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Banks mask risk through complex financial instruments from "summary" of The Big Short: Inside the Doomsday Machine (movie tie-in) by Michael Lewis
Banks had many ways to disguise risk. They could, for example, buy insurance on the bonds they owned. If the bonds defaulted, the insurer would pay up. Thus, the risk appeared to be elsewhere, with the insurer, rather than with the bank. This kind of insurance was known as a credit default swap. It was not an insurance policy in the traditional sense of the term. It was a bet. A hedge fund could, for example, buy insurance on a bond it did not own. If the bond defaulted, the hedge fund would collect many times the amount of the insurance policy. The banks created a market for these bets. They made the bets so complicated that the people who bought them didn't fully understand the risks they were taking. The people who sold the bets didn't fully understand the risks either. The complexity of these bets made it difficult to assess the true level of risk in the financial system. It was like a game of pass-the-parcel, with the music playing louder and louder. Everyone was making money; no one wanted to stop the music. The banks made huge profits from selling these complex financial instruments. They used the money to make more bets. The banks were like gamblers who had won big at the casino. They kept doubling down, thinking they were on a winning streak. But the game was rigged. The risks were hidden, disguised, masked. And when the music stopped, the losses were catastrophic. It was a financial meltdown of epic proportions. The people who had bet against the banks, who had seen through the smoke and mirrors, were the ones who profited. They were the ones who had the courage to go against the crowd, to swim against the tide. They were the ones who had understood that the risks were real, that the emperor had no clothes. They were the ones who had seen the truth behind the facade of complexity and deception. And they were the ones who came out on top when the dust settled.
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