Shorting on Wall Street

Imagine taking over the payments of a life insurance policy from a senior and also making yourself the beneficiary in the process. After all, your elderly friend doesn't need the policy anymore and he certainly doesn't need the monthly bill.

The benefit to you is that when he dies, and you're sort of betting that he will sooner rather than later, you will collect on his/her policy. This practice is called "life settlements" and is illegal in almost every state in the county. However, the practice is strikingly similar to the kind of betting practiced on Wall Street called "shorting".

Shorting is when an investor's interest in a particular security instrument is in the short term rather than in the long haul. If in the above example, you knew the old guy would live for decades after taking over his policy, you probably would be less attracted to the investment. However, if you had a strong expectation that his time is limited, the promise of that lump sum policy pay-out would perhaps interest you to take a short position on the investment. When he dies, you get paid.

Derivatives as we've heard them called in the news or Credit Default Swaps (CDS) are essentially short positions like in the above example. Derivatives insure questionable securities against default. Typically if a security has an excellent rating, such as AAA+ the expectation that it will perform well into maturity is assumed and the need for the pricey default insurance is not desired. When mortgage-backed securities fail and foreclosure ensues, the investor holding the insuring swap on that risky grade security is made wealthy.

In the recent Securities Exchange Commission (S.E.C.) fraud case against Goldman Sachs, a "short" investor helped select a pool of mortgage-backed-securities that he eyed to fail because he was a beneficiary of sort. Except the S.E.C. argues Goldman didn't tell their investors that this background individual was betting that the pool would fail.

It raises a legal and ethical question about what disclosures should be made to an investor making a securities transaction. Do you as an investor have the right to know that someone is betting against the portfolio being offered to you? In this case, the S.E.C only alleges the proper disclosure information was not made on "marketing material", which seems like a weak case.

What is strikingly odd about the Goldman case, is that their investors who were allegedly fooled, were sophisticated bankers who understood the type of low grade securities they purchased. They also have had to know that those low grade bonds are routinely "shorted" because of their high risk and low expectation of performance.

In fact, the junk bond market, according to the Wall Street Journal the Junk-Bond market is a 30+ billion dollar a month industry. Derivatives are routinely tied to junk bonds more so than the agency conforming paper that performs quite well most of the times.

The ratings on the fund-pool offered to Goldman's investors was BBB which spells "imminent disaster". Goldman's investors obviously gambled on that catastrophic disaster arriving later rather than sooner and the short investor obviously hoped the securities would fail much sooner rather than later. There was no question as to failier, the gamble was on the when.

Conventional wisdom would tell you the opposite of a short position is a long position. But in the Goldman case, it seems every one's expectation was in the short term. No one expected hat these doomed mortgages would perform for their 30 year term. What investors seeking high risk typically do on the so-called "long" side, is that they hold the mortgages for a short period of time and sell them for a profit to another investor willing to take the risk.

A 30+ billion dollar a month junk bond industry strongly suggests that there is no shortage of risk takers and casino-like gambling on Wall Street.