GRETCHEN MORGENSON and LOUISE STORY add more detail to the story of the collapse of our financial system and how it was brought down by the gang of financial innovators at such respectable financiers at Goldman Sachs, Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc. link here

The article strongly suggests that the bankers knew what they were doing. They created bundles of mortgages and sold them off to credulous investors. Then they cranked up mortgage creators to market still more toxic mortgages on which to sell more credit default swaps (CDSs).

When that didn't satisfy the demand from investors, they came up with synthetic swaps. They knew the many of the mortgages were toxic and after selling them, bought swaps against their failing. When the demand for these grew too large, they created synthetic collateralized debt obligations (CDOs) and bet against them as well.

The mechanics of these transactions is a little complicated. First there is a bundle of mortgages. The investors who buy the package expect a steady flow of income. They are okay until the mortgages go bad.

In a totally separate transaction, banks bet against the mortgages by creating a synthetic collateralized debt obligation (CDO) made up of credit default swaps set up to pay when the mortgages fail. The banks pay a steady income to the sellers of CDSs until it goes under as the mortgages default. Then the bank collects from each CDS writer for each mortgage that defaults. The losers in these transactions are the ones who bought the CDSs. They may have no knowledge of the quality of the underlying mortgages that they are guaranteeing but are depending on the good faith of the seller.

The article notes, "Goldman used these securities initially to offset any potential losses stemming from its positive bets on mortgage securities. But Goldman and other firms eventually used the CDOs to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients' interests."

These and other industry practices are now the focus of "investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street's self-regulatory organization."

We are likely to see some indictments, if the sources quoted in the article can back up their assertions in court. There clearly was a conflict of interest between the firms and the buyers of these securities such that the firms appear not to have been acting in good faith. Former representatives of these firms now hold high positions in Washington.

Right now, one would have to question the sanity of anyone who trusts any of these firms with his money but so far they are still profiting greatly. From a purely economic point of view, these transactions are totally unproductive--the gains are matched by the losses on the other side. They only add to gross output to the extent of the net fees to the banks for creating and marketing the obligations and even that is of negative value to society--equivalent to that of services provided by casinos.

Eh, I don't think the reporting on that story is that good.

For a good takedown of it:

http://blogs.reuters.com/felix-salmon/2009/12/24/is-there-a-goldman-cdo-scandal/

There wasn't a conflict of interest in what they were doing. They weren't betting other people's money. They were betting their own and serving a market that wanted it.

There are lots of scandals on Wall St. I don't think this is one.

The link John made didn't work for me. Maybe this one will:

"Banks won bets against debts they created".

I agree with Mike's comment. Bear, Lehman, and Merrill also created some of these derivatives; and they ate their own cooking by loading up their own balance sheets with these, as a front page Wall Street Journal article detailed a while back. They didn't do so to play the role of fall guy, to put their employees' jobs and clients' capital at risk, and to lose money for their shareholders.

To zoom in on the micro aspect of these things, they were so complex that Warren Buffett, no financial rube, called them "financial weapons of mass destruction." Anyone who claims he could trace, let alone calculate, the cash flows from these things, or what they were actually worth, should resign his job and become a politician.

While some of these transactions turned out to be antiproductive, that was not because they are inherently so, but because other events helped drive down their value. Exhibit A would be the Greenspan Fed driving down interest rates well below their market clearing level, and thereby inducing traders (and others) to mistakenly think the values of these instruments were higher than they were. Exhibit B would be various government interventions in the housing market (subprime, etc.), which induced banks and mortgage firms (e.g.,Country Wide, New Century Financial) to lower their lending standards, and sell mortgages to unworthy home buyers, who would have been turned down in an earlier era. This was the foundation of the mortgage securitization binge, and subsequent derivatives boom that came a cropper when economic reality set in. Many traders and investors (including a lot of home buyers) suffered losses and write downs when their investments were revealed to be malinvestments. Meanwhile, Buffett sat out the carnage and invested in real assets such as railroads. A few investors, such as John Paulsen, shorted these and profited when they collapsed. According to the new issue of The Economist, even Paul Samuelson expressed regret for his role in creating derivatives. But derivatives are not the problem, at least not when they are used properly. In the meantime, the Fed has to be abolished, and we should move to free banking and free market money. They the supply of money would automatically adjust to the demand for it; and the boom and bust cycle, which is a product of government intervention, would die down to a tolerable level, even if it didn't disappear entirely.

Two points from my original piece seem to have been lost so let me restate them. In judging GS and others' behavior, we have to ask what social purpose it serves at the micro level. I would argue there is none. Ask yourself if you can see any value added to society.

In fact, this behavior was one of several key elements in the collapse of the financial system. We all have paid a big price for that and will go on doing so for many years. We need to be clear-eyed about this or we won't fix it.

How to fix it is a tougher question. Isn't it clear that too big to fail has got to go? GS and others need to be broken up. I wish us all luck.

Bill,

Sorry, but you are dead wrong. Free Banking and Free Market Money would cause worse economic swings, and more damage to your economy. What you need is a highly regulated system like we have in Canada. While American banks and companies were failing, and American home owners were facing foreclosure, Canada, your next door neighbor, and largest trading partner rode out the storm with no bank failures, and no major corporate failures (I'm not counting General Motors of Canada or Chrysler Canada as Canadian companies).

Yes, we had a few layoffs as companies who traded with the basket case to the south reduced staff when they saw reduced orders. But the only problems we had, were the ones that our southern neighbor caused, and really, they were minimal.

What would you prefer - a stable system? Or one that causes massive economic problems on a regular basis.

Mat Hatter,

Canada avoided a central bank-fueled subprime mortgage binge, which is the main reason it didn't have the same problems. The fact that its system is more intelligently regulated (read: less poorly regulated) is not a good argument for bank regulation or against laissez faire in money and banking. But you're main point, that free banking and free market money would lead to more economic damage, is contradicted by comparing the history of free banking to both central banking and other regulated banking systems without central banks. A comparison of the history of Canadian vs. American banking is useful. Canada had no central bank until 1935; it had no bank failures during the Great Depression, and the Canadian economy did not suffer nearly as big a drop in production, nor as big an increase in unemployment, as its southern neighbor. The U.S., which had both central banking and more federal and state regulations of banks, had about 8,000 bank failures and a much worse depression.

In the 19th century, Canada's banking system was less regulated and stronger, with fewer failures per capita, than the U.S. banking system, which was regulated by the states and the feds, particularly during and after Lincoln's War. My limited understanding of the Canadian banks is that they imported some ideas from the Scottish free banking system (a lot of Scots went to Canada), which might be one reason that their banks were stronger, and why they weren't saddled with the Bank of Canada for so long.

We need anarchy in money and banking just like we need it everywhere else.

The financial meltdown points to two "flaws" in US Culture today. The first "flaw" relates tot he economy as a whole. Few people seem to realize that transaction fees do NOT add value to the economy. I will acknowledge that transaction fees do serve a valuable purpose of facilitating commerce by bringing a seller and buyer together. Think real estate, a realtor helps bring the seller and buyer together and obtains a commission from selling the property. The realtor however does not add value to the property. The commission the realtor receives actually reduces the value of the property. (This assumes the commission is tied to the property and does not come from an external source, such as employment income.)

The problem with our financial "experts" is that they were taking assets and stripping them of their value through transaction fees. Unfortunately, too many people seem to have accepted the premise that so-called "profits" generated by transaction fees were real and not illusionary.

Second, we seem to have an "entitlement culture" in the US. Usually one associates the entitlement culture with people who feel the government or others are obligated to give them something. Regretfully, the entitlement culture exists on wall street too. In this case, wall street feels that they are entitled to do anything they want, including selling junk, to make a profit. There seems to be no moral brake in our society today restraining bad behavior. Unfortunately it seems that few in wall street accept the premise that they have any obligation to act ethically, its all me, me, me, even to the point of destroying the financial system.

John,

You are right that TBTF has got to go. I think GS (and others in the same boat) should have been allowed to face the discipline of the market. I've never agreed with the Krugmanite, etc. line that if the Fed/Treasury had not bailed out the TBTF banks, the economy would have suffered a GD II. What we do know is that moral hazard (thanks FDIC, and now the rest of the U.S. vampire state) is alive and well, and living in Washington DC and in the banking industry. Btw, one great advantage of free banking is that it vanquishes moral hazard by forcing bank depositors and investors to scrutinize banks' financial strength. Adam Smith also pointed this out. Also check out Larry White's book on Free Banking in Scotland, and George Selgin's book The Theory of Free Banking. Kurt Schuler, another free banking scholar who wrote a good history of free banking, once pointed out that Selgin's book is the second best ever written on money and banking. Bonus Q: what's the best? Btw, The Vampire State is a great book too.

As for questioning the motives of GS and others from a macro perspective, this puts the cart before the horse. MBS's were created in the 1970s (the first tranch was in 1970) to increase the liquidity of the mortgage market and to reduce the balance sheet risk (caused by interest rate risk and mortgage prepayment) of lenders and investors. To the extent that MBSs and derivatives (CDOs, etc.) had adverse macro consequences, they were caused by other factors not inherent in these instruments, such as bad Fed policies, which we saw in spades during the Greenspan era, and now being repeated by Comrade Bernanke.

"Btw, one great advantage of free banking is that it vanquishes moral hazard by forcing bank depositors and investors to scrutinize banks' financial strength."

Are you mad?

Be realistic. You will NEVER get every Tom, Dick, and Harry to go through several banks' financial statements with a magnifying glass carefully evaluating stuff before they open that new savings or checking account. They will simply open a new account like always, and expect that the money they put in will still be there when they need to withdraw some and that the checks they write against it won't bounce if they put enough money in to cover them like always.

And then your precious unregulated banks will rob them blind, move it all to numbered Swiss accounts, fold up their tents, and disappear, and make Bernie Madoff look like a rinky-dink small-town carnival's rigged knock-over-all-three-bottles-and-win-a-teddy-bear game by comparison.

And then you'll get to see not only GD II, but probably CW II too, and maybe even WW III for good measure.

At least right now you need some kind of credit card debts, mortgages, loans, stocks, investments, etc. to get in trouble because of the banking system. If you do honest work, get steady pay, and don't play the markets, play the casinos, or spend beyond your means you won't go bankrupt. In your world, the only way to be sure of not losing your paycheck will be to quickly cash it and stuff it in a mattress and have a good goddamn lock on your door and preferably a can of pepper spray and an alarm system too. Depositing it at a bank will be no safer than putting it into one of Bernie's securities, unless one does major research and has a professional accountant go over the bank's books first -- and that accountant will charge more than what you'd be depositing, if you're a typical American with a degree, a McJob, and ten thousand unreturned phone calls from answering want ads for real jobs.

If you honestly think it'd be any different, then you must believe in Santa Claus. (And, if you do, I've got a bridge, some prime beachfront real estate in Nebraska, *and* a bunch of triple-A-rated CDOs I'd be willing to sell you at a special, one-time-offer rate! And I can put you in touch with a friend of a friend who needs to get a few million bucks out of a bank in Nigeria, too!)

NN writes:

Be realistic. You will NEVER get every Tom, Dick, and Harry to go through several banks' financial statements with a magnifying glass carefully evaluating stuff before they open that new savings or checking account. They will simply open a new account like always, and expect that the money they put in will still be there when they need to withdraw some and that the checks they write against it won't bounce if they put enough money in to cover them like always.

And then your precious unregulated banks will rob them blind, move it all to numbered Swiss accounts, fold up their tents, and disappear, and make Bernie Madoff look like a rinky-dink small-town carnival's rigged knock-over-all-three-bottles-and-win-a-teddy-bear game by comparison.

The "private policing" doesn't depend on every Tom, Dick, and Harry to review banks' financial statements. What matters is that a critical mass of them do, including both individual and institutional professionals. No one, including Smith or modern free banking historians, ever claimed otherwise. The facts will then become common knowledge, and the stronger banks will gain market share at the expense of the weaker ones, just like in any other industry. You are also unaware of the unintended consequences and history of central banking and government regulation on money and banking.

Your second paragraph is belied by the facts of history, and frankly is quite ignorant. GD II, CW II and WW III, and the rest of your post is hysterical nonsense. I think I've seen your stuff before, and ignored it because it wasn't directed to me. I'll continue to ignore it. Too bad that the founders of this blog allow anonymous and psuedonymous commenters, which is the main reason I left.

Bill writes:

"The "private policing" doesn't depend on every Tom, Dick, and Harry to review banks' financial statements. What matters is that a critical mass of them do."

And if you believe that even a critical mass of them will, let alone all of them, then I'd like to remind you that that bridge is hot hot hot and is going going gone if you don't buy it quick. :)

Also, how is your "critical mass" going to communicate which are the rotten apples in the bunch to the rest of the populace? Remember you'll have no properly functioning fifth estate, either professional or amateur, in your anarchist's paradise. The Bernie Madoffs of your world will simply pay the major news outlets a bit of hush money to not publish anything questioning them for long enough for them to bilk lots of people and then pull their disappearing act, and they'll pay ISPs to perform suitable "content filtering" too.

Bill also wrote several vicious and unprovoked insults.

None of the nasty things that Bill has said or implied about me are at all true.

NN writes: "If you honestly think it'd be any different, then you must believe in Santa Claus."

It's OK if you don't believe in me, son. I believe in you.

Now if you'll excuse me, I have a busy few hours ahead of me. The heavily-populated East Coast of Australia awaits! After that, though, I get to kick back and relax for 364 days, though I tend to spend the first two catching up on sleep. It's hard pulling allnighters at my age, even just once a year.

The issue of "private policing" has been raised. I am glad for that, but exactly how will that work????

To a degree, the Madoff ponzi scheme illustrates an inability of "private policing" to actually expose corruption. As the Madoff ponzi scheme unraveled it was disclosed that several firms where hired to investigate and concluded that investing with Madoff would be a mistake.

The fact that this information did not make it into the public arena points to a couple of issues that make "private enforcement" only theoretical. (Yes, in some cases the regulators where informed, but "critical mass" was not achieved)

1. What would be the obligation of a firm that uncovers fraud to actually disclose that information to the general public? Clearly they have an obligation to inform their client, the general public? I think not.

2. Suppose a firm, as a business model, investigates firms on a regular basis, has a (private) database, and only sells their results to anyone who pays. Now they uncover fraud, what do they do? To be consistent with my prior conclusion, I would have to say that they would not be obligated to disclose the fraud. However, I would say that at a certain point an obligation to disclose should exist.

My point, there is little incentive for private organizations to publicly disclose abusive business practices. Since corporation are not in the business of being altruistic, "Private enforcement" that would serve the public interest; while a nice concept, will not be pursued.

Now what happened to all the investigative journalists out-there who could fulfill that role of disclosure?

Steve writes: "There is little incentive for private organizations to publicly disclose abusive business practices."

Steve hits the nail on the head.

In fact, the incentive in Bill Stepp World would be for any organization or individual that discovered a Madoff-like fraud to:

1. Dis-invest in Madoff ASAP and then

2. *Threaten* Madoff: "I'll blow the whistle if you don't cut me in for a piece of the action".

The New York Times has a short editorial, "Betting Against All of Us", picking up on Morgenson's and Story's article link here. It makes several points.

*That Goldman Sachs was not just hedging when it took contrary positions to those of its clients who had placed bets; it was making enormous counter bets, far above the value of the positions it had sold to clients which would pay off if they went sour.

*That this gave it an incentive to sell rotten mortgage-backed securities so the buyers would fail and have to pay GS, possibly leading them to commit fraud on their clients.

*That neither the Congress nor the Administration had done anything about legislation to reform this practice which had contributed greatly to the financial meltdown.

*That the Treasury has a former high Tricadia official who had been involved in the practice and was in a position to influence administration policy in the interests of GS et al and against adequate reform to protect the public.

*That Wall Street generally opposed reform.

The editorial sums up the situation: "The House-passed bill would impose some controls over derivatives, although it is unclear whether it would stop this particular practice. The Senate has not yet produced a bill. And neither the White House nor Capitol Hill has adequately addressed the bigger question of how to curb the high-risk proprietary trading by banks that has created conflicts with clients and endangered the economy at large."

You wanted anarchy? Well now it looks like you might get a taste of it pretty darn soon. If either of us is still alive ten years from now I'll be the first to say "I told you so".

http://kunstler.com/blog/2009/12/forecast-2010.html

Steve R,

Long before the Madoff Ponzi swindle unraveled, a couple of prominent *private* analysts pointed out that his scheme was deeply flawed. In fact one of them went to the SEC not once, but twice, and his written warnings and entreaties were ignored. Along the way, the SEC did investigate Madoff's operation and concluded that nothing was amiss, in effect stamping the SEC Good Housekeeping seal of approval on his criminal enterprise. That stopped any potential criminal action against Madoff in its tracks, which, after all, can only be brought by the criminal enterprise known as the government. Civil actions (which have to wind their way through government-run courts) are another matter; but after the SEC said his organization was A-okay, what incentive did his investors have to dig deeper?

Contrary to your statement that this illustrates a problem with private enforcement, it does no such thing. As I pointed out the SEC brought no action against Madoff, nor did any other government law enforcement agency. In the U.S. private law enforcement has no standing; to cite what actually happened as a case against it makes no sense.

If a private firm discovered fraudulent activity, it might well have plenty of incentive to disclose it, if for no other reason than to enhance its repuation as a vigilant fraud buster. Why do you think Jim Chanos, a bear on Enron, went on every financial show during Enron's demise? For one reason, it enhanced his repuation with investors, and increased his assets under management. It might also win customers/clients from a fraudulent firm (and even from other honest competitors who were asleep at the wheel), and increase its own sales and profits. I see no reason why any private party who discovers fraud has an obligation to disclose it widely, but I also see no reason why such a party would not. More to the point, do you seriously think other people wouldn't discover it sooner or later, particularly if had been conducted on a large scale?

History demonstrates that private institutions work better than government institutions; look no further than the history of free banking vs. regulated and central banking. See also David Friedman's work in the JLS and in his book Law's Order.

There are lots of reasons why private businesses would publicly disclose fradulent business practices. I've listed only a couple examples.