rates, Su Nuan and her team hadn't made a single cent.
Ji Mo began to get anxious, and he immediately called Su Nuan.
"Ms. Su, the ABX index is still around 100. We suspect there might be a problem."
"Don't worry, I know the reason."
"What's going on?"
"First, the three major rating agencies colluded with Wall Street to give junk bonds a triple-A rating, and second, the emergence of CDOs."
"COD?"
"That's right. During the mortgage bond sales process, there were always some of the lowest-rated, high-risk bonds that couldn't be sold. Investment banks didn't want to hold these high-risk bonds, so they repackaged these high-risk bonds with a small portion of safe bonds to form a new investment product, which is the Collateralized Debt Obligation (CDO)."
"So what should we do?"
"It's just a flash in the pan. A large number of B-rated bonds have been packaged and sold as gold, but their essence is actually garbage. A large number of B-rated bonds have been packaged and sold as gold, but their essence is actually garbage."
"The subprime bond craze was followed by CDOs, which forcibly propped up the subprime and financial markets. There were $1.2 trillion in subprime loans on the market, and $5 trillion in CDOs were created on top of that. Soon, there would not be enough subprime loans for CDOs, so investment banks may create synthetic CDOs."
"Synthetic CDO?"
"Rating agencies' falsified bond ratings, research institutions' falsified real estate data, and the CDO investment frenzy all combined to mask the decline in the real estate market, allowing the already rising default rate to go largely unnoticed. This was good news for us. The market was propping up the remaining heat in the real estate market, making CDS very cheap."
"What should we do then?"
"We raised all the funds we had and bought CDS for all the financial products that could be shorted, including subprime mortgage bonds, ABX index, CDO, synthetic CDO, etc."
"As long as the Federal Reserve can no longer bear it, they will raise interest rates 17 times in a row to fight inflation, raising the interest rate from 1% to 5.25%. That will be the time to burst the bubble."
Ji Mo followed Su Nuan's request and began to wait and see. After a while, the Federal Reserve really began to raise interest rates. Just as Su Nuan expected, 17 consecutive interest rate hikes made many consumers with credit burdens miserable.
Ji Mo immediately told Su Nuan the good news.
"Ms. Su, some subprime mortgage borrowers who took out balloon loans to buy homes a few years ago have seen their mortgage rates suddenly rise to over 15%. As interest rate hikes continue, rates are rapidly increasing. Low-income or even non-income individuals who refinanced to finance their purchases and repay their loans have quickly run out of refinanced funds and have decisively stopped repaying their loans. Some clients are selling their homes for cash, and housing prices in Country A, which have risen 126% since then, will continue to fall. This is the first domino to fall."
"As long as the subprime loan index ABX falls, it's time for us to make money. Just wait and see."
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