Mr. Smith Goes to Wall Street
In 1776, as things were getting a little busy in the soon-to-be United States, a former philosophy professor in the progressive city of Edinburg was publishing a book on economics. An Inquiry into the Nature and Causes of the Wealth of Nations was an immediate hit. Not only did Smith give a systematic explanation for the rise and fall of salaries and prices, he explained how an open marketplace could enrich both buyer and seller. Overnight he became the patron saint of the "free market" (and the most misquoted man in history).
The basic assumption that Smith makes: that the market will be constrained to behave well because good behavior benefits all participants, might as well have been carved in stone. In fact, for many people it's the basis of the One Commandment: keep thy smelly regulating hands off my market.
But, smart as Smith was (and he was a terribly bright fellow), here's a bet -- he didn't see this one coming.
Earlier this week, the government filed charges against Goldman Sachs. The exact details of what Goldman did that's against the law are a little hard to pick out of most media reports. Basically, the accusation is that they misled investors by not letting them know that they, or firms they had partnered with, were betting against the same investment vehicles that Goldman was pushing.
What's more interesting is what Goldman was doing that may not be illegal. Goldman was involved in what's become known as the Magnetar Trade.
Magnetar is a hedge fund that moved into the collateralized debt obligation (CDO) market at the end of 2005, just as everyone thought the market was about to collapse. The way these instruments are structured is a bit like a multi-layer Tootsie Pop, with a really nasty core. That innermost layer -- the "equity tranche" -- is the riskiest part of an already risky package. Putting together a CDO is difficult unless you can find someone to buy that ugly little chunk.
For investors looking at the fading CDO market, it was Magnetar to the rescue. Magnetar swooped in and announced that they would buy the equity tranche of CDOs, and they didn't seem to be scared off by the low ratings of some of the CDOs they were buying into. Pretty soon, Magnetar's willingness to bottom feed wasn't just powering existing CDOs, it was causing new instruments to be generated. In fact, Magnetar began to order up new CDOs on demand, delivering to bankers specifications for how bad they wanted the loans involved to be. What they wanted were assets so risky that some bankers refused to sell what they wanted. If someone tried to slip good loans into one of the packages, Magnetar refused to buy. Around the industry, other analysts and hedge fund managers looked at Magnetar and snickered.
No matter what happened in the market, there seemed to be no way for Magnetar to avoid getting pasted. But everyone was relieved to have Magnetar there, because just by buying those equity bits, the CDO market wasn't just sustained, it actually grew. A lot.
It took awhile before everyone got the joke.
What Magnetar was actually doing was playing two of the markets most convoluted instruments against each other. Not only were they buying CDOs, they were buying credit default swaps. Default swaps started off as ways for investors to protect their investments, but by the time Magnetar entered the market, default swaps had become vehicles independent of original obligations. You could get someone to sell you a default swap on someone else'sdebt. In essence, you were insuring a loan you didn't make, and getting paid off if it failed. And that's just what Magnetar did. They took out default swaps not on the little equity tranche that they had bought, but on the larger layers built on top of that purchase. Those other layers could be ten times, or a hundred times Magnetar's original investment. Imagine that Magnetar was building foundations, putting in the specifications that only the weakest concrete and shoddiest construction could be used, then taking an insurance policy on the whole skyscraper built on that foundation.
What Magnetar was doing was shocking. They had found a way to game the system and profit by constructing instruments literally built to fail. You'd think that would have stopped anyone from dealing with them. Maybe even send up some warning flags. Certainly you'd think that the banks involved would put out a warning to investors.
That's not what happened. Instead, a dozen other hedge funds got into the act, including Paulson & Co., the fund that's directly involved in the charges against Goldman. And none of these guys had any trouble finding banks to create the CDOs. Hell, Goldman was not only selling these instruments, they were buying the CDOs themselves, even knowing that these things were ticking time bombs.
Goldman certainly wasn't alone. Merrill Lynch was doing the same thing.
Cooperatieve Centrale Raiffeisen-Boerenleenbank BA, known as Rabobank, claims Merrill, now a unit of Bank of America Corp., failed to tell it a key fact in advising on a synthetic collateralized debt obligation. Omitted was Merrill’s relationship with another client betting against the investment, which resulted in a loss of $45 million, Rabobank claims.
Who was that "other client" of Merrill? Magnetar.
But why would they do this? Why would banks destroy their relationships with long term customers by selling them instruments they knew to be heading for the Dumpster? Why in holy hell would the banks swallow this poison themselves? This is where Dr. Smith's two hundred year old perscription falls short. A rational bank wouldn't do these things. But a rational banker would. Why? Because the bonus structure at these banks rewarded bankers not for scoring profits for their customers, but for just setting up the deal. Individual bankers were pocketing a percentage of each CDO. Sell a hundred million, pocket two million. Sell a billion, pocket twenty. Unlike the customers they were selling to, the bankers made their money as soon as the deal closed, so they didn't have to be concerned about the ultimate outcome.
So the hedge funds and the individual bankers collaborated in destroying the banks and robbing their customers. In the process, they got very, very rich. If you can get payouts large enough, quickly enough, you can be sitting at your upstate mansion long before anyone realizes they've been screwed.
How big this market became isn't quite clear yet, but Goldman appears to be the tip of a very large, very dirty iceberg.
