The people who recognized the high likelihood of defaults were able to profit from that likelihood – First , they could sell the mortgage securities short – a straightforward wager that has long been available.
Second , they could buy credit default swaps (CDS) from banks and insurers like Merrill & AIG , who charged very little to the other side to make the bet. These were essentially a side bet that anyone could make about a certain mortgage bond or security. It paid off fantastically if the bond went into default or was close to default.
Where the junk mortgage bonds were in the hundreds of billions, the Credit Default Swaps were in the Tens of TRILLIONS – CREDIT DEFAULT SWAPS were a STAGGERLINGLY LARGE $72 TRILLION DOLLARS – that’s a Seven with Thirteen ZERO’s Folks – $72,000,000,000,000
If the sellers of the Credit Default Swaps had to pay off in large part , the liability greatly exceeded the total bank capital in the United States and possibly in the world.
The derivatives based upon the junk mortgage bonds could be , and were not in any way limited to the size of the mortgage. It is this liability that swamped the banks , investment banks and insurers. It is the Credit Default Swap Liability that broke AIG and Lehman Bros.
Lehman was so large that when it failed
Bankers panicked. If Lehman could fail , then anyone could fail. The banks that were still solvent figured they had better hoard their assets and stop making loans. This led to the ongoing credit freeze and economic downturn with a drastic fall in prices of all kinds of securities , real estate and commodities.
It also led to a massive credit squeeze on hedge funds , a credit dry up and monster fall of asset prices. This snowballed into forced stock and other assets on a huge scale leading to still greater falls in securitiy prices.
The worldwide panic is still unfolding , leading to huge infusions of liquidity into the Worlds Banks and the semi-Nationalization of United States Banks to bolster world markets and economies. These were drastic steps for drastic times , all generated by derivatives.
Warren Buffett had warned us against them back in 2002 and again he was right. Buffett stated that “ .. derivatives bought speculatively are WEAPONS OF FINANCIAL MASS DESTRUCTION .. the range of derivatives contracts is limited only by the imagination of man or sometimes , so it seems , MadMen.“
A new biography The Snowball: Warren Buffett and the Business of Life has been published , a million copies by Bantam Dell of which Buffet received $7 Million. The timing of its publication coincides with the greatest financial crisis since the Depression.
The title refers to a Buffett saying “Life is like a snowball. The important thing is finding wet snow and a really long hill.”
Recent financial crisis has been prime hunting season for Buffett, famous for snapping up high-quality investments at bargain prices.
On Sept. 24 Buffett agreed to invest up to $10 billion in Goldman Sachs (GS: 128.52, +7.82 ) .
On Sept. 18, Buffett’s Mid American Energy Co. bought Constellation Energy Group for $4.7 billion in cash — a discount of 60% from which the shares were trading two days prior.
Last week he acquired a 10% stake in the firm BYD Co , a Chinese producer of rechargeable batteries, electric cars and car parts.