No, that’s not someone talking about the banking industry. That’s Howard Wheeldon of BGC Partners (a brokerage firm) responding to Adair Turner’s statement last September that “Some financial activities which proliferated over the last 10 years were socially useless, and some parts of the system were swollen beyond their optimal size.” (Turner is head of the FSA, the United Kingdom’s primary bank regulator.) That’s from a recent profile of Turner on Bloomberg.
“‘How dare he?’ Wheeldon now says. ‘Markets will decide if something is too big or too small. It’s not for an individual, however powerful, to slam and damn nearly 1 million people.'”
Do we really need to point out that markets don’t always make the right decisions? Markets didn’t break up Standard Oil or AT&T–people did. And how is it wrong for public figures to be publicly stating their beliefs about what the objectives of public policy should be?
But the point of this post isn’t to single out another free-market zealot who apparently doesn’t think about the words he is saying. It’s to talk about John Paulson and Malcolm Gladwell.
On pages 179-82 of Greg Zuckerman’s book The Greatest Trade Ever (in the pre-publication version that Simon got for free), he describes how Paulson helped design CDOs so that he could short them (by buying CDS protection on them). The issue was that Paulson wanted to place as big a bet as possible against the housing market, and he wanted that bet in as concentrated a form as possible. He wanted to expand the set of assets that he could buy insurance on, and make those assets as toxic as possible. He was even willing to buy the equity (lowest-rated) slice of the CDO, so that the high returns on the equity would help pay for the CDS protection until the roof caved in. So his team would select mortgage-backed securities that they wanted to be bundled into a CDO; the bank would modify his selections, get the CDO rated, and then find counterparties willing to insure it so that Paulson could buy insurance from them. Some banks refused to participate; others, including Goldman Sachs and Deutsche Bank, went along.
Is this transaction socially useful? And is it ethical?
The main purposes of the financial system are processing payments and financial intermediation (conversion of savings into investment). Clearly neither one is happening here–at least not via the CDS transaction, which does not provide credit to anyone in the real economy. However, there’s another defense you can fall back on, which is that this transaction provides additional liquidity. Because it allows people to express their views about particular securities (mind you, securities that didn’t exist until Paulson got involved), it improves price discovery; and because more transactions are taking place, it makes it easier for investors to get in and out of positions (again, that argument is weakened since the transaction is just creating new, illiquid securities, not increasing liquidity for existing securities). On balance, though, I’d say the social utility is pretty small at best. It’s helping Paulson short the housing market, which should have the salutary effect of putting downward pressure on the bubble, but only by allowing someone else to go long on the housing market, which has the opposite effect.
Still, though, I wouldn’t say Paulson was doing anything unethical. His job is to make a lot of money, and he was looking for the most direct way to do it. The more interesting question applies to the bankers in the middle.
Compare this to two other transactions. In the first transaction, a banker sells his client a share of stock in an IPO. In that case, there is definite win-win potential: the company needs capital and is willing to pay a high (expected) rate of return and the investor wants that high rate of return. Although you can quibble about what the stock should be priced at, there’s no inherent conflict of interest in raising money for a company and selling its shares to investors.
In the second transaction, a broker convinces his client to buy a share of stock on the secondary market. Now this is a zero-sum transaction; if buying it is a good deal for one person, selling it is a bad deal for someone else. But here the broker is only representing his client; the share will be bought on an exchange, and he has no idea who is going to sell it. So while there is certainly room for unscrupulous brokers who convince clients to buy lousy stocks solely for the commissions, there is no inherent problem with this situation.
In the Paulson example, though, the same bank is working with Paulson to create a toxic CDO and convincing its client on the other side to buy or insure that CDO. Not only is it a zero-sum transaction, but it’s a zero-sum transaction between the bank’s clients. (This applies to many derivatives transactions, of course.) Now plausibly this could be in the interests of both sides, depending on their existing risk profiles; if Paulson owned billions of dollars of beachfront property in Florida, he might be shorting real estate as a hedge, and the investors might want to be long real estate because . . . well, who knows.
In any case, there isn’t anything necessarily unethical about this practice. If the bank clearly describes the transaction to the investor, and discloses that it has a client taking the other side (who, in this case, helped design the transaction), then the investor can make his own decision about it. Basically, it’s like placing a bet with a sports bookie. You know that the bookie is taking the same volume of bets on the other side (that’s how the line is set), and you know not to trust him if he tries to talk you into a bet, because you know he doesn’t have your interests in mind; he just wants his cut.
But what did the banks say? If they said, “You’re betting against Paulson, he’s pretty smart, you’re pretty smart, let the best man win,” then that’s fine. But if they said, “This guy Paulson, he’s nuts, we all know housing isn’t going to go down, just take his money,” then that’s a problem, at least in my opinion. Because if you’re a broker and you’re connecting two parties in a deal, you shouldn’t be arguing to both of them that they are getting the good end of the deal, even if it’s two different people at the bank doing the arguing. So this is maybe something for that Financial Crisis Inquiry Commission to look into: how were these things sold?
In the long run, the simplest solution would be for everyone to realize that their banks are not on their side, and that the famous “long-term greed” of Goldman is gone forever, replaced by the more plebeian short-term greed.
(Malcolm Gladwell will have to wait for another post.)
By James Kwak