The Goldman Sachs hearings missed the point - PART 5

Okay...sorry for another extended delay. It's been difficult knowing when to jump into the mix here when the financial reform package was still being hashed out. It has now passed the Senate and will be molded together with the House bill in the next few weeks. But before I talk about that at all...let's discuss this issue of 'Too Big To Fail'.

As I mentioned in the last post, I see two major categories for reform: 1) Increasing the transparency of financial transactions from the credit-card consumer-level to the hedge fund-level, and 2) breaking up the "Too-Big-To-Fail" banks. In my mind, both are absolutely critical and one is nearly useless without the other.

I know the phrase 'Too Big To Fail' has been thrown around A LOT lately (almost to the point of becoming cliché) but what exactly does it mean? Again, let's go to my current favorite book (13 Bankers):

Certain financial institutions are so big, or so interconnected, or otherwise so important to the financial system that they cannot be allowed to go into an uncontrolled bankruptcy; defaulting on their obligations will create significant market losses for other financial institutions, at a minimum sowing chaos in the markets and potentially triggering a domino effect that causes the entire system to come crashing down.

No one in their right mind would ever argue for the existence of financial institutions that are Too Big To Fail. Fixing this problem was the rallying cry from nearly everyone in the financial world (both financiers and regulators) at the time of the near-collapse in late 2008. The reason that everyone appeared on the same side was because the problem caused by Too Big To Fail institutions was such a blatant affront to the very foundation of the free market that no one in their right mind would argue for their existence. And the consequences of bailing out Too Big To Fail banks was clear as day to everyone in late 2008: the mega-banks get the benefits of all of the risks that they took over the preceding years and the taxpayer bears the enormous cost of these risks once they exploded. It is privatized gains and socialized losses. Essentially...if you think Obama's health reform plan was socialistic, then this is even at another level beyond that (at least in a socialistic system, the taxpayer gets the gains as well as the losses).

And once an institution realizes that they are Too Big To Fail, they now have the perverse incentive to take more risks because they are implicitly backed by the federal government. This gives them an enormous competitive advantage over smaller banks who do not have this implicit government backstop. It is completely unfair and antithetical to everything that capitalism stands for.

One of the big rallying cries of the right during the financial reform debate has been to get rid of Fannie Mae and Freddie Mac (the government-supported entities that create liquidity in the housing market). And I completely agree with that argument for the reasons I discussed above. Fannie and Freddie are Too Big To Fail. But in order to stay intellectually consistent, those same people who argue for the dissolution of Fannie and Freddie should also be for breaking up the mega-banks for the exact same reason. Essentially, Fannie and Freddie are explicitly backed by the federal government and the mega-banks are implicitly backed by the federal government. There is zero difference when it comes to their power to corrupt our economic system.

This is why this is so frustrating. This should not be a left vs right issue. This is clearly not an example of the free market working as planned. But those against reform are buying the completely bogus piece of propaganda from those interested in keeping the status quo: "This is a government takeover of the financial sector!" Good sweet Lord...it's just amazing to see and hear the financial sector make this argument. The mega-banks have been holding the American government and taxpayers hostage for years and they are the ones crying about being taken over? Give me a friggin' break.

Another way to address the Too Big To Fail issue is through a re-implementation of the Glass-Steagal Act which was enacted during the Great Depression in 1933 to formally separate the plain-vanilla commercial banks (like the one where you have your checking or savings account) from the speculative and inherently riskier investment banks. The idea is to have the safer commercial banks backed up by the federal government [through the Federal Deposit Insurance Corporation (FDIC)] to protect against a bank run and conversely have the riskier investment banks not backed up by the government. However, this perfectly reasonable separation provision was quietly repealed back in 1999 as the market for complex financial products was just starting to go into full swing.

Along the same lines, another proposal is to eliminate proprietary trading, which is when banks use their own money for trading financial products to gain profit as opposed to using their customers money. This is better known as the Volcker Rule. More details can be found here.

So why do we need hard and clear rules on the size and type of banks instead of just relying on regulations?

Banks will inevitably find loopholes and ways to have their activities exempted because of their enormous and unrelenting power over the political world. If you don't believe me, just look up the source of campaign contributions for nearly every politician with any significant say in financial legislation. That's one of the benefits to running a Too Big To Fail firm; you have lots and lots of money just lying around to pay lobbyists to push legislators to do just about anything in order to fund increasingly expensive re-election campaigns. This political power is also quite potent with the regulators (known as regulatory capture). All in all, it has really turned our political-economic system into something more resembling an oligarchy.

So the only way to play ball with the mega-banks is to implement clear and decisive rules that would essentially break them up into smaller less politically powerful institutions.

But what about the argument that we need big banks to compete in an international market full of other enormous banks? Well, it turns out that, yes, we are not the only country with enormous financial institutions. Some countries have banks that are better dubbed Too Big To Bailout (this is part of the reason that Europe is in their current economic crisis). But even with that admission, there is still no credible evidence to suggest that we (as a country and as players in the market) need Too Big To Fail financial institutions. The megabanks are currently at such a bloated size that the usual economies of scale no longer apply. They really only got uber-huge (relative to GDP) in the last 15 years and back then they could still compete quite well. Also take this argument from Simon Johnson:

Even the biggest nonfinancial companies do not, under any circumstances, want to buy all their financial services from one megabank.  They like to spread the business around, to use different banks that are good at different things in different places – in part to prevent any one bank from having a hold over them.  Playing your suppliers off against each other to some degree is always a good idea.

There is just no evidence for having these megabanks around. They are enormous liabilities!

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Okay, so what about the financial reform package? Well, I think I'll save more of a discussion on it after it passes both houses but things do not look all that great. It is still largely a technocratic fix...i.e., they really are only addressing the regulation side of things and nothing really structural (e.g., the size of banks...Too Big To Fail). I'm afraid that we really missed a huge political opportunity in early 2009. Some of the new rules will surely help but we are still poised for another situation where a future President decides between two awful choices: A) another massive bail-out of Too Big To Fail banks or B) collapse of the financial system leading to another Great Depression.
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UPDATE: Just so everyone is clear on what exactly a megabank is, Johnson and Kwak would like to start with a limit of 4% of GDP for all banks and 2% of GDP for investment banks. That would make the following banks "mega-banks" and definitely Too Big To Fail:

• Bank of America (16% of GDP)
• JPMorgan Chase (14%)
• Citigroup (13%)
• Wells Fargo (9%)
• Goldman Sachs (6%)
• Morgan Stanley (5%)

The Goldman Sachs hearings missed the point - PART 4

Sorry for the delay. I have waited to finish these last few posts on the financial crisis (for a while at least) until I finished the book 13 Bankers. And by the way, I just cannot possibly recommend it more to those interested and willing to take the plunge head-first down the rabbit-hole that is our broken financial system. It is a fascinating and well-written book by some really brilliant guys.

Okay...so here's a short, convenient summation of what I went through in the last 3 parts (quoted from 13 Bankers):

The end result was a gigantic housing bubble propped up by a mountain of debt - debt that could not be repaid if housing prices started to fall, since many borrowers could not make their payments out of their ordinary income. Before the crisis hit, however, the mortgage lenders and Wall Street banks fed off a giant moneymaking machine in which mortgages were originated by mortgage brokers and passed along an assembly line through lenders, investment banks, and CDOs to investors, with each intermediate entity taking out fees along the way and no one thinking he bore any of the risk. 

So, as we all know, the bubble did end up bursting and today we are continuously faced with the consequences in the form of high unemployment, cuts in government services, etc. But you might ask yourself...didn't we learn our lesson? Well, I wish that I could say 'yes' but I'm afraid we, as a country, are not even close to learning the larger lessons of this crisis.

The way the current financial system is structured, a future president (regardless of ideology or party) will inevitably look over the edge into a dark abyss of economic chaos and face the same decision that the Bush administration faced in the fall of 2008 after an asset bubble burst (this last time it was housing, the time before it was dot-com's, the next time...who knows?):

• let the mega-banks fail and cause a banking crisis that would lead to another Great Depression (many, many times worse than the current economic recession) OR 
• pledge an enormous amount of taxpayer money to bail out the mega-banks.

Both of these ideas are horribly unsustainable. Another Great Depression would dramatically change the world's economic status. It would be absolutely devastating. Another Huge Bailout for banks would funnel more money away from taxpayers to the financial elite plus it would dramatically increase the government's debt burden (with the worst consequences experienced by future generations). So that's why we cannot let this moment just pass and say 'Boy...that was close...we sure did learn our lesson...that shouldn't ever happen again.'

We have not truly come to grips with this crisis as a country. Those that are unemployed or otherwise severely affected by this recession are undoubtedly hurting and very interested in solutions but, as a whole, we are poised to repeat this mistake again. (See this new data on the decrease in the savings rate for a taste of this idea). More people need to be told about how close we came to plunging into a Great Depression...how the commercial paper market (the short-term loans that companies depend on to cover payroll) momentarily froze in September 2008 (the This American Life episode on this is great...the very first story beautifully explains the commercial paper market). This is all poised to happen again.

Alright...splendid. What to do? Now...on to the actual financial reform ideas.
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I think it's easiest to just break it up into two basic strategies: 1) Increasing the transparency of financial transactions from the credit-card consumer-level to the hedge fund-level, and 2) breaking up the "Too-Big-To-Fail" banks.

#1: Increasing transparency of financial transactions


A fundamental assumption of a fully-functional capitalist market system is that everyone has the correct information available to them and then they use that information appropriately and efficiently to make a "correct" economic decision. But the critical lesson of the crisis is that this assumption is totally bunk. People are irrational and information is conveniently and strategically hidden from those who are being duped.

This has been happening at all levels of the financial system but most people are much more familiar with the credit-card side of things. I think most of us would agree that credit card companies have become exceptionally good at deceiving people into high interest loans and charging for hidden fees. This has got to stop. But it's not at the heart of the crisis.

The other side of the system is where the huge problem is...in that maze of crazy acronyms that is the complex financial products for the "sophisticated" investors; a market that became a house of cards, which then imploded to trigger the meltdown. While greed was definitely a primary driver on both sides of each transaction, lack of information was surely another. As was argued recently, it is clear that some people knew much more about the complexities (and associated risks) of these financial instruments than others. Firms like Goldman Sachs manufactured these products, had contact with the individual lenders that fed into the products, and were able to "negotiate" (i.e., pay for) good ratings from the agencies responsible for assessing these products. Therefore, they are at a distinct advantage when compared with the average (even sophisticated) investor.

Some people will just say "buyer beware" and trying to fix a problem like this with government regulation would be equivalent to a nanny state but I think this is a case where overly deceptive (and sometimes illegal as we are seeing with Goldman and JPMorgan) practices are hurting the overall machinery of the economy more than helping.

That gets me to my main point here, as wonderfully summarized (again) by 13 Bankers:

The core function of finance is financial intermediation - moving money from a place where it is not currently needed to a place where it is needed. The key questions for any financial innovation are whether it increases financial intermediation and whether that is a good thing. 

I think it can be argued that these deceptive practices and overly complex products do not do anything to move money from a place where it is not currently needed to a place where it is needed (think greasing the gears of the economy). We are no better off as an economy because of these practices/products. It is squarely the opposite...our economy is much, much more susceptible to disaster as a consequence of them.

So I would recommend increasing regulations on the complex financial products (derivatives) market to increase transparency. The assumption of abundant information is so incredibly important in this market because of the enormous risks that get compounded and correlated together with each new bet on the same set of assets.

Currently, the proposal that claims to deal with exactly these types of regulations would be in the form of the recently proposed Consumer Financial Protection Agency. While I realize that another huge bureaucratic regulatory agency is rarely a good solution to anything, what else would you propose we do in the light of what I just discussed?

Okay, I have rambled on for too long again...I will save the Too-Big-To-Fail issue for next time.

The Goldman Sachs hearings missed the point - PART 3

Okay...now that we have that little bit of background behind us, what about those hearings last week?

So Goldman Sachs was charged with committing fraud in the course of selling a synthetic, synthetic CDO to a group of investors that consisted of the German bank, IKB and which also led to a lot of money lost by the Royal Bank of Scotland (through, yet another big insurance deal/bet). The complex product was called ABACUS and it was put together by the "Fabulous Fab" at Goldman Sachs along with the close advice of a big-time hedge fund manager, John Paulson, who also, it turns out, was "shorting" (betting against) the synthetic, synthetic CDO. The SEC alleges that the company that originally packaged up the synthetic, synthetic CDO (their name is ACA) thought that John Paulson was on the long side of the bet...not the short side. Hence, Goldman Sachs was at fault for knowingly avoiding to clear up this misunderstanding with ACA and committing fraud in the process. Clear as mud, eh? (Try this timeline for a full rundown of this case)

But as I said in the opening post...the Senate committee really missed the point here. They didn't argue about the specifics of the fraud charge. Instead, they focused on the fact that Goldman Sachs was also on the short side of many of these mortgage-backed securities and other financial products that were implicitly backed by the mortgages of ordinary Americans. The senators emphasized that Goldman Sachs was essentially "betting against the American dream" and that's why they are such cruel people. In addition, they lambasted them for betting against the very products that they were selling to their investor clients. But as this great post from the Economist's Democracy in America blog points out, that's a pretty ridiculous thing to scold them over:

It's important to distinguish between the SEC allegations and the allegations being aired in Congress, which I believe some senators are intentionally trying to confuse. The SEC is alleging that Goldman broke the law in a very specific way. Binyamin Appelbaum of the New York Times explains, "Rather than asserting that Goldman misrepresented a product it was selling, the most commonly used grounds for securities fraud, the Securities and Exchange Commission said in a civil suit filed Friday that the investment bank misled customers about how that product was created. It is the rough equivalent of asserting that an antiques dealer lied about the provenance, but not the quality, of an old table." That type of misrepresentation or misleading is illegal, no doubt about it. On the other hand, the accusations emanating from Congress—that Goldman took the opposite side of its clients' bets on the housing market—are certainly not. As we say in our leader on the subject, "the idea of willing counterparties, with full and accurate disclosure, each seeking to profit from the other's inferior grasp, is central to financial markets."

This may not seem like an important clarification—in the eyes of many, the story of Goldman during the crisis is already written and the firm acted unethically whether it broke the law or not. That was certainly the mood on Capitol Hill yesterday. But at least consider the following. In his opening statement Mr Levin asked whether Goldman's actions in 2007 were "appropriate", not whether they were lawful. If we agree with him that Goldman's actions were indeed inappropriate, but also lawful, what does that say about the politicians who were tasked with making the laws?

So yes, the Senate committee did reveal the Goldman Sachs executives as exceedingly greedy people but what they did was largely within the confines of a very loose regulatory structure within the financial system...a structure that was created and supported by the very same body of government that was apparently scolding them for making incredible amounts of money only because of how that system was structured.

It's true that some of what Goldman Sachs allegedly did in the ABACUS deal (the center of the fraud charge) was truly illegal (willfully misleading their client into thinking that another big-time investor was actually betting on the same side as them when in fact that big-time investor, John Paulson, was on the opposite side of the bet and hand-picking the risky pools of mortgage-backed securities). For that they should definitely be brought in front of a court.

The whole point that I am trying to get at is that it is much easier for a government official to remedy a situation where a party committed an illegal act...you put them on trial and hope to find them guilty. But it's far more difficult for a government official to remedy a situation where a party committed an "inappropriate" act. The only way to remedy that situation in the financial industry is to change the regulations so that you make an "inappropriate" act against the rules (i.e., you get a big fine if you break them).

So that's where we are now...back to the question of government regulation...the dicey area where we are headed in Part 4. We will actually look at some of the elements of financial reform that include more regulations. What do you think should be the role of government in this situation?

The Goldman Sachs hearings missed the point - PART 2

So before I get on to subprime lending, I forgot to mention one additional structured financial product which is yet another complex combination of what I already talked about: the synthetic CDO. Recall that a CDO is a pool of pools of mortgage-backed securities. So an investor could buy slices (aka tranches) of a large pool of thousands of mortgages depending on what type of risk they wanted to take (keeping in mind that the higher the risk, the higher the return for the investor). A "synthetic" CDO is really just a combination of a CDO and a credit default swap. It's a bet that the slice of the CDO will (short) or will not (long) default.

And then yesterday, I found out that there is such a thing as a synthetic, synthetic CDO. (Yeah...you read that correctly). Again, these new products weren't built out of anything tangible...they were just bets. But it allowed more people to make more money off of a single mortgage transaction than ever before (no one had to go to the trouble of lending new money) and it gave investment banks the opportunity to collect more and more outrageously large fees.

Subprime lending: So now that this structured financial product wormhole-of-a-market had been created and CDOs, synthetic CDOs, and CDSs were flying off the shelves into the arms of salivating investors...they needed the gravy train to keep coming. But there are only so many houses in this country and so many responsible people that can afford to buy houses. Well, that pesky little fact didn't matter after the invention of the subprime loan. Traditionally, mortgages were long-term, fixed-rate loans that were labelled "prime" because the borrower met specific criteria like possessing good credit, a satisfactory income, and collateral (i.e., the property was in good enough shape so that the lender wouldn't get stuck with a lemon if the borrower defaulted). So that means "subprime" mortgages didn't have to meet these strict (and totally reasonable) standards. But since these new subprime loans were much riskier, the interest rates were set higher, which led to higher-yielding CDOs (exactly what the investors way down at the other end of the pipe were craving like crack cocaine).

I think everyone has heard stories about these loans..."no doc" and "stated income" loans were better known as "liar loans". The lenders didn't require anything to indicate that someone would be a reasonable and prudent borrower. And the "predatory" lenders would lure the unsuspecting borrower into the loan with arrangements of lower monthly payments in the first year (which then jumped up to prohibitively high levels thereafter) or the "pay option" where borrowers would pay less than the monthly interest (but the principal would go up). It was a total and complete sham! But it didn't matter to the lenders because they were making a killing off of the fees and then just sending it down the pipe to the gluttonous and completely uninformed investors. Those that did think about the quality of the loans would just convince themselves that the subprime loans were still good business because home prices would just continue to rise indefinitely. Here's another passage from 13 Bankers:

But that [risk of default] no longer mattered - at least not to the lenders or the investment banks - because the lending business model detached itself from the requirement that borrowers pay back their loans. Lenders made fees for originating loans; the higher the interest rate, the higher the fees. Then, when interest rates reset and borrowers became unable to make their monthly payments, lenders could earn more fees by refinancing them into new, even-higher-rate mortgages. As long as housing prices continued to rise, a single borrower could be good for multiple loans, each time increasing his debt.

This situation had disaster written all over it. It was a teetering house of cards. Again, 13 Bankers puts it better than I could:

The end result was a gigantic housing bubble propped up by a mountain of debt - debt that could not be repaid if housing prices started to fall, since many borrowers could not make their payments out of their ordinary income. Before the crisis hit, however, the mortgage lenders and Wall Street banks fed off a giant moneymaking machine in which mortgages were originated by mortgage brokers and passed along an assembly line through lenders, investment banks, and CDOs to investors, with each intermediate entity taking out fees along the way and no one thinking he bore any of the risk.

Finally, the bubble burst. Housing prices started falling. Huge mega-firms like Bear Stearns and Lehman Brothers (plus the government-backed Fannie Mae and Freddie Mac) collapsed into bankruptcy. Panic spread like wildfire into every nook and cranny of the banking system...even into places where no one would have ever suspected anything bad to happen. The government stepped in with a colossal bailout package for the firms still standing in order to keep the world's largest economy away from the edge of a deepening abyss. And now today...we are still trying to stay afloat after all of this with an unemployment rate still hovering above 10% and very few signs of a sustainable recovery anytime soon.
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Okay...so that's the ugly background. In Part 3, I'll get back to the recent Goldman Sachs hearings, which came about because of some fraud charges filed by the Securities and Exchange Commission (SEC) related to some synthetic CDOs that Goldman Sachs arranged.

[By the way, if you want another refresher on the crazy financial terms, try this glossary.]

My Sources on Making Sense of The Financial Crisis

Before I continue the financial crisis/reform discussion, I wanted to divulge the majority of my sources. While, I like to think that my opinions are unique and defensible in their own right, I cannot help but admit that I have been influenced by the following:

• Baseline Scenario: This is a blog headed by MIT economist, Simon Johnson, who is the former chief economist of the International Monetary Fund. It is their goal to make the financial crisis understandable to all who make the effort to understand it. The guys are brilliant and their arguments are very well-crafted and well-reasoned.
• 13 Bankers: I have been reading this book for the last few weeks. It is by the same two people who run Baseline Scenario.
• Planet Money: This is the NPR podcast that was created following the financial crisis in order to better explain the complexities to the public (a challenging and honorable endeavor). They do an excellent job of explaining the crisis (and many other economic issues) in an interesting and, often, very entertaining way.
• This American Life: This great NPR show teamed up with the Planet Money team to do 5 shows specifically on the banking crisis that are outstanding: The Giant Pool of Money, Another Frightening Show About The Economy, Bad Bank, The Watchmen, Return To The Giant Pool of Money, and Inside Job. If you have the time, I highly recommend downloading and listening to all of these for your next long car ride.
• Felix Salmon at Reuters: a great financial journalist who can grind through a lot of the technical details.
• A couple of PBS specials also helped: Simon Johnson and Michael Perino on the historical lesson of the Pecora hearings, Simon Johnson and James Kwak on the current crisis and reform, PBS Frontline episode on "The Warning" and the blunders of financial deregulation

An Externality

ex·ter·nal·i·ty    (ěk'stər-nāl'ĭ-tē)
n.   pl. ex·ter·nal·i·ties


1 : the quality or state of being external or externalized
2 : something that is external
3 : a secondary or unintended consequence


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I'm really not trying to be melodramatic here or lay out a big guilt trip but I think these types of accidents are critical for making ourselves realize the consequences of being an oil-addicted civilization. We won't see an extra 5 cents tacked on to our next total at the pump to pay for this disaster clean-up, but we are all truly paying for this accident in complex and long-lasting ways. We cannot afford to shy away and plug our ears.

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 important...it 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 Money...it'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. Essentially...it'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.