The Cover-Up

By James Kwak

Wall Street is engaged in a cover-up. Not a criminal cover-up, but an intellectual cover-up.

The key issue is whether the financial crisis was the product of conscious, intentional behavior — or whether it was an unforeseen and unforeseeable natural disaster. We’ve previously described the “banana peel” theory of the financial crisis — the idea it was the result of a complicated series of unfortunate mistakes, a giant accident. This past week, a parade of financial sector luminaries appeared before the Financial Crisis Inquiry Commission. Their mantra: “No one saw this coming.” The goal is to convince all of us that the crisis was a natural disaster — a “hundred-year flood,” to use Tim Geithner’s metaphor.

I find this incredibly frustrating. First of all, plenty of people saw the crisis coming. In late 2009, people like Nouriel Roubini and Peter Schiff were all over the airwaves for having predicted the crisis. Since then, there have been multiple books written about people who not only predicted the crisis but bet on it, making hundreds of millions or billions of dollars for themselves. Second, Simon and I just wrote a book arguing that the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself. Since, probabilistically speaking, most people will not read the book, it’s fortunate that Ira Glass has stepped in to help fill the gap.

This past weekend’s episode of This American Life includes a long story on a particular trade put on Magnetar (ProPublica story here), a hedge fund that I first read about in Yves Smith’s ECONned. The main point of the story is to show how one group of people not only anticipated the collapse, and not only bet on it, but in doing so prolonged the bubble and made the ultimate collapse even worse. But it also raises some key issues about Wall Street and its behavior over the past decade.

This will require a brief description of what exactly Magnetar was doing. (If you know already, you can skip the next two paragraphs.) It’s now a cliche that a CDO is a set of securities that “slices and dices” a different set of securities. But it’s slightly more complicated than that. First there is a pile of mortgage-backed securities (or other bond-like securities) that are collected by an investment bank. The CDO itself is a new legal entity (a company) that buys these MBS from the bank; that’s the asset side of its balance sheet. Its liability side, like that of any company, includes debt and equity. There’s a small amount of equity bought by one investor and a lot of debt, issued in tranches that get paid off in a specific order, bought by other investors. The investment bank not only sells MBS to the CDO, but it also places the CDO’s bonds with other investors. Whoever buys the equity is like the “shareholder” of this company. There is also a CDO manager, whose job is to run the CDO — deciding which MBS it buys in the first place, and then (theoretically) selling MBS that go bad and replacing them by buying new ones. The CDO itself is like an investment fund, and the CDO manager is like the fund manager.

According to the story, in 2006, when the subprime-backed CDO market was starting to slow down, Magnetar started buying the equity layer — the riskiest part — of new CDOs. Since they were buying the equity, they were the CDOs’ sponsor, and they pressured the CDO managers to put especially risky MBS into the CDOs — making them more likely to fail. Then Magnetar bought credit default swaps on the debt issued by the CDOs. If the CDOs collapsed, as many did, their equity would become worthless, but their credit default swaps on the debt would repay them many, many times over.

The key is that Magnetar was exploiting the flaws in Wall Street’s process for manufacturing CDOs. Because the banks made up-front fees for creating CDOs, the actual human beings making the decisions did not particularly care if the CDOs collapsed — they just wanted Magnetar’s money to make the CDOs possible. (No one to buy the highly risky equity, no CDO.) Because the ratings agencies’ models did not particularly discriminate between the contents that went into the CDOs (see pages 169-71 of The Big Short, for example), Magnetar and the banks could stuff them with the most toxic inputs possible to make them more likely to fail.

Now, one question you should be asking yourself is, how is this even arithmetically possible? How is it possible that a CDO can have so little equity that you can buy credit default swaps on the debt at a low enough price to make a killing when the thing collapses? You would think that: (a) in order to sell the bonds at all, there would have to be more equity to protect the debt; and (b) the credit default swaps would have been expensive enough to eat up the profits on the deal. Remember, this is 2006, when several hedge funds were shorting CDOs and many investment banks were looking for protection for their CDO portfolios.

The answer is that nothing was being priced efficiently. The CDO debt was being priced according to the rating agencies’ models, which weren’t even looking at sufficiently detailed data. And the credit default swaps were underpriced because they allowed banks to create new synthetic CDOs, which were another source of profits. So here’s the first lesson: the idea that markets result in efficient prices was, in this case, hogwash.

By taking advantage of these inefficiencies, Magnetar made the Wall Street banks look like chumps. This American Life talks about one deal where Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.

But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers’ pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)

So who’s to blame? The first instinct is to get mad at Magnetar. But this overlooks a Wall Street maxim cited by TAL: you can’t blame the predator for eating the prey. Magnetar was out to make money for its limited partners; if it had bet wrong and lost money, no one would have bailed it out. Although I probably wouldn’t have behaved the same way under the circumstances, I have no problem with Magnetar.

I do have a problem with the Wall Street bankers in this story, however. Because losing $880 million of your own company’s money to make a quick buck for yourself is either incompetent or just wrong. And allowing Magnetar to create CDOs that are as toxic as possible — and then actively selling their debt to investors (that’s where the banks differ from Magnetar, in my opinion) — is either incompetent or just wrong. But even so, I don’t think the frontline bankers are ultimately at fault. Maybe they were simply incompetent. Or maybe, they were knowingly exploiting the system to maximize their earnings — only in this case the system they were exploiting was their own banks’ screwed-up compensation policies, risk management “systems,” and ethical guidelines.

In which case the real blame belongs to those who created that system and made it possible. And that would be the bank executives who failed at managing compensation, risk, or ethics, endangering or killing their companies in the process. And that would be the regulators and politicians who allowed these no-money down no-doc negative-amortization loans to be made in the first place; who allowed investment banks to sell whatever they wanted to investors, with no requirements or duties whatsoever; who allowed banks to outsource their capital requirements to rating agencies, giving them an incentive to hold mis-rated securities; who declined to regulate the credit default swaps that Magnetar used to amass its short positions; who allowed banks like Citigroup and JPMorgan Chase to get into this game with federally insured money; and who failed at monitoring the safety and soundness of the banks playing the game.

The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them — only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident.

96 responses to “The Cover-Up

  1. James, I have to mirror your frustration. That today you can point to five or six people who predicted it ahead of time, in particular in light of the self-reinforcing nature of bubbles (see, e.g., the writings of Soros), doesn’t change the fact that bubbles happen. Bubbles have always happened, and bubbles will always happen. That doesn’t mean that bubbles are the result of intentional actions.

  2. So much cute here. Juice boxes!

    http://www.chicagohomemag.com/Chicago-Home/September-October-2008/Well-Manored/

    From the always delightful wikipedia:

    “A magnetar is a type of neutron star with an extremely powerful magnetic field, the decay of which powers the emission of copious amounts of high-energy electromagnetic radiation”

    Get it?

    (Also… clever ducks…Basel-ine Scenario?)

  3. Brad Thrasher

    Not reading this one. Just can’t get past this:

    “Wall Street is engaged in a cover-up. Not a criminal cover-up, but an intellectual cover-up.”

    Mr. Kwak is telling me they’re not crooks, just intellectually challenged? Sorry, no sale.

    In the event that Mr. Kwak or Mr. Johnson take a position in the Obama Administration, words and phrases such as the above support my contention that the would be new bosses are no different from the old bosses.

  4. Can anyone explain what the advantage is, of having complex highly leveraged ‘derviatives” (other than obvious things like commodity futures)?

    Simplicity doesn’t guarantee transparency and honesty, but unneccesary complexity just creates rich opportunites for systemic corruption – and this recent precedent will just make looters more aware and comfortable with what can be achieved.

  5. > The CDO debt was being priced according to the rating agencies’ models, which weren’t even looking at sufficiently detailed data.

    No, rating agency models were not used in pricing. Banks and buyers had their own models, which were different. As to what information these models incorporated, the answer is that it varied.

    James, re: magnetar, you may want to look at this post, which I think is excellent: http://www.macroresilience.com/2010/04/11/the-magnetar-trade/

  6. I beg to differ mon amie. Who paid off the mispriced Credit Default Swaps, the “short” side of the bet. AIG?, who made good on AIG mispriced CDS, the US taxpayer. The US taxpayer paid off all the “big short” winners. Who in the government decided they should be paid 100 cents on the dollar. There is the cover up. The big shorts should have had to eat their shorts.

  7. Trying to follow this stuff makes me feel like the Dude in The Big Lebowski trying to figure out who kidnapped Bunny.

    All the Dude ever wanted was his rug back. The bankers peed on our rug man. And it really tied the room together.

  8. bungalowbill

    One word I learned reading Yves Smith’s Econned: CLAWBACK

  9. Wall Street bankers make most of their money through volatility. Catastrophic bubbles create the most volatility. Therefore, no one should be surprised that the people who made fortunes in the last bubble are want to protect their narrow self interests and want to maintain the conditions to create future bubbles from which to profit.

  10. The financial houses and the banks who wanted to play in the same ballpark constitute what would be, in any other time and place, a criminal enterprise. The garbage they packaged up and sold to individual and institutional investors was something they knew about. Their current contention, that no one saw this coming is a lie pure and simple as James points out.

    If more people really understood the duplicity of the system and how players were allowed to kill of the very offerings they were financing there would be blood in the streets. Why aren’t these people in jail?

    They need to be taken apart, they need to be punished. They’re responsible for the horrific loss of jobs that now plagues our economy. There’s no shame, no apologies, only more lobbying to try to keep their con games and the gambling houses they play them in alive.

    That’s what this is, gambling, but with public money and US livelihoods. If this is the only sort of economy we can have, then Wall Street be damned.

  11. Congratulations are in order for everyone involved in reporting this story. The beauty of the ProPublica/npr/tal coverage is tagging Magnetar with “The Rroducers” label. The complex story just got significantly easier to tell to non finance folks, and that’s been a long time coming.

    The next phase in the reporting of this is (hopefully)going to be a review of each of the “shows” produced by Magnetar. Although they weren’t the only ones follwing this strategy they were large and each deal attaches to the IBs and Comm Bank IB units in different ways, none of which are going to be put the IBs in an attractive light. At a minimum it should give people reason to recoil and rebel at any attempts at favorable treatment for the IBS in the regulatory reform legislation.

    The timing of the story makes me glad GS has embarked on their PR strategy that conceded their capture by their clients. We should take them at their word here and feel free to judge the activities of their clients to decide if IBs need to be ‘protected’ from their clients destructive impulses with intrusive regulation. How awful it must be for GS to have to kill themselves to get a AAA rating on crap to satisfy their buy side customers while they are forced to create CDS against that same product to satisfy their shorts customers. Why should they have to suffer? Brooksly Born has a solution to their dilema.

    Figure the managtar programs were 30b,in about 26 deals. Virtually all investors in the CDOs were losers. The shorts were winners .It will be revealing to line up the the hedge funds and IBs that won on the short side along side the investors who lost.

    Its makes it very easy to ask each IB involved in a Magnetar deal to identify, its fee income earned , bonus paid and ultimate losses to the firm. Given the size I’m pretty sure they would surpass materiality thresholds for detained reporting.

    Each bank likely managed them differently so it will be good to know how each IB Underwriter retained or distributed the resulting CDO, That analysis is going to lead down some interesting paths. (i.e how much of this ended up in SIVs, Conduits, money market account, retail bond accounts, local govt accounts, foreign bank and government entities.)

    If we understand just those 26 deals we’ll have a much more robust understanding of the dangers posed by the regulatory lapses of the recent past.

    Its hard for me to imagine anyone making a case against regulating Credit Deriviatives after even a brief review of these deals.

  12. Welcome to crapitalism.

  13. “Not a criminal cover-up, but an intellectual cover-up.”

    No, it’s also a criminal cover-up.

  14. Scot Griffin

    Yep. There’s a cover-up (and crimes were involved, actually). And it’s going to succeed.

    Are we helpless? No. Does shouting at the intertubes do any good? No.

    We can complain all we want, but all our complaints do is make the opposition smarter. Political economy is a chess match, not a game of checkers. Unless we have the kind of economic collapse that I expect to see in the next few years, it will take at least 10-20 years to overcome current economic and financial memes. We need to plan that far ahead if we’re going to have any hope of changing the narrative. This is true regardless of your political stripe or your economic school.

  15. Hillbilly Darrell

    This ISN’T Capitalism. It is well organized, and self interested ANARCHY.

  16. Hillbilly Darrell

    Great poiunt on the SIVs. And/or, even the very probable corresponding REPO transactions. Wouldn’t it be interesting to know how much of the $880 Million JPMorgan Chase held which got “repo’d” days before quarter and year end, and “re-repo’d” days after quarter and year beginnings? And, how these amounts varied (and probably increased) as time went on and chit hit the fan from 2006 through 09/08?

    Now, without even mark to market rules circa 2009, the need for REPO to hide garbage is effectively eliminated….holding to maturity…..

    Anyone else feel more comfortable playing a gentleman’s game of 3 card monte than try to play in this frankenstein rigged charade of the financial markets?

  17. There is just no way that no one saw this coming, i suppose that you could argue for denial of those who should have seen it coming but denial = willful ignorance = intentional. I read this blog daily and i understand about 40-60% of it (i don’t have any college economics experience)and i never heard of a cdo or a cds before the collapse, but even i knew a catastrophe was coming. when interest only loans are common when people are in unfurnished houses because they are house poor when i get 5 calls a day to refinance and more junk mail than that, and people asking me if i want a loan even if i don’t have any proof of income, something is just around the corner. We knew there was a housing bubble in 2000, we knew we were building new structures faster than demand allowed in 2000. people were sleeping at the wheel in the upper levels long before it made it down here to us (consumers and financial unsophisticates). once it got down here someone should have definitely been looking into what was going on. it was willful ignorance.
    anyway that is my 2 cents and i love this blog.

  18. Hillbilly Darrell

    1. Bait and switch
    2. Fees. Copious amounts. Both sides, coming and going.
    3. Being the DJ and knowing when the music will stop, while maintaining plausible deniability, so you can profit from the short.
    4. “Everybody’s doing it.” But no-one knew….
    5. Lack of transparency-helps with #3.
    6. Lack of standardization-helps with #3.
    7. Lack of centralized exchange or clearinghouse-helps with #3.
    8. Etc.-all being benefits inuring to the benefit of the financial oligarchs.

    For you, or me, unless we are financial oligarchs? These instruments offer the benefit of vaporizing our retirements, cratering our home values, eliminating our jobs, and leaving us will the bill….

  19. Please note the ‘r’.

    Crapitalism is the economic system where all participants have the same right to fail, but some participants have more equal rights to fail than others.

  20. Hillbilly Darrell

    As in two sets of rules:

    1) Financial oligarchs’ rules: heads we win, tails you lose…

    2) Everybody else: Normal harsh rules of Capitalism apply.

    I get it.

  21. I’m reminded of “There was an intel failure, no a failure to connect the dots. Who saw that memo-determined to attack the U.S.?”

  22. And GW liked to doodle when Paulson called.

  23. Brad Thrasher

    Exactly Hillbilly Darrell, give it the duck test.

  24. Cover-up is 70′s. This is something like post-neo-cover-up. Take the story about Lehman’s “alter ego” firm in today’s NYTimes. Who believes that Geithner, Paulson, Dimon, Prince, Rubin et.al. knew neither about it nor the similar entities that their own firms are probably using. Enron was doing the same thing – it’s called GAAP, standard operating procedure and the SEC looks the other way. Biggest bank heist in history and a countless brothers are doing serious time for trying to put together enough change to buy a Big Mac.

  25. The ending is really nice. Thanks, James

  26. Nice, clear explanation. However a small point: the equity tranche of a CDO isn’t actually equity; that’s a confusing misnomer.

    “The equity tranche is technically not `equity’; it is a debt instrument as are the others. It is referred to this way because it behaves like equity.”
    (The Complete Practitioner’s Guide to the Bond Market, Steven Dym)

    Basically, it’s the juniormost obligation and does really well when all the payments are flowing in and takes a big hit when things go sour.

  27. please explain absence of GAAP, absence of OCC, and all other former ‘regulators’ in this mess. What authority trumped proper regulation? How high in the Bush administration were the financial decisions made (in 2003-5)? Why no mea culpas. Why does Obama not want to “look back?”

  28. Excellent post, James. Bravo to TAL and everyone else who reported on this.

  29. I was wondering who the sucker on the other side of the CDS was, also. I don’t think it was AIG. AIG had gotten out of credit default swaps on collateralized debt obligations based on mortgages in late 2005(too late, as it turned out). According to this article, Magnetar was doing near deals in 2006 and 2007.

    These deals never would’ve been done if, as a condition for buying CDS, you actually had to own the underlying security. That should’ve been the first thing that was addressed in any financial reform bill. Let the big banks and hedge funds scream all they want about needing to buy CDS without owning the actual debt because they need to “hedge their exposure”. Tough s**t.

  30. CBS from the West

    Can we blame the predator for eating the prey?

    Didn’t the retail banks spot a flaw to exploit, too? That is, they noticed that most people are unrealistically optimistic about their ability to pay off balances, and typically don’t read or can’t understand lengthy boilerplate. From that they created a credit card industry that now has tens of millions of people in debt slavery at usurious interest rates: most of them people who never understand what they were getting themselves into when they signed up for that plastic. Is that OK?

    Is it OK when doctors administer unnecessary or useless treatments, recognizing that patients don’t know the difference. (Yes, many doctors themselves don’t know the difference, but over time more and more are just churning the system exploiting the flaws in its existing incentives.)

    At the end of the day, we have no future if our dominant business model is parting fools from their money. Capitalism is supposed to channel people’s greed and energy into useful purposes. But it isn’t working. And while we can blame the lack of appropriate regulation, it is also true that no system of regulation or restructuring of industries will ever be comprehensive enough if at some point people don’t abstain from exploiting things as a matter of conscience. And conscience, on a large scale, will never return if we don’t start blaming some of the predators for eating too many, or the wrong, prey.

  31. Magnetar didn’t need to actually collect the insurance in order to get paid. In 2007 the cost of CDS jumped and Magnetar only had to sell the contracts to the next guy who wants protection. This is what Paulson did.

  32. No, they didn’t need to collect the insurance. But somebody had to write the insurance. That’s what I’m wondering. Who was on the other side of the CDS transaction? And many, if not most, of these deals did actually go bust, so in many cases, somebody had to pay.

    Again, the deal makes no sense if you actually had to own whatever tranche you were buying the credit default insurance on. Require that, and much of this “innovative” financial engineering that brings no tangible benefit to the economy goes away.

    (It would be a laugher if on the final deal with J.P. Morgan Chase that Chase also sold the CDS protection. $880 million in soured investment, along with $290 million in credit default protection. Wonder what Jamie Dimon thinks of that deal now.)

  33. Nothing much to add here, just want to say it’s a terrificly insightful and informative post.

    They still haven’t changed the incentives for credit ratings agencies, they still haven’t created registered exchanges for derivatives and swaps, they still haven’t outlawed naked CDS, they still haven’t created vanilla flavored mortgages. On and on and on. They killed any CFPA not underneath Bernanke and the ABA’s eyes.

    The only change I foresee out of this is Credit Unions thinking “Well the banks crap on these people everyday and get away with it, what are WE waiting for??”

  34. I don’t know about GAAP, but I can tell you OCC has been useless ever since Dugan has led it. Everyone knows whose back-pocket Dugan is in. Even Dugan doesn’t make half an effort to hide the fact.

  35. The Magnetar incident is reminiscent of the California energy debacle of a few years back, in which power plants were taken off line for “maintenance,” causing shortages which ran up prices which enriched energy traders.

  36. I am not a lawyer nor an economist as this will probably show- but if I were to buy an old house, make some cosmetic improvements that masked an underlying rot, etc., got my insurance company to write an exorbitant homeowners policy exceeding any liens against the property , then burned it down, wouldn’t that be fraud? Isn’t that what Magnetar did in a perhaps more using a more sophisticated, slow burn process?
    Or this too elementary an analogy?

  37. The long side of the CDS contracts were made (at Magnetar’s behest) into synthetic CDOs which failed along with the original CDOs. Magnetar got twice the cash flow from buying two equity tranches, and their CDS premiums went partially into paying themselves.

    When the CDOs failed they could just grab the collateral from the synthetic CDO’s investors.

  38. Theoretically, the CDO manager could have refused to help set the “fire”, which happened in a few cases. That gives Magnetar plausible deniability.

  39. That word should be the taxpayer’s mantra for 2010. I don’t care if we have to go into the individual bank accounts of every Goldman Sachs employee, the taxpayer should get back every penny of the $13 billion in AIG counterparty monies GS stole from us and distributed among themselves as “profits”. They’re not entitled to that money by any argument whatsoever.

  40. “But who’s the chump”
    the answer to this is the voters Mr. Kwak.
    not the bankers who keep their money, or the banks who get bailed out. It is the voters who have let this happen to them, who didn’tpay enough attention in the voting booth, and who just keep buying into the sameold BS over and over.

  41. Nobody saw it coming. What a laugh. I remember back as early as 2001, yes 2001, there was an article in Fortune or Forbes by one of the economists–I can’t remember if it was Shiller or Roubini or who–but they were saying that if the real estate bubble continues on its course it would make the NASDAQ bubble look like a walk in the park in terms of its damage to the economy.

    I remember personally backing away from purchasing a condo in 2001 because the prices seemed out of whack. And when I started looking again in 2003, my real estate agent told me she could get me a mortgage for virtually any amount. I asked her what she meant, because it used to be about 2-1/2 times income max. She said things have changed. And when she told me I could get a mortgage for as much as $500,000 I told her–back in 2003–that people are going to go bankrupt right and left. And needless to say, I didn’t buy because prices were twice as wacky as they were in 2001.

    So, the point is, if the average schmuck like me can see a disaster in the making, what does that say for all the Ivy league Arrogant Savants running the economy? These sons of bitches are so arrogant they’re prepared to run the country further into the ground just for the chance to save their reputations. The only problem is, they’re so incompetent that they’ll just end up making things worse. And I’m starting to get really angry with Obama for letting these losers stay in control!

  42. Gambling has been universally feared as one of man’s most dangerous and ignoble predilictions since the dawn of recorded history. I am not a religious man yet if I were, gambling and the usury that feeds it would be the Devil incarnate. It’s Evil plain and simple. It makes Lord of the Rings seem like a documentary about U.S. Finance where the Eye of Sauron is 0 % interest rates.

  43. And it doesn’t mean that some bubbles are not the result of intentional actions. Our “best and brightest” who deserve these obscene salaries couldn’t figure it out? Give me a break.

  44. Dang. What I meant to say is that to have gambling at the root of the Financial System is Evil plain and simple…

  45. One of the best posts you’ve written.

  46. I wonder how much of this could be avoided if investment banks were partnerships, as they used to be.

  47. With full pockets, it’s a lot easier to turn prudent.

    “Mortgage Recovery Backstop: The Path to a Functional Market for Legacy Non-Agency Mortgages and Mortgage – backed Securities” (by Magnetar Capital)
    http://bit.ly/dqdWPK

  48. The worst part of the problem is this: take the bankers at their word – whether too ignorant or too stupid, and not criminal.
    OK
    Why do we have an affirmative action program for the stupid? Why O why do we save the captains of the Titannics and have them continue captaining large ships?????????????????????????????????????????

  49. “When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.” — Keynes, 1935.

    How quickly we all forget the lessons of history.

  50. Similar to Hurricane Katrina, where the fallout was amplified by the human error that was years in the making: we allowed the protective systems (both the natural wetlands barriers and the man-made levy/pump systems) to fall into decay, through corrupt partnerships between government and the private sector. Cut-corner no-bid contracts and selling the wetlands to oil companies are two of the worst examples.

    In the financial collapse we are seeing the same corruption of our human institutions, accompanied by the same doom-loop fallout.

  51. “Sung by John Treacy Eagan and Christian Borle in this fun video, the song succinctly explains how Magnetar concocted highly risky collateralized debt obligations (CDOs) while simultaneously betting that they would fail. When the housing market crashed and the value of the CDOs plummeted, Magnetar got rich.”

    “All we got to do, to make or dreams come true,” they sing, “is bet against the American dream!”

    Bet Against The American Dream from Planet Money on Vimeo.

  52. Gee wiz. It is a miracle we were all able to get by before the Cdo and cds were invented.

  53. I think this is a really excellent and informative post—thanks for linking to it.

    And thanks, too, to James for addressing head-on the absurd notion being constantly repeated that our financial crisis resulted from some kind of unpredictable perfect storm/natural financial disaster/cyclical event, etc., etc. that no one could or did see coming.

    It was of course none of that. And it is therefore essential that respected commentators like The Baseline forcefully refute the canard as often as they can—otherwise you get what I call the Liberty Valence effect: “This is the West, sir. When the legend becomes fact, print the legend.”

  54. Let me second that BDS, and all this ‘legacy’ crap in his FIRST year is disgusting. It’s the end of the line when politicians get all emotional about selling the country out.

    By the way, it’s not a cover-up, it’s a cover your a..

  55. Yeah, apparently no millionaires pre-1999. Of course, not many billionaires either, so I guess we’ve got that going for us.

  56. Planet Money’s tagline is ‘The Global Economy, Explained.’ I love what Planet Money and This American Life are trying to do; making economics and finance accessible and interesting to the ‘mainstream.’

    Planet Money just did a podcast called ‘Private Equity Boss in Four Inch Stilletos,’ (http://www.npr.org/blogs/money/2010/03/post_6.html). It was a profile of Lynn Tilton, CEO of Patriarch Partners, a private equity fund with 75 portfolio companies. She’s a dramatic character with roots in Wall St, yet advocating for Main St. For years, she’s been talking about the long-term dangers of a trading based Wall St. vs a Wall St. that supports the ‘real economy.’

    Here’s a link to her on Yahoo! Finance today, “Lynn Tilton: ‘Huge Disconnect Between Stock Market and the Real Economy.’”

    http://finance.yahoo.com/tech-ticker/lynn-tilton-%22huge-disconnect-between-stock-market-and-the-real-economy%22-465559.html?tickers=^dji,^gspc,spy,JPM,XLF,GS,FAZ

  57. I pay a great deal of attention in the ‘voting booth’ & have for many years yet the for last thirty+ it seems like no matter who gets elected the corporate party always wins leaving the interests of “we the people” in the dirt…

  58. The explosion happened because the terrorists wanted explosive belts to strap on the graduates of their Madrasas and went out and got them — only it turned out they were not as smart as they thought they were and blew themselves up.

    It was just an innocent accident.

  59. “At the end of the day, we have no future if our dominant business model is parting fools from their money.”

    “You got me where you want me
    I ain’t nothing but your fool
    You treated me mean oh you treated me cruel
    Chain, chain, chain, chain of fools”

    Aretha Franklin

  60. You should not scratch much the surface of those who hit the airwaves with having predicted the crisis. You can always predict a crisis and sooner or later you will be right. The importance is warning about what will cause the crisis.

    In May 2003 the Financial Times published a letter I sent them which ended with: “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.”

    Now this message was of course entirely for the regulators to hear… and so why do you insist on putting the whole blame on Wall Street and bankers… because otherwise it gets too uncomfortably close to the home of your brother in arms? Like the IMF? Are you James not covering up also?

    And by the way Magnetar and others, in order to place their bets… must have counted on someone to bail-out their bookies when they were going to collect on their bets.

    And you also say “The crisis happened because the banks wanted unregulated financial markets and went out and got them” and that you should by now know very well is far from being the complete truth.

    The banks (the big) wanted and got especially favorable regulations, which allowed them to become too big to fail. Again, much more than a market failure what we had was a regulatory failure… not because of less regulation… but because of much worse regulations. Why is it so impossible to envision the possibility that we just landed in the hand of a bunch of totally inept regulators? Is it because that goes against an agenda?

  61. Well I saw it coming in 2004. I was selling new homes in Oxnard, California. The homes were next to railroad tracks, and next to the “La Colonia Ghetto.” (Google “La Colonia Oxnard” to have your learn about the highest per capita murder rate in the US.) I was selling $500,000 homes to people who couldn’t speak English. One particular sale stands out in my memory. I was pre-qualifying a buyer with the lender over the phone. The conversation went like this:

    LENDER to ME: Ask the buyer if he has any credit problems.

    ME to BUYER: “Senor, do you have any credit problems in your recent background?

    BUYER to ME: I had a Bankruptcy 6 months ago.

    ME to LENDER: He had a bankruptcy 6 months ago.

    LENDER to ME: Is it discharged yet?

    ME to BUYER: Is it discharged yet?

    BUYER to ME: It gets discharged in 3 weeks.

    ME to LENDER: It gets discharged in 3 weeks.

    LENDER to ME: O.K. we can make the loan, just submit the application in 4 weeks.

  62. And that of course only because that mortgage was going to be repackaged in a security stamped AAA and then sold discounted at low AAA interest rates, bringing the dealers and pushers immense profit margins. http://bit.ly/gNemy

  63. James,

    As a real estate appraiser for 20 years I can tell with that without question they knew these intruments would fail. As an appraiser I get to see the transfers on a daily basis, even reviewing the previous transfers of sales I utilize for comparables. From 1997 to approx. mis 2007 it was almost impossible to perform an honest appraisal as a majority of the sales within a market were in fact bogus flips (transfers that have a much smaller sale within say 1-2 weeks of the current sale). These transfers would show up in predominantly inner city neighborhoods as the variance from low value to high value allows for greater equity(profit) for the flipper. Some time they would even close on both transfers the same day. For example purchase from the sherrif for 12K then refi at 70K the same day. Closing companies used to refer to these as 9-nooners. These type of transfers are impossible as even superman cannot rehab a house in that time period and the sherrif, allow typically below market, are never this far off.

    These loans were not risky and might fail.

    these defaults were not apart of a once in a lifetime event as Geithner, Greenspan and several CFR economist might have you think.

    These loans were guaranteed to default.

    More frightening is the fact that they are appearing again. Apparently they need replacement loans for some CDO’s in which they have taken the downside via swaps. From what I have seen it is apparently easier to get a fraudulent loan for an obvious flip than it is to get a 20% down quality loan.

    May the force be with us.

  64. I cant help but notice from the comments that many of your readers are are more knowledgeable then the average citizen and hopefully you have a good sense of humor cause this is as funny as it gets. Here it is…

    The Council of Foreign Relations has an economic segment within its website and it is named.

    “THE MAURICE R. GREENBERG CENTER FOR GEOECONOMIC SUTIDES”

    Whats next?

    Charles Manson Federal Prison

    Michael Jackson Daycares.

    Jeffrey Dahmer school for anotomical studies.

    I honestly wish I were making this up. Check it out for your self at their website.

  65. And it was not one or two bad loans… there were a couple of trillions of dollars!

  66. Parts of Wall Street must clearly be involved with criminal cover up… the intellectual cover up that’s what the regulators are doing

  67. The lender and I kept asking ourselves “Who’s buying this crap?” And “Who actually believes these appraisals? How can a home appreciate $150,000 in one year? All these loans are going bad, and quickly too.”

  68. Excellent analysis. So much so you should refer to yourself as HillWilliam” and not “HillBilly.”

  69. And when regulations get so complicated that not even a fraction of the regulators have an inkling of what they’re talking about then we really have the kind of confusion that allows some to get away with murder.

  70. If this had been a massive number of simultaneous crashes in an airport would the responsible traffic controllers still been acting? Clearly not, but the regulators in Basel still are… which should tell you something… that is if you wanted to know.

  71. Of course, like everyone who is educated on the advanced, deceptive, manipulative antics of Wall Street is so mad they could spit. But, the day Brooksly Born was dismissed by the Wall Streeters, Alan Greenspan, and the oligarch obfuscation team for suggesting that derivatives be regulated and publicly traded was the day the turned our economy in the wrong direction. We, the people, are the fools. We have ignored what has happened other than remonstrating on excessive bonuses to the deceivers. We stood by and allowed it to happen by not demanding good, honest governance; by allowing ourselves to be led over the cliff, like sheep. But, remember the old saying: Don’t get angry, get even. If we haven’t got the fortitude to demand that those we elect to pass rules and enforce them to prevent being taken to the cleaners in the future, we deserve to be. I say, pay the bonuses that those folks have earned by following the rules of the game. In the future, if someone develops an innovative product, do not allow it to enter the markets without at least putting it through extensive analysis. At least make the sun shine in all of the nooks and crannies of the regulatees, so that we all can clearly see what is happening. And, what happened to the idea that, as with all forms of insurance, the credit default swaps needed to be reserved for in order to sell them. It’s like we opened a casino and deliberately established games with odds to favor those with money and then failed to notice that they had cards up every sleeve. No casino operator in his right mind would allow his establishment to be run as we have run ours, but then they don’t have Ben Bernanke, Henry Paulson, Alan Greenspan, and Tim Geithner as pit bosses.

  72. “No casino operator in his right mind would allow his establishment to be run as we have run ours, but then they don’t have Ben Bernanke, Henry Paulson, Alan Greenspan, and Tim Geithner as pit bosses.”

    Getting there… getting there Bayard… now try to figure out how many posts of Baseline have mentioned the possibility that the financial sector just got saddled by pure lousy regulators… few or perhaps none… as if lousy regulators is such an impossibility.

  73. Banana Peel Theory: the Global Economy slipped on banana peel. Yeah right. No one saw the Giant Banana Peel because they were too busy playing casino.

  74. Per, OK suppose they got rid of the rating system, as you recommend, and it works going forward.

    What is going to happen to all the toxic debt in the system? How are they going to diffuse the AAA-rated bombs planted through out the financial system?

  75. Banana Peel Theory: It was just an accident. Honest.

  76. Brad Thrasher

    I have always been fascinated by con artists and bullies. Both archetypes are necessary for a con to be successful.

    Which is why the most compelling public scene from this entire saga is when Henry Paulson got on his knees before Speaker Pelosi and threatened martial law if Congress didn’t approve the initial bailout.

  77. In an otherwise sensible post, James commits the same error as Greenspan did in his famous “mea culpa.” Greenspan expressed shock that “lending institutions” did not protect shareholders. James refers to “banks” not being smart.

    Lending institutions, or banks, are not sentient. Greenspan, James, and everyone else should only be talking about “bankers.” This is not nitpicking. Thinking in terms of people instead of institutions in essential to sorting out the interests of bankers, shareholders, and citizens, and to effective financial-sector regulation.

    Leading up to the present calamity, bankers’ principal interest was not shareholders’ interest. It was their own, as Adam Smith long ago warned it would be if large public corporations were allowed to form. Not blowing up their institutions was not bankers’ primary focus.

    Bankers are motivated by the prospect of making money — for themselves. When it comes to formulating regulations, that’s the only motivation that should be considered, irrespective of other motivations that might be involved, because that’s the one that can, and often does, lead to destruction of shareholders’ and citizens’ interests.

  78. Tippy I am sorry I cannot offer “to diffuse bombs”.
    If it had been me I would have many more of those investors in the market to realize much more the losses so as to clean up the system. I would not have gone the route of bailing out banks without having the shareholders or senior creditors take a much larger hit than they did. In other words I would have called out much more forcefully the bluff that the risks had been allocated to those more capable to handle the risk.
    Unfortunately, the way they went about it left too much toxic material lying around supported only by a hypothetically willing-to-pay-up-tax-payer… and so there is not much we can do than to work ourselves out of whatever plentiful toxic material lies around… though that we had to do anyhow, even without any toxic material because we also need the creation of new jobs… or to teach in our universities how to be gainfully unemployed so that society does not break down.
    Many of the private now turned public AAA-bombs are of course still ready to explode… and so for many countries (Greece is but one) the option of having them to go boom and work with what is left over might be better than having to work under their heavy weights for decades. In other words, much of those losses that holders of AAA securities should have realized when they occurred will be realized through sovereign defaults
    Perhaps the following letter I wrote and that FT published in August, 2006 explains it better

    Long-term benefits of a hard landing

    Sir, While you correctly argue (“Hard edge of a soft landing for housing”, August 19,) that “even if gradual, a global housing slowdown would be painful” you do not really dare to put forward the hard truth that the gradualism of it all could create the most accumulated pain.

    Why not try to go for a big immediate adjustment and get it over with? Yes, a collapse would ensue and we have to help the sufferer, but the morning after perhaps we could all breathe more easily and perhaps all those who, in the current housing boom could not afford to jump on the bandwagon, would then be able to do so, and take us on a new ride, towards a new housing boom in a couple of decades.

    This is what the circle of life is all about and all the recent dabbling in topics such as debt sustainability just ignores the value of pruning or even, when urgently needed, of a timely amputation.

  79. Banana Peels! As I can document better than most, I, who was just an outside observer saw the peel and did my best to warn about it. But that is not even remotely as important as trying to understand why so many casino regulator experts did not?

  80. Right. They’re too stupid to run things, but yet they’re entitled to run things. Astounding.

    I don’t buy it–I think it’s a criminal cover up and Obama continues to front a criminal government by having these people in his Administration, but this is the essence of the so-called “intellectual” cover up the criminals have proposed.

  81. Per Kurowski wrote”

    “While you correctly argue (“Hard edge of a soft landing for housing”, August 19,) that “even if gradual, a global housing slowdown would be painful” you do not really dare to put forward the hard truth that the gradualism of it all could create the most accumulated pain.”

    More pain from the hard edge…

    75% Of Homeowners In Obama’s Loan Modification Plan Still Owe More Than Their Homes Are Worth

    04-14-10 – Huff Post – excerpt

    “More than three-quarters of homeowners who have had their monthly mortgage payments reduced under the Obama administration’s primary foreclosure-prevention program owe more on their mortgage than their house is worth, according to a new report by government auditors.

    Over half of the roughly 170,000 distressed borrowers who have gone through the program are seriously underwater, meaning they have negative equity of at least 25 percent, the report shows, citing data through February. In other words, for every $1.00 their home is worth, they owe at least $1.25.”

    http://tinyurl.com/y3qdl69

  82. They’re engaged in a criminal cover up too; see William Black on “accounting control fraud.” Black should know; he was an S&L enforcer, back in the day when the criminal justice system applied to CEOs. Good times….

  83. Well, when you see somebody get a jar of water, add soap to it, pick up a bubble blower, dip it into the jar, pull it out, and then put his lips together and blow, it’s hard to conclude that the bubble blowing isn’t deliberate.

    Remind me why that’s not a precise metaphor for the latest collapse? They don’t call it financial engineering for no reason….

  84. the pragmatist

    Blaming the financial crisis on the regulators is like blaming a murder on the cops. Which is ridiculous unless the cops are on the take. Even then there nees to be someone paying off the cops.

    You are right about one thing. Bad regulation can be worse than no regulation. Often the bad regulation is written by those who are nominally to be regulated.

    A good example of a very good regulation was the Glass Steagle Act. It prevented a whole host of bad behaviour, was simple to enforce and could not be perverted by the banks. That is why the banks worked so hard to get it off the books.

    Good regulation is often more like a hammer than a scapel.

  85. “I am become Shiva, the destroyer of worlds.”

    Dr. Oppenheimer

  86. Jacques le Fou

    Or more accurately, Dr. Oppenheimer, quoting The Bhagavad-Gita.

  87. You speak as though the pricing of toxic waste was the problem, as though if there had been some regulatory structure in place to govern pricing everything would have been ok?

    Funny, I always thought the problem was too many loans being given to people who couldn’t pay them back… The cause of this was interest rates being artificially held low by the Fed.

    This was not caused by a failure of the market, this was the market working. When there is money flowing around everywhere people are always going to want to get their share of it, and make that share as big as possible.

    Furthermore, banks were encouraged to take risks like this by Greenspan (his bailout of LTCM in 1998) proved that the Fed would not allow the irresponsibility of any one company destablize the system.

    To put it another way, do you think there would have been such a problem if there was not an excess of cheap credit and banks knew that if they took ridiculous risks they would be allowed to fail? I for one don’t.

    I see so many criticisms of the market as though the market is this sentient being that can act on it’s own. It’s not, the market is made up of individuals seeking to maximize their own personal gain and they will always do so in the most efficient way possible.

    The only way to prevent this happening again is to ensure that risk-takers are held fully accountable for the risks they take and for the government/Fed to stop sending the market false signals by tinkering with interest rates.

  88. A regulatory structure could have made quite a bit of difference. One of the astounding facts, confirmed for me by those involved in the creation of these debt obligations, is that there was no one tracking what went into them. The front end, with regular payments being made via relevant tranches to the equity holders, was well thought out. The back end, with the details of which chunk of which credit obligation was stuffed into which portion of each instrument didn’t exist.

    Think about that for a second. There are well-established techniques for developing data models. It’s done all the time by the likes of Google, Amazon, or any other outfit that sells goods and services, and to accumulate data about who buys how much of what and from where. That’s what needs to happen with CDOs: a public database of what each contains. I wrote about this, but had no takers till Felix Salmon graciously agreed to post it (http://blogs.reuters.com/felix-salmon/2009/11/23/the-role-of-the-database-in-the-financial-crisis/).

    Now the minute that happens, the money will drain out of the crap and, without the latency (that is to say the time it takes for people to actually figure out they were holding junk) there’s no place to hedge. End of that game. Not that there aren’t lots of other games to play, but selling toxic instruments while hedging against them and then actively working to kill those instruments so that you can collect, that would stop.

  89. JK wrote:
    “Although I probably wouldn’t have behaved the same way under the circumstances, I have no problem with Magnetar.”

    JK time to get your moral compass calibrated.

    When the people of Magnetar CREATE the toxic product AND knowingly allow the sale as mislabeled goods (AAA rating) AND then bet the whole thing will fail as their way to make money… the people of Magnetar are crooks.

    The “Wall Street excuse” of “you can’t blame the predator for eating the prey” may be true but when I see a RAT I kill it immediately with a stick if one is at-hand.

  90. There is too much use of the word “Reform” What Congress needs to do pass laws under which financial institution may function…Perhaps they grow too big to fail..but not too big to be ubove the Law…

  91. One thing I’ve been thinking about lately is whether anyone looked at the credit card debt in relationship to the sub prime borrowers. Seems like some people would be interested in where borrowers were with so much credit card debt and without incomes going up and about to have mortgages explode.

  92. Garrett Wollman

    James writes:
    “The answer is that nothing was being priced efficiently.”

    No, the answer is that CDOs *cannot, in principle, be priced efficiently*. “The market” does not have some magic power that allows it to solve a computationally-intractable problem (such as CDO pricing) which no individual market participant can solve. The only solution is to either require all CDOs to be constructed by trusted third parties (and I can’t think of a way to ensure that they don’t go byzantine, given the set of incentives that would have to exist) or to assign the assets entirely at random.

  93. If you are looking for criminal responsibility, go to the boards of directors of these organizations. By law, they have *fiduciary responsibility to the shareholders*. BoD membership is not an honorarium. Their attitude through all of this was to get along, go along. Let the people in the organization make their millions, my turn will follow. More important than any proposed reform would be the vigorous prosecution of these people who were totally derelict in their duty.

  94. This is an important point. Who will regulate the people in government? We have seen in history, in our country and others that governments tend to be inefficient in many avenues.
    Public education is a prime example of government inefficiency.