The Beginning of the End of the Age of Casual Fraud

One does not usually associate high finance with high drama. Oliver Stone pulled it off in his 1987 movie Wall Street – but that relied on a script full of over-the-top one-line zingers, and on Michael Douglas, with the slicked-back oiled hair and the sneer, chewing the scenery, mercilessly. That was a highly-stylized symbolic morality play, or a camp-art cartoon – someone had to play Snidely Whiplash. But when your father was a stockbroker and your best friend back east is a high-powered Wall Street attorney, specializing in securities law and dealing with the SEC and FINRA day in and day out, you know there’s not a whole lot of drama there. The offices are quiet, and no one seems particularly slick and deadly – but then Bernie Madoff seemed like such a nice avuncular sort of fellow. Everyone liked him. You never know.

But the work is dull – try spending your day reading this prospectus or that, or mulling over which subsection of which obscure law applies, or doesn’t apply, to the issuance of a new financial instrument your client just invented out of thin air, and then crafting a memo to explain what you discovered, in actual English or at least something close to actual English. This is not high drama.

But these are odd times. The was the Crash of 2008 – the failures of large financial institutions here, due to exposure of securities made up of packaged subprime loans, and credit default swaps issued to insure these loans and their issuers (with no underwriting so no one could collect the insurance) – and then the bank failures in Europe and equities and commodities prices dropping like a rock. On October 11, the head of the International Monetary Fund warned that the world financial system was teetering on the “brink of systemic meltdown.”

Yeah well, September had been bad. September opened with the Federal takeover of Fannie Mae and Freddie Mac, which at that point owned or guaranteed about half of our twelve trillion mortgage market, effectively nationalizing them, and panic because almost every home mortgage lender and Wall Street bank relied on them to facilitate the mortgage market, and investors worldwide owned over five trillion of debt securities backed by them. Oops. And a week later Merrill Lynch was sold to Bank of America because of fears of a liquidity crisis and the possibility Lehman Brothers might collapse, and Lehman Brothers filed for bankruptcy protection a few days later. Then Moody’s and Standard and Poor’s downgraded ratings on AIG’s credit – it was the losses on mortgage-backed securities – and insolvency loomed – the same day there was a run on the money market funds, and the commercial paper market, a key source of funding for corporations, collapsed. The system was freezing up. The US Federal Reserve lent eighty-five billion to American International Group (AIG) to avoid bankruptcy, to help a bit. It didn’t help. On September 18, Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke meet with key legislators to propose a seven hundred billion emergency bailout through the purchase of toxic assets. Bernanke put it nicely – “If we don’t do this, we may not have an economy on Monday.” That was voted down on September 29 – the markets crashed – but it was finally passed three days later and signed by Bush on October 3rd. In the middle of all that Washington Mutual had been seized by the Federal Deposit Insurance Corporation and its banking assets sold to JP Morgan-Chase for two billion. And that’s just a bit of it. It was high drama – and many lost their savings and retirement funds, and their jobs and their homes. GM and Chrysler went into bankruptcy. Unemployment soared. And who the hell had been watching the store? How did this happen?

It seemed the long march from Reagan through the second Bush – toward a world where inherently inefficient government doesn’t interfere in markets with silly regulations – had been a march off a cliff. Unlike conservative economic theory, the markets didn’t regulate themselves, with everyone making sure nothing nasty went on, because that’s in everyone’s self-interest and no one was dumb enough to screw up a good thing. Shedding regulations and not enforcing those that remained had not led to unimagined prosperity, vast wealth and true freedom for all. And Ayn Rand was just a second-rate novelist after all.

So now, two years later, with Bush gone, the issue is regulation, on something to make sure this doesn’t happen again. And at CNN’s Political Ticker, we see that as of Friday, April 16, that might not happen:

As Democrats prepare to bring the contentious issue of financial reform to the Senate floor next week, Republicans say they have enough votes to block the proposed financial reform bill unless changes are made. Senate Republicans say all 41 GOP members will vote against a parliamentary procedure to allow the current bill to proceed.

They don’t even want to talk about it, at least not on the floor of the Senate:

In a letter Friday to Reid, the Republicans said they are united in opposition and added “We simply cannot ask the American taxpayer to continue to subsidize this ‘too big to fail’ policy. We must ensure that Wall Street no longer believes or relies on Main Street to bail them out. Inaction is not an option. However, it is imperative that what we do does not worsen the current economic climate or codify the circumstances that led to the last financial crisis.”

As the bill is specifically designed to make sure no bank is too big to fail – they screw up and they go into receivership, and the shareholders are wiped out, and what remains is split up and sold to others to run more efficiently – no one know quite knew what this is about. CNN reported that Democrats say they are prepared to start debate, but they do know they would need at least one Senator from the other side to vote with them if the Republicans filibuster. But that’ll be hard. Republicans stick together, and want no regulation or reform, or so it seems. But that’s not quite true. They know something must be done, but it’s just that after healthcare reform passed they need to prove Obama can be beat, that people trust them, not him. The latter is more important to them at the moment.

And the response was clear:

“At this point, I say to my colleagues, bring me your ideas, let’s work on this together, let’s debate the bill, and pass strong Wall Street reform to protect our country from the kinds of abuses that lost so many their jobs, their homes, and their life savings. But let’s not engage in nonsense,” Senate Banking Chairman Chris Dodd said in reaction to the Republicans’ letter. …

“This bill has been written specifically to end any notion of any kind of a bailout by the American taxpayer again,” Dodd said Thursday. “Our bill stops bailouts by imposing tough new requirements on Wall Street firms. Being too big and too interconnected will cost these firms dearly. And should that not be enough, our legislation, regulators can use the new powers in our legislation to break these firms up before they can take down the economy of our country.”

And Obama was in the mix:

Specifically he said there needs to be strong reform and more accountability regarding the trading of the complex risky investments called derivatives which were one of the major causes of the economic meltdown.

“I hope we can pass a bipartisan bill, but bipartisanship cannot mean simply allowing lobbyist driven loopholes that put American taxpayers at risk. That would not be real reform,” he told the meeting of his advisers.

Asked by a reporter whether he would veto legislation if the derivatives reforms are weakened, Obama said “I want to see what emerges. But I will veto legislation that does not bring the derivatives market under control in some sort of regulatory framework that assures that we don’t have the same kind of crisis that we have seen in the past.”

But what about freedom! That’s the Republican line.

But the AP does report an Obama concession:

In the face of stiff GOP opposition, Obama administration officials want Senate Democrats to purge a $50 billion fund for dismantling “too big to fail” banks from legislation that aims to protect against a new financial crisis. Republicans contend the provision would simply continue government bailouts of Wall Street.

So we’ll still go about dismantling “too big to fail” banks when we must, but if it makes the Republicans happy, we won’t set aside any funds to do that. It looks as if Obama is out to make them look like fools. But if it comes out looking like he’s trying to get things under control, and they feel they must make him look bad and insist he’s dead wrong, they end looking like they’re against getting things under control. And that a reverse of their old trap – if you oppose the Iraq war that must mean you love Saddam Hussein and wish he had remained in power. Now it’s that if you hate these reforms that means you must have loved what happened in September 2008 and want more of the same. Two can play at that game.

And then the Republicans position got much worse with the high drama of the day:

Goldman Sachs Group was charged with fraud by the U.S. Securities and Exchange Commission over its marketing of a subprime mortgage product, igniting a battle between Wall Street’s most powerful bank and the nation’s top securities regulator.

The civil lawsuit is the biggest crisis in years for a company that faced criticism over its pay and business practices after emerging from the global financial meltdown as Wall Street’s most influential bank.

It may also make it more difficult for the industry to beat back calls for reform as lawmakers in Washington debate an overhaul of financial regulations.

Goldman called the lawsuit “completely unfounded,” adding, “We did not structure a portfolio that was designed to lose money.”

That’s Reuters. But for a simple explanation, regarding a hedge fund manager named John Paulson (no relation to Hank), see Matthew Philips in Newsweek:

According to the SEC, Paulson went to Goldman in early 2007 and said that he wanted to bet against (short) a portfolio of subprime mortgages. Goldman essentially said sure, no problem. First it created the CDO, dubbed ABACUS 2007-AC1, and then found some suckers (counterparties) to buy the thing, all the while (and here’s the basis for the SEC’s charge) allegedly touting that Paulson had invested $200 million in it, when in actuality he’d bet the other way. Those suckers turned out to be German bank IKB and Dutch bank ABN AMRO, which is entirely owned by the Dutch government. The deal closed in April 2007, and within a year ABACUS had gone kablowey, costing IKB $140 million, and ABN AMRO $890 million. Goldman meanwhile made $15 million in fees from Paulson for structuring and marketing ABACUS, and Paulson made a cool $1 billion off the credit default swaps he bought on ABACUS. Paulson responded by saying he is not the subject of the SEC’s complaint, made no misrepresentations and is not the subject of any charges. For its part, Goldman calls the charges “completely unfounded” and has vowed to fight them.

Or see Joe Nocera in the New York Times:

Remember in the months leading up to the crisis, when the Federal Reserve chairman, Ben Bernanke, and Henry Paulson Jr., then the Treasury secretary, were assuring everyone that the “subprime problem” could be contained? In truth, if the only problem had been the actual mortgage bonds themselves, they might have been right. At the peak there were well over $1 trillion in subprime and Alt-A mortgages that were securitized on Wall Street. That’s a lot, to be sure – but it was a finite number. You could have only as much exposure as there were bonds in existence.

The introduction of synthetic CDO’s changed all that. Unlike a “normal” collateralized debt obligation, which contained the bonds themselves, the synthetic version contained credit-default swaps – derivatives that “referenced” a particular group of mortgage bonds. Once synthetic CDO’s became popular, Wall Street no longer needed to feed the beast with new subprime loans. It could make an infinite number of bets on the bonds that already existed.

And why did synthetic CDO’s become popular? One reason was that the subprime companies were starting to run out of risky borrowers to make bad loans to – and hitting a brick wall. New Century, a big subprime originator, went bankrupt in early April 2007, for instance. Yet three weeks later, the Goldman synthetic CDO deal, called Abacus 2007-ACI, went through, because it was betting on subprime mortgage bonds that already existed rather than bundling new ones. It didn’t even have to go to the trouble of repackaging old CDO tranches into new CDO’s, which was also a common practice. (Goldman has vehemently denied any allegations of wrongdoing, pointing out that it lost $90 million on the particular Abacus deal that is the subject of the SEC complaint.)

The second reason, though, is that synthetic CDO’s gave people like John Paulson a way to short the subprime market. Mr. Paulson’s bet against the subprime market, which famously reaped the firm billions in profits, was the subject of a recent book, “The Greatest Trade Ever.” Boy, I’ll say.

But it was kind of a game:

It is important to note that every synthetic CDO required both investors who were long and others who were short. That is, there needed to be investors who believed the “referenced” bonds would rise in value, and others who believed they would fall. Everyone, on both sides of the transaction, understood that. What makes it feel like dirty pool is the allegation that Paulson & Company and Goldman Sachs were actively involved in choosing the bonds that would be bet on – knowing they were going to be short. In its filing on Thursday, the SEC charged that Goldman never told investors of Mr. Paulson’s involvement. “Credit derivative technology helped people disguise what they were doing,” said Janet Tavakoli, the president of Tavakoli Structured Finance and an early critic of many of the structures that have now come under scrutiny.

But it wasn’t just Goldman – he cites a report on how a Chicago hedge fund, Magnetar, helped put together synthetic CDO’s – precisely so that it could bet against them. It happens. And this stuff doesn’t regulate itself:

The people on the short side of those trades were truly savvy investors, who, unlike so many others, did their homework and had insights that made them a great deal of money. But the rise of synthetic CDO’s that they pushed for – and their ability to use credit-default swaps to short subprime mortgage bonds – took an already bad situation and made it worse.

And here we are now, all of us, paying the price.

As for the Reuters account, it’s clear no one is watching out for anyone:

The lawsuit puts Goldman Chief Executive Lloyd Blankfein further on the defensive after he told the federal Financial Crisis Inquiry Commission in January that the bank packaged complex debt, while also betting against the debt, because clients had the appetite. “We are not a fiduciary,” he said.

Well, who is? Actually he was just saying Goldman had no responsibility to protect anyone. They’re big boys. They can take care of themselves. Goldman just sold stuff people wanted.

But this is curious:

Goldman had not disclosed that the SEC was considering a lawsuit but had known charges were possible and had urged the SEC not to file them, people familiar with the situation said on Friday. The sources requested anonymity because the probe was not public.

They knew this might happen. They knew a lawsuit was coming. Perhaps they should have told their clients about it. Or perhaps they should have realized they shouldn’t have done this in the first place.

And this may be the start of something serious. Goldman was not alone. See Saturn Smith at with this:

The most surprising thing about this is not that Goldman Sachs is in trouble, or that the whole deal was done by its vice president, Fabrice Tourre, implicating the highest levels of the business in unscrupulous practices: the surprising thing is that the SEC is doing something about it.

This is the SEC! They don’t enforce stuff. They whine. They whimper. They usually back down. Now, though, under Mary Shapiro, and under the gun from Congress and the White House about how their lax regulation has been a big cause of the current problems, it seems a spine has shown itself inside the SEC offices. Maybe even two. Eventually, there might be enough spines that they don’t have to pass them around.

And there’s Andrew Leonard noting that the timing of the SEC fraud charges looks suspicious, but right now, attacking Wall Street works for the Democrats:

An e-mail from Barack Obama arrived just as I was wading my way through the SEC’s complaint accusing Goldman Sachs of securities fraud. What an amazing coincidence – the president wanted to talk with me about Wall Street reform!

“We cannot delay action any longer. It is time to hold the big banks accountable to the people they serve, establish the strongest consumer protections in our nation’s history — and ensure that taxpayers will never again be forced to bail out big banks because they are ‘too big to fail.'”

Banking reform has been up front and center in Washington this week, and Senate Majority Leader Harry Reid is promising to bring the bill put together by Sen. Chris Dodd to the floor as early as next week. So it’s not much of a surprise that the White House would be trying to rally support. But the timing of Obama’s missive is so exquisite – within an hour of the SEC dropping its Goldman bomb – that one immediately has to wonder: Did the SEC coordinate with the White House for maximum political effect? Goldman Sachs is, after all, the poster boy for Wall Street arrogance and power. How fortunate for the Democrats that just as Republicans started a campaign to paint their financial reform bill as too friendly to Wall Street, the government brought the hammer down on the investment bank that everyone loves to hate? …

As Slate economics writer Dan Gross tweeted, “now would be a good time for Chris Dodd to redub his [bill] “The Goldman, Sachs Restraint Act of 2010″ and bring to the floor for a vote.”

And he says the display of Republican recalcitrance is impressive, but also risky:

The Democrats are licking their chops at the prospect of more GOP obstructionism.

And why not? The situation would seem tailor-made for the White House. The government can point to the SEC’s crackdown on Goldman Sachs as evidence of concrete determination to rein in Wall Street, and at the same Democrats are pushing legislation that, while far from perfect from a progressive standpoint, is certainly better than the status quo. …

Certainly the White House can’t be unhappy with the SEC’s decision to charge Goldman with fraud. If you are going to be relentlessly attacked by both left and right for bailing out Goldman Sachs, you might as well embrace criticism engendered by striking an adversarial stance. And make no mistake, bringing charges against Wall Street’s best and brightest is not a trifling matter.

So it comes down to this:

No matter how you parse it, there is now some meat on the bones of the perception of the Obama administration as being in some way “anti-Wall Street.” Earlier this year, when the White House responded to Scott Brown’s surprise victory in Massachusetts by suddenly adopting harsher-than-usual political rhetoric against the banks, it was easy to dismiss the pivot as nothing more than words. Charges of fraud against Wall Street’s premier financial institution are a different order of business altogether.

And earlier Leonard had said this:

The significance of the SEC’s action is difficult to understate. Goldman’s political influence is legendary – two of the most prominent Treasury Secretaries in the last twenty years, Robert Rubin and Hank Paulson, were former Goldman CEOs. The SEC’s action comes just as political debate over banking reform legislation heats up, with the GOP Senate leadership apparently intent on scuttling a bill that includes provisions aimed at regulating precisely the kind of derivatives trading involved in the Abacus deal. Financial bloggers are already suggesting that the complaint may offer AIG reason to sue Goldman and a civil suit brought by burned investors is undoubtedly in the offing. Share prices for Goldman Sachs stock plummeted early Friday, and spreads on credit default swaps written on bonds issued by Goldman widened dramatically – a sign that the market, for now, is taking the news quite seriously.

The shoe has finally dropped.

And that’s high drama.

But of course now things change. The Dow may open down a thousand points the Monday after people realize what this fraud case means. Something is ending. That long march from Reagan through the second Bush – toward a world where inherently inefficient government doesn’t interfere in markets with silly regulations – seems to be coming to a halt, at the cliff’s edge. And there will be much weeping and gnashing of teeth, and perhaps some rending of garments and that sort of thing. But that won’t make a difference now. No one in their right mind jumps off a cliff.

Not that that ever stopped anyone.

About Alan

The editor is a former systems manager for a large California-based HMO, and a former senior systems manager for Northrop, Hughes-Raytheon, Computer Sciences Corporation, Perot Systems and other such organizations. One position was managing the financial and payroll systems for a large hospital chain. And somewhere in there was a two-year stint in Canada running the systems shop at a General Motors locomotive factory - in London, Ontario. That explains Canadian matters scattered through these pages. Otherwise, think large-scale HR, payroll, financial and manufacturing systems. A résumé is available if you wish. The editor has a graduate degree in Eighteenth-Century British Literature from Duke University where he was a National Woodrow Wilson Fellow, and taught English and music in upstate New York in the seventies, and then in the early eighties moved to California and left teaching. The editor currently resides in Hollywood California, a block north of the Sunset Strip.
This entry was posted in Economic Issues, Economic Theory, Financial Meltdown, Financial Reform, Goldman Sachs Charged With Fraud and tagged , , , , , , , , , , , , , , . Bookmark the permalink.

1 Response to The Beginning of the End of the Age of Casual Fraud

  1. Douglas says:

    Just to thank you for these nice articles, I enjoy reading them and gives me the value in diversity in America and the world. Malawi as far away from american politics as can be. Thank you.

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