Sharpening the Pitchforks

As I read various comments about the Goldman Sachs lawsuit, I can’t help but thinking it might not be so good if Goldman takes a very public loss in the suit.

That’s not to say that fraud should go unpunished.  If proven, they should pay.

The negative would be the fact that it was the stuff that was not illegal that really needs to be fixed.

If Goldman were to go down in its role in the final push of subprime garbage into the CDO and CDS market, too many people would conclude that we don’t need any new regulations, especially because they already believe we have too many.

Note that John Paulson is not being considered.  He “didn’t do anything wrong,” after all.  He just made billions off doing his part in destroying our private home financing market.  All nice and legal, just like the Magnetar trade was nice and legal.

Here’s the issue:

Thanks to the “Enron exemption” put into the last Act of the last day of the last session of Congress when Clinton was a lame duck, a completely hidden, potentially infinite leverage Pandora’s box was sprung open.

Greenspan, Rubin, Summers, Clinton, the majority in Congress, and the entire incoming administration all agreed that unfettered free markets were the way to go, and that America was leading the way in financial innovation.

That was the Swap market, and with a little imagination, almost anything could be turned into a Swap, making it completely hidden, and requiring no capital at all if the counterparty to the contract agreed.

Infinite Leverage!

Once it was possible, why do we act surprised that some people used it?

The Greenspan answer is that market forces would keep people from accepting a counterparty exposure without requiring some kind of capital reserve.  Of course, he wasn’t in the room when AIGFP and a handful of others simply said they would post no collateral or the supplicant who wanted to “rent” their AAA name would have to go elsewhere.

Some played the game even more extremely.  I heard a tale, quite believable, that a major bank that was creating CDO’s and holding the super-senior AAA’s actually bought billions in CDS coverage from a tiny hedge fund with less than $100 million in assets.

How could that be?  Well, let’s see.

If the unnamed big bank could make $10 million in current fees by structuring the deal, and have 80% of the deal “disappear” by taking it onto the bank’s balance sheet, that would be pretty attractive to the individuals charges with doing CDO’s at that bank.

But why would management let them do that?  Easy.  If they went out and bought insurance that cost them a million less per year than the bonds were paying them in spread, those bonds would no longer be on the balance sheet from a capital regulation point of view.

Stay with me here, because the pea is still under one of the walnuts.

1) Super-senior bonds pay quarterly, and pay half a percent per annum more than the bank has to pay on interbank brokered deposits (CD’s for us peons, but considered “retail” in face amounts under $100 million).

2) Specialty HedgeCo, Ltd. of the Caymans will charge only 40 basis points per annum to insure the bonds, which have a 1,000 to one chance of defaulting.

3) Since Specialty HedgeCo is in the business of insuring 1,000-1 events, the fact that they have 80-1 capitalization means they are “safe”.

4) So Specialty HedgeCo writes $8 billion in super-senior AAA CDO insurance with their capital of $100 million, and advertises that they are “conservative”  at 80-1 compared to the traditional bond insurers that carry 150-1 insurance-to-reserve ratios.

5) The beauty of it is that this kind of insurance is done as a Credit Default Swap, so no insurance commissioner anywhere has a right to even question Specialty HedgeCo, much less demand to see how they support their $8 billion in “insurance.”

6) The only issue is for Specialty HedgeCo to get its ratings reaffirmed by the Rating Agencies.  Since they only insuring bonds already rated AAA by the Rating Agencies, and even those have been sliced one more time to make them “super” senior to even the AAA bonds, it’s kind of hard to imagine the Rating Agencies saying anything other than Specialty HedgeCo will never have to pay off on its CDS.

7) Specialty HedgeCo makes 32% on its $100 million capital, and everybody’s happy.

And then there’s the perfectly legal Magnetar trade.  They created demand, at very high prices (low yields) for tens of billions of mezzanine and junior bonds from subprime and alt-A mortgages.

Unfortunately for the bagholders (that’s us taxpayers, pension holders, and insurance policyholders), when you create $1 billion of BBB subprime mortgage bonds, you also create $16 billion of AAA bonds.

This comes from the simple fact that 80% of the deals were AAA, and only 5% were BBB.

That was a huge amount of AAA bonds, more than even all the pension funds and insurance companies could swallow.

But Merrill, Citi, UBS, Goldman, JP Morgan, etc. had a fix for that… they could create SIV’s — off balance sheet investors in AAA paper that could issue Commercial Paper (CP).  Either that, or they kept them, but bought insurance in the form of CDS so their wasn’t a capital charge.

By the fall of 2007, there was almost $750 billion of Asset-Backed CP, and all us, the unwashed masses, were quite willing to support that by keeping our cash in money market accounts.

So why did all the dealers who were buying and securitizing the mortgages keep doing it?  Why did the bond investors keep buying the bonds?

The answer is that the SIV’s, the credit-protected retention of AAA bonds, the “synthetic” CDO’s were non-human “customers” who owed their existence to the dealers who were running the show.  Do you really think CitiSIV (made up name) was going to say it didn’t want another $800 million of AAA bonds from this month’s deal?  Of course not — there weren’t any people at CitiSIV.

With the Magnetar trade, the loop got closed completely.  Not only did they sponsor new deals by investing in the equity tranche, they created ten to fifty times as much exposure by having the dealers write CDS contracts that would pay off at par if the bonds failed.

That made the dealers hugely long, so their only choice to hedge their exposure was to avoid lending to or even short the lenders that originated and sold loans.

Since nobody told anybody just how much exposure they had, and to which names, in the $60 trillion CDS business, the only people who knew were those betting against it.  They were able to buy insurance many times the size of the mortgage bond market they were betting against.  The existence of such a large, effectively infinite leverage bet was enough to put the lenders, all of them, out of business.

All legal.  No rules against it.  No way for anyone other than the people doing it to know just how big their bet was.

But now comes the issue — the other side of the bet was taken by banks and insurance companies, and to a lesser extent by pension funds and other investors, many of whose balance sheets are backstopped by taxpayers.

If I’m ultimately going to have to pay if things go terribly wrong, then I say I have a right to know who is making the bets and how big those bets are.  I’m also going to say that I should be able to set rules that require the gamblers making those bets show us the money, and put it where it can’t disappear until the bet is paid.

So, the issue is not whether there was poor enforcement of our “burdensome” regulations.

The issue is the unregulated business, and the fact that we are now on the hook to pay off those bets to the winners, a debt that will take generations to pay.

And what assurance do we have that those guys who won this time will actually pay if they were to make a losing bet instead of a winner?  One thing we do know — they didn’t pay income tax on the income they got for making the bets.



One Response to Sharpening the Pitchforks

  1. W.Kinsolving says:

    Is it okay to throw out the bondbaby with the bathwater if the water is polluted?

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s

%d bloggers like this: