Arnold Kling  

Outsiders

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Am I too weak to resist financial crisis porn?

The latest example of my shameful indulgence is The Greatest Trade Ever, by Gregory Zuckerman. As with Andrew Ross Sorkin's Too Big to Fail, I could not put it down. Even though, as with Sorkin, there is essentially no economic analysis.

Zuckerman's writing has less sizzle and pop than Sorkin's. In fact, I have this fantasy that Sorkin wrote Too Big to Fail in one continuous manic Kerouacian burst of intensity.

But Zuckerman has something that Sorkin does not have--a portrait of Outsiders, a handful of contrarians, mostly hedge fund traders, who bet against Wall Street right before the housing bubble burst. Zuckerman's tale is not one of Insiders trying to merge banks and shore up the faltering giants. It is about Outsiders who set out to make a killing, and they did.

In Sorkin's book, we see Geithner and Paulson going all-out to protect their Insider siblings, raising taxpayer money to pay their gambling debts. Ben Bernanke's role is to help by promulgating the narrative that this is a Grave Situation that requires Major Efforts to Save the System.

For now, Bernanke's narrative reigns in the media. However, if history has any justice, that narrative will be replaced by one in which last year's episode is viewed less as a financial crisis and more as a crisis in Insiders' status, brought on by their own reckless stupidity.

Zuckerman's characters are people I had never heard of, including John Paulson (no relation to Henry), whose hedge fund reaped the biggest profits from betting against the Insiders, and Michael Burry, a self-taught, Aspergers'-diagnosed money manager. They are by most standards wealthy, but in status terms they are losers, loners, unfit to work at Goldman Sachs. For them, the bet against the housing bubble represents an opportunity for vindication, to overcome years of being held in low regard by Insiders. I identify with them completely, and I root for them with pleasure.

Zuckerman informs us that John Paulson is capable of taking subways and buses. It is almost as if Paulson is determined to differentiate himself from Chauffered America.

Paulson and his friends needed three things: insight, timing, and a trading vehicle. The insight was relatively simple--all they had to do was see that house prices had shot past fundamental values and that any drop in house prices would lead to widespread mortgage defaults. One of my friends saw it, and he made money shorting New Century Financial, a subprime mortgage lender that went bankrupt.

The timing issue comes from the fact that if you are too early, you get wiped out by the last wave of euphoria. That is where the trading vehicle came in. The Outsiders discovered credit default swaps on mortgage securities and on mortgage security tracking indexes. Credit default swaps behave like out-of-the-money put options. If the market rises against you, you can stay solvent a lot longer buying out-of-the-money puts than you can taking a straight short position. Because credit default swaps were esoteric and generally not available to individuals, the Outsiders had an advantage over people like my friend--they could take larger positions at less risk.

As those credit default swaps began to pay off, the Outsiders started asking themselves, "who has been selling us these things?" That is when they figured out that major financial firms would be the next to fall. So they rolled their bets over into bets against AIG, Freddie, Fannie, Bear, Lehman, and so forth.

What Zuckerman enables you to see is the anxiety of someone betting against a bubble when the bubble is still inflating. How long can you hold out? How do you deal with doubt coming from your friends, relatives, and investors? How do you handle your own self-doubt? Above all, how do you deal with the contemptuous laughter of the Insiders? You can see why it takes an Outsider to make this sort of bet and to stick with it. It is, as the saying goes, so much easier to fail conventionally than to succeed unconventionally.

As I was reading, I started to think about my own views that the U.S. is headed toward a sovereign debt crisis. This is clearly an Outsider view. The market for U.S. Treasuries suggests that investors are quite sanguine about those investments. My own portfolio is (for me) precariously skewed toward investments that will pay off under a scenario in which inflation soars.

It was comforting, then, to reach the last page of Zuckerman's book.

"With all this spending, we're going to have massive inflation," [John] Paulson told Hoine, arguing that almost every major currency was at risk, other than the Chinese yuan. "What's the only asset that will hold value? It's got to be gold."
Paulson never had even dabbled in gold, and had no currency experts on his team. Some of his investors were skeptical of his argument, noting a burst of inflation was unlikely with unemployment high, wages stagnant, and businesses running at a fraction of their potential capacity. Other said too many other investors already had flocked to gold...
...but he paid the critics little heed...Betting against the dollar would be his new trade.
One point that I would make is that gold is not the equivalent of a credit default swap. It is not a deep, out-of-the-money option that allows you to make a big killing with little risk. I'm still thinking about the best way to do the trade that will pay off in a sovereign debt crisis. Part of the problem is that you have to hedge against all sorts of economic and political disruption.



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COMMENTS (6 to date)
MrTuttle writes:

Out of the money calls on the GLD ETF.

steve writes:

I agree absolutely. The problem is how to hedge against insiders simpy choosing to substitute violence for their rigged game in order to maintain their status. I see two choices.

The simple answer is too simply diversify your bets into a number of different physical locations in the hopes that not all of them would fail in the worst case.

The big win however would come fromm examining in detail the apparent beliefs of different sets of insiders around the world as well as accurately determing whether they would have the ability to resist threats or actual violence. If you find some insiders to your liking, then place your bets within their borders.

Yancey Ward writes:

History only has justice if the right people win to write it. I wouldn't bet on that.

If I were people someone like John Paulson, I wouldn't become to visible. No one likes someone that bets against the system, not the crooks, not the media, and certainly not the government (not that those three groups are mutually exclusive in either totality or any significant way).

TDL writes:

Yancey,
That is a very good point. That might be one of the reasons that lead Paulson to set up a fund (I believe he seeded it with a couple hundred million) to help people stay in their homes. It's a lot harder to be demonized when you are an active & open philanthropist. Then again, the insiders were able to grab Milken even though he was an active philanthropist as well.

Arnold,
As a former trader, I would suggest being vigilant against viewpoints that make you feel comfortable with your existing positions. I would argue that it's best to always challenge the reason why you took the trade.

Regards,
TDL

caveat bettor writes:

I don't think Paulson's gold trade is going to do well. There is no real economic demand for gold, except with financial speculators who chart back to the days of Bretton Woods.

Paulson has a been a bit like Billy Beane since Moneyball came out; after his huge credit derivatives short trade, his performance has come back into the crowd. For some reason, he has been dabbling in Proshares Ultrashort ETFS, which have signficant negative gamma effects. I asked one of his analysts why he would hold those, and the analyst couldn't defend the trade.

A lot of Outsiders will get known for One Big Trade, and then they are quiet. Some are Big Traders in a certain age, but then fade. What has Soros/Rogers or Buffett done for their investors lately?

Gena Kukartsev writes:

Arnold,

regarding your pondering on how to cash in on future inflation, here is a naive question from a non-economist: why don't you get tons of fixed-rate debt and buy something tangible like... a house or ten? Seems like an obvious thing to do if one believes in future inflation.

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