CONTAMINATED COLLATERAL: THE ACHILLES HEEL FOR BANKERS

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WAIT FOR ARMAGEDDON OR PREVENT IT?

“Thus a decision awaits us which is more a matter of timing than substance. The system is going to collapse in its current form because it is and always was a pyramid scheme. They all fail every time. The question is when. So the only question that remains is whether we will assert ourselves now and start building from within, or pass the opportunity and try to arise from the rubble of what remains when this pyramid collapses under its own weight. Or, put another way, do we want to be the Phoenix that rises out of its own ashes, or the falcon that does what is practical to stay alive and bring home dinner? It seems that the Occupyers have that answer — do it now!” NEIL F GARFIELD, LIVINGLIES.ME

THE BIGGER THE LIE, THE HARDER THE FALL

EDITOR’S NOTE: The simple fact is that they don’t have any collateral in most instances and their assets are accordingly grossly overstated on their balance sheet. And the fact remains, no matter how they try to spin it, that Wall Street simply dipped into the pockets of people’s savings, pensions and taxes, pretended the money was their own, and then convinced people to borrow their own retirement money in ways that could never be paid.Now they claim to be creditors to whom the debt is owed even though the money came from the very person they claiming owes them still more money. And they are getting paid very well to assume this position while the average person of even substantial means is being ordered to “assume the position” to take it again.
With credit card interest at 20%-30%, private student loans going to 18%, and home equity being an irresistible target for Wall Street game players, people are now left without any meaningful amount of savings, a decrease in the amount of their pension plans, and a nearly permanent block to ever getting out of debt. And Wall Street is still successfully positioning itself as the injured party to whom the debt is owed. According to them, the Occupyers just lack the sophistication to understand why the Banks are not at fault for anything.
In truth our reliance on self-governance by Wall Street was misplaced the moment we allowed them to go public and transfer the risk to the public. In the end the people always get the shaft no matter which way they turn and no matter which “class”they think they are in. Each person is getting shafted by the Banks under the current infrastructure regardless of whether they think of themselves as an investor, a consumer, a creditor or a debtor.
The collateral claimed by banks is irretrievably broken by their own intervention in the chain of title. But the really pernicious quality of this mess is that people are under the gun by virtue of debt that was forced upon them using their own money. The cost of servicing that debt that steadily increased just as wages stagnated. But by “giving” people the money to buy things, the banks created the appearance of real commerce. In reality most of the commerce was built on debt — but the other side of the equation is never mentioned. The debt arose not just because someone borrowed money but also because someone loaned the money. And the parties who loaned the money were and remain the people themselves who, as a class of taxpayers, savers and pensioners, are the same on BOTH SIDES OF EVERY TRANSACTION.
If you ask the average 401k person whether he would have taken money out to purchase something, their answer is almost always negative. Yet placed in the hands of money managers who were institutional investors, these same people in fact did borrow the money indirectly without any knowledge of what place they held in the securitization hierarchy. They were dead last. As the source of the funds, they had a sure loss coming eventually whether it was a mortgage, credit card, or student loan debt. Then, encouraged by promises of never-ending replacement loans, they accepted loan products that were unworkable. The result is that they have no money to pay their debt because their own money was used to create the debt and now of course that money is gone — into the pockets of Bankers as fees and profits — they are guaranteed to have diminished capacity to pay off the debt.
Bankers always resist regulation. And “free market” believers are drawn into the narrative by ideology and the mistaken factual belief that the lenders, as a class and the borrowers, as a class, are not one and the same. Ask one of these bankers or “free market” enthusiasts whether Wall Street should be allowed unlimited access into the pension funds and taxpayer funds to lend people their own money, raking off absurd profits, and they would probably not be able to sustain any argument against regulation. To be sure, in the interest of financial liquidity, the function of Wall Street has a value and they should be paid for their services — a real amount based upon real service.  
The problem arose when through deregulation the goal of liquidity became the only goal. That is why, in the absence of regulation, courtesy of legislation passed in 1998, Wall Street was the only one at the table who could  pursue self-interest. Everyone else had to go through their gate if they wanted to do anything. And so they were allowed to issue private currency in a very public way, drawing upon funds from hardworking people who had earned the pensions that awaited them and then, in pursing their interests for ever increasing profits and fees, produced a stupid amount of liquidity that exceeded real money issued by all the governments around the world. They didn’t just exceed it. They issued 12 times the amount of real money in the world.
Now in order to make the profits they intended, they are demanding that taxpayer money be used to cover the profits and fees they think they earned. Every time we do that the taxpayer is paying another dollar toward pornographic profits, salaries and bonuses on Wall Street, while our lives, our infrastructure and our prospects crumble under the weight of a financial infrastructure that must collapse at some point because there literally is not enough money in the world to cover the paper issued by Wall Street.
Thus a decision awaits us which is more a matter of timing than substance. The system is going to collapse in its current form because it is and always was a pyramid scheme. They all fail every time. The question is when. So the only question that remains is whether we will assert ourselves now and start building from within, or pass the opportunity and try to arise from the rubble of what remains when this pyramid collapses under its own weight. Or, put another way, do we want to be the Phoenix that rises out of its own ashes, or the falcon that does what is practical to stay alive and bring home dinner? It seems that the Occupyers have that answer — do it now!

Behold the dangers of contaminated collateral [updated]

Posted by John McDermotton Oct 10 22:06.

Yale University’s Gary Gorton and Guillermo Ordoñez have a new working paper out on the role of collateral in financial crises. This may not pass for exciting news in some places but FT Alphaville is not like other places. Gorton is renowned for his work on shadow banking and wrote an excellent short primer on the recent crisis.

(Update: He’s also, as our commenters point out, the man behind some of the AIG’s risk-management models. Take that as you will, we still think there are some interesting insights in the paper.)

The paper, “Collateral Crises”, uses complicated mathematics we don’t understand want to discuss at this point. But don’t let that put you off: it has some important insights for those interested in the role of information and collateral in the financial system.

First, a very important caveat: the below refers to a model. The empirical evidence presented in the paper is labelled “Very Preliminary and Incomplete” so consider the ideas below as educated musings rather than empirical statements.

The hypothesis is a neat one and although the authors readily admit it’s just one way of looking at recent troubles, it’s an interesting way of thinking about how the crisis hit when it hit.

The argument runs something like this: short-term private funding markets such as money markets or interbank markets work by dealing in “information-insensitive debt”. In other words, there’s buying and selling without anyone worried about adverse selection. Collateral is put down and — assuming it’s AAA — no questions are asked. These ideas have been suggested before (such as here) but this paper is the first to look at its macroeconomic implications.

In particular, it uses this micro model to explain how small shocks can translate into big events. To understand the professors’ logic it’s useful to grasp their version of financial crisis events (our emphasis):

Financial crises are hard to explain without resorting to large shocks. But, the recent crisis, for example, was not the result of a large shock. The Financial Crisis Inquiry Commission (FCIC) Report (2011) noted that with respect to subprime mortgages: ”Overall, for 2005 to 2007 vintage tranches of mortgage-backed securities originally rated triple-A, despite the mass downgrades, only about 10% of Alt-A and 4% of subprime securities had been ’materially impaired’-meaning that losses were imminent or had already been suffered-by the end of 2009” (p. 228-29). Park (2011) calculates the realized principal losses on the $1.9 trillion of AAA/Aaa-rated subprime bonds issued between 2004 and 2007 to be 17 basis points as of February 2011.  The subprime shock was not large. But, the crisis was large…

The authors hypothesise that when these types of collateral markets exist, no useful information is created because it’s too costly (at least for market participants in the short-term) to do so. Thus there’s no information that can help one distinguish between good and bad collateral — between Scandinavian government bonds, say, and AAA-rated sub-prime mortgage bonds.

Indeed, there’s more consumption and lending when there are no questions asked. The longer the boom continues, the more ignorance percolates and bad collateral gets into the system.

When information is not produced and the perceived quality of collateral is high enough, firms with good collateral can borrow, but in addition some firms with bad collateral can borrow. In fact, consumption is highest if there is never information production, because then all firms can borrow, regardless of their true collateral quality. The credit boom increases consumption because more and more firms receive 3financing and produce output. In our setting opacity can dominate transparency and the economy can enjoy a blissful ignorance.

Here’s the problem. The bigger the lie, the harder the fall:

In this setting we introduce aggregate shocks that may decrease the perceived value of collateral in the economy. It is not the leverage per se that allows a small negative shock to have a large effect. The problem is that after a credit boom, in which more and more firms borrow with debt backed by collateral of unknown type (but with high perceived quality), a negative aggregate shock affects more collateral than the same aggregate shock would affect when the credit boom was shorter or if the value of collateral was known. Hence, the size of the downturn depends on how long debt has been information-insensitive in the past.

Gorton and Ordoñez are not rubbishing the importance of leverage — indeed they’re sort of talking about leveraged opacity. But their original argument is that the sub-prime shock was not large and not in itself the cause of the subsequent fall-out. It was the overall reduction in perceived quality of collateral.

A negative aggregate shock reduces the perceived quality of all collateral. This may or may not trigger information production. If, given the shock, households have an incentive to learn the true quality of the collateral, firms may prefer to cut back on the amount borrowed to avoid costly information production, a credit constraint. Alternatively, information may be produced, in which case only firms with good collateral can borrow. In either case, output declines because the short-term debt is not as effective as before the shock in providing funds to firms.

There’s a fair bit to critique here and not just to state the obvious point that credit rating agencies are supposed to provide the sort of information found useful by market participants. Leverage also probably does matter “per se”: it affects the pace in which margin calls come in and funding crises hit. Moreover any notion of intent is missing here — opacity serves some interests more than others.

Still, there are some interesting ideas here and we’ll be cockahoop to see some empirical evidence about the importance of not being able to separate good and bad collateral.

The big sort, rather than the big short.

Update II: Not for the first time, the comments section on an FT Alphaville post are more enlightening than the main text. Scroll down for more, and do contact rob2.7 if you can speak complex mathematics.

Related links:
Shadow banking – from Giffen goods to Triffin troubles – FT Alphaville
Regulating the shadow banking system – Marginal Revolution
Interview with Gary Gorton – Minneapolis Fed
Gary Gorton on Financial Crises – The Browser” href=”http://thebrowser.com/interviews/gary-gorton-on-financial-crises” target=”_blank”>Gary Gorton on Financial Crises – Five Books Interviews

Discovery Hints: Goldman Sachs may not be the only firm in SEC cross hairs

REGISTER NOW FOR DISCOVERY AND MOTION PRACTICE WORKSHOP 5/23-24

Editor’s Notes: These lawsuits from the SEC, the Class Action lawyers etc., are already producing fall-out — dozens of articles and production of secret emails etc. that can only help your case. Follow them closely as they will inevitably lead to admissible evidence of what you can only argue generally now.Use Google and other search engines and subscribe to securitization sites.

In motion practice your credibility will be enhanced if you can refer to other cases where government agencies, attorneys general, U.S. Attorneys etc. have filed cases alleging the same thing you are alleging. To the extent that it is truthful to say so, you can point to various elements of proof that are coming out of those cases. This will vastly enhance your ability to gain the Judge’s attention — but don’t try to prove YOUR case simply on the basis that it appears to be true in OTHER cases. Use these other cases to establish your foundation for discovery requests and why they MUST come up with all the documents, ledgers, accounting and bookkeeping data, distribution reports, emails etc. related to the pool in which your particular loan is located.

Goldman Sachs may not be the only firm in SEC cross hairs

The agency’s fraud suit against the Wall Street giant may foreshadow similar cases against other financial firms and trigger a wave of private litigation.

By E. Scott Reckard, Los Angeles Times

April 22, 2010 | 3:32 p.m.

The government’s fraud lawsuit against Goldman, Sachs & Co. could portend cases against other financial giants that turned subprime mortgages into complex securities while also accelerating a surge in private litigation against Wall Street.

In announcing the Goldman case, Securities and Exchange Commission enforcement chief Robert Khuzami said the agency was looking into similar transactions at other firms. As the SEC struggles to shed its image as the snoozing securities cop that missed Bernard L. Madoff’s vast Ponzi scheme, the agency is likely to bring additional cases, said Alan Bromberg, a securities law professor at Southern Methodist University.

“The SEC has become pretty aggressive, so it’s a good bet,” Bromberg said. Goldman, he said, was probably chosen as the first target because of its prominence. “It is the biggest and by most estimates the best firm on Wall Street.”

Goldman Sachs is accused of failing to disclose that a hedge fund that helped it create complex securities had actually placed a bet that the investment would fail. Goldman has said it provided full disclosure to sophisticated investors who knew that some other knowledgeable party was betting against them.

The suit against Goldman will undoubtedly encourage similar claims by investors, said Boston University securities law expert Elizabeth Nowicki.

Private lawyers “are going to start filing these suits like they’re going out of style,” she said.

It’s not unusual for SEC cases to pave the way for private lawsuits. For example, the SEC’s announcement that it was investigating conflicts of interest by securities analysts in 2001 triggered a wave of private litigation making the same allegation.

In the case of the mortgage-linked investments known as collateralized debt obligations, a variation of which is at the heart of the Goldman Sachs case, lawyers for investors had already begun their assault.

UBS, Morgan Stanley, Merrill Lynch and Deutsche Bank face private lawsuits alleging they misled investors in CDOs or similar investments. The firms, like Goldman, have denied any wrongdoing.

“The question is whether the SEC has uncovered the tip of the iceberg,” Nowicki said.

The issue is especially important, she said, because the high-risk investments caused such huge losses for financial firms and investors around the world, magnifying the effect of the collapse of the housing and mortgage markets.

“Without these devastating transactions we would have had a regular downturn in the housing markets and not a near depression,” said Nowicki, a former SEC attorney who practiced securities law on Wall Street and has testified as an expert witness in disclosure cases.

The financial crisis has spawned hundreds of lawsuits, with the targets shifting from the lenders that made dubious home loans to the Wall Street firms that transformed mortgage bonds backed by subprime loans into supposedly solid investments, Jonathan Pickhardt, a securities-law attorney, wrote in a recent legal journal article.

The suits that deal with CDOs include allegations that some of the firms creating and marketing CDOs stuffed troubled assets into them without disclosure, especially as mortgage defaults surged in 2007; improperly influenced CDO management firms that were hired to pick assets independently; and withheld key information from credit-rating firms.

The bar of proof appears higher in CDO cases than in the SEC’s suits last year against former executives of Countrywide Financial Corp. of Calabasas and New Century Financial Corp. of Irvine, two major companies brought down by the mortgage meltdown.

That’s because the suits against the executives, including Countrywide co-founder Angelo Mozilo, accuse them of misleading individual shareholders and other members of the investing public. Mozilo and the other defendants in these cases have denied the allegations.

In contrast, the participants in the CDO transactions were, as UBS put it in statements responding to two CDO-related lawsuits, “professional and knowledgeable” banks and sophisticated investors who knew what they were buying.

Making it tougher still to prove fraud, the transactions in the SEC action against Goldman and a private suit targeting Merrill Lynch involved so-called synthetic CDOs. Such creations don’t contain actual mortgage bonds. Instead they hold insurance-like instruments tied to a portfolio of mortgage bonds. The CDOs essentially sold insurance on the bonds. Other investors bought that insurance, betting that home-loan defaults would lower the value of both the bonds and the CDOs themselves.

As a result, the structure of synthetic CDOs required outside investors to bet that the CDOs would incur losses.

For example, in a case brought by Rabobank, a large Dutch financial firm, against Merrill Lynch, now part of Bank of America Corp., the Wall Street firm said the CDO contract contained standard language obliging investors to conduct their own research on the deal and not rely on information provided by Merrill.

scott.reckard@latimes.com

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