krebscycle

The Frontline PBS “expose” of the financial crisis has an indignation set-piece on everyone’s favorite villain Goldman Sachs and their cartoon bad guy CEO Lloyd Blankfein. It’s worth a look just to see why so many of the “obvious” fraud prosecutions that journalists, pundits, and grandstanding politicians yell about are nothing of the sort. The key segment is a Senate hearing featuring Michigan Democratic Senator Carl Levin (recently in the news for defending GOP filibustering).

MARTIN SMITH: Blankfein was unapologetic.

LLOYD BLANKFEIN: Clients know our activities and they understand what market making is.

Sen. CARL LEVIN (D), Michigan: Do you think they know that you think something is a piece of crap when you sell it to them and then bet against it? You think they know that?

LLOYD BLANKFEIN: The nature of the principal business and market making—

TED KAUFMAN (D-DE), United States Senator 2009-10: Lloyd Blankfein argued it was perfectly OK, that “At the same time we were selling securities to you, we were betting on the fact these securities were going to go down. But that’s OK because we’re a market maker and we’re allowed to do that.” That sounds like fraud to me.

[at hearing] In the first half of 2007, Goldman Sachs sold long-position CDOs to its clients, right?

LLOYD BLANKFEIN: We sold— we reduced our risk.

Sen. TED KAUFMAN: So you were selling CDOs at the same time you were taking short positions on the same CDOs?

LLOYD BLANKFEIN: The best way of reducing your risk is to sell what you have.

Sen. CARL LEVIN: I believe in a free market. But if it’s going to be truly free, it cannot be designed for just a few people. It must be free of deception. It’s got to be free of conflicts of interest. It needs a cop on the beat, and it’s got to get back on Wall Street. We stand adjourned.

Hurrumph! The deal in question was almost certainly the infamous Abacus synthetic CDO sold to a German bank. So let’s take a look at the Abacus,  “prospectus"  the information  disclosure to the buyer about the deal. It begins with a warning:

Prior to making an investment decision, prospective investors should ensure that they have sufficient knowledge, experience and access to professional advisors to make their own legal, tax, accounting and financial evaluation of the merits and risks of investment in the Notes and should carefully consider the nature of the Notes, the matters set forth elsewhere in this Offering Circular and the extent of their exposure to the risks described in "Risk Factors”.

That is: don’t enter into this deal unless you are very sophisticated indeed. Then they describe the deal – here is part which I will translate into English below.

the Issuer will sell credit protection to the Protection Buyer with respect to a portfolio of Reference Obligations consisting of RMBS

The Issuer is the company set up in the Cayman Islands to do the deal. The “Reference Obligations consisting of RMBS"  are the crappy mortgages themselves. The Protection Buyer is whoever is buying "credit protection"  that the mortgages will not be too crappy. That is: the Customer is investing in a company – "the Issuer” – whose only business is a bet that a portfolio of crappy mortgages will not fail. The way the Customer makes money is when the Issuer collects monthly payments from the Protection Buyer for keeping the “protection” active.  So the fact that someone is betting these mortgages are crappy is not hidden from the Customer at all. In fact, the bet is the deal.  The only way the Customer profits from this deal is if the Protection Buyer is the sucker and is buying insurance against something that won’t happen. (In case you don’t know – the mortgages are just out there, owned by who knows who, the Issuer is created only to allow this bet to be constructed out of thin air.)

And how good were the mortgages – the Reference Obligations – that are the subject of the bet? The “Risk Factors” includes a serious warning about those Reference Obligations. The note warns the customers that they need to look at those mortgages very very carefully and that Goldman-Sachs is not making any promises at all about their quality.

As the occurrence of a Credit Event may result in a permanent decrease in the amounts payable in respect of the Notes, investors should review the list of Reference Obligations set forth herein and conduct their own investigation and analysis with respect to the credit worthiness of each Reference Obligation and the likelihood of the occurrence of a Credit Event with respect to each Reference Entity and Reference Obligation.

Sounds great, no? But it gets even better. The Risk Factors include a warning to the customer that  Goldman-Sachs or the Protection Buyer “may have” information about the quality of these mortgages that they are not going to share with the Customer.

The Protection Buyer or its affiliates and/or the Portfolio Selection Agent or its affiliates may have information, including material, non-public information, regarding the Reference Obligations and the Reference Entities. Neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer, the Trustee, the Issuing and Paying Agent, any Noteholder or any other Person with any such non-public information.

So: you the Customer are supposed to be an expert and do independent evaluation before insuring these mortgages, we have another customer who is putting up serious money that you are a fool if you do so, we are not making any promises about these mortgages, and, in fact, we might know something about them that we are not going to share with you.  And these warnings are far from the only ones that Risk Factors points out. If you want to understand something about the financial crisis, understanding why a German Industrial Development Bank even considered engaging in this absurd transaction would be a good start. (And if you want to understand politics, think about how the  German government managed to blame poverty level Greek pensioners for the bailout costs of this and similar banks.)  And most important: when economists talk about the role of the financial markets in allocating investment, consider how much effort and money was put into this elaborate casino deal instead of into a plant making solar panels or a wind farm or something else boring. But now, perhaps you see why a US Prosecutor would not want to take this case to a jury in Brooklyn. He or she might not expect  the average New Yorker to muster all that much sympathy for a wealthy bank that made a greedy, stupid transaction after being repeatedly warned.

Here’s the part of the risk note on information.

 Limited Provision of Information about Reference Obligations/Reference Entities

This OfferingCircular does not provide any information with respect to any Reference Obligation or Reference Entity other than that contained in a description of the Reference Portfolio set forth under “The Credit DefaultSwap—The Reference Portfolio”. As the occurrence of a Credit Event may result in a permanent decrease in the amounts payable in respect of the Notes, investors should review the list of ReferenceObligations set forth herein and conduct their own investigation and analysis with respect to the credit worthiness of each Reference Obligation and the likelihood of the occurrence of a Credit Event with respect to each Reference Entity and Reference Obligation.The Protection Buyer or its affiliates and/or the Portfolio Selection Agent or its affiliates may have information, including material, non-public information, regarding the Reference Obligations and the Reference Entities. Neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer,the Trustee, the Issuing and Paying Agent, any Noteholder or any other Person with any such non-public information. In addition, neither the Protection Buyer nor the Portfolio Selection Agent will provide the Issuer, the Trustee, the Issuing and Paying Agent, any Holder of any Note or any other Person with any such information that is public (including financial information or notices), except in the case of information pertaining to one or more Credit Events with respect to each Reference Entity and one or more Reference Obligation(s) of such Reference Entity in connection with which the Protection Buyer is seeking payment of one or more Cash Settlement Amounts.