Wednesday, April 28, 2010

The Goldman Sachs hearings missed the point - PART 1

Although the hearing yesterday was pretty entertaining (the word shitty was said more than a dozen times), I'm afraid that the committee completely missed the opportunity of the moment; the opportunity that would propel us into a new mindset for how the financial world should work in a sustainable economy.

I guess it should be to nobody's surprise that these hearings were a lot of theatrics and not that much substance. The committee members were definitely successful at painting the Goldman executives as greedy, disingenuous, arrogant, and unethical. The truth is, they really didn't even need to try that hard...especially after several e-mails were released from Goldman Sachs employees including from bond trader Fabrice Tourre (aka Fabulous Fab), who is the only Goldman Sachs employee named in the present fraud charge by the SEC. Here he is explaining to one of his girlfriends how he perceives one of the complex financial products that he created:
...a product of pure intellectual masturbation, the type of thing which you invent telling yourself: ‘Well, what if we created a “thing,” which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?’
He goes on to explain that he has sold some of these products "to widows and orphans that I ran into at the airport". That's lovely. What a swell guy.

So I am happy that these people have been clearly exposed as the greedy bastards that they are but the whole reason that this hearing was called in the first place was because Goldman Sachs was just charged with fraud. Not because they are greedy bastards. We are a country that is chock full of greedy bastards. That doesn't mean that we should drag them all into the chambers of Congress for a good grilling. Far from it.

No...what needed to happen was some tough questioning about how Goldman Sachs crossed the line from greedy bastards to lawbreakers. This really didn't happen because the Senators kept muddying the water by misunderstanding the issue.

So before I go further...a few explanations are needed:

I think most people perfectly understand that the underlying cause of the recession has to do with people taking out mortgages on homes that they really could not afford. That doesn't mean that they were the only ones at fault (far from it). The culture of the 80s, 90s, and 00s really solidified the idea of homeownership as quintessentially American. The government encouraged it at every opportunity that it could by creating incentives and keeping interest rates at very low levels. And in a lot of cases, homeownership is a great thing. But it's the combination of 1) the cultural appeal of homeownership, 2) the view that the value of homes would perpetually increase as an investment, and 3) the creation of new highly complex financial "innovations" in the 90s that dramatically increased the amount of money that could be made on mortgages that got us into HUGE trouble (This is why the discussion of these complex financial products has become so has now become not just of interest to the Wall Street big-whig but to anyone who depends on a healthy economy)

So let's talk a bit about these new financial "innovations". In the book that I'm currently reading (13 Bankers by Simon Johnson and James Kwak...excellent so far) they break these up into three categories: structured finance, credit default swaps, and subprime lending. But before we get too deep into this, it's important to know that this whole twisted system is made up of two different sides: on one side you have ordinary people taking out mortgages and on the other side you have this long and enormously complex chain of different parties, companies, and investors. A few months after a mortgage contract was signed, it could have theoretically changed hands dozens of times and the affected parties could have been from all around the world (for more on this idea, listen to the This American Life podcast, The Giant Pool of's terrific)

Structured Finance and Credit Default Swaps: So when we think of investing, we usually think of buying something tangible, whether it is a stock, bond, gold, etc. But there are also other types of investments that are known as structured products that don't necessarily include these tangible assets in the product itself. For instance, you give $100 to a bank and sign a contract that says that the change in that $100 over a certain time period will be directly tied to the change in value of some foreign currency.'s a bet. Investors call them pure derivatives. You can opt to be on the short (you get money if the currency value goes down) or long (you get money if the currency value goes up) side of the bet. An investor could do the same thing with interest rates in place of foreign currencies.

Another structured product is created by pooling actual financial assets (mortgages, student loans, credit card loans, etc.) together and then slicing them up in various ways. These are known as asset-backed securities [the major players in the housing crisis were mortgage-backed securities (MBS)]. They are different than the above example in that they aren't just a pure bet because the investor actually owns part of the asset. But commonly, these asset-backed securities are combined with derivatives or a derivative could be created based on the value of an asset-backed security. Another popular product was the collateralized debt obligation (CDO) which were pools of mortgage-backed securities (MBS). So yeah...pools of pools.

Is your head spinning, yet? Wait...there's more: the mighty credit default swap (CDS). I'm just going to quote directly from 13 Bankers (don't sue me, Pantheon Books):
A credit default swap is a form of insurance on debt; the "buyer" of the swap pays a fixed premium to the "seller", who agrees to pay off the debt if the debtor fails to do so. Typically the debt is a bond or a similar fixed income security, and the debtor is the issuer of the bond. Historically, monoline insurance companies [i.e., insurance companies that just sold insurance] provided insurance for municipal bonds, and Fannie Mae and Freddie Mac insured the principal payments on their mortgage-backed securities. With credit default swaps, however, now anyone could sell insurance on any fixed income security.
The line between "bet" and "insurance" is now largely obscured. The invention of the credit default swap has enabled the "sophisticated" investor to bet for or against any type of debt.

So why the hell would someone want to buy one of these complex transactions? Why were they even created in the first place? Well, the first purpose is to increase the amount of things that the market can invest in. The theory goes that now there are more products with a wide variety of risk associated with them and each has a unique set of characteristics to attract a specific investor. Second, these products should make it easier for businesses to raise money in that they can now hedge their bets (cover their asses) more efficiently. The consensus of the finance world was that these products made it much easier to manage financial risk (as long as you had the correct mathematical model to tell you what to buy). Everyone was drinking the Kool-Aid including all of the major government regulators over the last several decades (e.g. Alan Greenspan). Finally, another huge reason that these products were created in such abundance was that each new transaction led to fees for the banks that set them up for their "sophisticated" investor clients. Enormous fees! (A former trader said that Morgan Stanley earned $75 million on a single trade)

Okay...enough for now. The second part will deal with subprime loans and my main beef with yesterday's hearings.

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