I was asked a marvelous question in a comment to the last post: who is Sue Goldman?
Sue Goldman is a seductress that always comes along during periods of financial flimflam innovation and with the most meager of bribes campaign contributions can bend Congress to her will and permit her to do her tricks on the unsuspecting public.
I will spare you the Santayana quote, but clearly we have not learned from financial history.
Financial flimflam touted as innovation always seems to come with a credit bubble, often powered by government sanction:
- 1929: “Sue Goldman” got caught with The Goldman Sachs Trading Company, a leveraged investment trust, that collapsed in 1929. Goldman was the largest promotor of investment trusts backed by enormous leverage, the flimflam of 1928 foisted on a blissful public.
- 1907: The Knickerbocker Trust, started by a close friend of J.P. Morgan, the Goldman of his day, tried to corner the copper market, and set off the Panic of 1907. (It is fascinating to study how the oligarchical control of banking and these trusts led to instability, an indictment of putting all the financial eggs into a few huge interlocking banks that are, of course, now “too big to fail”).
- 1873: J. Cooke, the Goldman of its day, had prospered selling War Bonds during the Civil War. J. Cooke helped drive one of the first big RR Bubbles in the US using the flimflam of that day – buying RRs with excessive leverage – and sparked the Panic of 1873.
What we saw with the recent S&L crisis is the government privatized the upside but socialized the downside: it released S&Ls to pursue broader markets with higher interest rates, but maintained government deposit insurance. Then the problems emerged, not before. Deposits flew in at higher rates, and the S&Ls participated in the financial flimflam of the late ’80s: LBOs. This time around the government backed the mortgages packed into these these synthetic instruments (CDOs, SIVs, etc.), which were sold with CDS’s as insurance.
Sensible, But The Wrong Fix
Geithner’s course, to fix the system first and prosecute later, is a sensible choice, but he chose the wrong fix. Now we have the worst of both worlds:
- the moral hazard of banks “too big to fail” remains high, so bankers will continue to do bad things
- the system is in zombieland, engaging in speculation not lending (did you notice how Bank of America’s just-announced large earnings were driven by trading, not banking?)
What is missing from reasonable discourse is this: banks are not too big to fail, but too integral to fail.
Yet this does not mean they should get bailed out.
Instead they should have been cleansed, and quickly – wash-out the equity and unsecured debt, reduce secured debt positions based on the value of remaining collateral, and restructure to attract fresh capital. Sweden did this by separating each bank into a good and bad bank, and letting the bad banks work off the bad stuff. The US did it in the S&L crisis by using a resolution process: a rapid, pre-packaged bankruptcy with a resolution trust working off the bad debt and the cleansed banks being restored to solvency.
After that, which could have ‘saved’ Lehman, then we prosecute.
The Biggest Bank Robber of Them All?
The most curious character in the Sue Goldman story is John Paulson, the guy who caused Goldman to set up the vehicles he could short while Goldman sold them to the unsuspecting public. He reminds me of the characters in the Panic of 1907 who used Knickerbocker to help them pull a short squeeze on the big owner of the copper interests. Paulson may have done nothing wrong, just something too clever.
I have seen a lot of anger directed at Paulson:
- Is it conceivable that Paulson did not know Goldman was lying to the clients?
- Is it conceivable he was not in cahoots with Goldman? He is said to have directed Goldman to figure out what toxic debt to put in these things, but do we expect he picked the stuff out himself?
We could have dealt with Paulson by a stroke of the pen: declare certain types of CDS’s as fraudulent instruments and unwind them. Paulson would be required to pay back his ill gotten gains. Goldman pays back their fees. The owners of the risk get paid the higher interest the instrument would have required absent the CDS. AIG would have become solvent overnight. The system would be back in balance.
Are CDS’s Fraudulent Instruments?
Karl Denninger is on a crusade to consider CDS’s fraudulent instruments. At a minimum, he thinks they should trade on an open exchange, as should all of these sorts of derivatives. Absent that, he argues they are subject to manipulation, especially when the CDS protects an instrument that itself does not trade or is hard to value. Here is his logic (simplified) for why CDS’s can be at their core fraudulent:
- a CDS acts as an insurance policy to protect the principal on default
- an instrument that pays 8% without a CDS might have paid 6% with a CDS
- the 2% spread is pocketed by the banker after paying for the CDS
- the nominal value in the aggregate of CDS’s is so huge there is inadequate capital among AIG and other issuers to cover any run on CDS’s, or if you like any systemic risk
- the meager 20 bp or whatever that is paid to AIG does not make up the 200 bp of risk
How can 200 bp of risk go away for a mere 20 bp? Or 30 or 40? CDS’s becomes another form of leverage, and makes these instruments more risky than the 6% rating says they are – indeed, still close to 8%! Hence the fraud.
Is this argument compelling? If the underlying instrument the CDS backs is itself traded, this argument is not convincing, because the buyers can price the underlying risk. If the CDS also is traded, the premium paid for the insurance will also be less subject to manipulation. So, for example, if you had bought WaMu corporate bonds, which traded, the CDS on them was not fraudulent, and probably highly useful to determine the real underlying value of the bonds. Greek bonds trade on broad sovereign debt markets, and the CDS’s on them seem quite good at reflecting the underlying risk.
On the other hand, the class of CDS Denninger is crusading against were not traded, nor were the underlying instruments. They were complex combinations of mortgages, stripped and repackaged, and very difficult to evaluate. In retrospect, the ratings agencies were way too generous. They did not trade on public exchanges, and as markets froze up, didn’t trade at all. While they were not sold to the general public, but to sophisticated investors who should have had the tools to evaluate risk, the lack of transparency made them easy to manipulate at issuance – hence the fraud risk.
Further, in a credit bubble, these tools are often put aside as people chase yield. I like to say that there is not fear & greed, but only fear; in a bubble “greed” is fear of falling behind. Forcing the derivatives onto an open exchange would have helped investors protect themselves.
Where Denninger scores a direct hit is on a second reason why there is fraud: the instruments in the Sue Goldman case were created specifically because Paulson wanted to short them. As Karl asks, if the essential purpose of the instrument (to fail!) were disclosed, would anyone have bought them?
Is Regulation the Solution?
I am not taking a position on Goldman or Paulson’s liability here, but exploring what should be done about the recent bubble and fixing the system. The NYT runs an interesting set of opinions on whether regulation would have caught out Goldman ahead of time. The conclusion seems to be that it will be hard come up with sound regulations.
The derivatives mess, however, can be fixed. In 2000 at the end of the Clinton Presidency, a Republican slipped into an appropriations bill an act to completely deregulate derivatives. No oversight at all. No public exchange to trade them on. Since we have a commodities regulator already, and a stock exchange regulator, this seems like an extreme gift to Wall Street, not sound policy. At a minimum we should force derivatives onto public exchanges.
Beyond that, one of the big risks we are running is over-reaction, too much re-regulation. I do not want to go back to the bank strictures of the 1970s – I welcome innovation and derivatives in general. Put them on open exchanges for honesty. But the larger issue is psychological, and may not be possible to regulate away with stifling the whole system: during bubbles, financial flimflam emerges and wreaks havoc under the guise of innovation, and investors feel compelled to participate to keep up.
“This time is different!” they say. They always say that.
We need to bring back moral risk – make nothing too big too fail – to restore balance. It may be time to end deposit insurance, government backing of lending for housing, and the implicit Greenspan Put. Or, create a safe banking sector, highly regulated, with deposit guarantees, and keep it completely separate from the robust and innovative unprotected banking sector. Suing a mid-level Goldman banker makes great PR, but is not the solution.