Treacherous Waters

No, this isn’t another post about Somali pirates.  It is another post about criminal investigations of financial institutions, relating to their involvement in synthetic CDO on MBS transactions.  This time it is Morgan Stanley (MS) in the cross hairs.

The WSJ article is maddeningly short on details.  For instance, it states that there was an option feature in the deals (“a structure that could increase the magnitude of the bullish investors’ exposures to the underlying mortgage bonds”) but it doesn’t say who had the option–the buyer or the seller.  Not that it matters if the feature was in the contract and the parties both knew about it.

These are treacherous waters for several reasons.  First, the WSJ article suggests that the crime is being short and making money on a deal.  Look, with a synthetic CDO there’s always a short.  Even the accusations against Goldman Sachs (GS) look sketchy; the allegations here look even sketchier because there’s no indication of a Paulson lurking in the background.  And even if MS was short this deal, the article suggests that it was actually net long mortgages.  Is it somehow a crime to reduce length by shorting?  How would that be different than selling some of the mortgage positions it already held?  And even if the short was a speculation not a bet–should that even matter?  But given the superheated atmosphere in Washington, the routine demonization of shorts in general, and the special demonization of those who shorted CDO on MBS (even if on net you were long), you can’t rule out the possibility that shorting itself is the crime.

Does this mean that markets should only have buyers?  Just asking.

Second, as I wrote in my piece on the Goldman criminal investigation, a criminal case against a big financial firm could cause it to unravel, with knock on effects hitting other institutions it trades with, and other entities that buy its paper.  In brief, a criminal case could cause a systemic event.

This is all the more true inasmuch as it appears that the inquiries regarding CDOs are widespread, and touching virtually ever major financial institution.  This could become the mother of all systemic crises.  Given the serious potential fallout, it better damn well be that shorting itself is not the crime.

Michael Lewis makes this trenchant observation, in a mock memo to Lloyd Blankstein:

This time, please, do not wait five months to internalize my new action items. They are:

No. 1: Implicate the rest of Wall Street, as quickly as possible.

It’s always unnatural to hear the name of Goldman Sachs in the same sentence as Deutsche Bank, much less Merrill Lynch. We must put aside our revulsion. The American people might enjoy seeing one firm being driven out of business by a criminal investigation. They’re less likely to allow for the destruction of every big Wall Street firm. They just forked over trillions to keep them afloat.

If being short is the crime, certainly all Wall Street can be implicated.  Or maybe the name given to the deals (“The Dead President” deals, since they were named Buchanan and Jackson*) is the sin.  Sounds bad, must be bad.  (This actually seems like something out of Camus, like in The Outsider.)

Look, this is deadly serious business.  There better be something really substantial in any indictment: and no, being short deals with bad names doesn’t count as substantial.

And even if there was wrongdoing, as I wrote in the Goldman post, indicting firms is an inefficient way to go.  Let those allegedly victimized make their case in court and collect damages.  The fallout from criminal indictments would be disproportionate and indiscriminate.

* It would be ironic if a deal named after Andrew Jackson would bring down a big bank.  And who in their right mind would name anything after James Buchanan, arguably the worst president in US history/

About Craig Pirrong 228 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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