Saturday, April 24, 2010

Falling Ideology?

In addition to running good steady commentary on the banking reform legislation (e.g here), Simon Johnson remarks on the Baseline Scenario that "the ideology of unfettered finance is crumbling."  Clearly top Obama economics advisor Larry Summers hasn't heard. It's worth watching the clip to see the weird blasé attitude towards "things that happen on Wall Street" - the tone is more important than the words.  I'm not feeling the shift yet but he's there and I'm not so here's hoping.

Monday, April 19, 2010

Finance as Fraud Itself

This morning the Vulcan cloud of cinders is as good a commentary as we're going to get on the fragility of an economy that depends on unsustainble long range transport. 

Krugman is a bit late but still lucid defining the crisis as issuing from deliberate fraud. He mentions a good ProPublica piece on the same kind of toxic stuffing at a hedge fund with one of the stupid fake names bankers love - Magnetar, which immediately dissolves into several variants composed of amputated partwords stitched together by Dr. Frankenstein - Mangy-tar, eat-tar (from the French manger- to eat), eat nectar, magnet-star . . .)

A commentary on Goldman Sachs by Will Hutton gets at two other core issues in the rise of finance over the past 30 years in the Anglo-American version of capitalism (beyond the use of complexity to defraud one group of clients for the benefit of another).  The first is the abuse of independent professionals as fronts of legitimacy: clients couldn't see under the hood of the instruments they were buying, so they took the word of analysts on the basis of their professional stature and institutional affiliation.  "A court-appointed examiner found that collapsed investment bank Lehman knowingly manipulated its balance sheet to make it look stronger than it was – accounts originally audited by the British firm Ernst and Young and given the legal green light by the British firm Linklaters."

And in the Goldman Sachs case,
Goldman allegedly went one step further, according to the SEC actively creating a financial instrument that transferred wealth to one favoured client from others less favoured. If the Securities and Exchange Commission's case is proved – and it is aggressively rebutted by Goldman – the charge is that Goldman's vice-president Fabrice Tourre created a dud financial instrument packed with valueless sub- prime mortgages at the instruction of hedge fund client Paulson, sold it to investors knowing it was valueless, and then allowed Paulson to profit from the dud financial instrument. Goldman says the buyers were "among the most sophisticated mortgage investors" in the world. But this is a used car salesman flogging a broken car he's got from some wide-boy pal to some driver who can't get access to the log-book. Except it was lionised as financial innovation.

The investors who bought the collateralised debt obligation (CDO) were not complete innocents. They had asked for the bond to be validated by an independent expert into residential mortgage-backed securities – a company called ACA management. ACA gave the bond the thumbs-up on the understanding from Fabrice Tourre that the hedge fund Paulson were investing in it.
 Whether or not Goldman Sachs' Tourre lied to his investors and said that Paulson was investing in the CDO when in reality he seems to have made it as toxic as possible so he could bet it would collapse, as it did, the deeper point is that these transactions were confidence games, literally speaking.

The further issue is that the transactions had no value except in the confidence game that constructed them. Outside of that, they had no value, certainly not for society.  Hutton writes,
It is time to reframe the question. Banks and financial institutions should do what economy and society want them to do – support enterprise, direct credit to where it is needed and be part of the system that generates investment and innovation. Andrew Haldane – and the governor of the Bank of England – are right. We need to break up our banks, limit their capacity to speculate and bring them back to earth.
That would be to end high finance as we know it, because that does not invest in enterprise or places where credit is socially needed.  The returns there are lower than what it can get elsewhere.

In a similar spirit, see the Stiglitz presentation on financial reform at a large economics conference at Cambridge University a couple of weeks ago.  It comes from a world that doesn't yet exist.  Perhaps it will be revealed by the passing of the Vulcan cloud of ash.

Saturday, April 17, 2010

The Goldman Sachs Complaint

Joe Nocera has a good summary of the issues involved in its Goldman Sachs complaint, and the SEC has a condensed description of it. Here are the two key paragraphs:
According to the SEC's complaint, filed in U.S. District Court for the Southern District of New York, the marketing materials for the CDO known as ABACUS 2007-AC1 (ABACUS) all represented that the RMBS portfolio underlying the CDO was selected by ACA Management LLC (ACA), a third party with expertise in analyzing credit risk in RMBS. The SEC alleges that undisclosed in the marketing materials and unbeknownst to investors, the Paulson & Co. hedge fund, which was poised to benefit if the RMBS defaulted, played a significant role in selecting which RMBS should make up the portfolio.

The SEC's complaint alleges that after participating in the portfolio selection, Paulson & Co. effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (CDS) with Goldman Sachs to buy protection on specific layers of the ABACUS capital structure. Given that financial short interest, Paulson & Co. had an economic incentive to select RMBS that it expected to experience credit events in the near future. Goldman Sachs did not disclose Paulson & Co.'s short position or its role in the collateral selection process in the term sheet, flip book, offering memorandum, or other marketing materials provided to investors.
These are our financial geniuses at work on a straight con. The CDO lost 83 percent of its value in the first six months.  Nice.

James Kwak at Baseline has a helpful exegesis on the "type of transaction involved — in which a hedge fund makes a CDO as toxic as possible in order to then short it."  He notes:
It seems like the key will be proving that Paulson influenced the selection of securities enough that it should have been in the marketing documents. Paragraphs 25-35 include quotations from emails showing that Paulson was effectively negotiating with ACA over the composition of the CDO, so it’s pretty clear he had influence. The defense will presumably be that ACA had final signoff on the securities, and Paulson was just providing advice, so Paulson’s role did not need to be disclosed. (I don’t know what kind of standard will be applied here.)
Kwak adds, "no doubt to the annoyance of many, I don’t blame Paulson. It’s Goldman that had the duty to its investors, not Paulson."

Michael Lewis is more explicit about all this in an interview that Kwak quotes elsewhere:

all of the people you mentioned all swallowed a general view of Wall Street, which was that it was a useful and worthy master class, that these people basically knew what they were doing and should be left to do whatever they wanted to do. And they were totally wrong about that. Not only did they not know what they were doing, but the consequences of not knowing what they were doing were catastrophic for the rest of us. It was not just not useful; it was destructive. We live in a society where the people who have squandered the most wealth have been paying themselves the most, and failure has been rewarded in the most spectacular ways, and instead of saying we really should just wipe out the system and start fresh in some way, there is a sort of instinct to just tinker with what exists and not fiddle with the structure.
Lewis also hits this blog's humble theme, the intellectual limits of the mass middle class that continues to prevent it from overcoming its humiliating defeat by financial forces it never bothers to understand:

The question is how does Washington move away from those institutions and make decisions that are in the public interest without regard for the welfare of these institutions. It’s a hard question because . . . this is the problem. Essentially the public and their representatives have been buffaloed into thinking that this subject — financial regulation, structure of Wall Street — is too complicated for amateurs. That the only people who are qualified to pronounce on this are people who are in it. And there are very very few people who aren’t in it in some way who have the nerve to stand up and fight it. . . .

The reporter as much on this beat as anyone in the U.S. Gretchen Morgenson, discusses why John A. Paulson who set this up was not indicted. Paulson's firm released a statement that said in part,
There’s no question we made money in these transactions. However, all our dealings were through arm’s-length transactions with experienced counterparties who had opposing views based on all available information at the time. We were straightforward in our dislike of these securities, but the vast majority of people in the market thought we were dead wrong and openly and aggressively purchased the securities we were selling.
Morgenson (and Louise Story) continue:
After analyzing risky mortgages made on homes in Arizona, California, Florida and Nevada, where the housing markets had overheated, Mr. Paulson went to Goldman to talk about how he could bet against those loans. He focused his analysis on adjustable-rate loans taken out by borrowers with relatively low credit scores and turned up more than 100 loan pools that he considered vulnerable, the S.E.C. said.

Mr. Paulson then asked Goldman to put together a portfolio of these pools, or others like them that he could wager against. He paid $15 million to Goldman for creating and marketing the Abacus deal, the complaint says.

One of a small cohort of money managers who saw the mortgage market in late 2006 as a bubble waiting to burst, Mr. Paulson capitalized on the opacity of mortgage-related securities that Wall Street cobbled together and sold to its clients.
 In a video clip, Story points out that the case seems to be proof that Goldman does bet against instruments it markets to its own clients, contrary to its repeated denials.  In another clip, the SEC's Robert Khuzami answers questions about the compliant.

The complaints are finally getting under way.

Thursday, April 15, 2010

Long Slide in the Post-Crisis

Some good books on the financial crisis have come out in the past month, including two I've bought but am still waiting to get time to read. One is 13 Bankers, by Simon Johnson and James Kwak (who also run the blog Baseline Scenario, an excellent source for blow-by-blow commentary on the ongoing struggle for a soupçon of financial reform. Another is Econed, by the author of the blog Naked Capitalism, which details the intellectual failures of doctrinal US economics and their real world impact.

Kwak has a good review of another of the good recent books, The Big Short by Michael Lewis.  Kwak gets at the crucial problem with the financial system in general, which is that the supposedly iron logic of objective market forces to which financial players are all subject in fact masks rules made up by a fairly small number of insiders to maximize their take.  Here's just a taste:
The problem was that the banks, as the swap dealers, got to decide what the swaps were worth. So, for example, Charlie Ledley bought an illiquid CDS on a particular CDO from Morgan Stanley. Five days later, in February 2007, the banks started trading an index of CDOs that promptly lost half its value. But, as Lewis writes, “With one hand the Wall Street firms were selling low interest rate-bearing double-A-rated CDOs at par, or 100; with the other they were trading this index composed of those very same bonds for 49 cents on the dollar” (p. 162).* That is, the market price of the already-issued CDOs didn’t affect the sale price of new CDOs. And what’s more, Ledley’s broker insisted that the price of his CDS (which should have soared as the index of CDOs fell) had not changed. Here you see the banks simultaneously ignoring a market price in two separate ways: once so they can continue selling new assets that are extremely similar — worse, if anything — to assets that they are trading as garbage; and again so they can avoid sending collateral to their hedge fund client.
Got that?  It's people making stuff up, and making a pile of dough as a result. This is finance that has nothing to do with investment, productive or otherwise. Its only impact on society is to damage it.  The rest of us are supposed to believe in its objectivity and defer to the outcome.  How far along are we in knowing enough to think otherwise?

We're looking as usual at a huge gap between the insight of experts and that of the general public.  A sign of where the public discussion is can be found in Jane Hamsher's comment on the its basic non-existence.

The social damage continues to spread. People are looking at Portugal next, and even the best financial commentators, like Simon Johnson, counsel cuts and austerity till the end of financial time.
For example, just to keep its debt stock constant and pay annual interest on debt at an optimistic 5 percent interest rate, the country would need to run a primary surplus of 5.4 percent of G.D.P. by 2012.  With a planned primary deficit of 5.2 percent of G.D.P. this year (i.e., a budget surplus, excluding interest payments), it needs roughly 10 percent of G.D.P. in fiscal tightening.

It is nearly impossible to do this in a fixed exchange-rate regime — i.e., the euro zone — without vast unemployment.  The government can expect several years of high unemployment and tough politics, even if it is to extract itself from this mess.

Neither Greek nor Portuguese political leaders are prepared to make the needed cuts.
Greece's crisis has settled into semi-permanence in the style that is becoming typical of our new post-crisis era: permanent low-level anxiety, permanent austerity, and permanent stagnation in wages. All of this is imposed with a financial logic of inevitability. The continuous message is that there is no escape.  Greece is looking at a lost decade for its society. The West is dealing with a crisis caused by its small, arrogant, uncaring, incredibly rich financial sector by downgrading the resources and the vision of its societies.  After ten more years of this, what visions and aspirations will be left?