[280] The Den of Corruption, Wall Street 1
In truth, banking is a straightforward business. It’s all about collecting fees, known as the interest margin, from the difference between the interest rates on loans and deposits.
In the past, bank jobs were seen as stable, much like government positions, thanks to their simple, error-free processes, steady paychecks, and job security. However, they also carried a reputation for being dull and uninspired.
Yet, in every field, there are those who can’t help but shine with brilliance.
Even in the seemingly mundane world of banking, there were hidden geniuses whose talents were focused on figuring out how to make a fortune in one fell swoop.
In the early 1980s, while South Korea was still grappling with the aftermath of a military coup and backward political processes, three geniuses in the United States, the epitome of capitalism, came together to devise an extraordinary money-making scheme.
Louis Ranieri, head of the bond department at Salomon Brothers, Larry Fink, founder of BlackRock, and David Maxwell, CEO of the Federal National Mortgage Association, created—no, invented—the Mortgage-Backed Security (MBS).
Before this, mortgage lending was a simple affair: lend money against a house, and collect the principal and interest over 10 or 20 years. For banks, it was stable but tedious work, tying up large sums of money for long periods.
These three visionaries looked at mortgages not from a bank’s perspective but as a product.
They realized that while mortgages generated modest returns, they were stable over the long term, aligning perfectly with the desires of retirees, income investors, and asset holders who feared principal loss. Thus, they transformed mortgages into the MBS product.
The catalyst for their innovation was interest rates.
In 1979, when the Federal Reserve raised rates, the financial sector faced a liquidity crisis, and the mortgage market began to wobble.
In a high-interest environment, few were willing to take out loans to buy homes.
But politicians always side with the wealthy, ensuring they never suffer losses.
On September 30, 1981, the U.S. Congress passed a clever law to support the financial sector.
The law allowed financial institutions to defer taxes if they sold off mortgage loans, with the government compensating for any losses incurred in the process.
This created a system where selling loan bonds brought in money, ushering in the era of bond securitization.
Banks began lending heavily against homes, collecting fees, and then passing the bonds to others.
Concerns about recovering the principal vanished, and loans no longer tied up funds for long periods.
Banks focused their efforts on aggressively marketing mortgage loans.
Investment bank Salomon Brothers divided these bonds by risk, repackaged them, and sold them, earning massive brokerage fees.
Even when mixing a few risky loans with a safe one, they managed to secure AAA credit ratings, raking in over $200 million in net profits in 1983 alone.
Now, financial professionals no longer spent weekends golfing. They partied on luxury yachts and flew private jets to Venice for a slice of pizza.
But the time to end their extravagant parties was approaching, and I planned to show up just as the party ended to present the bill.
Of course, the bankers wouldn’t pay the bill. The American public would.
Rachel Arieff, CEO of New York Miracle, was initially pleased to see me after a long time, but her expression soon turned serious.
“So, you’re saying we should leave it to the investors’ choices?”
“Yes. My judgment isn’t always right. We should let those who still believe in the stability of MBS stay, and only pull out the money of those who see it as risky.”
“What about those who want to withdraw their investments?”
“Let them choose as well. There are stable government bonds and the Hollywood Fund, after all.”
“You’re betting on the collapse of mortgage-backed securities?”
“Yes. If any investors want to follow my lead, that’s their choice too.”
“Do you think anyone will follow you?”
“What about you, Rachel? Where will you place your bet?”
Rachel Arieff frowned.
“I know MBS is high-risk, but I don’t think it’ll collapse. It’ll be a soft landing.”
“Because a collapse would mean the downfall of American finance?”
“Exactly. The federal government will do whatever it takes to prevent a crash. The fall of Wall Street would sink not just the U.S. but the global economy.”
At this moment, the idea of the U.S. economy collapsing is as absurd as suggesting America would suddenly turn from capitalism to socialism.
“So, Rachel, you’re going to sustain?”
“No, I’m waiting. I’ll pull everything out and hold it for now. I’ll watch before making the next investment.”
“Then let’s send out emails to clients, clearly classifying risk levels.”
“What do you think the risk level of your investment is?”
Betting on the collapse of the U.S. economy might seem absurd, but given that I’ve never been wrong in my predictions, it seems they’re genuinely curious.
I didn’t use words like certainty or assurance.
“As always, it’s fifty-fifty. Isn’t that the truth?”
“All in on 50%? Your entire fortune?”
“Not my entire fortune, just what I have in the U.S. And I’m still young. Even if I lose it all, I have the time and resources to start over.”
Rachel sighed again.
“Just the movement of your money will make Wall Street nervous. Has there ever been such a large sum moved at once in Wall Street’s history?”
“Only half.”
“What?”
“I’ll only spread half of my assets on Wall Street.”
A smile spread across Rachel’s face.
“Betting only half because it’s a 50% chance? Isn’t that too textbook?”
“What do you mean? Didn’t you just say Wall Street would be on edge? So, to keep them from getting too nervous, I’ll only spread half. The other half will go to London. Surely you don’t think Wall Street is the entirety of global finance?”
“The City?”
The City is shorthand for the City of London, the smallest administrative district in London and the historical and financial heart of the city. It enjoys a unique level of autonomy.
It’s home to over 5,000 financial institutions, including the Bank of England, JP Morgan Chase, Goldman Sachs, Morgan Stanley, Bank of America, Citigroup, and HSBC. The area is the same size as Yeouido, but the scale of money moving through it is on a different level.
“Yes. They can handle half of it. They’ll be thrilled to see a sucker like me show up.”
Rachel’s eyes wavered.
She realized that if Wall Street were to crash, I might be the one pulling the trigger.
It would be like dropping a multi-billion-dollar bomb all at once.
The first thing to do was to withdraw the money tied up in mortgage-backed securities.
If I pulled it all out at once, Wall Street would be in an uproar. So, I carefully switched products little by little, ensuring the transactions appeared normal as I sold off the MBS.
Since it was a popular product, there was no major issue in absorbing the sell-off.
“I’ve disposed of all the MBS. What will you do with the money now?”
“Betting. All in on the idea that mortgage bonds will turn to trash!”
“When will we know the result of this bet?”
Rachel still looked skeptical.
“Next year.”
The fact that it was coming so soon made it even harder to believe. If I had said ten years, she might have nodded. In ten years, there would be time to manage bad debts, but next year, it would be impossible.
Impossible is just another word for highly improbable.
“Since 2005, the volume has been pouring in. For two years, it was at a fixed rate of 2%, but this year, adjustable rates apply. With interest rates over 10%, American citizens can’t afford it.”
“These are stable people who own homes. It might be precarious, but they won’t collapse all at once.”
“Who said they’re stable? Subprime, as in below prime, just candidates. The problem is, people without the means own two or three houses. Even with just three, the interest they have to pay jumps to 30%.”
Rachel, who had only ever made stable investments, couldn’t see the greedy essence of Wall Street.
Whether they fail or not, whether the risk is high or low, those guys are so focused on the money in front of them that they’d approve a mortgage for anyone who takes a number and shows up at the counter.
“Alright, let’s say that’s true. How will you place your bet?”
“Credit Default Swap (CDS).”
A Credit Default Swap is a type of insurance against default.
For example, if you hold $1 million in Apple bonds and Apple defaults, that $1 million vanishes. To avoid this risk, you take out insurance. The insurance is simple.
If Apple defaults within ten years, the insurer pays the full $1 million, and you pay an annual premium of $20,000. The premium is low because Apple is a very solid company with virtually no chance of defaulting in ten years.
No risk means low premiums.
For companies with low credit ratings and poor stability, the premiums naturally rise.
The interesting part is how the greedy people on Wall Street turned insurance into a gamble.
Even if you don’t own a single 10-won bond from Apple, you can still buy insurance. Anyone can pay 200,000 won annually, and if Apple goes bankrupt within ten years, they’ll receive 100 million won.
It’s a bet on whether Apple will fail, without needing to own any of its stocks or bonds. The annual insurance premium is your betting chip, and if you win, you earn 100 million won.
Rachel shook her head.
“There hasn’t been a credit default swap issued for financial products like this yet. Howard, you’re talking about buying something that doesn’t even exist.”
The conclusion felt so absurd that Rachel sighed.
“We can create it. The people in finance who believe mortgage-backed securities are safe will think of my insurance premiums as free money and welcome it with open arms. The challenge is setting the insurance premium, but I don’t see any real issues.”
“Who in the financial world would entertain such a ridiculous idea?”
“Goldman Sachs, Deutsche Bank, Morgan Stanley, Barclays Capital, Merrill Lynch, Citigroup, Bank of America, Credit Suisse, J.P. Morgan, UBS. The list goes on.”
“Why leave out Bear Stearns and Lehman Brothers? They’re top-tier too.”
As I rattled off the names of the colossal financial firms dominating Wall Street, Rachel responded with a sarcastic tone.
“Oh, those two will go bankrupt. Even if you sign a credit default swap with them, they won’t have the money to pay up.”
When I confidently predicted that these financial giants, practically synonymous with America, would collapse next year, Rachel’s jaw dropped.