Year: 2010

The Best Thing I Have Read on SEC-Goldman (So Far)

By James Kwak

Actually, two things, both by Steve Randy Waldman.

Part of Goldman’s defense is that it was in the nature of CDOs for there to be a long side and a short side, and the investors on the long side (the ones who bought the bonds issued by the CDO) must have known that there was a short side, and hence there was no need to disclose Paulson’s involvement. Waldman completely dismantles this argument, starting with a point so simple that most of us missed it: a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does. Since a synthetic CDO by construction mimics the characteristics of a non-synthetic CDO, the same thing holds. (While the credit default swaps that go into constructing the synthetic CDO have long and short sides, the CDO itself doesn’t have to.) Here’s the conclusion:

“Investors in Goldman’s deal reasonably thought that they were buying a portfolio that had been carefully selected by a reputable manager whose sole interest lay in optimizing the performance of the CDO. They no more thought they were trading ‘against’ short investors than investors in IBM or Treasury bonds do. In violation of these reasonable expectations, Goldman arranged that a party whose interests were diametrically opposed to those of investors would have significant influence over the selection of the portfolio. Goldman misrepresented that party’s role to the manager and failed to disclose the conflict of interest to investors.”

Waldman follows this up with an analysis of the premium that Goldman extracted from the buy-side investors and transferred to Paulson (in exchange for its own fee). The point here is that Goldman could have simply put Paulson and the buy-side investors together and had Paulson buy CDS on RMBS directly — but that would have affected the price of the deal, because Paulson wanted to take a big short position. So instead, they created the CDO (a new entity) and then drummed up buyers for it, in order to avoid moving the market against Paulson. The advantage of thinking about it this way is it shows what the function of a market maker is and how that differs from the role Goldman played in this transaction.

The posts are long, so sit back and enjoy.

Update: Nemo points out that I misinterpreted Waldman’s post, and Nemo is right, although I think I got the substance of Waldman’s point right. Here is what Waldman says:

“There is always a payer and a payee, and the payee is ‘long’ certain states of the world while the payer is short. When you buy a share of IBM, you are long IBM and the firm itself has a short position. Does that mean, when you purchase IBM, you are taking sides in a disagreement with IBM, with IBM betting that it will collapse and never pay a dividend while you bet it will succeed and be forced to pay? No, of course not. There are many, many occasions when the interests of long investors and the interests of short investors are fully aligned. When IBM issues new shares, all of its stakeholders — preexisting shareholders, managers, employees — hope that IBM will succeed, and may have no disagreement whatsoever on its prospects. . . . The existence of a long side and a short side need imply no disagreement whatsoever.”

So I was clearly wrong when I said, “a CDO is just a way of repackaging other bonds (residential mortgage-backed securities, in this sense), so it doesn’t necessarily have a short investor any more than a simple corporate bond or a share of stock does.”

But — and I don’t think I’m engaging in sophistry here — Waldman’s underlying point is that even though there is a short position, that doesn’t mean that the long and short investors have diametrically opposed interests. That’s true of stocks, and it’s also true of CDOs. And so it’s disingenuous of Goldman to imply that buyers of any CDO always know that there is someone who is actively betting on it to go down in value.

Clinton Confesses: Rubin and Summers Gave Bad (strike that) Excellent Advice on Derivatives

The following guest post was contributed by Jennifer S. Taub, a Lecturer and Coordinator of the Business Law Program within the Isenberg School of Management at the University of Massachusetts, Amherst (SSRN page here).  Previously, she was an Associate General Counsel for Fidelity Investments in Boston and Assistant Vice President for the Fidelity Fixed Income Funds.

Considering that much of the disastrous deregulation of the U.S. financial system occurred on President Bill Clinton’s watch, I was encouraged by his televised confessional Sunday. He admitted to Jake Tapper that he was led astray by two of his secretaries of the treasury, Robert Rubin and Lawrence Summers.

What an important and timely revelation. Admitting we have a problem is the first step to recovery. With financial rehab next up on the Senate’s agenda, it’s useful that someone is discrediting those who persist in promoting failed ideas. What to do about the $450 trillion (notional) over-the-counter (OTC) derivatives market will be at the top of the agenda. This is about big money. Really big. Industry began lobbying last year to protect the annual $35 billion haul that just five US banks bring in trading derivative contracts.

Reform ideas range from the most sensible recommendation by Professor Lynn Stout (return to a regime where naked credit default swaps are not enforceable), to Senator Blanche Lincoln’s very strong amendment (prohibiting the banks that have access to the Fed’s discount window from trading derivatives), to the necessary but insufficient (mandating all standard derivatives be cleared on exchanges and requiring collateral to be posted), to the weak (the current Senate bill, rife with exceptions).

Remember, this market includes potent credit default swaps, a key ingredient to the crisis. The existence of this $60 trillion (now $45 trillion) notional value market, protecting and connecting counterparties across the system, led to a $180 billion taxpapayer-funded bailout of AIG. And, as we have just learned, CDS played a central role inside the synthetic Abacus 2007-AC1 vehicle, a device that helped Goldman Sachs rob purchasers to pay Paulson.

Yet, in spite of the power of Clinton’s admission, or perhaps because of it, just after the interview with Tapper, Clinton counselor Doug Band swiftly dispatched a disclaimer. In a moment of blatant grade inflation, Band said that Clinton believed Rubin and Summers provided “excellent advice on the economy and the financial system.”

Continue reading “Clinton Confesses: Rubin and Summers Gave Bad (strike that) Excellent Advice on Derivatives” →

Jamie Dimon Should Debate Us

By Simon Johnson

This weekend Jamie Dimon (head of JP Morgan Chase) told the German newspaper Welt am Sonntag that he needs “better access for bankers to politicians” and that the banking industry could do with more influence on politicians.   He also mentioned the need for a forum where banks can “demonstrate their arguments to politicians and supply them with the right facts” (that wording is from Reuters’ summary).

We would welcome a debate with Mr. Dimon in any forum, preferably in public and with TV cameras present.  We have previously extended a similar invitation to any bank executives – including but not limited to the 13 Bankers in the title of our book. 

One of the 13 appeared in an off-the-record panel last summer with me; it’s not clear that he would agree to do the same again today.  One other leading person from the financial sector – although not a current top executive – has expressed interest in a public debate; we agreed and now the ball is in his court. Continue reading “Jamie Dimon Should Debate Us” →

Break Up The Banks

By Simon Johnson, co-author of 13 Bankers, as discussed on the Today show this morning with Matt Lauer and Erin Burnett

The biggest banks in the United States have become too big – from a social perspective.  There are obviously private benefits to running banks with between $1 trillion and $2.5 trillion in total assets (as reflected in today’s earnings report), but there are three major social costs that the case of Goldman Sachs now makes quite clear.

1)      The megabanks have little incentive to behave well, in terms of obeying the law.  There is fraud at the heart of Wall Street, but these banks have deep pockets and suing them is a daunting task – as the SEC is about to find out.  The complexity of their transactions serves as an effective shield; good luck explaining to a jury exactly how fraud was perpetrated.  These banks have powerful friends in high places – including President Obama who still apparently thinks Lloyd Blankfein is a “savvy businessman”; and Treasury Secretary Geithner, who is ever deferential.

2)      The people who run big banks brutally crush regular people and their families on a routine basis.  You can see this in two dimensions

A. They are not inclined to treat their customers properly.  They have market power in particular segments (e.g., new issues or specific over-the-counter derivatives) and there are significant barriers to entry, so while behaving badly undermines the value of the franchise, it does not destroy the business.  Talk to some Goldman customers (off-the-record; they don’t want to bite the hand that hurts them).  Lloyd Blankfein still claims that the client comes first for Goldman; most of their clients are surprised to hear that.

B. Small investors also lose out.  Who do you think really bears the losses when John Paulson is allowed to (secretly, according to the SEC) design securities that will fail – and then pockets the gains?

3)      Underpinning all this power is the ultimate threat: Too Big To Fail.  If a big bank is pushed too hard, its failure can bring down the financial system.  This usually means protection when the system looks shaky, but it can also protect big banks from serious prosecution – if their defenders, like Jamie Dimon, can make the case that this would undermine system stability and slow the creation fo credit.  (This is startlingly parallel to the arguments made by Nicolas Biddle against Andrew Jackson during the 1830s; see chapter 1 of 13 Bankers).

In turn, this puts competitors at a major disadvantage, because the bigger banks can borrow on better terms.  The extent of protection provided to management and boards in 2008-09 was excessive, but what really matters is the protection perceived and expected by creditors going forward.  And this is all about whether you can credibly threaten the creditors with losses.  This, in turn, is about a simple calculus – if a firm is in trouble, will it be saved?

There are simply no social benefits to having banks with over $100 billion in total assets.  Think clearly about this – and if you dispute this point, read 13 Bankers; it was written for you.

The Discount Rate Mismatch

. . . or, how finance is like quantum mechanics.

This guest post is contributed by StatsGuy, an occasional commenter and contributor to this blog.

Many pundits like to discuss the issue of Maturities Mismatch – that banks borrow short (at low interest), lend long (at higher interest), take the profit and (allegedly) absorb the risk.  We often hear talk about how the Maturities Mismatch is integrally linked to liquidity risk – the sometimes self-fulfilling threat of bank runs – which the FDIC is designed to fight.  Rarely if ever do we see anyone making the connection to the Discount Rate Mismatch . . .  In fact you’ve probably never even heard of it, and neither have I.

What is the Discount Rate Mismatch?

It is the difference between the risk-free return on investment that investors demand, and the risk-free return on investment that can be generated by real world investments.  And by investors, I do not just mean individual retail investors or hedge funds.  I also mean retirement accounts and state pension funds as well, which rely on massive 8% projected returns in order to avoid officially recognizing massive fiscal gaps between their obligations and funding requirements.

It has been well documented that the existence of these gaps implicitly forces state and municipal retirement agencies to engage in risky investments to hit target asset appreciation goals.  This strategy sometimes works.  And, sometimes, it does not – as Orange County well remembers.

Continue reading “The Discount Rate Mismatch” →

Goldman Sachs: Too Big To Obey The Law

 By Simon Johnson, co-author of 13 Bankers.

On a short-term tactical basis, Goldman Sachs clearly has little to fear.  It has relatively deep pockets and will fight the securities “Fab” allegations tooth and nail; resolving that case, through all the appeals stages, will take many years.  Friday’s announcement had a significant negative impact on the market perception of Goldman’s franchise value – partly because what they are accused of doing to unsuspecting customers is so disgusting.  But, as a Bank of America analyst (Guy Mozkowski) points out this morning, the dollar amount of this specific allegation is small relative to Goldman’s overall business and – frankly – Goldman’s market position is so strong that most customers feel a lack of plausible alternatives.

The main action, obviously, is in the potential widening of the investigation (good articles in the WSJ today, but behind their paywall).  This is likely to include more Goldman deals as well as other major banks, most of which are generally presumed to have engaged in at least roughly parallel activities – although the precise degree of nondisclosure for adverse material information presumably varied.  Two congressmen have reasonably already drawn the link to the AIG bailout (how much of that was made necessary by fundamentally fraudulent transactions?), Gordon Brown is piling on (a regulatory sheep trying to squeeze into wolf’s clothing for election day on May 6), and the German government would dearly love to blame the governance problems in its own banks (e.g., IKB) on someone else.

But as the White House surveys the battlefield this morning and considers how best to press home the advantage, one major fact dominates.  Any pursuit of Goldman and others through our legal system increases uncertainty and could even cause a political run on the bank – through politicians and class action lawsuits piling on.

And, as no doubt Jamie Dimon (the articulate and very well connected head of JP Morgan Chase) already told Treasury Secretary Tim Geithner over the weekend, if we “demonize” our big banks in this fashion, it will undermine our economic recovery and could weaken financial stability around the world.

Dimon’s points are valid, given our financial structure – this is exactly what makes him so very dangerous. Our biggest banks, in effect, have become too big to be held accountable before the law. Continue reading “Goldman Sachs: Too Big To Obey The Law” →

John Paulson Needs A Good Lawyer

By Simon Johnson, co-author of 13 Bankers: The Wall Street Takeover and The Next Financial Meltdown

Of all the reactions so far to various dimensions of Goldman fraudulent securities “Fab” scandal, one stands out.  On Bill Maher’s show, Friday night, I argued that John Paulson – the investor who helped design the CDO at the heart of the affair – should face serious legal consequences. 

On the show, David Remnick of the New Yorker pointed out that Paulson has not been indicted.  And since then numerous people have argued that Paulson did nothing wrong – rather that the fault purely lies with Goldman for not disclosing fully to investors who had designed the CDO.

But this is to mistake the nature of the crime here – and also to misread the legal strategy of the SEC. Continue reading “John Paulson Needs A Good Lawyer” →

Our Pecora Moment

By Simon Johnson

We have waited long and patiently for our Ferdinand Pecora moment – a modern equivalent of the episode when a tough prosecutor from New York seized the imagination of the country in the early 1930s and, over a series of congressional hearings: laid bare the wrong-doings of Wall Street in simple and vivid terms that everyone could understand, and created the groundswell of public support necessary for comprehensive reregulation.  On Friday, that moment finally arrived.

There is fraud at the heart of Wall Street, according to the Securities and Exchange Commission.  Pecora took on National City Bank and J.P. Morgan (the younger); these were the supposedly untouchable titans of their day.  The SEC is taking on Goldman Sachs; no firm is more powerful.

Pecora exposed the ways in which leading banks mistreated their customers – typically, retail investors.  The SEC alleges, with credible detail, that Goldman essentially set up some trusting clients and deliberately misled them – to the tune of effectively transferring $1 billion from them to a particular unscrupulous investor. Continue reading “Our Pecora Moment” →

SEC Charges Goldman with Fraud

By James Kwak

Press release here. Complaint here. The allegation is that Goldman failed to disclose the role that John Paulson’s hedge fund played in selecting residential mortgage-backed securities that went into a CDO created by Goldman. Here’s paragraph 3 of the complaint:

“In sum, GS&Co arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.”

The problem is that the marketing documents claimed that the securities were selected by ACA Management, a third-party CDO manager, when in fact the selection decisions were influenced by Paulson’s fund. Goldman had a duty to disclose that influence, especially since Paulson was simultaneously shorting the CDO. (According to paragraph 2 of the complain, he bought the credit default swaps from Goldman itself. I used to wonder about this; if he bought the CDS from another bank, then Goldman could claim it didn’t know he was shorting the CDO, implausible as that claim might be. But in this case Goldman must have known.)

Continue reading “SEC Charges Goldman with Fraud” →

We’re Big . . . and We’re Connected

By James Kwak

MBIA, the big bond insurer, is actually headquartered in Armonk, New York, about forty miles from Wall Street, and it’s not quite one of the swaggering elite. But it plays its own crucial role in the financial system, insuring municipal bonds as part of a tight oligopoly. Then it recently expanded into writing credit default swaps on mortgage-backed securities and collateralized debt obligations, raking in profits during the boom while loading up on exposures that would almost kill it during the financial crisis.

But when it comes to attitude, MBIA wanted to be every bit the financial oligarch. Bloomberg has an excerpt from Christine Richard’s upcoming Confidence Game, which tells the story of hedge fund manager Bill Ackman’s short position on MBIA. (Here’s a previous Bloomberg story on the topic.) There isn’t much in the excerpt, but there is this choice quote from MBIA CEO Jay Brown, as recalled by Ackman:

“You’re a young guy, early in your career. You should think long and hard before issuing the report. We are the largest guarantor of New York state and New York city bonds. In fact, we’re the largest guarantor of municipal debt in the country. Let’s put it this way: We have friends in high places.”

(The next year, New York attorney general Eliot Spitzer began investigating Ackman for market manipulation, but Ackman was never charged with anything.) It doesn’t get much more clear than that.

(Disclosure: I knew Bill Ackman a long, long time ago. We took calculus together in high school; I was a sophomore and he was a senior. And I vaguely recall helping him with it. Nice guy. Yes, he had gray hair in high school.)

Michael Lewis on Wall Street

By James Kwak

The Big Short is a good story and provides some illuminating lessons about Wall Street. Lewis doesn’t really come out and say what he thinks about Wall Street; he lets his characters do that for him. But in his recent interview with Christopher Lydon, he really lets loose. Here are some direct quotations.

Lewis: “The people who were responsible for orchestrating the crisis, because they’re on top and they’re in the middle of it, they’re the only ones who are sort of fluent in the language of it. I mean, who’s to question Tim Geithner, the secretary of the treasury, about this or that, because he’s the only with the information . . . even though he is clearly culpable in what happened.”

Lydon: “Not to mention Larry Summers and Bob Rubin and all the other architects of the deregulation. They’re still calling the shots in a new administration after a change of party management. It’s unreal.”

Lewis: “It is unreal, because basically all of the people you mentioned all swallowed a general view of Wall Street, which was that it was a useful and worthy master class, that these people basically knew what they were doing and should be left to do whatever they wanted to do. And they were totally wrong about that. Not only did they not know what they were doing, but the consequences of not knowing what they were doing were catastrophic for the rest of us. It was not just not useful; it was destructive. We live in a society where the people who have squandered the most wealth have been paying themselves the most, and failure has been rewarded in the most spectacular ways, and instead of saying we really should just wipe out the system and start fresh in some way, there is a sort of instinct to just tinker with what exists and not fiddle with the structure. And I don’t know if that’s going to work. When you look at what Alan Greenspan did, or what Larry Summers did, or what Bob Rubin did, there are individual mistakes they made, like for example not regulating the credit default swap market, preventing that from happening. But the broader problem is just the air they breathe. The broader problem is just the sense they all seem to have that what’s good for Goldman Sachs is good for America.”

***

Lewis: “The question is how does Washington move away from those institutions and make decisions that are in the public interest without regard for the welfare of these institutions. It’s a hard question because . . . this is the problem. Essentially the public and their representatives have been buffaloed into thinking that this subject — financial regulation, structure of Wall Street — is too complicated for amateurs. That the only people who are qualified to pronounce on this are people who are in it. And there are very very few people who aren’t in it in some way who have the nerve to stand up and fight it. . . .

“The elected representatives look at the financial system, I’m sure, and they think, it’s too complicated for me to understand, I’m going to be quickly exposed as a know-nothing if I take the lead on regulation, and in the bargain I’m going to miss out on all these campaign contributions from the financial industry because I’ll alienate them.”

***

Lewis, on Barack Obama: “He’s been captured by his banker, just like the ordinary American’s  captured by their stockbroker. He’s been buffaloed by the complexity of it all, he doesn’t have time to sort it out for himself, and he has to trust the people who seem to know. The alternative is for him to set off on his own in a quixotic quest to reform the financial system without having any experience of the system. It’s sort of like the presidential version of regulatory capture, that he is at the mercy of the people who really don’t have probably his long-term best interests at heart but who seem to know what they’re talking about.”

The Few: Sensible Republican Senators On Financial Reform

By Simon Johnson

There are three kinds of Republicans in the Senate today.  First, there are those willing to follow the lead of Senator Mitch McConnell – whose approach to financial sector reform apparently amounts to little more than, “Don’t worry, be happy”.  If Senator McConnell has a reform plan he would like to lay out for review, now would be a good time to put some credible details on the table. 

Based on what we have seen so far, Senator McConnell proposes to do nothing regarding the systemic risks posed by today’s megabanks and just “let ‘em fail” when necessary.  This is a dangerous and irresponsible position, and it should be opposed tooth-and-nail by anyone who actually cares whether or not we run ourselves into a Second Great Depression.

The second group has remained silent so far, waiting to see which way popular opinion and their leadership will go.  Most likely, almost all will cast their lot in with Senator McConnell. 

And if Senator McConnell brings 40 Senators with him, they will defeat the Dodd bill – and then smash themselves into the rocks of November 2010 as the “too big to fail” party.  Perhaps we should welcome that.

But there is also a third group, not yet numerous, that is more inclined to be sensible or – as Senator Corker aptly put it – to “act like adults.” Continue reading “The Few: Sensible Republican Senators On Financial Reform” →

The Next Global Problem: Portugal

By Peter Boone and Simon Johnson

The bailout of Greece, while still not fully consummated, has brought an eerie calm in European financial markets.  It is, for sure, a massive bailout by historical standards.  With the planned addition of IMF money, the Greeks will receive 18% of their GDP in one year at preferential interest rates.  This equals 4,000 euros per person, and will be spent in roughly 11 months. 

Despite this eye-popping sum, the bailout does nothing to resolve the many problems that persist.  Indeed, it probably makes the euro zone a much more dangerous place for the next few years. 

Next on the radar will be Portugal.  This nation has largely missed the spotlight, if only because Greece spiralled downwards.  But both are economically on the verge of bankruptcy, and they each look far more risky than Argentina did back in 2001 when it succumbed to default. Continue reading “The Next Global Problem: Portugal” →

The Other Battle

By James Kwak

One battle in Washington — the one that has been in the news this week — is over resolution authority and the supposed “bailout fund” attacked by Mitch McConnell. Another battle will be over the Consumer Financial Protection Agency, which Republicans are likely to try to cripple behind the scenes. While most of the reviewers of 13 Bankers have seized on the call to break up big banks, few have discussed the first part of that chapter, which argues for strong consumer protection. Simon and I wrote an op-ed in The Hill to reiterate the point and warn against some of the tactics opponents may use.