Ji Mo now admires Su Nuan very much. From the initial planning to the execution, Su Nuan has made accurate estimates of every step, even predicting the possibility of the Federal Reserve raising interest rates.
How could he not admire this?
At the end of the month, a large number of customers of New Century, the second largest subprime mortgage company in Country A, defaulted on their loans. After Wall Street discovered that there was a problem with the "raw materials" of the bonds, it forced New Century to recall these subprime loans.
Unlike commercial banks like Citigroup, New Century Bank lacked the ability to attract deposits. The funds it used to issue mortgages to clients were all raised through Wall Street financing. Unable to sell subprime mortgages and facing defaults, New Century Bank, facing a lack of income and the need to repay debts, suffered a sharp loss in the fourth quarter, nearly wiping out its annual profits. At the end of the month, New Century Bank issued a profit warning for the fourth quarter.
The next day, New Century's stock plummeted 36%. The subprime mortgage index, ABX, fell 5 points. For the first time, the market felt the chill of the subprime mortgage crisis.
Just as Su Nuan expected, ABX fell by 5 points. They held nearly $80 billion worth of subprime mortgage CDS. With ABX falling by 5 points, they made $12.8 billion in profit in just the morning.
Upon the release of this performance, those who had previously predicted the Ji family consortium's decline were stunned. The news sent shockwaves through Wall Street. Citigroup, Merrill Lynch, UBS, and other retail investors flooded Ji Mo's phone with calls, all seeking to understand how CDS (Debit-Backed Schemes) actually worked. A wave of shorting subprime mortgages using CDSs erupted in the market, further exacerbating the decline in the ABX. In just two weeks, the ABX index plummeted from 100 to 60.
Ji Mo made a fortune.
Anxiety over the ABX's decline spread throughout the financial markets. Bear Stearns, the fifth-largest investment bank, could not sit idly by while the mortgage and mortgage bond markets collapsed. Bear Stearns announced to the media, "The market's reaction to New Century has been excessive. Now is the time to buy the ABX at the bottom." Simultaneously, Bear Stearns and other institutions forcefully supported the subprime market, and the ABX began to rebound. After the ABX rebounded, institutions like Bear Stearns mocked the bearish camp in public opinion, calling Ji Mo a mere "speculator who only saw the market."
But soon, he couldn't laugh anymore.
Early the following month, Wall Street began demanding repayment of $17.3 billion in debt from New Century, forcing the company to publicly admit its impending bankruptcy, further inciting market panic. With $8.2 billion in unpayable debts, New Century filed for bankruptcy and laid off 54% of its employees. The subprime mortgage crisis had fully erupted.
When house prices rose, subprime mortgage customers, with the help of intermediaries, refinanced their original homes to obtain new loans for consumption and to buy houses again.
When house prices fell, the loans obtained through refinancing were no longer enough to pay off the previous mortgages, and interest rates also rose significantly due to interest rate hikes, turning the original positive feedback into negative feedback.
More and more people joined the wave of selling their homes, and as the sell-off spread across states, the housing market entered a vicious cycle. The lower the price, the fewer buyers there were, and the lower the price, the more people defaulted on their mortgages, causing subprime bonds to rapidly depreciate.
Bear Stearns, however, persisted. He led other institutions in buying the ABX index, forcing the index to ignore New Century's collapse. The index rebounded to 77 points in mid-May, but this was only a fleeting glimmer of hope. Overwhelmed by $8.2 billion in unpayable debts, New Century filed for bankruptcy and laid off 54% of its employees. The subprime mortgage crisis had fully erupted.
As the real estate market deteriorated, rating agencies could no longer sit still and finally used their remaining morals and professional ethics to begin re-rating the financial market.
In July 1990, Standard & Poor's downgraded the ratings of 612 mortgage bonds issued between 1989 and 1990, totaling $12 billion. Subsequently, Standard & Poor's downgraded the bond ratings of Lehman Brothers and Bear Stearns.
This hit Bear Stearns so hard. Two of its hedge funds suffered losses. The downgrade and Bear Stearns' losses made the reality clear to the market: a real estate market crash was inevitable.
People with funds began to customize or purchase CDS contracts frantically. The price of CDS in Ji Mo's hands began to skyrocket. At Su Nuan's suggestion, he sold part of the CDS and pocketed nearly 50 billion US dollars.
Some people who lacked the financial resources to buy CDS against the subprime mortgage market began using them to short their own homes, hoping to receive compensation to hedge their risk if house prices fell. Some renters began using CDS to short their landlords' or neighbors' homes.
At this point, the market experienced a dramatic reversal. Investors who had fueled the real estate bubble began to short sell, and the rush to buy MBS and CDOs gave way to a rush to buy CDS. Amidst widespread market distress, the ABX index plummeted to 37 points, leaving Bear Stearns completely powerless to recover.
Fannie Mae and Freddie Mac also joined the CDS buying frenzy. Since their lending was restricted, they began holding large amounts of mortgage-backed securities they had developed themselves, as well as subprime mortgage bonds packaged by investment banks. By 1990, these high-yielding subprime mortgage bonds accounted for two-thirds of their profits. When the value of subprime mortgage bonds began to plummet, the two banks were forced to buy CDS to hedge their risks.
But all those who bought CDS overlooked one question: who would compensate them? Was the compensation really ready?
At this moment, Ji Mo received a piece of news and told Su Nuan immediately.
"Ms. Su, Goldman Sachs, Country A's largest investment bank, has detected a potential real estate collapse. They've secretly switched from long to short positions, liquidating their own CDOs while simultaneously purchasing $2.2 billion in CDS against those CDOs. If these CDOs depreciate, Goldman Sachs will receive approximately $12 billion in compensation from Country A's largest insurance company, AIG."
"AIG? Did they agree?"
"Of course, AIG accepted everything. They figured, why not take advantage of a free ride? AIG happily fell into Goldman Sachs' trap, unaware that Goldman Sachs had set a hidden clause requiring it to pay a certain amount of collateral to Goldman Sachs if its rating was downgraded. Goldman Sachs also sold its own CDS to AIG. This meant that the CDS that previously required Goldman Sachs to pay now fell to AIG, but the premiums for the CDS contracts also shifted from Goldman Sachs to AIG."
"Are you worried that such a large amount of compensation will bankrupt AIG?"
"That's right. After all, the CDS underwriter we hold is AIG. If AIG goes bankrupt, we will suffer huge losses."
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