Geithner sees no evil in the bubble

Two moments in Tim Geithner's exit interview with the Wall Street Journal's David Wessel struck me as noteworthy. First, this:

MR. WESSEL: Is there a risk that a combination of the backlash to the bailouts and the changes to the authorities of the Treasury and the Fed has been your successors, if confronted with something like 2008, will be unable to respond as effectively?

MR. GEITHNER: [One risk is that] they're not willing to respond . If you look at the history of crises, what most distinguishes how countries fare is whether people who are willing to do those tough things really do them or whether they sit there and wait—hope it burns itself out, decide to try to teach people a lesson, worry about moral hazard, not protecting the innocent. So one risk is that people are going to be more tentative about that because they just looked at the backlash in this crisis, and they decide to try to wait a little bit, and hope they don't have to do the hard thing.

Geithner appears here to set up an either/or: either the regulator "worries about moral hazard" or he or she "protects the innocent."  The "worry" about moral hazard, of course, is that it may precipitate the next crisis by shielding those who triggered the last one from the consequences of their recklesssness.

To be fair, Geithner says at a different point, "if you’re in policy or you’re in markets, you should always worry about moral hazard"-- so it would appear that his point above is limited -- that in the crisis hour moral hazard should not be the primary concern.  But it's fair to wonder whether moral hazard is ever a primary concern of Geithner's, given that he doesn't see much moral transgression in our banking system. Which brings us to the next  moment:

Scrutinizing Warren's warranty for Goldman

Good for James B. Stewart for pushing back against Warren Buffett's defense of Goldman's conduct in the Abacus CDO deal that prompted the SEC to sue Goldman for fraud.  Buffet, Stewart recounts, affirms that there was nothing wrong in Goldman's failing to disclose the identity of the short investor, Paulson, to those going long on the portfolio of mortgage bonds that comprised the synthetic CDO.

"The essence of the alleged fraud," Stewart reminds readers, is not that Goldman did not disclose Paulson's identity, nor that there was a short seller, but "that Goldman let the short seller choose some of the underlying subprime mortgages, failed to disclose that, and instead promoted the idea that an independent third party chose those securities."  He then joins the panoply of observers who have sought a metaphor to illuminate the moral essense of this kind of dealmaking, and comes up with a good one:

With the Kentucky Derby in mind, let's consider a horse-racing analogy. There are just two horses and two bettors. The promoter offers you the opportunity to bet on one horse. Someone else is betting on the other. He doesn't tell you that the other bettor chose the two horses in the race, and picked one horse with no chance of winning. Instead, he says the horses were picked by an independent racing federation. You bet and lose. Would you feel that was fair?

If I may venture an emendation: it's as if Goldman allowed "the other bettor" not to choose two horses but to assemble one horse, Frankenstein-style, picking more than half of its genes at the outset from an available pool (admittedly of a specified, dicey quality) and signing off on every gene eventually included -- all with an eye to creating a horse misbegotten enough to be almost certain to break all its limbs should the race terrain grow at all rocky  (the race will be across unknown terrain) . The promoter seeks bettors on the other side, emphasizing that an expert genetic designer of horses created this specimen, and thus suggesting that it is  sturdiest horse that could be created from the agreed-upon gene pool.  (I've compiled various other informed perspectives on the ethics of the deal here.)

Does Goldman's "it's perfectly normal" defense hold water?

In a reading of Goldman's September letter of defense against the SEC investigation into the synthetic CDO it created at Paulson's behest, one question stands out: is it really true, as Goldman's claims, that investors in a synthetic CDO would accept as a matter of course that short as well as long participants might have not only an active but a formative role in shaping the portfolio? Paulson initiated the CDO, suggested the initial portfolio to the selection agent ACA, and ultimately approved every bond in the portfolio, more than half of which were in its initial selection. Is that business as usual? Goldman says yes:

There is no industry definition of "Portfolio Selection Agent" that implied that ACA would operate within an ivory tower or refuse to consider suggestions made by interested parties in exercising its independent judgment. In fact, it was a customary feature of the market that participants (including those here) often offered their views on potential securities to be included in referenced portfolios, so no one would have been surprised that Paulson was doing so.

Depending on industry norms, this could either be a particularly brazen bit of sophistry or an effective defense.