When Investments Sound like Cruise Missiles: United States v. Goldman Sachs

Today, the United States Securities and Exchange Commission filed a civil suit against Goldman Sachs for fraud.

Yes, f-r-a-u-d.

The decision is a landmark one for the SEC, which up to this point has yet to file suits against firms whose financial instruments depended upon the fate of the housing market, and more specifically, the bursting of the housing bubble in 2007.

The financial instrument in question, the ABACUS 2007-AV1, sounds more like a weapon of war (think F-18 Hornet, the super-fighter plane, or the MGM-1 Matador, a nuclear-capable cruise missile) than any money-based product. Yet those analogies are eerily perfect: with these devices deployed, Goldman Sachs was in a position to benefit from the downfall of the housing market. The interests of the society at large became antithetical to their own interests. Problem is, Goldman Sachs used fraudulent practices to stack their own deck.

The process worked like this: Goldman Sachs had many loans on their books. Some were good (they would, most likely, be paid back in full and on time), and some were bad (the most likely outcome was that the debtor would not be able to pay back the loan). Goldman and its friends picked from among all those loans the very worst of them--the loans most likely to fail. They then offered these investments as bets to other hedge funds, banks, etc., except GS told these clients that the loans had been randomly chosen by an independent third party, which led the other clients to believe they had a better chance of profiting than was actually the case.

Let's put this in simpler terms. I hold a deck of cards in front of you and say, "I bet you $5 that the random card you chose will be a red card." You, thinking the chance you have of winning is 50/50, agree to the bet. Only I've done something nasty, I've filled the deck with red cards, and there's only one black card left. Inevitably, you will probably pull a red card, and I will win. This was Goldman Sach's strategy.

While these are not the kind of strategies that make the financial system, as a whole, melt down, they are indicative of a kind of mindset that clearly pervaded--and pervades to this day--the Wall Street crowd. In Krugman's taxonomy, these investments would be just the type he would insist on curbing, without trying to minimize banks' overall size. A first step?

Krugman's Banking Regulation Study Guide

Paul Krugman, Nobel-winning economist and columnist for the New York Times, used his column a couple of weeks ago to spell out in simpler terms--terms average people like us can understand--who is for what kind of banking reform, and what each kind of reform package looks like. Keep in mind, Krugman is a dyed-in-the-wool progressive and Keynesian (he advocated a much larger stimulus package than the one delivered in Spring 2009) and his tone and content reflect that.

On one side of the debate are those who simply won't stand for banking reform. Many of these people are conservative members of Congress. They appear so opposed to reforming the financial system, it sometimes looks as if they're (figuratively) in bed with the hedge fund managers and the CEOs of big Wall Street firms (foreshadow.......). Limit the size of big banks? No. Limit banks' risky practices? No. Make bank? We'll let the revolving door theory answer that one.

For better or worse, the pro-reform side of the issue is fractured into two main camps. The first, led by Paul Volcker (see this blog's first post), views the growing stature of big financial firms as the heart of the problem. He wants to end of the "too-big-to-fail" era by limiting their size. To take such action would presumably prevent the disastrous consequences if even one of them were to fail, and limit taxpayer "liability." Krugman, who disagrees, replies:

Breaking up big banks wouldn’t really solve our problems, because it’s perfectly possible to have a financial crisis that mainly takes the form of a run on smaller institutions. In fact, that’s precisely what happened in the 1930s, when most of the banks that collapsed were relatively small — small enough that the Federal Reserve believed that it was O.K. to let them fail.

Krugman forms the other side of the pro-reform crowd. His plan is "to update and expand old-fashioned bank regulation."

What ended the era of U.S. stability was the rise of “shadow banking”: institutions that carried out banking functions but operated without a safety net and with minimal regulation. In particular, many businesses began parking their cash, not in bank deposits, but in “repo” — overnight loans to the likes of Lehman Brothers.

These "shadow banks are the keys to Krugman's reform ideas. Regulators should be able to seize failing shadow banks, he says, and put strict limits on their activities and their influence in the banking system.

Krugman followed up with a couple of brief notes on his NY Times blog. To the dissenters who say that deposit insurance will keep us truly safe, he responds that the deposits are not the source of our problems. Our banking system has "grown up" and now plays with more sophisticated and dangerous toys like "repo and other forms of short-term borrowing." These are the devices that took down Lehman Brothers. And for Krugman, they could do it again.