Chapter 280: The Simple Business of Banks and a High-Stakes Gamble

In reality, the business of banking is quite simple. It’s all about pocketing the difference—known as the net interest margin—between the interest rates paid by borrowers and those earned by depositors.

This straightforward work, conducted with meticulous precision according to established procedures, along with a stable salary and job security, once led people to view bankers as akin to civil servants. However, this also meant they struggled to shake off a dull and unimaginative image.

Yet, in every field, there are those whose brilliance cannot be contained.

Even within the seemingly mundane world of banking, geniuses lurked, focusing their talents on how to make massive amounts of money in one fell swoop.

In the early 1980s, while South Korea remained mired in the throes of a military coup and sham elections, three brilliant minds in the bastion of capitalism, the US, put their heads together to devise an extraordinary way to make money.

Lewis Ranieri, head of the bond department at the investment bank Salomon Brothers, Larry Fink, the founder of the asset management firm BlackRock, and David Maxwell, the CEO of the Federal National Mortgage Association (Fannie Mae), created—or rather, invented—an ingenious product called MBS, or Mortgage-Backed Security.

Before this, mortgage lending was a simple process: money was lent out with a house as collateral, and the principal and interest were collected steadily over ten or twenty years. While stable for the bank, it was also a tedious affair of lending large sums and receiving small payments over a long period. Furthermore, it tied up significant capital.

These three geniuses looked at mortgages not from the bank’s perspective but from the product’s.

Mortgages, while generating small amounts, provided a stable income stream over an extended period.

They realized this perfectly aligned with the needs of retired individuals, those living off investment income, and wealthy individuals who were highly risk-averse. Thus, they transformed mortgages into a product called MBS.

The underlying reason for their innovation was interest rates.

In 1979, the Federal Reserve Board’s decision to raise interest rates caused a ‘money’ sclerosis in the financial sector, and the mortgage market began to falter.

Because no one takes out loans to buy a house in an era of high interest rates.

However, politicians invariably side with the wealthy, ensuring legislation prevents them from incurring losses.

On September 30, 1981, the US Congress passed a clever bill for the benefit of its cherished financial sector.

This legislation provided tax relief to financial institutions that restructured their mortgage loans and, moreover, guaranteed compensation from the national treasury for any losses incurred in the process.

This created a system where simply selling off loan debts generated income, ushering in the era of bond securitization.

Now, banks could lend heavily against homes, collect their fees, and then pass the debt on to someone else.

Worries about recovering the principal vanished, and loan amounts no longer remained tied up for extended periods.

Banks made mortgages their primary focus and dedicated all their efforts to aggressive sales.

Salomon Brothers, an investment bank, divided these bonds by risk level, repackaged them, and sold them, raking in massive brokerage fees.

They even managed the magic trick of securing AAA credit ratings by mixing safe loans with three or four risky ones, netting over $200 million in pure profit in 1983 alone.

Now, people in the financial world no longer spent their weekends on the golf course. They enjoyed lavish yacht parties and chartered private jets to Venice for a taste of authentic pizza.

Their extravagant party was nearing its end, and I planned to arrive as it concluded to present the bill.

Of course, the bankers wouldn’t foot the bill. The American people would.

Rachel Arieff, CEO of New York Miracle, briefly acknowledged my presence with polite enthusiasm before her expression turned serious.

“So, you’re saying we should leave it to the investors’ discretion?”

“Yes. My judgment isn’t infallible. We simply allow investors who still believe MBS are stable to remain, and those who perceive a high risk can withdraw their funds.”

“And those who withdraw their investments?”

“Let them choose as well. There are stable government bonds and Hollywood funds available.”

“You’re betting on the collapse of mortgage-backed securities?”

“Yes. If there are investors willing to bet with me, that’s their choice.”

“I doubt you’ll find many investors to follow you.”

“What about you, Rachel? Where will you place your bet?”

Rachel Arieff furrowed her brow.

“I know MBS are high-risk, but I don’t believe they’ll collapse. I think they’ll achieve a soft landing.”

“Because a collapse would mean the downfall of American finance?”

“Exactly. The federal government will do everything in its power to prevent a crash. The collapse of Wall Street would sink not only the US but the entire global economy.”

At this moment, the notion of the American economy collapsing was as absurd as suggesting the US would abruptly transition from capitalism to socialism.

“So, Rachel, you’re going to sustain?”

“No, waiting. Withdraw everything for now. I’ll hold onto it and consider the next investment later after observing things further.”

“Then I’ll have the emails sent to the clients, with a clear breakdown of the risk levels.”

“What risk level do you think your investment carries?”

Betting on the collapse of the American economy was outlandish, but the fact that the one making this bet was me—someone who had never been wrong in their predictions—seemed to genuinely pique her curiosity.

I avoided using words like ‘certainty’ or ‘definitely’.

“As always, it’s fifty-fifty. Isn’t that the truth of it?”

“All in on 50%? Your entire fortune?”

“Not my entire fortune, just the portion in the US. Besides, I’m still young. Even if I lose it all, I have the time and money to start over.”

Rachel sighed again.

“Just the movement of your money alone will make Wall Street nervous. I doubt Wall Street has ever seen such a large sum move at once.”

“Only half of it.”

“Huh?”

“I’ll only be deploying half of my assets in Wall Street.”

A smile touched Rachel’s lips.

“Betting only half with a 50% chance? Isn’t that a bit textbook?”

“What are you talking about? Didn’t I just say Wall Street will be nervous? So, I’m only deploying half to avoid making them too anxious. The other half will go to London. Surely, you don’t think Wall Street encompasses the entire global financial system?”

“The City?”

‘The City’ is the colloquial name for the City of London, the smallest administrative district in London, its historical heart, and its financial center. It’s also a unique jurisdiction with its own governing bodies.

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 City’s area precisely matches that of Yeouido, but the scale of money flowing through it is on an entirely different level.

“Yes. They can absorb half as well. They’ll probably be thrilled that some sucker has shown up.”

Rachel’s eyes flickered with unease.

She understood that if Wall Street were to collapse, I might be the one pulling the trigger.

It would be like dropping a multi-billion dollar bomb.

* * *

The first order of business was to withdraw the funds invested in mortgage-backed securities.

Pulling it all out at once would send shockwaves through Wall Street. I sold off the mortgage-backed securities gradually, shifting to other products, careful to maintain the appearance of normal trading activity.

As a popular product, there was no significant issue in absorbing the sell-off volume.

“The MBS are all disposed of. What are you going to do with this money now?”

“Bet. Go all-in on the premise that mortgage bonds will become worthless!”

“When will we know the outcome of this bet?”

Rachel still wore an expression of disbelief.

“Next year.”

Her disbelief seemed amplified by the speed of the anticipated outcome. If I had said ten years, she might have nodded. Ten years would provide time to manage even the emergence of non-performing loans, but next year was impossible.

Impossible was just another way of saying the odds were incredibly long.

“The real wave of issuance started in 2005. For two years, they were fixed at around 2%, but starting this year, variable rates apply. People will have to pay interest rates of 10% or higher, which American citizens simply can’t afford.”

“These are people stable enough to own homes. It might be precarious, but it’s unlikely to collapse overnight.”

“Who’s stable? Subprime—literally below prime, candidate level. The problem is, these people own three or four homes each. Even with just three, the interest they have to pay jumps to 30%.”

Rachel, accustomed to stable investments, hadn’t fully grasped the greedy nature of Wall Street.

Whether they went bankrupt or not, whether the risk was high or low, those guys, obsessed with immediate profits, were approving mortgage loans to anyone who showed up at the counter with a ticket.

“Okay, let’s assume that’s true. How will you place this bet?”

“Credit Default Swaps (CDS).”

A credit default swap is a type of insurance against default.

For example, if you own ₩100 million in Apple bonds and Apple defaults, those bonds become worthless. To mitigate this risk, you buy insurance. The insurance works simply.

You pay an annual premium of ₩200,000 with the condition that if a default occurs within ten years, the insurer will pay the full ₩100 million. The premium is low because Apple is a very solid company, and the probability of default within ten years is near zero.

Low risk means low premiums.

If a company has low creditworthiness and is not financially sound, the insurance premium naturally increases.

The interesting part is how the greedy folks on Wall Street turned insurance into gambling.

Anyone can buy insurance, even if they don’t own a single Apple bond. Anyone can pay the annual ₩200,000 premium and receive ₩100 million if Apple defaults within ten years.

You can bet on whether Apple will go bankrupt or not without owning any of their stock or bonds. The annual premium you pay is your betting chip, and if you win, you make ₩100 million.

Rachel shook her head.

“Credit default swaps on financial products haven’t been issued yet. Howard, you’re talking about buying a product that doesn’t even exist.”

Finding the conclusion absurd, Rachel sighed.

“We’ll create them. People in the financial sector who believe mortgage-backed securities are safe will gladly welcome my premium payments, viewing it as free money. Setting the premium might be tricky, but I don’t see any fundamental problems.”

“Who are these financial people who would listen to such a ridiculous idea?”

“Goldman Sachs, Deutsche Bank, Morgan Stanley, Barclays Capital, Merrill Lynch, Citigroup, Bank of America, Credit Suisse, J.P. Morgan, UBS. There are countless others.”

“Why leave out Bear Stearns and Lehman Brothers? They’re also top-tier groups.”

As the names of the colossal financial corporations dominating Wall Street rolled off my tongue, Rachel seemed dumbfounded and spoke with a hint of sarcasm.

“Ah, those two companies will become insolvent. Even if you enter into a credit default swap agreement, you won’t be able to collect due to their lack of funds.”

Stating with such certainty that these colossal financial institutions, practically synonymous with the US economy, would collapse next year left Rachel utterly speechless.