Creating Risk, And Shuffling It

Paul Krugman denounces Goldman Sachs with vigor, and well he might.  However, he conflates two types of risk which probably ought to be viewed separately.  Here w ego:

Most discussion of the role of fraud in the crisis has focused on two forms of deception: predatory lending and misrepresentation of risks. Clearly, some borrowers were lured into taking out complex, expensive loans they didn’t understand — a process facilitated by Bush-era federal regulators, who both failed to curb abusive lending and prevented states from taking action on their own. And for the most part, subprime lenders didn’t hold on to the loans they made. Instead, they sold off the loans to investors, in some cases surely knowing that the potential for future losses was greater than the people buying those loans (or securities backed by the loans) realized.

What we’re now seeing are accusations of a third form of fraud.

We’ve known for some time that Goldman Sachs and other firms marketed mortgage-backed securities even as they sought to make profits by betting that such securities would plunge in value. This practice, however, while arguably reprehensible, wasn’t illegal. But now the S.E.C. is charging that Goldman created and marketed securities that were deliberately designed to fail, so that an important client could make money off that failure. That’s what I would call looting.

...So what role did fraud play in the financial crisis? Neither predatory lending nor the selling of mortgages on false pretenses caused the crisis. But they surely made it worse, both by helping to inflate the housing bubble and by creating a pool of assets guaranteed to turn into toxic waste once the bubble burst.

Well.  Predatory lending and aggressive generation of sub-prime mortgages to dubious borrowers are examples of the creation of risk.  If aggressive mortgage originators sign up a million dollars in new mortgages today, that represents a new opportunity for someone to finance that and make (or lose) money.

But the third type of risk described by Krugman represents a shuffling of risk.  In the Goldman instance, a hedge fund (Paulson) wanted to bet against mortgages; to facilitate this, Goldman found clients willing to bet on the mortgages.

Per the complaint, Goldman engaged in a bit of fraud and misdirection in describing the counterparties to each other, and they deserve to get thumped.  But the key point sidestepped by Krugman is that the Goldman fraud did not add (directly) to the supply of mortgages in the world.  Instead, market participants bet on or against mortgages that were already in existence.

Goldman's fraud is problematic here because it interferes with the price signals in the market.  Normally, if there are lots of committed, well financed sellers and fewer, less committed buyers, prices fall.  But Goldman managed to keep some relevant information from some buyers, thereby propping up prices a bit and sending a false signal to the world about the underlying demand for mortgage backed securities.  That is unfortunate - had mortgage prices begun to fall sooner and further, there would have been fewer originations (hence, less new risk) throughout 2007 and 2008.

So, Goldman's fraud muddied the proper price signaling of the market.  But had it been done honestly, would the creation of these securities made the market worse, better, or unchanged?  That is tricky, which is why Krugman danced around it:

As for the alleged creation of investments designed to fail, these may have magnified losses at the banks that were on the losing side of these deals, deepening the banking crisis that turned the burst housing bubble into an economy-wide catastrophe.

Absolutely - they *may* have added to losses at already troubled banks.  Or they may have been bought as a substitute for other securities that also went down in flames.  Hypothetically, a Goldman client may have been holding residential mortgage backed securities yielding 7% and sold them to Goldman in exchange for the shiny new whiz-bang synthetic CDO yielding 7.25%.  In the latter case, the client's actually losses on the Goldman CDO need to be compared with their prospective losses on the bonds they had been holding to get a fairer sense of their fleecing.

And absent fraud, it is obvious to everyone buying a synthetic CDO that there must be a short side to it, so one might hope the normal price signaling would be in effect.

Do keep in mind - AIGFP lost billions by insuring mortgage backed securities, but the parent company lost a comparable number of billions by directly investing in mortgage backed securities.  The problem wasn't derivatives per se - the problem was their ultimately unfounded confidence in the US housing market.

Vigorous regulation at the origination end, by cracking down on no-down payment loans, balloon payments and the like, would have made the overall housing bubble smaller (and shut a lot of working-class minorities out of the housing market.)

Vigorous regulation of the re-shuffling of the risk that has already been created has a more uncertain result.  To the extent it managed to slow the flow of money around the world it probably would have slowed the growth of the sub-prime market, as originators filled their own risk appetite and were left unable to pass the mortgages along.  Had the market been less liquid there probably would have been fewer total buyers and less total risk.  Since the reduced total risk would have been more concentrated, it is hard to say whether we would have seen more bailouts, although I'd bet the foreign impact would have been reduced.  However, making markets less liquid is not the typical goal of regulation.

And to the extent that the buyers and sellers were scarred and scared but not impaired, well, that is a triumph of capital markets!  Setting aside their possible role in Goldman's misdirection play (and they have not been hit with a complaint yet), the Paulson people called the market correctly, deployed their capital accordingly, and now have more capital to direct.  Their opposite numbers called the housing market wrongly and now have less capital to direct.  As long as no one needs to bail out either side (a big IF!), that is just capitalism in action - the dummies have less cash to throw at their next bad idea and the smart guys have more.

Comments

[Walter]

Shouldn't "w/ ego" be an understood component of any Goldman-related posts?

[Walter]

Come to think on it, what does Krugman do without an excess of ego?

[Melinda Romanoff]

no time, later.

[Charlie (Colorado)]

What's the difference between a crooked politician and a reform pol?

A crook stays bought.

[matt]

topic 1 on Journo-List today seems to be redefining Tea Party participants as privileged populists, per E.J. Dionne.

Topic two is the demonization of Goldman.

These people are incredibly smug and stupid.

LUN

[Patrick R. Sullivan]

But Goldman managed to keep some relevant information from some buyers

Almost certainly untrue. Did they buy up all the copies of the March 7, 2007 Business Week identifying Paulsen as bearish on MBS? That article appeared before the ABACUS deal closed in late April.

But, I hope Rick Ballard and friends are comfortable having Krugman on their side. You know, the guy who put his faith in e-mail snippets given to him by Jason Leopold.

Also good to see that Tom Maguire is smarter than many of his commenters:

The problem wasn't derivatives per se - the problem was their ultimately unfounded confidence in the US housing market.

Rush had an interesting take on this today. His Wall Street sources--the people who handle his millions?--say they think senior execs at Goldman (Democrats, mostly) signed off on this charade to ingratiate themselves with Obama, and insure themselves a place at the table on what goes into the latest regulatory legislation. That makes Machiavellian sense.

Consider the timing; Chris Dodd and Barney Frank are promoting such legislation, Obama makes a speech supporting it, and on Friday morning the SEC files its lawsuit in time for it to become fodder on the Sunday morning Pro Wrestling Circuit, where such famous portfolio analysts as Donna Brazile and Al Hunt can pontificate about 'exotic securities'.

Entirely possible.

[jimmyk]

Goldman managed to keep some relevant information from some buyers, thereby propping up prices a bit and sending a false signal to the world about the underlying demand for mortgage backed securities.

I don't see that. The only information Goldman kept was the identity of the short side. No information about the assets themselves was withheld. And since it was a synthetic CDO, the fact that there was a short side was a given. (Never mind that Goldman itself claims to have taken a long position.)

Apart from the politics of all this, which was discussed in the previous thread, this seems to be a case of the losers claiming victim status. I'm not too sympathetic.

[Ignatz]

--I don't see that. The only information Goldman kept was the identity of the short side.--

IIRC, one of the allegations (which may or may not be supported by the evidence) is that GS misled investors that Paulson was going to be long this particular portfolio.

[Rick Ballard]

"I'm not too sympathetic."

I'm a little sympathetic towards the German and American taxpayers. They didn't choose to sit down with the "sophisticated" players at the Rules? What rules? Sporting House and Casino but they had to pick up the check anyway.

As to the "sophisticates" involved - I'd be happy to toss each and every one of them on either side of the fraud a nice hefty anchor, should their heads bob above the surface momentarily. That's about the limit of my sympathy.

[Ignatz]

An observation and a question:

It would seem that the GS thing certainly did not cause any kind of mass selling this morning nor am I aware of a rush of the class action jackals.

It is asserted that hedge funds and derivatives provide needed liquidity to the markets. In what way did this tranasaction accomplish that in any way that was helpful to the economy?

[Rick Ballard]

"GS misled investors that Paulson was going to be long this particular portfolio."

Nah - they just didn't disabuse the 'sophisticated' marks of their fantasy that he was.

[Neo]

Frankly, I a bit confused with this reform.
The "consumer protection" part of all of this is supposed to protect whom from what ?

I mean, would it have protected those who bought MBS-s from the ways of Fannie Mae and Freddie Mac ? ... or in this case of Goldman, who would have been protected ? ... and if they are now in court, why do we need more regulation when it seems there is already protection out there ?

[Extraneus]

Entirely possible.

Understatement of the day contender.

[Rob Crawford]

Paul Krugman denounces Goldman Sachs with vigor...

So, how much work did Krugman do for GS over the last decade?

(I have no idea. I'm just speculating based on his tendency to have been a big-time stooge for whatever fraud is the Big Thing, then to go ape-poo in denouncing the fraud when it blows up. See also Enron.)

[matt]

Neo, the consumer protection was supposed to protect Lehman, Merrill,and all the other stooges on Wall Street, I presume.

The American individual investor is simply collateral damage.

[Patrick R. Sullivan]

As stupid as Krugman is being, he's nothing like Simon Johnson accusing Paulson of being a felon:

Mr. Paulson only stood to gain on a massive scale (or at all) if the securities in question were mispriced, i.e., because their true nature (that they had been picked by Mr. Paulson) was not disclosed. In other words, the Paulson transactions at this stage of the game only made sense if they involved fraud. The principals involved (Paulson and top Goldman people) are all super smart, with unmatched practical experience in this area; they get this totally.

John Paulson was not the trigger man – it was Goldman and its executives who withheld adverse material information from their customers. But if the entire scheme was Mr. Paulson’s idea – if he was in any legal sense the mastermind (obviously he was, but can you prove it beyond a reasonable doubt?) – then we are looking at potential conspiracy to commit fraud. And if he had conversations of any kind and at any time during this period with top Goldman executives, this will become even more interesting - so of course all relevant phone records will now be subpoenaed.

Mr. Paulson should be banned from securities markets for life. If that is not possible under current rules and regulations, those should be changed so they can apply. If that change requires an Act of Congress, so be it.

So, in addition to putting himself in jeopardy of a defamation suit, Johnson doesn't appear to have read the Constitution's prohibitions against ex post fact laws and bills of attainder. Amazing.

[W. R.]

Did they really understate risk? The majority of mortgages are FANNIE and FREDDIE backed - considered very safe investments. They were until FANNIE and FREDDIE threw over their lending standards and bought up and packaged subprime and risky mortgages as "safe". As far as most investors knew, these Govt. packaged mortgages were safe as US bonds. No coincidence that US bonds are now considered much less secure than before.

[Charlie (Colorado)]

Mr. Paulson only stood to gain on a massive scale (or at all) if the securities in question were mispriced,

Y'think?

[matt]

AP tells us that momentum on Wall Street reform is building....I love how these guys manipulate the news....

[bunkerbuster]

What about the counterparties for the credit default swaps Goldman entered into, effectively "shorting" the CDOs they helped create?

Wouldn't these counterparties have every reason to be at least curious about why Goldman was effectively shorting assets it had helped create? And wouldn't that curiosity prompt them to raise the price of that ``insurance?''

I find it very hard to believe that the people who got shafted in this deal should not have to accept responsibility for being misled. How could they NOT have smelled the turds???

[Ignatz]

--I find it very hard to believe that the people who got shafted in this deal should not have to accept responsibility for being misled.

That's a curious legal theory that would, on its face, appear to make fraud a legal anachronism.

[Rick Ballard]

Dunno, Matt. Nobody seems to want to answer Ignatz's very pertinent question:

It is asserted that hedge funds and derivatives provide needed liquidity to the markets. In what way did this transaction accomplish that in any way that was helpful to the economy?

You can repeat "this transaction" re JPM, Citi or Merrill numerous times because GS certainly wasn't alone in running a Sporting House and Casino specializing in rolling "sophisticated" Johns dumb enough to believe a square game was being run.

The Reps might be able to get in front on this if they focus on regulation of synthetics and CDS in lieu of the Dem atrocity but I would not minimize the public's desire to see some investment bankers swinging gently in the breeze. GS may not be deserve to go first and they certainly don't deserve to be the only one but they bought miles of rope when they accepted Treasury money to cover their blunder in laying off their bets to a bankrupt bookie.

[Ignatz]

--Nobody seems to want to answer Ignatz's very pertinent question:--

I noticed that myself.

[Pagar]

"I love how these guys manipulate the news"

Citibank was up on reported increased profits this morning, but at least one report I read said "the reserves were lower than they should have been and the tax rate they used was lower than it should have been".

Profit or Manipulation?

[Danube of Thought]

Almost certainly untrue. Did they buy up all the copies of the March 7, 2007 Business Week identifying Paulsen as bearish on MBS?

They identified him as a "sponsor," which they contend implies that he was long on the particular instruments involved here.

[Danube of Thought]

Simon Johnson's remarks about Paulson do not expose him to liability for defamation.

I understand him not to be calling for an ex post facto law that would be applied to Paulson, but for a prospective change in the law or regulations that would provide for bans for such conduct in the future.

And I sure don't know the answer to Ignatz's questions.

[Danube of Thought]

I would be very surprised if there were any coordination at all between the White House and the SEC over the filing of this action or the timing of it. If it did occur, it would be grossly inappropriate and perhaps unlawful, and would be very likely to be exposed at some point, to the huge embarrassment of the agency and the administration.

The SEC staff--who began pursuing the matter last July--are career professionals. The commissioners are appointed by the president, but no more than three of the five can be from either political party. They are an independent regulatory agency.

[Danube of Thought]

I find it very hard to believe that the people who got shafted in this deal should not have to accept responsibility for being misled.

Sure would provide an ironclad defense to 10b-5 actions.

[Danube of Thought]

They identified him as a "sponsor," which they...

The first "they" is Goldman Sachs. The second one is the SEC.

Sorry about that.

[matt]

it is perfectly logical, by the way, for Goldman to be on both sides of the transaction. That is basically what market makers do. The due diligence paperwork is reams thick and each side is supposed to do their own anyway.

That the Federal government has decided to file now is simply a part of Ogabe's propaganda offensive. Soon he will be appropriating the farms of Goldman, Citi, and all of those other white planters.

Zimbabwe or Washington. Same result.

I wonder how Wall Street feels now that the screws are being applied. Sort of like rooting for the cobra or the mongoose as far as I'm concerned, in that respect.

[bunkberbuster]

``That's a curious legal theory that would, on its face, appear to make fraud a legal anachronism.''

Touche, ignatz.

I should have said: I find it very hard to believe that the people who got shafted in this deal should not have to accept responsibility for ALLOWING THEMSELVES TO BE misled.

It's well established that there are two sides to every CDS...

[Danube of Thought]

"I wonder how Wall Street feels now that the screws are being applied."

Particularly after all that cash they gave to O's campaign.

I don't have much doubt that the SEC has its own political agenda, and in this matter it may be the same as Obama's. But the president doesn't tell the SEC whom to sue, or when.

[bunkberbuster]

Call me a rube, but I wonder why Goldman's customers didn't take this disclaimer seriously enough:

``Goldman Sachs does not provide investment, accounting, tax or legal advice and shall not have a fiduciary relationship with any investor. In particular,
Goldman Sachs does not make any representations as to (a) the suitability of purchasing Notes, (b) the appropriate accounting treatment or possible tax
consequences of the Transaction or (c) the future performance of the Transaction either in absolute terms or relative to competing investments.''

[Thomas Esmond Knox]

Goldman is reported to have lost $75m net on the deal. They were on the long side.

As to the merits, I also have sold things that I thought were too dear. Where are the handcuffs?

[bunkberbuster]

If you're going to make cynical and/or paranoid speculations about motive, doesn't it make more sense to assume that the fix is in for Goldman and Wall Street, not against it?
I know it militates against the shibboleth that Obama is a secret communist, but the plain fact is that Goldman has tremendous influence at the highest levels of government. Doesn't the cynic, then, have to consider:
1. No criminal indictments, so worst case scenario is probably a fine Goldman can pay from its office beer and pretzels fund.
2. While some quarters of the press are sensationalizing the damage to Goldman's "reputation,'' the smart money says this suit can only enhance it with the people who really matter. People pay big to have Goldman on their side because they want bankers who are smart enough, powerful enough and amoral enough to circumvent the rules without going to jail. Win or lose, this case underscores that Goldman is that banker. They're not in business to be the banker EVERYONE trusts.
3. More regulation is most likely to enhance Goldman's power since it merely creates more rules that people will seek to circumnavigate and/or bend and Goldman will still be the first-class place to have that done for you.

[Danube of Thought]

"If you're going to make cynical and/or paranoid speculations about motive,..."

I'm not going to. And the absence of a criminal complaint, which is routine, means nothing.

[matt]

DoT;

15 months ago I would have agreed. No longer. This evening, another story about the supposed central position of one Paulo Pellegrini.

We're going to see this all week long. Drip, drip, drip. Sizzle but no steak. It is media manipulation by the administration. Trial by media, and the real prize for both the SEC and Obama is the bill.

[jimmyk]

IIRC, one of the allegations (which may or may not be supported by the evidence) is that GS misled investors that Paulson was going to be long this particular portfolio.

I fail to see whether some guy named Paulson (remember, he wasn't particularly famous at the time) is long or short represents "material" information. If he was long then someone else was short. Sure, he made the initial selection of the securities, but then ACA got to make its own choices.

As for Ignatz's question, "In what way did this tranasaction accomplish that in any way that was helpful to the economy?": Not sure, but why does that matter? It's not specific transactions that help the economy, it's the sum of actions by market participants that result in prices, and those prices convey information. Make it more risky for people to participate in markets (for fear of getting sued) and that information will be lost.

[Imogene]

Patrick Sullivan is a cocksucker. Just sayin.