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. 

A tailor's yard for cutting megabanks to size

Ever wonder how a regulatory regime with a mandate to break up banks that are "too big to fail" would operate?  Every article I recall reading on the subject treats the question structurally -- that is, by addressing what activities a single financial entity should not be allowed to engage in simultaneously. For example, Paul Volcker recently recommended forbidding deposit-taking banks from engaging in proprietary trading. John Gapper has proposed.separating the functions of retail banks, investment banks and asset managers.

But leaving aside function-based restrictions, how would a regulator determine how big is too big -- literally, from the standpoint of creating systemic risk?  Peter Boone and Simon Johnson, posting on The Baseline Scenario, provide a legislative update, an analogy, a guideline, and a recommendation:

The Kanjorski amendment recognizes that the systemic and societal danger posed by banks can be hard to recognize, and it proposes a number of potential objective criteria that could be used by the Financial Services Oversight Council (to be created by legislation in progress) to determine when banks need to be broken up, including the “scope, scale, exposure, leverage, interconnectedness of financial activities, as well as size of the financial company.”

The Kanjorski amendment does not impose a hard size cap on banks, but lawmakers in the House are discussing amendments that would do so.

There is, of course, a strong precedent for capping the size of an individual bank: The United States already has a long-standing rule that no bank can have more than 10 percent of total national retail deposits.

Why the banks *held* toxic securities

John Gapper of the FT is proving himself to be eponymous (or rather the reverse -- whatever you call someone who's named for what he does). As the financial crisis has enfolded, he's emerged as a master at pinpointing the gaps in regulatory regimes that the banks have exploited.

Today he provides a primer in how the banks evaded capital requirements, why they loaded up on mortgage-backed securities, and how they rendered the 1988 Basel Accord (Basel I), which set capital adequacy standards for global banks, obsolete. Basel I, he recounts, set the minimum ratio of capital to assets at a conservative 8%, "but some investment banks entered this downturn with capital-to-asset ratios of 30 times or more." How did they pull that off? Gapper:

On assets, Basel introduced the notion of risk weighting, which essentially meant that some kinds of loans – for example, highly rated corporate bonds and, yes, residential mortgages – were considered less risky than others, so less capital needed to be held against them.

It was not a bad idea in principle but it set off two decades of financial engineering by banks to classify as many of their assets as possible as low-risk weighted in order to swell their balance sheets and so make a higher return on capital.

One of the puzzles of the financial crisis is why banks were caught with huge amounts of securitised mortgage debt when the point of securitisation – turning assets into securities – is to be able to sell loans.

Viewed through the Basel lens, however, the hoarding of securities made sense. By transforming 50 per cent risk-weighted mortgage loans into triple A securities, and with the help of rating agencies, banks reduced the amount of capital that they needed to hold against these assets.

That explains why the banks were not just packaging and selling toxic mortgage-backed securities for luscious fees, but holding these securities. And that was only step one in the metastasizing of leverage enabled by illusory risk management. Gapper again:

A bit of insurance wizardry took the regulatory arbitrage further. Banks could cut their capital charge to near zero by laying off the credit risk of mortgage securities to AIG through credit default swaps. Hey presto, billions of dollars of assets absorbing virtually no capital!

As the debt securities were illusory wealth, the CDS's proved to be illusory insurance. That's because they were not regulated as insurance -- CDS issuers were not under the jurisdiction of state insurance regulators, and so were not required to hold reserves to pay "claims," as payouts on credit defaults would be called if CDS's were true insurance. Quite a double-reverse the banks pulled off to get themselves past regulators and downfield into leverageland.

It has often been observed that as surely as bacteria adapt to antibiotics, human beings and the institutions they create will find the gaps in regulatory regimes. That's no reason to despair of regulation, though, any more than we abandon antibiotics. Regulatory reform must be ongoing as conditions change. And the best defense against corrupted regulatory reform is effective lobbying reform. Which in turn generates its own cycle of creative evasions. This cycle itself cannot be evaded.

From financial shotgun marriages, miscarriages

Perhaps Federal takeovers of large banks ain't so easy. A little foretaste in fallout from the FDIC-directed shotgun marriage of Washington Mutual to JP Morgan Chase. From American Lawyer's Litigation Daily:

Battle Brewing over Fire Sale of WaMu Banking Assets

In one sense, at least, Lehman Brothers's precipitous Chapter 11 filing was a blessing in (very heavy) disguise: The investment bank was involved in the sale of its assets in the days and weeks after it entered bankruptcy. Washington Mutual wasn't as fortunate. Seized by the Federal Deposit Insurance Corp. on September 25 last year, the bank had no control over the disposition of its core banking assets, which were quickly sold to JPMorgan Chase & Co. for $1.9 billion.

Now that hasty sale has become the subject of what promises to be protracted litigation. At its core is a question: What, exactly, did JP Morgan buy on that fall day?

Both sides are suing the FDIC, with WaMu's holding company "seeking to recover billions of dollars in tax refunds, capital contributions, and trust securities," while JPM looks to ""protect its economic interests in the assets."

Now, imagine those spats cubed in the wind-down of a global bank with assets and counterparties on every continent. The FT's John Gapper offers a preview.

John Gapper plumbs AIG's heart of darkness

The Financial Times' John Gapper has perfect pitch on the AIG bonus firestorm. He has sympathy for where both Geithner and Liddy were coming from in this collision, but highlights the myopia of both. And he comes up with an extended metaphor that plumbs the moral depths of Wall Street's perverted pay incentives.

Here's Gapper on a distracted Geithner:

If there is one thing everyone should have learnt about Wall Street by now, it is that the financial contract a trader takes the most care to hedge properly – and to ensure is profitable in the long term as well as the short term – is his or her own employment contract.

Tim Geithner, the benighted Treasury secretary, forgot this point when he approved the doling out of $30bn more in US government support to AIG at the start of this month. Hence he is now struggling to survive the Washington maelstrom.

Mr Geithner has excuses for this oversight, since he was trying to save the rest of the financial system at the same time, and has few senior officials in place to help.

Still, as a Wall Street figure – I count him as such because he used to work within a stone’s throw of the Street of Shame at the New York Federal Reserve – he ought to have known better than to overlook $165m in “retention bonuses” AIG has paid to those who made it fail.

And on Liddy, trapped inside the AIG black hole:

My sympathies are with Mr Liddy, who is being paid only $1 a year and is not responsible for the debacle at AIG. He is doing his best to sort out all the mess, while public servants with megaphones bellow into his ear and Chuck Grassley, a Republican senator, suggests bone-headedly that AIG traders should atone by committing suicide.

That said, his reasons for paying the bonuses share the characteristic of being internally logical yet ludicrous when one takes a step back to consider the context.

And then, picking up his opening trope: the derivative from which only the individual trader derives benefit:

Mr Liddy’s second point is that AIG is better off retaining the traders who wrote the disastrous CDS contracts because only they know them well enough to keep them safely hedged while winding them down. Some are so complex and bespoke that an outsider could be stumped.

A lot of people, including politicians who do not care much one way or the other about the truth of the matter, dismiss this as more self-serving Wall Street claptrap. Personally, I think the appalling thing is that Mr Liddy could well be correct.

Consider the implications. We are by now familiar with the trader’s option – that an employee of an investment bank has an incentive to take big risks to make money. If his trading strategy works he gets a bonus but if it fails, the bank (and ultimately the taxpayer) pays.

In recent years, a lot of traders, including those at AIG, exploited this by coming up with derivatives that were very profitable in the short term but had expensive long-term risks embedded in them. That allowed the traders to enjoy several years of large bonuses before the bill for their recklessness fell due.

Now, the ever-ingenious AIG traders have come up with a derivative of the trader’s option. Call it the trader’s option squared.

They had an incentive not only to sell financial contracts that paid out a lot of money immediately in return for assuming a long-term liability, but also to make these contracts very complicated and opaque.

This allowed them to charge big fees (which brought big bonuses) and it also made them irreplaceable at the institution that employed them. If you are the only one who can understand your own handiwork, it puts you in an enviable bargaining position.

Wall Street banks used to believe it was in their financial interest to keep the credit derivatives market as an over-the-counter, high-margin, complex business. It turns out to have been a financial disaster for everyone involved except – surprise, surprise – derivatives traders.

And the final irony: the institutions composed of these self-aggrandizing geniuses are devoured by their children:

But for the financial institutions involved in credit derivatives, it is worse than that. To be taken for such a ride by their employees is a humiliation, one that has been in the making since the old Wall Street partnerships went public in the 1980s (in Goldman’s case 1998).

The denouement is practically a consensus theme among FT Comment writers: pay-for-performance as currently practiced is the root of all financial industry evil:

But for the financial institutions involved in credit derivatives, it is worse than that. To be taken for such a ride by their employees is a humiliation, one that has been in the making since the old Wall Street partnerships went public in the 1980s (in Goldman’s case 1998).

Robert Frost said that a good poem was like a piece of ice that runs on its own melting. The same is true of a good opinion column. The trader's contract as derivative is only partially a metaphor. But it's one that takes us into the heart of darkness.