Shorting, leveraging and false ratings
Posted: Friday, April 30, 2010 8:03 pm
By: Douglas Cohn and Eleanor Clift
By DOUGLAS COHN
and ELEANOR CLIFT
WASHINGTON — The debate on Capitol Hill about financial reform is extremely complex, but there are a few core principles to keep in mind as the politicians talk about derivatives and toss around the phrase, synthetic collateral debt obligations (CDOs), the instruments responsible for sending the economy into a tailspin.
Here’s all you need to know: The triple evils at the root of the economic meltdown are shorting (betting on failure), leveraging and false ratings.
Financial institutions dealing with other people’s money should not leverage more than 10 or 11 to one, meaning that for every dollar they take in, they shouldn’t borrow more than 10 or 11 times that. Goldman Sachs and other Wall Street firms were leveraging 30 times and more in real estate that had been securitized intoderivatives, a lucrative area that had no government oversight.
When Congress in 1998 overturned the Glass-Steagall Act, a Depression-era law that banned institutions from mixing commercial banking, investment and insurance activities, an enormous loophole emerged when derivatives were left unregulated. What followed was an explosion in the trading of derivatives, which are essentially bets on the future and a vehicle to make Wall Street a lot of money.
Wall Street was leveraging real estate in multiples of 35 to 1, and when the markets fluctuated, as they tend to do, it didn’t take much for Lehman Brothers and AIG to get wiped out. The Bush administration let Lehman Brothers fail, and the television images of Lehman employees hurriedly hauling out boxes with their belongings became a symbol of Wall Street’s downfall.
We learned later that Lehman went down in part because it couldn’t pay its debt to Goldman Sachs, and that AIG, another financial behemoth, escaped the gallows because government officials decided it was too big to fail. If AIG had gone the way of Lehman, the ripple effect taking down other institutions, domestically and internationally, would have brought the global economy to a standstill. At least that’s what the experts in Washington believed.
We then learned that AIG’s biggest single creditor was Goldman, which somehow floated above it all with a bottom line in the billions. Now we know, thanks to a complaint filed by the SEC last week, Goldman made out like a bandit because the fix was in.
They were highly leveraged, and they must have known that with leverage at 30 or 35 to one, the chance of failure was almost certain. (In contrast, the stock market is leveraged 2 to 1; if you buy $10,000 worth of IBM, you have to put up $5,000, and if IBM stock falls, you get a margin call.)
To offset likely losses, Goldman went short, meaning they bet on failure. John Paulson, the manager of a hedge fund that bears his name, put together a package of handpicked securities that were almost certain losers, and Goldman sold them to unsuspecting clients.
We should point out here that what Goldman execs knew and when they knew it is an issue in the SEC investigation. But one thing is clear, Goldman would never have been able to market these toxic assets without the Triple-A rating awarded them by the Big Three rating agencies, which are supposed to be independent, but because they get fat fees from the institutions they regulate, represent another dark underbelly of Wall Street.
If the rating agencies had given Paulson’s basket of CDOs a junk bond BB rating, nobody would have bought them, and the taxpayers would have been saved a whole lot of grief. What Goldman did may or may not be proved illegal, but it has such a bad odor in the eyes of the public, that one thing is certain among all the partisan wrangling on Capitol Hill, and that is that the derivatives market will finally come under the regulatory eye of government.
Published in The Messenger 4.30.10