A Busy Week, but No Joy in Mudville
Last week was a busy week in the world of financial reform. Congress passed “the most sweeping financial reform legislation since the Great Depression" (at least measured by its 2,300 pages). Treasury appears to be blocking the selection of Elizabeth Warren to head the new consumer financial protection agency, despite its denials. And the SEC declared victory and settled its fraud case with Goldman Sachs for $550 million, the largest ever on a Wall Street firm. Some question whether 2.8% of it’s 2009 pretax profits and less than 1% of its market cap constitutes a large fine.
Regarding financial reform, Wall Street clearly won. The best we can say is at least there was a fight even if ill-informed. It’s business as usual, only with bigger and more dominant banks receiving greater direct and implicit subsidies from the taxpayers allowing them to return more emboldened than ever to the grotesque bonus culture at the expense of shareholders, customers, taxpayers, and the profound needs of the real economy that remains in intensive care. But this is a topic for another day.
Regarding the Treasury Department’s displeasure at the prospect of Elizabeth Warren to lead the new consumer financial protection agency, what is noteworthy is the reason. One could argue that she has little experience to draw upon to help her manage a large bureaucracy, but that’s not the argument. It does not appear to be personal. Shockingly, the argument appears to be that her strong convictions about real reform combined with her intellect and competence could put the safety and soundness of the financial system at risk. In other words, if we don’t allow the banks to continue exploiting consumers at least somewhat, their profitability could be damaged, putting the entire system at risk. This threat comes right at the time when we all know the banks are still undercapitalized so that reduced profits might cause them to contract credit. We’ve allowed them to become so big and powerful that we’re totally dependent upon them to provide credit to the real economy, the key purpose they have that serves the public good. So we subsidize them with implicit and explicit guarantees, reducing their cost of funds, we set interest rates at zero, ensuring them massive profits in the short term at the expense of real savers, and we grant them the ability to speculate with our money for their own bonuses, and to abuse us as consumers so they don’t withhold the credit we need in the real economy. Good system!
That Goldman prevailed with a slap on the wrist is no surprise, validating its earlier judgment not to disclose the pending lawsuit by the Government of the United States against Goldman Sachs for fraud on the grounds that it was not material to the firm’s financial condition. They got that one right - no one said those Goldman guys aren’t smart. The SEC’s claim to victory rests on a large fine – half a billion dollars used to be a lot of money – and Goldman’s admission that it made a “mistake” and that “it regrets” putting out “incomplete information.”
How about adding at least a zero to the fine, and this instead from Goldman:
Having watched the fraudulent underwriting process of "liars' loans" play out for years on a scale we never would have imagined possible (it required even us to swallow hard but it was a good run while it lasted), we now believed the end was near and the market would implode. We were caught long billions of this crap, confirming to us the end was in sight since the waste disposal system (our “distribution”) was clogging. The really frightening thing was that we were leveraged 30 to 1, which we know was really dumb, life threatening actually. If we even tried to dump our positions, we would have triggered the self-fulfilling prophecy that could be our demise. What to do? We needed to quietly get short an offsetting equal amount of subprime risk before all the idiots figured this out.
Then our brilliant 29-year-old “structured finance” experts, together with a couple of our savviest speculator clients, devised a truly evil weapon. We could create a “neutron bond” whose architecture ensures it would inflict maximum damage to the suckers who bought them (and profit to those of us who short them). These bonds were evil (seemed brilliant to us at the time) because of three characteristics that together created the potential for such a toxic combustion:
1. The underlying collateral that we knew was going to hit a wall, and in many cases was already showing evidence of terminal stress.
2. The bonds’ sinister plumbing of default triggers and cash flow waterfalls deeply imbedded in the thousands of pages of “disclosure” that we knew no one could possibly read but gave our lawyers the comfort they desired, while ensuring “shock and awe” performance of these bonds (they would quickly collapse in value with only a modest deterioration in fundamentals).
3. With a little persuasion and finesse, the reference bonds were still eligible to be packaged into securities rated AAA because we had the rating agencies conflicted and blinded by the same delusions that fueled their own earnings and bonuses.
The beauty of these bonds was that shorting a synthetic AAA security meant we could create these “bonds” out of thin air and place the bonds with investors least equipped to uncover our evil. We knew they were suckers for the little excess yield we were offering them. Shorting real bonds that behave like bonds to investors who know what they are doing is so 1990s! The street smart, cynical and very smart bond investors lurked in the junk bond departments, and hedge funds, not on the desks where big institutions purchased AAA bonds or wrote “insurance” by gaming the regulatory agencies.
Equally important, because these were AAA bonds, they were very efficient for us (and our savvy clients) to short. Therefore we could ride out whatever period it took for the bombs to go off with very little use of our own capital. We call this structural leverage, the only antidote to our out-of-control financial leverage.
We must acknowledge that this brilliance, looked at with the benefit of hindsight, was evil manifested in finance. We truly regret the horrific damage caused to the real economy (and many individuals and institutions) by the huge blast zone these “neutron bonds” left in their wake. We acknowledge that the crash was exacerbated by this financial evil-doing, and society is left as a result with structural unemployment, underemployment, unmanageable fiscal deficits, and sovereign debt crises at home and abroad inflicting extreme hardship throughout the world.