I'm sorry "A Heart of Pure Darkness" is not correct.
August 14, 2012 1:33 PM   Subscribe

What did Michael Milken, Enron, and Goldman Sachs have in common? Not only were they at the centers of three of the biggest financial scandals of the last 30 years, but it turns out they all used the same financial instrument to help pull off their plans. A Transactional Genealogy of Scandal: from Michael Milken to Enron to Goldman Sachs

A very interesting paper that talks about how the advent of the synthetic CDO created a structure rife with conflicts between legal and economic obligations and how those conflicts were abused in different ways by different parties at the centers of three discrete scandals.
posted by JPD (57 comments total) 41 users marked this as a favorite

 
Looks interesting. Thanks!
posted by Sticherbeast at 1:38 PM on August 14, 2012


And the abstract is scarier to read than the paper itself. No equations or anything like that, just some jargon.
posted by JPD at 1:38 PM on August 14, 2012


JPD, you should get a little gavel and a dollar sign next to your name, for meritorious service in the field of explaining business law.
posted by benito.strauss at 1:43 PM on August 14, 2012 [7 favorites]


Years ago I was a junior woodchuck at a boutique firm specializing in asset-backed securitizations. Bankruptcy-remote special purpose vehicles, collateralized debt obligations, the whole nine yards. On my very first deal after joining the firm, I went through all the documentation: the indenture agreement, the notes, everything. I got to the ISDA swap documentation (laying out the terms of the CDO), it was a binder about three inches thick and I could not make heads or tails of it. I figured that the first deal was my window of opportunity to go ask questions, so I went in to the partner on the deal and asked about it. "Oh that. Nobody understands those things." She literally waved her hand and said "if those things ever actually come into play, we are all in a lot of trouble."

That was 2001.
posted by ambrosia at 2:03 PM on August 14, 2012 [29 favorites]


"Why Goldman Sachs, Other Wall Street Titans Are Not Being Prosecuted".
posted by resurrexit at 2:11 PM on August 14, 2012


"Why Goldman Sachs, Other Wall Street Titans Are Not Being Prosecuted"

This would be funny, if not for the fact that JPD also did a good job of saying what the real reason for this was just a couple days ago.
posted by zombieflanders at 2:32 PM on August 14, 2012 [2 favorites]


I assumed that the instrument they all used was a captive SEC.
posted by Pope Guilty at 2:38 PM on August 14, 2012 [5 favorites]


"Welcome to Dick Cheney's America."
posted by Aquaman at 2:52 PM on August 14, 2012


Read the article. They specifically cite when regulators figured out there was a "regulatory arbitrage" going on and when they did not.
posted by JPD at 2:54 PM on August 14, 2012 [1 favorite]


Summary: they all used carefully crafted sockpuppets.
posted by b1tr0t at 3:06 PM on August 14, 2012


What made the Milken move and the Enron maneuver illegal is that they were small enough to fail.
posted by bukvich at 3:19 PM on August 14, 2012


As Dealbreaker recently pointed out, which is easier to understand: a CDO that consists of a list of assets, each one of which you can analyze and understand, and a written contract about how those assets are to be handled? Or a traditional corporate bond issued by a financial institution that invests in a variety of assets that you can't see and that may change from day to day without warning or notification?

The problem isn't the CDO structure, it's the fact that lazy buyers are lazy,* and rather than doing due diligence and forming their own opinions about the assets in a CDO, they glanced at a graph of recent performance, relied on a vague and stupid understanding of the market (like "housing prices always go up!"), and asked rating agencies that they didn't pay (ratings agencies are paid by the issuer) and that had no contractual or legal obligation to them to confirm their broker's opinion of the asset.

The answer here is that corporate investors need to pay their lawyers and their risk managers more, slow down, and do fewer deals. But there is no regulation in the world that will prevent municipalities from making stupid investment decisions based on who they play golf with or based on an irrational desire for rapid growth and high return without risk.

* feel free to delete "buyer" and substitute the word "regulator" throughout this paragraph. The point is the same, with the added complication that regulators are usually less sophisticated than, and care less about, the financial health of the people they're regulating.
posted by gd779 at 3:56 PM on August 14, 2012 [4 favorites]


I'll be sure to read the paper tomorrow (we have academic library subscription privileges at work), but I have an open question: do SPE cause/predict scandal, synthetic derivatives cause/predict scandal or is it a combination of SPE+synth finance that has the emergent property of destabiizing a system?

This is at the heart of the clamor for regulation. If it's the ease of creation and use of SPEs that enables the misuse of synth derivatives, we have a moral hazard problem: institutions are able to take on the upside of risks without the downside of risks. If the leverage and complexity generated by synthetic derivatives are alone to blame, we pretty much have to ban all future contracts -- and look, a magazine subscription is a future contract.

If there's a single fused phenomenon, that is, mutually feeding SPEs and synth finance, then we have to go one dream deeper and inquire whether the rise of synthetic finance (which can be tracked to the 1976 papers on option pricing by Merton, Black and Scholes) created an unique incentive for the proliferation of SPEs, or whether deregulation created an unique demand for complex synthetic finance.

So what do you want regulated, MeFi, derivatives or shell companies?
posted by syntaxfree at 4:15 PM on August 14, 2012 [1 favorite]


The problem isn't the CDO structure, it's the fact that lazy buyers are lazy,* and rather than doing due diligence and forming their own opinions about the assets in a CDO, they glanced at a graph of recent performance, relied on a vague and stupid understanding of the market (like "housing prices always go up!")

This is a pretty dumb explanation of the reality. There is nothing special about the CDO structure, yes. This is not the point. The point is that banks have both the means and the motive to inflate any and all assets. The failure didn't happen when investors fell victim to 'ratings arbitrage' and were suckered into purchasing these products, it failed when these products were created in the first place. That Dealbreaker article is hilariously stupid and so transparently misleading -- really, it's like, 'golly gee, it takes buyers and sellers to make an asset bubble!'
posted by nixerman at 4:17 PM on August 14, 2012 [4 favorites]


So what do you want regulated, MeFi, derivatives or shell companies?

Again, this completely misses the point. Derivatives are one of wide variety of possible tools that can be used to produce leverage. Who cares? In modern finance there is absolutely nothing that can stop banks and non-banks from achieving whatever risk profile they want. Banning derivatives or any product or 'prop trading' will not prevent financial firms from getting the leverage they want. Even if one were to craft perfect laws and regulations than the firms will simply break the law. Who still thinks banks fear justice?

Volcker famously declared that the only financial innovation of any value was the ATM machine and, frankly, it's not too far from the truth. But it's a waste of time to argue over the value of this or that so-called innovation. This isn't the problem.
posted by nixerman at 4:28 PM on August 14, 2012 [2 favorites]


is the upshot of this that legal liability + CDOs + SPEs = rewrite of what equity fundamentally means? that seems backwards, why would you allow basic ideas of ownership be changed to accommodate exotic investment vehicles?
posted by ennui.bz at 4:28 PM on August 14, 2012


( i mean i suppose you could take the Rand/Greenspan answer and remove legal liability from Wall Street deals but...)
posted by ennui.bz at 4:30 PM on August 14, 2012


A couple jobs back I worked at a company that attempted to specialize in SPE and SPAC compliance. I was writing EDGAR automation software at the time to generate XFDL EDGAR headers. We kinda tried to pivot to that after all the RMBS deals stopped overnight. We went bankrupt, mainly beacuse the flood of SPAC work our CEO predicted never materialized. What a joker that guy was, we were just making money because everyone was making money.
posted by Ad hominem at 4:40 PM on August 14, 2012


SPACs are back. In pog form.
posted by dr_dank at 4:51 PM on August 14, 2012


The problem isn't the CDO structure, it's the fact that lazy buyers are lazy...

That isn't the case. CDO structures are complex, and the person or firm who constructs them has an information asymmetry over the buyer. In fact, it appears that it is computationally infeasible for a buyer to do the type of checking you are suggesting to verify that the CDO isn't rigged against them.
posted by procrastination at 4:51 PM on August 14, 2012 [6 favorites]


But there is no regulation in the world that will prevent municipalities from making stupid investment decisions

Or prevent Bear Sterns, Lehman Brothers, and basically all of Wall Street from making stupid decisions that would have themselves out of business entirely if it weren't for the government and the tax payer.
posted by Golden Eternity at 4:58 PM on August 14, 2012 [1 favorite]


It isn't stupid decisions if you know you either win or get bailed out. There is no downside.
posted by Ad hominem at 5:05 PM on August 14, 2012 [2 favorites]


Let me rephrase that. There is a downside for all my co-workers at that company and perhaps millions of other people. But no downside for some people.
posted by Ad hominem at 5:08 PM on August 14, 2012


Volcker famously declared that the only financial innovation of any value was the ATM machine and, frankly, it's not too far from the truth

You hedged well. But the reason we have derivatives in first place -- in all likelihood must have had some form of them in imperial Rome, even -- is the pig cycle. Pure buying and selling risk doesn't create new value, but managing to come out ahead because of information you couldn't sell directy if you wanted?

Of course, the most harm plain future markets can do is to amplify oscillations until they reach the amount of information the uninformed nonparticipant had anyway. Pandora's box was the asymmetric options of the Bachelier-Merton-Black-Scholes model. If you have building blocks like that, you can synthesize all kinds of funny exposures, not to mention trade in abstract derivatives of portfolio exposure. (Yes, my opinions are shifting because of your last post -- I'm not inconsistent, I'm like water. Maybe I'll argue against this very same point later.)

So maybe there is a need for regulation in finance in light of your perspective. What should be avoided is trading risk directly.


PayPal, Amazon and Apple have changed capitalism more drastically than the ATMs. The lower-priced Kindles are probably sold at a loss, because it's so easy to just buy a book whenever you hear a review of it and start reading right ahead? (Impulsive app purchases too.)

posted by syntaxfree at 6:01 PM on August 14, 2012


I guess, it's all made up right? I mean, even at the basest form of currency, gold, we imagine it to be representative of some made up crap in our head.

Gold, CDS, oil, dollars or leaves falling from trees, this was all created from our silly heads.
posted by roboton666 at 6:17 PM on August 14, 2012


>Gold, CDS, oil, dollars or leaves falling from trees, this was all created from our silly heads.

That's close, but not quite. Currency is a legal mechanism to distribute potential energy in a society. It's value is based in the abstract system of laws, but the potential energy it represents does exist.
Now to show that energy is a real, measurable thing- it's the ability to do work.

example:
X amount of money buys Y quantity of gas which powers my car over Z distance.
posted by MisplaceDisgrace at 6:25 PM on August 14, 2012 [2 favorites]


What made the Milken move and the Enron maneuver illegal is that they were small enough to fail.

It's high time we had a "Too Big to Succeed" rule.
posted by ZenMasterThis at 6:28 PM on August 14, 2012


Why are there not dozens of fine SEC employees not fired let alone under indictment/serving hard time for Madoff's ponzi scheme? Compared to that the banks and just selling skanky CDO's were fine upstanding...
posted by sammyo at 6:29 PM on August 14, 2012


is the upshot of this that legal liability + CDOs + SPEs = rewrite of what equity fundamentally means? that seems backwards, why would you allow basic ideas of ownership be changed to accommodate exotic investment vehicles?

I think the authors think that's backwards too. Its just sort of something that was stumbled in to without regulators really grasping what was going on. Regulation/Law has to change.

The problem with what a lot of people here argue for, is that in a rules based regulatory system like we have in the US once you have a set of rules you can pay a bunch of really smart lawyers to figure out a way around them.

You are basically always writing rules for the last crisis. I'm not sure anyone knows what the answer is.
posted by JPD at 6:34 PM on August 14, 2012


I guess, it's all made up right? I mean, even at the basest form of currency, gold, we imagine it to be representative of some made up crap in our head.

Gold, CDS, oil, dollars or leaves falling from trees, this was all created from our silly heads.


The entire financial system, including money itself, is based on trust, on the belief that the securities we own are worth what we are told they are.

rather than doing due diligence and forming their own opinions about the assets in a CDO, they glanced at a graph of recent performance, relied on a vague and stupid understanding of the market (like "housing prices always go up!"), and asked rating agencies that they didn't pay (ratings agencies are paid by the issuer) and that had no contractual or legal obligation to them to confirm their broker's opinion of the asset.

We really need to be able to trust our regulators, rating agencies, banks, brokers, etc, to some extent or the entire system will fail. If the government (FDIC) hadn't stepped in to basically guarantee money markets and keep the banks afloat the system would have failed. The US government was the one institution people still trusted, perhaps by necessity. Does everyone need to investigate every stock in every mutual fund they own, or instead do what my Grandfather did after getting burned in the great depression and invest only in US savings bonds? Maybe that is the answer.

You are basically always writing rules for the last crisis. I'm not sure anyone knows what the answer is.

We can sky-crane an automobile sized vehicle onto Mars (almost all done by a government agency), but Wall Street can't figure out how to create mortgage securities without destroying the entire banking system. And when this happens they blame it on government involvement. Its incredible.
posted by Golden Eternity at 6:45 PM on August 14, 2012 [1 favorite]


Who is blaming it on government involvement? The regulator has an impossible job.
posted by JPD at 7:03 PM on August 14, 2012


CDO structures are complex, and the person or firm who constructs them has an information asymmetry over the buyer. In fact, it appears that it is computationally infeasible for a buyer to do the type of checking you are suggesting to verify that the CDO isn't rigged against them.

Sellers almost always have an information asymmetry of some sort over the buyer, whether you're talking about CDO's or used cars. That isn't a reason to outlaw markets.

As for your second sentence, if true that may be a good reason not to buy a CDO'S, but it's not a good reason to say they should be regulated out of existence. After all, not everyone agrees with your assertion, and maybe someone sufficiently smart can find a way around the problem. In any event, we're talking about large, supposedly sophisticated, institutional investors - they should be free to make decisions and live with the consequences. It is neither possible nor desirable to protect everyone from all loss caused by bad decisions.

You are basically always writing rules for the last crisis. I'm not sure anyone knows what the answer is.

Here's a suggestion in two parts.

First, stop thinking there's an answer that will protect us from unforeseen risks. There's not. Get comfortable with that fact and build your risk management model and procedures to withstand unexpected losses, a la Taleb.

Second, make people eat their losses and live with their bad decisions. Do that consistently over time, even when it's hard, even when it hurts. Teach them that no one will bail them out if they blow themselves up. This will eliminate moral hazard, teach caution and risk aversion, and improve decision making.

We really need to be able to trust our regulators, rating agencies, banks, brokers, etc, to some extent or the entire system will fail. If the government (FDIC) hadn't stepped in to basically guarantee money markets and keep the banks afloat the system would have failed.

No, we don't need to trust "the system." We each need to take responsibility for ourselves and live with the consequences of our decisions. If that means investing only in savings bonds, then so be it. That would eliminate a lot of speculative bubbles - bad money chases out the good - and restore stability to the system.

We are currently trying to tell ourselves that if we just try hard enough, and regulate earnestly enough, then markets will always go up and the last few decades of post-war prosperity for everyone can continue forever. That's not how it works, and the harder we try to keep the high going, the harder the ultimate crash will be.

Investing is "easy money" until you lose everything, so if you can't afford to lose everything, if you haven't planned for that, if you don't know enough to be willing to accept that risk, then you shouldn't be investing.

A stable financial environment will low inflation, lower credit availability, and investors that prize careful risk management due to the certainty that bad decisions will be punished with losses. That's what this country needs, because it permits planning and rewards both saving and prudent investments.
posted by gd779 at 7:14 PM on August 14, 2012 [1 favorite]


Oh, and a sane tax code. We need that too As long as I'm dreaming about things that this vountry will never, ever allow to happen, I might as well list everything.
posted by gd779 at 7:17 PM on August 14, 2012


I see your credit default swap and raise you one moofledorp royal shuffle.
posted by roboton666 at 9:13 PM on August 14, 2012


procrastination: CDO structures are complex, and the person or firm who constructs them has an information asymmetry over the buyer. In fact, it appears that it is computationally infeasible for a buyer to do the type of checking you are suggesting to verify that the CDO isn't rigged against them...

gd779: Sellers almost always have an information asymmetry of some sort over the buyer, whether you're talking about CDO's or used cars. That isn't a reason to outlaw markets.

As for your second sentence, if true that may be a good reason not to buy a CDO'S, but it's not a good reason to say they should be regulated out of existence. After all, not everyone agrees with your assertion, and maybe someone sufficiently smart can find a way around the problem.


gd799, the paper linked by procrastination makes an overwhelming argument against your theory that everything would be peachy-keen if only "lazy buyers" would do their due diligence. Why? Because that paper shows that performing due diligence for certain realistic CDOs is akin to breaking encryption. That paper further does not suggest regulating these devices out of existence, but advocates that computational complexity be explicitly accounted for in regulation and rating agency assessments.
posted by qxntpqbbbqxl at 9:14 PM on August 14, 2012 [1 favorite]


Everyone has a share!
posted by flabdablet at 10:12 PM on August 14, 2012


We can sky-crane an automobile sized vehicle onto Mars (almost all done by a government agency), but Wall Street can't figure out how to create mortgage securities without destroying the entire banking system. And when this happens they blame it on government involvement. Its incredible.
This is a very silly analogy.

The Mars lander depends on understanding Newtonian and relativistic physics. Some chemistry, mechanical engineering, computer engineering and a half-dozen other flavors of engineering are helpful too. The underlying physics doesn't change, and the underlying engineering just becomes better and better understood over time. The goal is dramatic, it is easy to explain to your grandmother that you helped put a lander on Mars. It doesn't happen often, so you can bask in the glow of your achievement. The whole thing has been several decades in the making.

Compare with regulating the finance industry:

Humans are greedy. Capitalism is based on the premise that money is used to motivate some of the best and brightest people to make you more money. Unless you live in a Randian dystopia, government regulation is present to moderate the capitalists.

The problem is that there is a disproportionate payoff for the financial engineers compared to the regulators. Regulators are defenders - they have to keep the economy safe for everyone else. They have to do this every day, forever. They are paid fixed salaries. If they get bonuses, they are probably measured in tiny percentages of their overall pay.

Financial engineers stand to dramatically multiply their earnings if they can find ways to evade the regulators. And there are far more financial engineers than regulators.


NASA has it easy compared to the SEC.
posted by b1tr0t at 11:40 PM on August 14, 2012


We each need to take responsibility for ourselves and live with the consequences of our decisions

That would be great, but it is impossible. There's a pension fund right now taking decisions for me that I have no influence over, but I will have to live with the consequences - and the people at the funds making the decisions won't have to live with these consequences. Doing the investments for this yourself instead of in a fund is only possible for a few of us.
posted by DreamerFi at 11:45 PM on August 14, 2012 [1 favorite]


There is nothing wrong with cash or synthetic CDOs as structures, including, without limitation, the SPEs utilizes in their formation. They have functioned exactly as designed before, during and after the financial crisis -- absorbing loss as the junior level and (when cash flows sufficed) mitigating loss at the senior level. What people assert to be the most complex or misleading things about those structures were in fact very well understood by the rating agenices and buyers. What buyers and rating agencies got wrong was their model for delinquency and default for the ultimate NON-COMPLEX underlying or reference obligations comprising the instrument. No matter how much people want to blame nasty I-bankers, it just ain't so: "housing can't go down" was the original sin.
posted by MattD at 4:34 AM on August 15, 2012 [3 favorites]


That would be great, but it is impossible. There's a pension fund right now taking decisions for me that I have no influence over, but I will have to live with the consequences - and the people at the funds making the decisions won't have to live with these consequences. Doing the investments for this yourself instead of in a fund is only possible for a few of us.

So the first mistake here was creating a distortionary tax system that encouraged the growth of pensions that made us dependent on our employers for our retirement.

The second mistake was thinking that investing is an appropriate way for the average person to compensate for improperly low levels of retirement savings and the government policies that created rampant inflation. Investing in stocks and bonds has, for the last several decades, been an outstandingly good idea: but that isn't a necessary truth about the universe and it won't be true forever.

Instead, people should simply receive a paycheck that represents payment for their work. They should be free to, and responsible for, saving for retirement in whatever way they think is best. That might or might not include investing. And while a certain minimum standard of living should be guaranteed by the government, to protect the poorest and the unlucky from starvation, we should otherwise be on our own and forced to live with the consequences of our investment decisions.

gd799, the paper linked by procrastination makes an overwhelming argument against your theory that everything would be peachy-keen if only "lazy buyers" would do their due diligence. Why? Because that paper shows that performing due diligence for certain realistic CDOs is akin to breaking encryption. That paper further does not suggest regulating these devices out of existence, but advocates that computational complexity be explicitly accounted for in regulation and rating agency assessments.

First of all, breaking encryption is very hard, but not impossible. If a large institutional investor wants to buy CDO's because they believe the figured out how to do it right, shouldn't they be permitted to do so? Due diligence is hard, but not impossible. Or maybe it is impossible, and CDOs need to be simplified to be marketable. whatever the truth, the market will sort it out eventually.

So the first point i am making is that investing is hard, but as MattD points out the asset models, not the CDO structure itself, is to blame. And to the extent that CDOs are opaque, it's mostly laziness (no one wants to look at the underlying assets because that takes time and effort and it is way easier to look at a rating and a graph of recent performance) rather than the structure itself. There is no cure for laziness except consequences.

The second point I am making is that institutional buyers are in the best position to make the decision on CDO's for themselves, and that we need to give up on the idea that either regulators or ratings agencies can protect us: they can't, both because they are dumber and less motivated than the buyers and also because some risks are always unknowable. All we can do is create strong incentives for the people making the decisions to be careful, be right, and have plenty of reserves.
posted by gd779 at 5:05 AM on August 15, 2012


Go back and read the MBIA or AMBAC transcripts during the crisis where they talk about their exposures to CDO^2, CDOs of HELOCs and Mezzanine CDOs. Those things were basically impossible to figure out and or the asset cashflow models completely failed.

I mean those were sort of the esoteric of esoteric, and yeah they probably just shouldn't exist, but its naive to say people only got burned because of a lack of DD. Actually if you believe the monolines most of their exposure to more vanilla things ended up being money good excepting those situations when the collateral turned out to be something different from what the originator told them it was - and that matter is still in the courts.
posted by JPD at 5:27 AM on August 15, 2012 [1 favorite]


MattD - I think the point of the article was that an SPE + Synthetic risk exposure allows you to replace the equity with a contract and that has all sorts of implications for changing the economic incentives around in ways the law and regulators are not prepared to handle. That's why I thought it was interesting - no because it was another "bash the bankers" piece. I mean I'm not that self-loathing.
posted by JPD at 5:30 AM on August 15, 2012


We don't need more trust in the financial system, we need less. Wariness about investments and products makes everyone more careful.
posted by blue_beetle at 5:40 AM on August 15, 2012 [2 favorites]


I mean those were sort of the esoteric of esoteric, and yeah they probably just shouldn't exist, but its naive to say people only got burned because of a lack of DD. Actually if you believe the monolines most of their exposure to more vanilla things ended up being money good excepting those situations when the collateral turned out to be something different from what the originator told them it was - and that matter is still in the courts.

Proper due diligence would have revealed, in advance, that the extremely esoteric CDO's were basically impossible to figure out. If the buyer did its due diligence and knew this, but bought them anyway, en the buyer is now getting what it deserves. If the buyer didn't know this because it didn't do its due diligence (which is in my experience the case most of the time), then it is now getting what it deserves.

As for the monolines, if their assertion about the facts is correct, then the courts will provide them with at least partial recovery. Since that seems to be what is happening or most likely to happen, I think the system is working.

We don't need more trust in the financial system, we need less. Wariness about investments and products makes everyone more careful.

Exactly. This is the fact that we, as a society, don't seem to want to acknowledge, because it will slow down the incredible growth and prosperity we've been enjoying. We want the upside of the bubbles but not the downside. It doesn't work that way.
posted by gd779 at 5:53 AM on August 15, 2012 [1 favorite]


Proper due diligence would have revealed, in advance, that the extremely esoteric CDO's were basically impossible to figure out. If the buyer did its due diligence and knew this, but bought them anyway, en the buyer is now getting what it deserves. If the buyer didn't know this because it didn't do its due diligence (which is in my experience the case most of the time), then it is now getting what it deserves.

This is sort of like magical thinking. The reason why the models failed had to do with the behavior of the super senior tranches of the CDO's whose equity tranches were recollateralized into CDO^2. Don't forget as well that the monolines were writing super senior protection on the CDO^2 not the subordinated bit. It became an instance where the law didn't track the economics of the deal. No one knew that this could happen. Not the original sponsors, not the buyers of the equity tranche, no one. I'm not defending their decision to write the protection. It was dumb on its face, and its even dumber when you learn a little bit about how the structures worked, and they deserved to lose the money they lost. I'm just saying there were CDO's out there where it was literally impossible to evaluate the collateral.
posted by JPD at 6:22 AM on August 15, 2012


And to the extent that CDOs are opaque, it's mostly laziness (no one wants to look at the underlying assets because that takes time and effort and it is way easier to look at a rating and a graph of recent performance) rather than the structure itself. There is no cure for laziness except consequences.

to be clear this is the point I'm objecting to. Although I certainly agree most of the clowns who bought these things were doing exactly what you said they were doing.
posted by JPD at 6:25 AM on August 15, 2012


I don't think it was so much laziness as it was money managers having big egos. They look at the guy across the street making money on these things and worries they're losing out on some easy gains and don't want to admit to the sellers or themselves that they can't figure out the structure.

What they should have done was look at the three-inch thick binder and said, "Bring this back to me when you can simplify it down to a half-inch think binder and then I'll take a look."

Then, had their egos not gotten in the way, they might have included older housing market data or just put more weight on pricing models that assumed cyclical downturns in home values.

There is also an issue with favoring short-term over long-term performance. It would be hard to say no to an investment that everyone is making money on and getting huge bonuses as a result even if you knew the whole thing was bogus. Your ego will tell you, "You're smart enough to get out before the whole thing explodes."

Even just letting everyone take their losses would only be a short-term cure. It wouldn't take long for everyone to forget or for a new generation of money managers to emerge and think that they know better.

I think it really does take a dis-interested third party reel in all these egos. Once I know that the dumbass in the firm across the street can't get too far ahead by making stupid bets, it makes it easier for me to say no to them myself.
posted by VTX at 7:14 AM on August 15, 2012 [2 favorites]


The Randian "greed is good" philosophy with its corollary "caveat emptor" is at the root of the problem. Financial engineers don't "make money." They find ways to take other people's money away from them. That is their only purpose. It provides no social benefit.

Some financial engineering is useful but the great majority is only a scheme to "make money" by taking other people's money. One of the most important purposes of finance is to transfer risk from those who need to avoid risk to those able able to carry risk, for a premium. But in many cases the instruments created by Wall Street are intended to purposely conceal risk and transfer risk to those who don't understand it by pushing it downhill in every increasing layers of obfuscation. All the due diligence in the world is defenseless against malicious intent. There is no "qualified investor" exception.

George Akerloff won a Nobel prize for his description of how markets break down under conditions of asymmetrical information. Much of financial engineering is designed to increase the asymmetry of information in order to create an advantage. This tendency is destructive to proper operation of markets. Caveat emptor is no way to run a market and not an excuse for anything goes, including lying and deception.
posted by JackFlash at 8:09 AM on August 15, 2012 [1 favorite]


This is sort of like magical thinking. The reason why the models failed had to do with the behavior of the super senior tranches of the CDO's whose equity tranches were recollateralized into CDO^2. Don't forget as well that the monolines were writing super senior protection on the CDO^2 not the subordinated bit. It became an instance where the law didn't track the economics of the deal. No one knew that this could happen. Not the original sponsors, not the buyers of the equity tranche, no one.

This simply isn't true. I understand what you're saying: you're saying that the people involved in the deals didn't understand that this could happen. That's because the deal was handled by traders and finance people and business people, without the necessary legal expense that would have been a drag on profits. Because, speaking as a lawyer who works in a closely related industry, I can tell you the lawyers knew this could happen. It's just that no one asked them or wanted to pay for that opinion.

You get what you pay for.

Oh, and the law doesn't track economics. That was one fundamental mistake that the industry made. The law never tracks the economics: the economics track the law. Legal reality is the reality in these deals, and you can't gloss over that reality and pretend it doesn't exist because it doesn't fit the model you want to use or because you don't want to pay for very good, very expensive lawyers.

VTX: you are mostly correct. I agree entirely with your assessment of the problem. The only place we part ways is that I don't believe that regulators are smart enough, motivated enough, or well funded enough to ever regulate away the problem. So unless your disinterested third party is going to shut down every market with even the slitghtest whiff of risk or complication (which would be disastrous for the economy, as business is inherently risky), the disinterested third party will always lag behind the industry. This means we always have risk, but worse, we think we've eliminated it.
posted by gd779 at 9:50 AM on August 15, 2012


But in many cases the instruments created by Wall Street are intended to purposely conceal risk and transfer risk to those who don't understand it by pushing it downhill in every increasing layers of obfuscation. All the due diligence in the world is defenseless against malicious intent.

This is why God made lawyers. The contract is right there in front of you, in black and white. There is no way, short of fraud, to hide the risk if you have the right lawyer and the right risk manager spending the time to understand the deal. The problem is, that's expensive, so no one wants to do it. It's way cheaper, in the short term to just cross your fingers amd hope for the best, and know that you can always complain that you've been "cheated" when the deal blows up later.
posted by gd779 at 9:54 AM on August 15, 2012 [1 favorite]


I totally agree. I don't think that the current regulation scheme has the right incentives to get the job done. I think it's more a matter of the third party being rewarded for taking a longer, more pessimistic view. That is basically the government's role on behalf of society so that we balance out those that create the boom-bust cycles and everyone benefits from a smoother running economy. I just think that the rewards are too macro in nature. The benefits are too vague and spread out so we don't really have the political will to pay the regulators what they deserve or give them the tools they need be proactive. If we did, a high level regulator would be paid nearly as well as the average money manager.

What we really need is someone who works with the money manager who's job is to keep the manager from f-ing things up. But how do you figure out how that incentive works? It would be like giving a massive bonus to the Fed for taking action to prevent a recession. How do you really know that what they did prevented anything? "Ah ha, since you made me restructure that deal in a way that was less risky, you prevented a loss of $xxx,xxx,xxx twelve years from now. Here is your cut."

So basically, I think the most we can hope for is slightly less bad with better regulation but we're mostly hosed.
posted by VTX at 10:16 AM on August 15, 2012 [1 favorite]


There is nothing wrong with cash or synthetic CDOs as structures, including, without limitation, the SPEs utilizes in their formation....What buyers and rating agencies got wrong was their model for delinquency and default for the ultimate NON-COMPLEX underlying or reference obligations comprising the instrument. No matter how much people want to blame nasty I-bankers, it just ain't so: "housing can't go down" was the original sin.

Some version of this is becoming the go-to for Wall Street apologists, but it's highly misleading at best. The economy could have taken the hit from the loss of ALL subprime loans, what caused the crisis was the multiplication of housing exposures through complex synthetics and liquidity/funding arrangements that were based on highly rated CDOs. See Bernanke's speech from earlier this year. Quote:

"it is not clear that even the large movements in house prices, in the absence of the underlying weaknesses in our financial system, can account for the magnitude of the crisis. First, much of the decline in house prices has occurred since the most intense phase of the crisis; the decline in prices since September 2008 is probably better viewed as largely the result of, rather than a cause of, the crisis and ensuing recession. More fundamentally, however, any theory of the crisis that ties its magnitude to the size of the housing bust must also explain why the fall of dot-com stock prices just a few years earlier, which destroyed as much or more paper wealth--more than $8 trillion--resulted in a relatively short and mild recession and no major financial instability. Once again, the explanation of the differences between the two episodes must be that the problems in housing and mortgage markets interacted with deeper vulnerabilities in the financial system in ways that the dot-com bust did not."

Those vulnerabilities have everything to do with the games the I-bankers were playing.
posted by zipadee at 10:41 AM on August 15, 2012 [1 favorite]


They didn't pay for good lawyers?

Don't pretend like the lawyers also arent complicit here. Some of the big white shoe firms basically lived off of securitization work from 03-07. Not to mention the number of lawyers in house at the financial guarantors.

And yes, all this stuff was invented to get around the law - that's basically the point of it.
posted by JPD at 10:56 AM on August 15, 2012


This is really interesting, thanks for sharing. I'm slowly making my way through it - I'm only up to page 15.

About three or so years ago I had a meeting with a fund manager in the UK and he had a fantastic presentation on the shadow baking system and off balance sheet vehicles. It was one of the most interesting presentations I've heard. He talked for like 2-3 hours and I constantly kick myself that I didn't keep a copy of his presentation.
posted by triggerfinger at 11:20 AM on August 15, 2012


Don't pretend like the lawyers also arent complicit here. Some of the big white shoe firms basically lived off of securitization work from 03-07. Not to mention the number of lawyers in house at the financial guarantors.

Sure, the sellers (especially on the lending side) were happy to pay lawyers to draft the transaction documents. But did the buyers get an opinion from their lawyers on how the documents worked and where the risks were? If they did, and the opinion did not disclose the risks accurately, then the buyers now have a malpractice claim against their lawyers that they can use to recover some of their losses. But that isn't happening, because that isn't how these deals happened. On the other hand, if the buyers got a legal opinion and choose to assume the risks anyway, or didn't understand the risks because they didn't want to pay for a lawyer, then they deserve their losses.

Your original contention was that due diligence could not have possibly disclosed the way the CDO's worked and the attendant risks. That is manifestly false. I'm not saying lawyers are blameless: I'm saying that people who charge by the hour are happy to spend time reading contracts and summarizing them for you. If you are entering into a complex legal transaction with sophisticated and untrustworthy counterparties, and you don't hire a lawyer to do that before you buy something, whose fault is that? Hint: not the lawyer's.

But the culture of the financial industry is to do everything fast, cheap, and based on the numbers.
posted by gd779 at 11:32 AM on August 15, 2012 [1 favorite]


Do you not think the financial guarantors had lawyers doing this? Sure were most of the economic long guys fools for not using lawyers? yes, but we've already agreed they were fools.

This is a truly bizarre angle you are trying to take here. Can you provide me an opinion pre-07 talking about the issues with CDO^2? I mean its not like these guys didn't use sophisticated outside counsel.

This was not a case of untrustworthy counter parties that I am talking here BTW. Perhaps that's why we are having this disagreement? It was a problem with the actual cash flows in the bond not behaving as expected because the underlying math was wrong.
posted by JPD at 1:45 PM on August 15, 2012


But did the buyers get an opinion from their lawyers on how the documents worked and where the risks were?

On the deals that I am familiar with, Opinion Letters covered all the usual bases (legal formation, etc.,) and the contentious area, the part that lawyers argued back and forth over, was perfection of the secured interest in the underlying asset. The concern was that the underlying asset would be found to be inadequately secured.

Personally I believe that buyers placed an inordinate amount of confidence in the opinion of the ratings agencies to evaluate the complexities of the transaction. I think people assumed that if S&P or Moody's rated it AAA, then the fact that they didn't understand the CDO terms was less problematic.
posted by ambrosia at 2:18 PM on August 15, 2012 [1 favorite]


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