“Appalled, Disgusted, Ashamed and Hugely Embarrassed”

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

36 thoughts on ““Appalled, Disgusted, Ashamed and Hugely Embarrassed”

  1. James, good post as always, but I get a little uncomfortable when people start to bash short-sellers and others who bet against bubbles. God knows there are way too many people on the other side of bubbles – the media, banks, politicians, homeowners, etc.

    These guys ARE performing a socially useful function. Well, ex ante, anyway. I suppose we would be better off heavily curtailing the activities of the bubble-pushers so there would be less of a need for the bubble-bursters.

  2. I don’t know James, I think Goldman’s long term greed is alive and well. I think the short-term greed is just the instrument of achieveing the long-term goal.

  3. I guess the question is whether you think allowing one guy to bet short and another to bet long is socially useful.

    Personally, I don’t think it matters much what the banks said to most of the people buying CDOs. These weren’t exactly retail customers (although there are a number of sad stories out there of bankers selling products to organizations that they shouldn’t have been selling to).

    Which brings me back to my view that the issue isn’t really the existence of these products, but their prevelance. If Paulson wants to bet with Soros, for example, I don’t think anyone should care. But when he is betting with a rural school district in Wisconsin, on the other hand, that is socially destructive.

  4. “‘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.’”

    The market did decide. And on appeal by Wheeldon’s Wall Street buddies, that decision was overturned.

  5. “free-market zealot”

    “Is this transaction socially useful?”

    “I’d say the social utility is pretty small at best.”

    Who wrote this? Karl Marx?

    The line of Main St. people who borrowed more than they could ever repay, and invested in products they admittedly didn’t understand, is too long to count. Was that socially useful?

  6. The current Atlantic carries a piece by their Business Editor Megan McArdle titled ” Capitalist Fools” about Tishman- Speyer’s and BlackRock’s acquisition of Stuy Town on the Lower East Side.

    The article is about the high degree professionals on all sides of commercial real estate transactions being simply fools.

    I have been part of the contracting scence for these mega deals for most of my adult life. I saw the same collapses in the early eighties when very involved in tax benefit real estate syndication. I saw them a decade later and now there will be another massive unraveling.

    The behaviour of professional finance is fee based as was my activity. What better skill is there than selling the Brooklyn Bridge to Queen Elizabeth? The answer must be in the affirmative in the real world of those with the skills to be cruising the financial Spanish Main in their frigate Skillsets. The problem is social. What else would you expect when the children of the overseer become Old Massa. Behind every fortune is a mass crime the saying goes.

  7. Do we really need to point out that markets don’t always make the right decisions?

    Of course markets make the right decision, if they are not back-stopped by public taxes. Let’s not take the last 2 1/2 years and use them as the framework to pass the final judgment on Capitalism and Free markets. The world hasn’t seen those two hanging around any time in the last century.

  8. Here’s the problem in a nutshell: you have legalized leveraged gambling by individuals responsible for INVESTING other people’s money; those people are permitted to book ‘profits’ based upon ‘risk models’ having no real world validity; alhough it is too soon to tell whether there actually will be any profits, the gamblers are rewarded with a percentage of the profits, generally about half. There is no other word for this system but INSANE.

    The resulting problem would have been only casually catastrophic (that is, resulting in nothing more than the odd meltdown of individual companies, as per 1991-2003) had it not been for credit default swaps and synthetic CDOs wrapped around residential mortgages, which turned a $1.7 trillion problem into a $20 trillion disaster with no end in sight.

    THEN, when the $hit hit the fan, our leaders turned for solutions to the very criminals who created the problem, and rewarded them for pretending to fix it, and augmented their power to cash in on the solutions, which are doomed to failure, although no one can be quite certain when they will fail.

    I admire your ability to write about this day after day after day after day after day. For myself, however, I am simply counting the days until the entire country looks like Detroit. Unlike others, I am not looking forward to a revolution, having learned from Hayek that under socialism the very worst people inevitably end up on top.

    For those seeking explanations, everything which has happened makes complete sense once you understand that free market capitalism is a religion. There is no science involved, merely misplaced faith. Thus, financial innovation, the resulting crisis and the real world consequences are simply the cost of an Idiots Crusade.

    A helpful guide to all this is Extraordinary Delusions and the Madness of Crowds, by Charles Mackay.

    Those interested in my own view of the Crisis, documented in November 2008 should consult the link which has appeared next to my name for about a year. If anyone has done this they haven’t told me about it.

  9. I agree with Pete above.

    “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.’””

    Wheeldon seems to have missed the fact that markets did decides that we don’t need any investment banks. There’s abundant evidence — for example the testimony of Paulson and Bernanke in support of TARP — that all the investment banks failed the market test in September 2008. It was governments that thought the banks deserved to live, not markets.

  10. > it improves price discovery

    That is all that is needed to defend the public benefit of shorting. The housing bubble was going to bust, and the sooner, the better. If the increase of house prices would have been due to fundamentals, Paulson would have lost his money through his own choices. He didn’t, and I am fine with that outcome. Only the involvement of banks that lend to speculators leads to bad consequences for the public – time for separating commercial and investment banking again.

  11. I don’t know if any other sector other than finance where a company can sell a product and simultaneously bet money that it will fail. It is a destructive practice and I do not understand the purpose it serves.

    Imagine if any other industry engaged in this horrible practice – pharma, hospitals, meat, processed food, children’s toys, etc. When they sell poisonous stuff, it gets recalled and the company is usually penalized, not bonused.

  12. Technically in the Paulson example, from the perspective of the buyer-seller the transaction is not zero-sum, it is actually negative sum, since presumably both parties pay a fee/commission to the bank.

  13. Here is the thing, and why the CDOs and the credit default swaps are to blame for 85% of this whole mess. And it was lack of regulation that caused that, not low interest rates.

    You know I have a high high degree of respect for Mark Thoma, and I’m extremely reticent to disagree with him. But he wrote a recent post where he was saying (I’m paraphrasing) “Hey folks, it was BOTH” (low rates and lack of regulation), and Thoma is right it’s not an “either or” choice, it WAS both. But also nobody should believe it was a 50/50 deal either. Lack of regulation was at least 75% to blame, and I think looking at it, lack of regulation was more like 85% to blame. Low interest rates were part of it, but at least 3/4 of the problem was absence of regulation. And people who are trying to put the focus on interest rates are trying to get people’s eye off the ball or are well intentioned people but doing the systemically threatening bankers the greatest favor they could possibly give.

  14. Exactly. And it was not “markets” that encouraged banks to grow to their current size. They were incentivized to grow by implicit guarantees turned explicit with bailouts in the 90’s. Not to mention things like deposit insurance, regulatory arbitrage and the drive to be considered a “primary dealer” with all the benefits it entails. I could go on forever with these. There are dozens of incentives in our regulatory structure and in the framework of our financial system (fractional reserve) that encourage banks to grow into monstrosities.

  15. Absolutely, lack of positive regulation is a major or dominant part of the problems that created financial collapse. Was that not the people’s choice since 1980 if not before? That was thirty years ago. Informal inquiry over those thirty years by anyone interested in politics and commerce would force the conclusion that no regulation was the ideal of most of the electorate. Breaking it down over thirty years there was a high plurality group that simply despised governance from perspectives all over the political spectrum. Hated might even be a decent description of this high plurality. The other contributors were those groups that did not care about the issue very much. There were those that waxed and waned and those that simply did not care.

    The passage of thirty years accomplished the goal of rendering regulation ignorable as matter of citizen viewpoint. The US citizen majority more or less secured the result they desired.

    What few seem to actively realize is that there is always regulation of day to day conduct of the citizenry and during those thirty years huge increase in regulation of the citizen by the corporations substituted for the state itself in day to day life.

    The elites deregulated themselves and created regulation of those under them via the corporation, school board and so forth.

    One is a professional to gain power of those who are clients in the Roman sense. That means the professionals network and try to dissuade networking among those that are their clients.

    It seems most everyone in the US achieved the bulk of their desires in the upper half anyway.

    Choices were made by the citizenry and now they are upset at the consequences. Yet, the citizenry seems incapable of banding together because they cannot arrive at a political consensus.

    At some point the citizenry will arrive at a consensus and the elites will not enjoy the consequences. In the meantime, we have been living in a grifter’s paradise. The best mark of all is the mark that occupies personal true and only heaven’s .

  16. We don’t usually think about this way, but insurance can be a bet on failure. Doctors have malpractice insurance, for instance, which you can this of as a bet that the service they provide will fail (and that they will be liable).

  17. “The main purposes of the financial system are processing payments and financial intermediation (conversion of savings into investment).” To what end? I would say that the purpose of the financial system is to provide a path for currency that amasses wealth to the most effective player. Recent events say that it works as designed.

  18. actually i think the market encouraged the creation of the TBTF as the bigger the institution the more money it makes (or can). deposit insurance was created to protect depositors and ensure that banks don’t get destroyed by rumor, and try to keep banks in line (they did tend to misuse depositors money too). it also keep the banking system from collapsing this time unlike the last time we had this mess

  19. “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.”

    This is what we bailed out? The kazillionaire bookies – AKA Wall Street investment bankers?

    This is what controls the financial sector? Banker bookies placing bets that the products they sell will fail? (In what other sector is this even imaginable?! Think about execs in pharma, meat packing, toys, etc. placing bets that the products they sell to consumers will kill them!)

    How is our financial sector promoting growth and innovation? And by innovation, I don’t mean innovating tools to rip off investors.

    Because of the gambling over there on Wall Street, retirement portfolios and college funds have lost significant value. Because of the unregulated gambling on Wall Street, our economy is in the toilet.

    Preserving this status quo is not the “change we need.”

  20. AT&T is a good example of how anti-trust works, and how it ultimately loses to corporate pressure. AT&T has rebuilt everything we tore apart by gobbling up all the companies we told them they had to break in to.

    Even if we break up the banks now, we’ll have them repealing the legislation (just like they did to Glass-Steagal, just like AT&T has patiently lobbied and repealed and persuaded) and rebuilding their empires within 50 years. Even if we got legislation in place, is there something we could do to really make it stick?

  21. That bet is a hedge. It is not used, or intended, by the entity that buys it to profit from “cashing in”.

  22. Yes, but can one doctor take out medical malpactice insurance on another doctor? Better yet, can I take out fire insurance on my neighbor’s house? The temptation (aka conflict of interest) just becomes too great.

  23. Oldgal, I do not know the answer to your first question.

    If the entity is willing to issue insurance policies to parties that, themselves, have nothing to lose should the policies pay out, then the insurance issuer should really ask why? Where is their “skin” in the game?

    True, conflict of interest is there, but only if the insurance issuer wants to play. (A.I.G. being a nice “little” example.)

  24. So many people like to blame the failure on our failure to regulate. Could it be that Greenspan, and all of those who followed him in the rampant late 90’s deregulation, was substantially planting the acorn that sprouted into massive uncontrolled oak trees that now have put the rest of the economy deep in the umbral economy and unable to live and profit. We can blame all of this (equally) on regulators, Congress and Wall Street, who conspired to bilk the public of hard earned retirement funds, etc., and have essentially put (and as we speak continue to put) our national economy in a seriously crippled state for years, if not decades.

    Derivatives were the core problem, but many other factors contributed. Our situation won’t change until and unless we take the steps that are not being taken now, to do away with all public subsidy for the new Las Vegas: the New York financial district.

  25. Okay, time to speak as an antitrust lawyer again.

    The decision was an age ago in terms of the development of antitrust law, but I have to say, the remedy never made all that much sense to me. Creating a series of regional monopolies to replace one national monopoly didn’t create new alternatives for customers. Maybe it made entry a little easier by making the minimum required scale a bit smaller, and regional competitors did spring up, but wired phone service is kind of the definition of natural monopoly – really high fixed costs the cost of duplication of which are a questionable cost.

    What really made a difference was innovation – cable, satellite, the internet and mobile phones are the real constraint on the old local phone monopolies. Even with those new entrants, there is still room to question whether there is enough meaningful competition, but nonetheless, innovation has been the only real solution.

    Finally, you are just factually wrong. ATT&T has hardly rebuilt what it once had, which was total control of telecommunications.

  26. It’s not even the right analogy that James is making in my opinion. James should take it one step further–it’s a sports bookie who has mob connections who are influencing the outcome of the game.

  27. In other words, the bookie is taking bets on both sides, the line is being adjusted, AND the bookie is making his own bet (with his personal money) knowing full well what the result of the game will be.

  28. 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.</i.

    Markets *tried* to break up the banks, James. It was *government* that kept them afloat. Something to bear in mind when advocating yet more government.


  29. This may just be semantics, but so is JDM’s initial critique…
    There’s what an asset is — in this case, a bet that a doctor will make an error — and there’s the motivation for buying the asset — to hedge.
    This asset *is* a bet. If I buy it as a speculator, it’s not a hedge, it’s a bet. And if I sell it back to the doctor, it doesn’t magically turn back into a hedge.

  30. “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.”
    If I have said it once, I have said it a thousand times. The market comes up with all sorts of products that are crap – Sears sells appliance insurance on toasters that make no economic sense, but people but it! Most financiers are no smarter than the toaster insurance buyers (i.e., why does anyone pay any attention to Fitch, S&P, and Moodys????)

  31. very, very good point.
    And than we have to put up with people who are paid 10’s upon 10’s of millions who say it was so complex that nobody knew what was going on.
    We have a solution – Bankruptcy. Its called Profit and LOSS. The system doesn’t work if you don’t punish with losses the imprudent, the venal, the stupid.

  32. I agree that their clients must recognize that the investment bank, say Goldman Sachs, is primarily self interested, like any other person or business entity.

    However, I largely disagree with the assessment of the Paulson thing, according to my understanding of it. Which is that, at the time these deals went down, GS was shorting the market alongside Paulson and consequently *deliberately* misadvising their other clients in order to benefit from their participation. To me, this constitutes fraud.

    Even if you don’t think it’s fraud–and I’m not sure I’m comfortable with a floating, subjective definition to be determined by investment banks–it’s still a terrible business plan.

    In which case, why is GS, the institution, benefitting from so much government support? GS also no doubt thinks it can count on industry spin to protect it from the hit its reputation *should* take in the market.

    Where are those short sellers when you *really* need them? MIA, it seems to me, because they’re colluding with the problem. How is the Paulson deal not insider trading?

  33. Great post, as usual. The argument to allow certain practices because they “increase liquidity” is one that Wall Street loves to trot out, but it’s a canard because most of these markets are already liquid. There were gajillions of dollars of CDOs being traded; did Paulson’s new securities create a meaningful increase in liquidity? The same is true of high-frequency trading and naked access. Wall Street says it increases liquidity, and at the margin it does, of course, but the vast majority of stocks being program traded are already highly liquid. IBM, anyone?

  34. Markets haven’t fed the hungry, provided pensions and economic security to everyone,or stopped the dumping of CO2 into the atmosphere in our pre-appocalyptic world. Market allocation of investment appears to be less than useful or efficient for many people and purposes.
    In the current derivatives bubble it seemed most efficient in expanding risk and spreading fraud.

  35. It seems to me the critical questions concerning this passage of Zuckerman’s book (pp 179-182) have yet to be asked. Bear Stearns turned it down for ethical reasons. Greg Lippmann of Deutsche Bank and Goldman Sachs accepted and went to work constructing CDOs at Paulson’s direction. Paulson & Co. were known to “crack the tape” and look at the underlying mortgages that made up these MBS’s. So did Deutsche Bank and Goldman do their own due diligence, or just accept Paulson’s picks ? How many of Paulson’s picks went into the final product ? Did Deutsche Bank and Goldman tell the rating agencies that Paulson had picked them ? Did they share their own due diligence if they did any ?

    There have been various published reports of mortgage lenders saying they were paid more by Wall Street for “no doc” mortgages than they were for fully documented ones. These guys were “market-makers” alright. They created the demand for the worst mortgages conceivable…..negative amortization, huge pre-payment penalties for no-escape. They weren’t interested in catch and release.

    Paulson reportedly wanted mortgages of “recent vintage” because he knew that with those there’d be less chance of the properties appreciating sufficiently that the owners could refinance. Deutsche Bank and Goldman knew exactly what he was after, exactly how he made his selections, and why. They packaged it for him. He deceived no one. They deceived everyone.

    Why would they go along unless they were seeking, in the words of the Mass AG, mortgages “designed to fail at the inception?” How much of that was disclosed to the buyers of these CDOs, you know, their clients?

    Zuckerman says Lippmann and his clients made $25 billion shorting the very products Deutsche Bank sold to others. Did they tell these (long) clients that Paulson had picked them?

    Were there multiple CDS’s secured by Deutsche Bank and Goldman from various, equally unwitting issuers, none of whom knew how many other CDS’s had been written against these same hand-picked losers. And how many CDS’s were for their own accounts? These are some questions that should be asked, under oath, by the FCIC.

    The Food and Drug Administration was started after a guy in Pennsylvania put poison in a bottle and sold it as a “cure-all” elixir. He killed 127 people. No one argued “caveat emptor” then. No one argued for phony “free market” principles to allow people to sell what they knew was toxic. Fraud is fraud is fraud.

    If these people didn’t actually seek out what was poison, they knew Paulson had when he came to them. By putting it in CDOs but concealing their contents from the rating agencies as well as their own clients, they were worse than the charlatan in Pennsylvania.

    They received it from the poison apothecary himself, bottled it, got a “AAA” label slapped on through deception, sold it and then took out life insurance policies on their victims (Goldman bought $2.5 billion in CDSs on AIG). They then made multiple side-bets (and billions of dollars) on how many would die.

    If there’s any justice in this world, they will become the smartest guys on Cell Block “D”. If not, there’s always the seventh circle in Hell…..I hope.

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