"Your concerns are correct. We will sell some of the tradable CDS against AIG and purchase some other CDS."
"If AIG goes bankrupt, we can cash in these CDS at a profit."
“Okay, I understand.”
Just when Ji Mo was processing the CDS of AIG's insurance policy, the subprime mortgage crisis had spread to Europe, a major customer of Country A's subprime mortgage market.
The Industrial Bank of Country D lost €8.2 billion on subprime mortgage investments. On August 9, BNP Paribas, the largest bank in Country F, froze three funds due to losses from investments in subprime bonds.
In September 1990, Northern Rock, a bank in Country Y, faced a liquidity crisis due to losses from its subprime bond investments and sought help from the Bank of England. On September 13, the BBC reported on Northern Rock's call for help, sparking panic among the public. Crowds rushed to Northern Rock's counters to withdraw cash, triggering a bank run. Over the next three days, €1 billion was withdrawn.
In October, Northern Rock Bank declared bankruptcy. On October 23, the Bankruptcy Association of Country A announced that the number of consumers filing for bankruptcy in September was close to 69,000, a year-on-year increase of 23%.
Since August 1990, news of bank losses and bankruptcies, large and small, has been circulating in Country A, Europe, and Japan. Despite central banks worldwide injecting over $400 billion into the banking system for two consecutive months starting in August, the housing and stock markets have remained stagnant.
In October 1990, Moody's downgraded the credit ratings of $33 billion in mortgages.
In December, the ratings of $153 billion of CDOs were downgraded, leaving Citigroup, Merrill Lynch, and Morgan Stanley facing a $70 billion asset write-down. The world entered 1991 amidst a constant stream of downgrades, devaluations, losses, and bankruptcies.
The downturn in the housing and bond markets made Su Nuan and Ji Mo rich. They had already recovered their original $100 billion investment. At the same time, each of the three shareholders earned no less than $20 billion.
Even though Su Nuan had already made a fortune, she was still not idle. She studied the debt problems of banks such as Bear Stearns and Lehman Brothers. Soon, she discovered a shocking problem: leverage.
If you have 1 million yuan in cash and invest it all, and the investment increases by 10%, you'll earn 10%. But if you borrow 9 million yuan to bring your total capital to 10 million yuan, this is 10x leverage. If the investment increases by 10%, you'll earn 1 million yuan, a 100% return on principal. After repaying the 9 million yuan principal and interest, your return will still be several times higher than the original amount. However, if the investment declines, without leverage, it would take a 100% drop to completely lose your principal, but with 10x leverage, it only takes a 10% drop to lose everything.
Su Nuan told Ji Mo about this discovery.
After Ji Mo learned about this situation, he went to verify it immediately and got the result.
During the market frenzy, Bear Stearns and Lehman Brothers used extremely high leverage to expand their investment profits in the subprime mortgage market. Lehman's leverage ratio was 30.7 times, and Bear Stearns' was 40 times.
After Su Nuan learned about this situation, she guessed that if the two housing companies were 75 times larger, the collapse of the housing market and the bond market would mean that these companies would all go bankrupt.
So she made another decision to switch from shorting subprime mortgage bonds to shorting these companies: Lehman Brothers, Washington Mutual Bank, Merrill Lynch and Fannie Mae.
Ji Mo was very surprised when he learned about her idea, but after Su Nuan's previous prediction, he now trusted Su Nuan's idea 100%, and started to act without saying a word.
At the same time, Su Nuan also noticed that since the real estate market boom, borrowing for consumption and life has become the mainstream of people in Country A.
Su Nuan asked Ji Mo to conduct a survey on the number of credit cards applied for by people in Country A and the default rate.
Ji Mo's investigation revealed that the average person in Country A owns at least five credit cards. If the market were to decline, credit card default rates would rise, just like mortgage default rates, which would drag down the real economy.
Su Nuan planned to short the credit card and construction sectors at the same time. She firmly believed that the subprime mortgage crisis was just a prelude to a bigger crisis.
In early March 1991, rumors began circulating that Bear Stearns was running out of liquidity. From March 7th to 14th, Bear Stearns' stock price plummeted from $77.32 to $62.30. The price of CDS contracts covering $10 million of subprime bonds soared from $316,000 to $619,000. Lehman Brothers' CDS prices also rose from $228,000 to $398,000, compared to $35,000 a year earlier. Clearly, short sellers were aggressively shorting both investment banks.
Su Nuan shorted two investment banks in advance and made a huge profit at this time.
Between March 10 and 14, panicked clients withdrew $18 billion. The rumors were now true, and Bear Stearns faced a liquidity crisis.
The newly appointed Treasury Secretary Henry did not care about the life or death of a single investment bank. What he was worried about was that if the fifth-ranked Bear Stearns collapsed, panic and short selling would cause the fourth-ranked Lehman Brothers to follow suit and then swallow up all the investment banks, which would be the collapse of the entire financial system.
With Henry's help, Bear Stearns was sold to JPMorgan Chase for $2 per share, compared to its peak price of $173.
JPMorgan Chase's acquisition of Bear Stearns came with the condition that the Federal Reserve would actually hold $35 billion of Bear Stearns' mortgage assets. In other words, taxpayers' money would cover Bear Stearns's liabilities. Henry thought the risk to the financial system was over. He soon discovered he was wrong.
In early May, Fannie Mae released its quarterly report, indicating three consecutive quarters of losses. As previously mentioned, two-thirds of Fannie Mae's profits came from subprime mortgage bonds, so it would be surprising if they didn't suffer losses. In early June, Lehman Brothers released its second-quarter results ahead of schedule, projecting a loss of $2.8 billion.
By the end of June, Lehman Brothers' stock price had fallen to $19.81, down from $39.56 in mid-April. By September 4th, Fannie Mae and Freddie Mac had suffered a net loss of $5.5 billion. Fannie Mae's stock price was $7.32, down from $66 a year earlier. The only product related to the three institutions that saw price increases was the CDS shorting their positions.
The three institutions were on the verge of collapse under the attack of short sellers. President George W. Bush and Henry reached a consensus in July that Fannie and Freddie Mac must not fail. They issued half of the mortgages and mortgage-backed securities issued in the United States, and their customers were spread all over the world.
The two largest clients are Russia and China, the largest holder of US Treasury bonds. The reason why China became the largest holder of Country A's Treasury bonds was Su Nuan's suggestion.
Because of this, President George W. Bush and Henry of Country A felt for the first time the financial balance of terror between China and the United States.
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