The Century's Guillotine Match
The earnings announcement of HSBC’s $8.9 billion loss hit like a thunderclap. Even the term Earnings Shock—the phrase Wall Street used when a company’s results came in disastrously below expectations—felt laughably inadequate. After all, the bank had posted a $7 billion net profit in the same quarter the previous year. To swing from a $7 billion profit to an $8.9 billion loss in a single year wasn’t merely shocking. It was terrifying.
The astronomical loss stemmed, of course, from the bank’s disastrous bets on subprime mortgages and the derivative products tied to them. Put another way, the record-breaking profits of 2006 had also come from those same subprime investments. The house of cards had simply flipped.
“How much leverage did they pile on for a few percentage points of MBS default rates to cause losses this massive?”
— Leverage exceeds 220%.
The crisp answer came while Yoo Jae-won was alone in his study. No one else was present; neither Kim Dae-seok nor Vincent Greenhill had been summoned. The response had come from Gold, the artificial intelligence running in developer mode. Thanks to the recent heavy reinforcement of its logical reasoning module, Gold could now produce surprisingly plausible answers even to difficult questions. Still, trusting its inferences completely was premature. Both the underlying data and the algorithms driving the reasoning remained insufficient.
Yet the 220% leverage figure for HSBC was reliable. As ID Group’s primary banking partner, the conglomerate had accumulated more than enough internal data on the institution.
“Yeah, that level of leverage makes sense. But a bank pulling 220% leverage? That’s outright insanity.”
The words slipped out before Yoo Jae-won could stop them. With 220% leverage, a $10 billion gain on the original investment would balloon to $32 billion. Conversely, a $10 billion loss would explode into the same $32 billion hole. More damning was the fact that no respectable bank should have been able to obtain that kind of leverage through legitimate channels. The realization that an institution entrusted with safeguarding assets had behaved like a high-risk hedge fund left a bitter taste in his mouth.
He wanted nothing more than to withdraw every dollar ID Group had deposited with HSBC. The only problem was that, by the standards of this collapsing industry, HSBC was still one of the better-behaved players.
He still remembered the early days of his business when he had used a Korean bank as the primary partner, only to have confidential information leak. The memory of switching to an overseas bank remained vivid. When selecting the new partner, stability had been the top priority. HSBC had topped every category—safety, interest rates, everything—and it still maintained that position. The fact that it remained at the top even after announcing an $8.9 billion loss told him the other major banks and insurers had performed even worse.
Next came the earnings reports from Citibank, Wells Fargo, and giant insurers like AIG. Every single one delivered an earnings shock that dwarfed HSBC’s numbers.
The barrage of grim forecasts sent investors spiraling into panic. People woke up each morning to find huge chunks of their financial accounts simply gone. Yet the worst suffering belonged to those who had bought homes with subprime loans—especially those who had overleveraged far beyond their actual assets. It had never been investment. It had been pure speculation.
A year earlier, none of this had seemed like a problem. The key variable in housing investment had been home prices, and across America those prices had risen relentlessly. In Silicon Valley, values had doubled in mere months. The global epicenter of tech startups had drawn challengers from every corner of the world, creating a severe housing shortage. Simply buying a property meant its value would climb on its own. That was why someone with $100,000 in total assets could take out a $900,000 subprime mortgage to buy a $1 million house. If repayment became difficult, they could simply sell. And in the meantime the house might have doubled to $2 million, delivering a $1 million profit after costs and catapulting the owner into the middle class.
Those who tasted easy money rarely stopped. They repeated the process, buying more houses, making more profit. The entire scheme had rested on the unshakable belief that home prices could only go up and on the flood of capital that financial institutions had poured into the market.
Now the situation had reversed completely. Mortgage bonds backed by houses, once treated as ultra-high-credit instruments, had become toxic waste. Houses that had sold the moment they were listed were now sitting unsold even with steep discounts. The concrete examples were even more brutal. Mansions once moved at $2 million now failed to find buyers at half that price. Meanwhile, the principal and interest on those subprime loans kept growing. More and more borrowers declared personal bankruptcy, dragging the financial institutions that held their debt into insolvency. The very mechanism that had propped up the American housing market was collapsing.
The Fed’s rate hike had come in early October. Discussions had begun in July, yet the decision had been delayed for a full three months—an obvious case of too little, too late. Timing mattered as much as direction. Acting earlier would have produced a far less catastrophic outcome.
“The media is the real problem,” Yoo Jae-won muttered, teeth clenched.
The White House had made the correct call when it decided to rescue New Century Financial. Yet relentless criticism from every corner of the press had distorted market perception, forcing the administration to back down. As a result, New Century had gone bankrupt just as it had in his previous timeline. The bankruptcy unleashed a fresh wave of foreclosed homes onto an already frozen market. Creditors, desperate to recover even a fraction of their investment, flooded the market with properties. The amounts they ultimately recovered were pitiful—less than a tenth of their original stakes. When a deluge of inventory hit an ice-age housing market, buyers naturally vanished. Who would purchase a house when prices were clearly headed lower?
In the end, the properties sold at half price, sometimes even a quarter of their former value. The effect was the same as driving a stake through the heart of an already dying market. Had New Century been successfully restructured and its collateral kept off the market, the carnage would have been noticeably less severe.
“The one silver lining is that Lehman Brothers seems to have stopped doing anything stupid,” Yoo Jae-won said, half to himself.
Working with Gold, he had analyzed Lehman’s strategy: artificially inflating CDO yields at any cost. The plan had been absurd, yet Lehman had created detailed blueprints and executed them. One tactic involved circular trading of houses. When assessing the housing market, transaction volume and price were the two critical metrics. Lehman had conducted internal trades to make it appear as though the homes backing their Class A CDOs were trading vigorously. For a brief moment, the reported yields on their CDOs actually rose.
But it was the financial equivalent of urinating on a frostbitten foot. The flood of inventory from New Century’s bankruptcy, combined with surging personal bankruptcies, had quickly grown beyond Lehman’s ability to absorb. Economic experts had already concluded that Lehman had crossed the point of no return. Yet the firm’s executives still clung to hope.
A cheerful notification chime sounded. Vincent Greenhill’s message arrived via ID Talk.
AIG had also been on the watch list during the subprime crisis. As one of America’s largest insurers, it had suffered substantial losses from subprime investments. When ID Investment had bought CDO put options, Lehman Brothers had been the most aggressive seller. AIG, however, had sold $500 million worth of those same puts.
“At least AIG is facing reality faster than the others,” Yoo Jae-won noted.
Though smaller in scale than Lehman, the damage was still fatal. Unlike Lehman, which continued to nurture futile hopes, AIG appeared to have accepted the situation. Of course, that assessment was relative to Wall Street’s standards. In Yoo Jae-won’s eyes, Lehman and AIG were essentially in the same sinking boat.
A few months earlier the same analysts had been shouting that now was the perfect time to buy a house and that anyone avoiding CDO investments was hopelessly behind the times. Now they had flipped 180 degrees, spreading fear about inevitable negative yields. The tragedy was that their current warnings were actually correct. The avalanche of selling pressure meant the collapse of CDO yields was inevitable. Individuals were going bankrupt. Major mortgage companies were going bankrupt. The money investors had lent or entrusted to funds was vanishing into thin air.
“If we could display the housing market’s scale in real time, we’d see a billion dollars disappearing every second,” Yoo Jae-won said.
In early 2006, when everyone had been drunk on dreams, the U.S. housing market had been valued at roughly $4 trillion—approximately 4,400 trillion won. That figure, however, had been calculated like market capitalization, using current prices. In a market where everyone was desperately trying to sell to recover principal, home values were in free fall. The supposed size of the housing market had been an illusion. Yet in finance, even illusions carried enormous weight because loans and investments had been predicated on those inflated prices.
“At this point, a billion dollars a second feels like an underestimate.”
The housing market that had once expanded like a supernova was now contracting at a murderous pace. The word was not metaphorical—actual people were dying. There had been no war, no collapsed buildings. Yet those who had lost the homes they had struggled for years to pay for were taking their own lives in despair. Even more infuriating was the legal reality that the executives of the giant investment firms responsible faced no meaningful punishment. Even if they were ousted for mismanagement, they could live comfortably on the astronomical incentives they had earned while peddling toxic CDOs.
This time, Yoo Jae-won would not allow that outcome.
How will you proceed?
“There are still two weeks until the 31st, correct? We only need to wait a little longer. There’s no reason to meet before expiration.”
The outcome was already decided. The guillotine match of the century was nearly upon them. Yet as the old saying went, the more famous the feast, the less there often was to eat. One week before the final reckoning, internet news outlets exposed that giant credit rating agencies such as S&P and Moody’s had systematically falsified credit assessments for the underlying assets of MBS and CDO products. They had colluded with the very investment banks that created the CDOs, assigning Class A ratings to instruments stuffed with junk-level mortgage bonds.
The exposé broke on a Sunday evening. By the time the markets opened on Monday, the stock market faced a collapse on an entirely different scale. From the opening bell, the Dow Jones Industrial Average plunged 13%.