Wednesday, April 28, 2010

Damned if You Do and Damned if You Don't

In the recent past, we were shown the spectacle of CEO's of failed and almost failed financial institutions (i.e. Fuld (Lehman) and Prince (Citibank)) raked over the coals in the Senate. Their crime was to buy, and promote to their customers, what the Government (Fannie and Freddie) was selling and not being smart enough or insightful enough to foresee the coming housing collapse and therefore not able to position their institution to weather the financial storm. They were forced to act contrite (even as they assert that "everyone was doing it" and "nobody was smart enough to foresee the collapse"). It was not pretty, but understandable; big losers often get pilloried.

Now, however, we have the spectacle of a CEO of a successful financial institution (Goldman) that did foresee the collapse (or at least recognized the significant risk and took steps to manage that risk) being raked over the same coals in the Senate. Their crime was in participating in the marketplace, buying and selling instruments that regulators permitted to circulate there, and to do so in such a way as to avoid losing (and even worse, perhaps making) money during the financial meltdown.

So, there we have it. The crime is not being stupid (failing the trust put in them by others), the crime is just being a financial institution in bad times.

The Government (including the Fed) serves up a dangerous cocktail of easy credit and legislatively mandated reduction of credit standards, and a major increase in the availability of Government guarantees for dubious credits. Private institution take these components and play a furious game of musical chairs for profit. The music stops. Some are winners and some are losers. And the guys who created the environment sit in judgment of the players and declare that winners and losers are both at fault.

Judge not lest ye be judged. Election time is coming. The public is not as gullible as populist demagogues think.

Friday, April 23, 2010

Abacus 2007 AC-1

A sophisticated gambler ("A") walks into a casino and joins a private game of poker. He knows some but not all of the other gamblers at the table, but they all appear to be pros like him. The house has set the rules (maximum bet, maximum number of raises, permissible poker games which may be called by the dealer, and so forth). Unbeknownst to A, one of the anonymous faces at the table is a gambler ("B") who is as experienced as he is, and was consulted by the casino concerning the setting of the house rules. The casino itself is represented at the table by one of the players. A loses heavily, as does every other player (including the house), except B, who wins everything. Later, the Government sues the casino for fraud: it failed to tell A the identity of B and that B was on the other side of each bet A made. Further, the complaint alleges that the casino committed fraud by failing to tell A that B had been consulted on the setting of the house rules. The case was launched by the Government just as it ramped up its efforts to pass legislation to further regulate casinos.

I submit that this is an accurate analogy to the fraud case launched by the Government against Goldman Sachs (with the exception that there is no law requiring material disclosure in the casino world). I also suggest that, just as in the analogy, there is no fraud in the case. Any sophisticated gambler knows that in order to have a chance to win money, some other gambler must be willing to take the opposite side of each bet he makes. Who was involved in setting the house rules is not material, the house rules themselves were fully disclosed at the start of the game, and each player could analyze the impact of those rules on his style of play and his chances of winning.

The bigger issue posed by the facts of the Abacus 2007 AC-1 deal is whether such deals should be permitted at all (other than in a casino).

Healthy capital markets are necessary for the smooth and efficient movement of capital from those who have it and want to invest, to those who do not, and need investment capital. The entire structure of our (small "l") liberal western economy since the Renaissance is built on such a financial foundation. However, that does not mean that any transaction that can be imagined, that has the potential to create winners and losers, should be allowed to occur within the precincts of the capital market. We do not allow investment banks to create synthetic securities, the purchase and sale of which is the functional equivalent of betting on the outcomes of the following week's sports events. Such a side bet does not facilitate the larger purpose of a capital market.

I suggest that before any product is allowed in the capital marketplace its proponents must give satisfactory answers to two questions (1) “What legitimate purpose does it serve?” and (2) who has a legitimate need to buy or sell the product?” Credit default swaps pass the first question—they allow those with credit default risk to insure against it. However, that does not mean that those who do not have a credit default risk should be allowed to buy a swap. If the proper analogy for a credit default swaps is insurance, than the prohibition against a person without an insurable risk buying an insurance policy should apply.

Allegedly, Abacus 2007 AC-1 was fashioned for the sole purpose of permitting one party to place a massive bet that a certain group of securities collateralized by a pool of mortgages would be downgraded and ultimately default (and, of course, to generate fees for Goldman). There is nothing wrong with wanting to profit from a market insight you have that others don’t share. But that does not justify building a security for that specific purpose. There were ample other means of placing negative bets on the mortgage market (although those means would, undoubtedly, be more expense and more transparent). In addition, it masks price information. If all those who think x will go up or down must place their bets by buying or shorting x, this activity affects the price of x. A side bet does not. Furthermore, creating such a security also has a money supply inflationary effect, it creates an “asset” out of thin air, out of the fact that there is a person who thinks x will go up and another who thinks x will go down.