“Is Blaming AAA Investors Wall-Street Serving PR?”

By Thomas Adams, at Paykin Krieg and Adams, LLP, and a former managing director at Ambac and FGIC.

In my view, Goldman, and a host of other clever bankers, are deliberately obscuring one of the most important points about modeling, CDOs and sophisticated investors. One of their defenses against the tremendous losses these products delivered amounts to “caveat emptor”: everyone is a grown up and should have known what he was buying.

But that conveniently obscures a critically important fact: for so-called ABS CDOs (the kind made from asset backed securities, meaning tranches of either residential or commercial mortgage bonds), 75% to 90% of the deal was rated AAA. And these ratings did not depend on the insurance provided by AIG or monolines; those ratings were issued on the CDO as concocted by the packager/underwriter.

The argument that the CDO market blew up because it was so complex and speculative is fundamentally flawed. Believe it or not, the bonds that caused the damage to AIG, the bond insurers, and banks were not highly speculative, high risk bonds. They were AAA securities and were supposed to be virtually free of credit risk. In many cases, they were “super senior” bonds – meaning they had another layer of protection above the AAA level to make them even safer than regular AAA bonds. In return for this high level of safety and large levels of protection, the investors or insurers received a very low AAA level yield. In addition, because the bonds were heavily protected, AAA rated and presumably safe, the investors and insurers did not (and were not required to) allocate very much capital to them. The bonds were not considered risky, so there was little need to reserve capital against them. In contrast, the investors and insurers held much more capital against the BBB bonds in their portfolio. This was fundamental to their business model.

Historically, investors viewed super-safe, high quality investments, such as Treasury securities, as simple, non-sophisticated investments where their money could be placed safely without worry about complex models and detailed review. In most institutions, a novice portfolio manager starts out by investing in AAA bonds, and works his way up the sophistication curve over time. Over the past few years, many investors seem to have forgotten this. But anyone who thought they needed to be super-smart, sophisticated and using “cutting edge” models (the phrase my old boss used) in order to invest in AAA bonds was either a fool or a fraud. In retrospect, there were plenty of both types.

In other words, these highly complex products were targeted to buyers who in many cases were the very least sophisticated institutional investors. And fund managers, both freestanding ones, and ones within larger organizations (think portfolio managers at insurance companies) are subject to competitive pressures. If industry benchmarks for AAA returns start to include complex, manufactured AAA paper, these investors would damage their careers by sticking to what they were sure they understood and shunning the more complex instruments that offer a bit of a yield pickup. As Keynes observed,

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.

The whole notion that an investor must do complex, detailed, sophisticated analysis of AAA bonds in order to understand them and not get ripped off is, as a result, completely upside down. A high yield or a distressed bond requires a lot of analysis to determine if it is safe. This may involve elaborate models and multiple scenarios. Investors who pursue these types of risky bonds believe they have the tools to understand all of the considerations that go into the decision to purchase it or not. This type of investor is sophisticated and is aware that he is either taking risk or making a speculative bet. To compensate this investor for such a bet, the bonds pay a high yield and, if the bet is right, produce a high return. Even if the bet eventually goes bad, the yield may be enough to pay the investor so that the loss is offset. Often, investors in these bonds employ teams of quants and Phd’s to help them understand their bets.

Investments in AAA bonds are supposed the opposite of this type of high yield investment. It makes absolutely no sense that a AAA investor should need the same high tech models to make his investments or that if he fails to properly use his models he will be completely blown up and his investment will be worthless.

This “highly sophisticated investor” argument has been used by Goldman, other banks and a remarkably high number of journalists (in my opinion just repeating the crap they have been fed by their sources) as a way of getting the banks off the hook. But it is a fundamentally flawed argument. The CDO bonds that AIG insured were rated AAA. If you have to be a rocket scientist to understand the investment and if anything short of perfect analysis of the bonds means you will be blown up – then by definition the bonds are not AAA.

AAA = easy and low yield. BBB = complex, high yield. This is a pretty simple and bright light distinction. And yet it has been blurred and ignored throughout the discussion of this asset, as recently as two days ago by Goldman.

A “super senior” investment in any asset should, by definition, not require sophisticated analysis. it should be as safe as, or safer than, Treasury securities from a CREDIT perspective (ratings do not address market value or interest rate risk – which could be more complex).

Neither investors in, nor insurers of, AAA or super senior bonds were compensated with high yields – they were not yield hogs, as suggested by one comment on NC the other day. If they were getting huge yields they would have been on notice that their risk was high.

I don’t want excuse the insurers or investors of all of their responsibility. I was one of them. We got sucked into the game of “complex” AAA bonds and believed that we were sophisticated. It was part of the cultural experience of the era – even boring old muni people wanted to believe that they were “special” and “sophisticated”.

An investment that purports to be AAA or super AAA should be obviously of high quality. There should be “no ifs ands or buts” about it. The investment should not be binary, such that if you are “right” it is AAA and if you are wrong it is worthless. Model sophistication, extreme diligence, the need to have skepticism about potential lies or misrepresentations from sellers and issuers – all of this is completely incompatible with a AAA bond.

Goldman Sachs and dozens of other banks and captured journalists want the story to be about the failure of the investors who were sophisticated and assumed the risk. They ignore the crucial fact that the bonds that blew up were AAA and were sold as virtually risk free. The entire environment created by the banks, managers and rating agencies for the AAA CDO market was false and contrary to the definition of what was being sold.

The reason that is most frequently cited as why AAA CDO bonds collapsed in value is that they had extreme cliff risk, or tail risk. However, the notion of “cliff risk” should be incompatible with a AAA bond – by definition. Any model that obscures or ignores or adjusts this issue away, is a form of sophisticated lying, as it relates to AAA bonds.

The problem with the CDO market, and a good chunk of the financial crisis, is that the participants took complex, highly volatile, highly risky and highly leveraged assets and passed a magic wand over them to turn them into AAA. Unfortunately, this process did nothing to remove the volatility, risk, complexity or leverage (in fact, the CDO made all of these worse). From the very start, the market for AAA CDO bonds backed by ABS collateral was a fraud; the advocates of these bonds used fancy models, flashy Powerpoint presentations, expensive meals and a whole lot of flattery to convince people it wasn’t a fraud, but that didn’t change the truth.

The essence of the issue is that these AAAs that blew up and went to zero (and this is no exaggeration, many former AAA-rated CDOS are utterly worthless) were hopelessly badly designed and/or fraudulently sold. As Yves and I will be discussing in upcoming posts (and Yves covers at some length in her book), there is ample reason to believe a lot of the CDO packagers and underwriters knew exactly what they were doing

The rating agencies should have known that this degree of complexity and an AAA rating were fundamentally incompatible, but they were financially incented to ignore it (they got paid much more money for rating CDOs). The investors and insurers should have known it too. But I am pretty confident that the biggest responsibility lies with the sellers and the creators of the bonds – they were selling something that was supposed to be super safe but turned out to be worthless – and they knew this to be the case, one way or the other.

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  1. Blurtman

    The rating agencies committed fraud. Goldman Sachs committed fraud. The USA had a Treasury Secretary who was a common criminal.

    Why oh why is white collar crime described in such hushed tones?

    1. LeeAnne

      Great question. In a country where Forest Gump, a retard, is a model for morality and financial success …

    2. jake chase

      Nobody with the smallest understanding of what a CDO of MBS actually was can seriously contend he viewed it as safe. Those ratings were fig leaves which managers chasing yield chose to hide behind. There is an obvious correlation risk associated with a real estate bubble based upon unaffordable mortgages granted borrowers with no equity at stake: the borrowers are guaranteed to default as soon as prices stop going up, and the defaults are cumulative. No matter what tranche he may have bought, any investor had to know his principal was at risk. Moreover, the fact that synthetics made the volume of CDOs a big multiple of the actual mortgage volume made the entire market a complete disaster waiting to happen.

      Anyone associated in this market is a criminal until proven otherwise. If participants believed anything it was that SOMEBODY would come to their rescue when disaster struck. Incidentally, the fact that something is rated AAA means that you are PERMITTED TO BUY IT, not that you are SUPPOSED TO BUY IT.

  2. Francois T

    Excellent point!
    AAA should have been (and should still be) a no-brainer. But not in the USA, where rating agencies won’t even face inquiries from regulatory authorities, Congress or law enforcement.

    State capitalism at its finest in the (former) greatest country in the world.

  3. Sestina

    Interesting piece. I’d always assumed that reaching for yield was part of the problem. What was the spread between the yields on AAA rated CDO tranches and treasuries or agency bonds from say 2002 to 2006? Weren’t interest rates pretty low during a lot of the period when these markets took off?

    I’m not sure what duration the average AAA rated CDO was but could that have been part of the problem? Customers wanted longer duration paper so the banks were constructing it for them?

  4. fresno dan

    I think it is much, much more disconcerting that it may be that the rating agencies (again, I think not enough attention that they have a defacto monopoly and government imprinteur) really did not know what they were doing.

    I think it brings up some very troubling questions: are stocks really good in the long term (I fully expect my portfolio to recover in 2 or 3 hundred years)? Does a rising tide really lift all boats? Is credit the lifeblood of the economy – borrowing is income, debt is wealth??? How is it that stocks can theoretically go up up by smounts significantly greater than the GDP? Is there is a correlation between renumeration and the person’s knowledge, honor, and results (i.e., bank CEO’s)?

    I think the toughest thing in the world for many people is to utter the words, “I don’t know.” I don’t know how many articles I read prior to the meltdown about how all these mathamaticians were now working on derivatives – and don’t worry about them because these people are much, much smarter than I. Well, I agree they are – they are still rich, and I have less money. But I have learned that maybe, just maybe, they are not as smart as they think they are.

    1. liberal

      “How is it that stocks can theoretically go up up by smounts significantly greater than the GDP?”

      They can’t, in the long run, if you properly define things.

      The investment return in a stock comes from three quantities, according to the Gordon formula: change in P/D, dividend growth, and initial dividend. If you look at the details, comparing the total return to change in GDP is an apples-to-oranges comparison. The _proper_ comparison is dividend growth to GDP growth. (This is putting aside issues like returns from overseas.)

      1. jake chase

        The value of stocks is a function of the supply of stocks and the money demand. Stocks go up because Wall Street cannot inflate supply fast enough, although it does keep trying.

        Stocks go down when overleveraged speculators suddenly have to sell them because all the other drek they own enjoys no liquid market. What cratered the stock market last year was forced selling by hedge funds.

        As for what will happen next, I have no idea whatsoever.

    2. jdmckay

      the rating agencies (…) really did not know what they were doing.

      Actually, they did know what they were doing. In (very) short, that means in this affair, related to their stated professional services, they did not do what they purport to do. Period.

      For starters, if you’ve never watched or read summaries, take a look at the WAXMAN hearings on these guys on 10/22/08. First one is here. The panel:

      * Raiter, Frank – Managing Director (Fmr.), Standard and Poor’s
      * Egan, Sean – Co-Founder and President, Egan-Jones Ratings
      * Fons, Jerome S. – Managing Director (2001-2007), Moody’s Investors Service, Credit Policy

      WAXMAN’s 2nd hearing, here. The panel:
      * McDaniel, Raymond W. Jr. – Chairman and CEO Moody’s Corporation
      * Sharma, Deven – President Standard and Poor’s
      Joynt, Stephen – President and CEO Fitch Rating

      And if you really want some giggles, next day (10/23/08) WAXMAN had Greenspan, John Snow (Treasury) & Christopher Cox (SEC). A bit of knowledge on Cox’s backround as a Republican/K-Street & ultra partisan/corrupt enabler of any hair-brained issue that his biggest contributors stuffed his pockets to promote will go a long ways towards putting his 1/2 assed comments into context.

      In that hearing, summary (from C-SPAN) of Greenspan’s comments:

      In response to sometimes partisan and pointed questioning Mr. Greenspan said that he may have been mistaken about the reliability of some financial instruments, such as insurance-like credit-default swaps, that were not yet common when he expressed his views about markets being able to police themselves.

      A MarketWatch summary of McDaniel’s comments, both from the hearings and in subsequently released internal Moody’s memos/emails:

      “We drank the ‘Kool-Aid,'” McDaniel wrote in an internal memo released Wednesday.
      Between 2002 and 2007, the agencies rated a flood of mortgage-related securities issued by Wall Street firms, giving many of the securities a coveted AAA rating at the time, only to downgrade most of them as house prices tanked and defaults spiked. The subsequent collapse in the value of those securities has taken the global financial system to the “brink of the abyss,” in the words of the head of the IMF.
      The companies were rewarded not by having high standards to come up with honest assessments, but by lowering them, McDaniel said in an internal memo written almost exactly one year ago.

      In a section of his memo titled, “Conflicts of interest,” McDaniel said the market “actually penalizes quality” because companies hire rating agencies based on which agency is willing to give a securities offering the highest rating, not on which one is the most honest.

      “Unchecked competition on this basis can place the entire financial system at risk,” McDaniel wrote in the Oct. 21, 2007 memo. “It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want ratings downgrades; short-sighted bankers labor short-sighted to game the ratings agencies for a few extra basis points on execution.”

      Here’s Moody’s Statement of Professional Conduct. From the Preamble:

      Financial markets should be efficient and fair to all market participants. Credit rating agencies
      play an important information role in these markets. Moody’s Investors Service (“MIS”) provides
      opinions in the form of credit ratings and related research about the creditworthiness of Issuers
      of securities and their financial obligations. Our credit ratings are forward-looking opinions that
      seek to measure relative credit loss. That is to say, they forecast the likelihood of default on a
      bond and the estimated severity of loss in the event of that bond’s default.

      Given the vast amount of information available to investors today — some of it valuable, some
      of it not — MIS helps investors and others sift through this information and analyze the credit
      risks they face when lending to a particular borrower, or when purchasing an Issuer’s debt or
      debt-like securities.1(…)

      The whole thing’s worth a read-through (IMO), in particular for what it has to say about what they don’t do. I
      ‘d also be real interested to compare this w/comparable statements from a decade or more previous. Especially I wonder if “opinion” replaced more substantial wording.

      Here’s link to Moody’s Report on the Code of Profesional Conduct from ’08. In particular, take a look @ Section II, and especially Section 1.7 — Quality of the Ratings Process. This ’08 report starts off explaining that ’08 was a “difficult year”: Section 1.7 explains some of their more specific changes in response to these “difficulties”.

      Interestingly (at least to me), the ’06 report contained these changes and more. An excerpt:

      The Core Principles, among other things, provide that a Credit Rating be the product of a rating committee,11 that rating decisions be consistent with existing policies and methodologies, that rating committee composition be based on
      relevant expertise and diversity of opinion, that Analysts not give any assurance or guarantee of a particular rating prior to a rating committee, and that conflicted Analysts be excluded from a rating committee. The Core Principles also identify various types of potential conflicts that would make an Analyst ineligible to participate in a rating committee. (See Section II.B.3 below for additional
      information on how the Core Principles address management of conflicts of interest.)

      Moody implemented none of these core principles in rating these mortgage bonds… none of ’em. Barry Ritholtz had a summary of those Waxman hearings w/some informative links here.

      Lastly, here’s a link to Janet Tavakoli’s (Yves cites Janet on this blog from time to time) presentation to IMF on this debacle, last Sept 29 (’08). A couple excerpts:

      Wall Street gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private‐label residential mortgage backed securities (RMBS). Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre‐agreed amount of loan losses. But many RMBSs were backed by portfolios comprising risky fraud‐riddled loans. Most of the “AAA” investment was imperiled, and subordinated “investment grade” components were worthless. Wall Street disguised these toxic “investments” with new value‐destroying securitizations and derivatives.1
      Meanwhile, collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in doomed securities. New money allowed Wall Street to temporarily hide losses and pay enormous bonuses. This is a classic Ponzi scheme.
      Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities. Underwriters are responsible for appropriate due diligence, an investigation into the risks.2 If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed. If you fail to disclose material information, expect to be investigated for fraud. If you have a mortgage subsidiary, expect it to be investigated, too.
      Wall Street protests that it sold toxic assets to sophisticated investors obliged to perform independent due diligence, so those investors may have trouble claiming damages. But the ballgame has changed. Massive fraud damaged the U.S. economy. (Housing prices didn’t just fall; they plummeted as the fraud unraveled.) U.S. taxpayers became unwilling unsophisticated investors funding Wall Street’s bailout.
      By the end of 2006, public reports of implosions of large mortgage lenders eliminated CEOs’ plausible deniability. By January 2007, many (including me) publicly challenged the failure to account for losses. Instead, toxic securitization accelerated in the first half of 2007—classic malfeasance as a Ponzi scheme collapses.
      An IMF official asserted: “You can’t prove fraud” and insisted it was in the interest of risk managers not to let their institutions collapse. (He was unable to attend my exposition based on Chs. 5‐12 of Dear Mr. Buffett). This IMF officer isn’t just soft on crime; he’s in denial. Failure to recognize fraud led to statements like the one that opened Chapter 2 of the IMF’s April 2006 Global Financial Stability Report:
      There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient.
      The IMF’s source was a 2006 speech made by Treasury Secretary Timothy Geithner, then president and CEO of the New York Fed.
      In the recent Ponzi scheme only the agents—mortgage lenders, rating agencies, fund managers, securitization professionals, CFOs, CEOs, and other fee or bonus beneficiaries—prospered. Controls and risk management were undermined. The financial institutions and their shareholders, for which these agents are failed stewards, collapsed. Investors in toxic securitizations lost money. Had regulators done their jobs, they would have shut down Wall Street’s financial meth labs, and the Ponzi scheme would have quickly choked to death from lack of monetary oxygen.
      After the Savings and Loan crisis of the late 1980’s, there were more than 1,000 felony indictments of senior officers. Recent fraud is much more widespread and costly. The consequences are much greater. Congress needs to fund investigations. Regulators need to get tough on crime.

      In other words, it’s all connected. Moody’s & S&P did no due diligence, period. Fitch almost as bad. And just in case anyone thinks any of this has been fixed, these mortgage bonds have been repackaged and now being sold, again, as AAA.

      The reliance on these rating agencies cannot be overstated. A whole lot of investment managers pay good $$ subscribing to their services, and base decisions on what/how much to invest where entirely on data they receive from these guys. Literally, rating agencies have been the oracle. The malfeasance of these guys cannot be understated AFAIC.

      I read a lot from some of these econ blogs… one opinion says it’s not WS’ fault, it was regulators asleep on the job. Someone else says no, it was lazy investment/portfolio managers… they didn’t do their jobs. Others say the mortgage companies, Countrywide and such. Others blame ratings agencies, and others asleep-at-the-wheel SEC.

      A case could be made for accounting profession as a whole. Similarly for bank managers.

      Thing is, they were all corrupt… all of ’em. They all abandoned professional conduct and diligence… all of ’em. The whole system is rotten, and pretty much nothing’s being done about it: the system remains the same w/the same players, just a lot of public wordsmithing trying to convince us all they’ve mended their ways.

  5. RebelEconomist

    I do not, and never have, worked on the sell-side or as a journalist, but I totally disagree (not for the first time on this blog, which is becoming a platform for whiners). Credit ratings are an assessment of the danger of credit losses, not some investment difficulty tariff. Blaming complex products and weak regulation for the crisis diverts attention away from the ignorant plan sponsors and either complacent or cynical fund managers who are at least as responsible. Leaving these people in their positions unchastened will, given the ability of the sell side to find ways around new rules, lay the foundations for the next crisis. (Disclosure: as a former investment manager who was marginalised during the boom as being too “hair shirt”, I have a personal interest in seeing such a shakeout).

    1. Richard Smith

      Well I will leave Tom to defend himself against the ‘whiner’ charge, again; and I expect platform-provider Yves will be pretty robust as well, so I’m not going there either.

      The substantive points you make are more interesting.

      “Credit ratings are an assessment of the danger of credit losses, not some investment difficulty tariff.”

      Well, that’s true, though from 1909-2004 the distinction between capital losses and credit losses was less important than it has been lately. They tended to amount to the same thing, if you were investing in bonds and holding them to maturity, and if you ignore the yield curve for a moment. But now that one can buy something that looks like a bond, is priced like a bond and performs like a portfolio of deep out of the money options, your point is very relevant. You are right, the rapid mutation of the assumed meaning of the triple ‘A’ rating from ‘suitable for widows and orphans’ to ‘says nothing whatsoever about the safety of your capital’ certainly caught out the buy side, big time. And you are right also, the assumed meaning was not correct in the first place, though perhaps not dramatically wrong for straight bonds, I would suggest.

      “Blaming complex products and weak regulation for the crisis diverts attention away from the ignorant plan sponsors and either complacent or cynical fund managers who are at least as responsible.” You are right about this too. Trouble is, there’s far to much blame to go around, and not nearly enough attention. Suppose it was an epidemic of seriously impudent housebreaking, not a financial crisis. Would you expend effort on catching the perpetrators (sell side), or educating the public (buy side) to fit better locks and to stay alert? Where is the biggest bang for buck? NC seems to think, catching the perpetrators. You think, educating the public. It might be kinder to see those choices as value judgments, or based on some metric of efficacy, rather than on a differential taste for whining. I expect you have some thoughts on that.

      “Leaving these people in their positions unchastened will, given the ability of the sell side to find ways around new rules, lay the foundations for the next crisis…as a former investment manager who was marginalised during the boom as being too “hair shirt”, I have a personal interest in seeing such a shakeout.”

      Well, precedent is not on your side. Little has changed since Keynes wrote this:

      “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”

      Just drop in “fund manager” instead of banker. You are to be congratulated on your relative unsoundness, and I really hope you get back to the centre of things, of course, but as you have seen, the market can stay irrational longer than you can avoid being pushed to the margins. So I don’t see how that sort of stand can be anything other than quixotic. The buy side is big and you individualists are outnumbered by the sheep. The sell side is smaller – more practical to pick those guys off. The moral difference implied in the choice? Not huge.

      1. Kid Dynamite

        “A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him.”

        i’ve now seen that quote 3 times on NC in the last week – once in this article, once in a comment from Yves last week, and just now. Are you guys using it as an excuse for the behavior of the fund manager? I still can’t tell… it SEEMS like you’re using it as en excuse, but it’s no excuse! I can’t be certain, but it seems obvious to me that Keynes wasn’t stating it as an excuse or advise on how to behave!

        To me, that quote demonstrates everything that is wrong with our system. This is further evidenced in the comments by “rebeleconomist” who seems to have been fired for being prudent and avoiding risks that he saw but few others did.

        1. Richard Smith

          No, most emphatically not an excuse. The buy side has this giant agency problem. Overlay a speculative mania on top of that, some smart spivs, and it can only end in tears.

      2. LeftCoastTom

        Would you expend effort on catching the perpetrators (sell side), or educating the public (buy side) to fit better locks and to stay alert? Where is the biggest bang for buck? NC seems to think, catching the perpetrators. You think, educating the public.

        Don’t police, when faced with an unusually high rate of break-ins, commonly do both, trying to catch perpetrators (sell) as well as encouraging neighborhood watches (buy)?

    2. charcad

      (Disclosure: as a former investment manager who was marginalised during the boom as being too “hair shirt”, I have a personal interest in seeing such a shakeout).

      At what annual ROI did you “rebel” and start warning that higher expectations required excessive risk taking almost guaranteed to lead to permanent capital losses?

  6. RebelEconomist

    To be more precise, I should have said that credit ratings are an assessment of the danger of DEFAULT losses. I wonder how many of these AAA CDOs have actually suffered default losses, even now. The last time I heard (admittedly several months ago – from an FT article by Gillian Tett), not many had, so maybe the credit ratings were not so unrealistic after all. I always suspected that many of these structured products were deliberately designed to accept exposure to, and therefore offer (some of) the associated risk premium for all manner of risk short of actual default loss (at least subject to the constraint set by the target credit rating). As such, they arbitraged the aforementioned carelessness of investors.

  7. Uncle Bill

    If it’s so easy — all you have to do is look at the ratings — why don’t you just have your secretary manage your AAA bond portfolio? Give her the list of AAAs, and let her choose. Why should you bother paying the astronomical salaries of your portfolio managers if all they have to do is pick from the list of AAAs? Essentially, you’re letting the rating agencies do your job by proxy. OK, let’s assume you did that — wouldn’t you at least investigate the agencies to whom you have given this duty? First, I don’t believe you chose bonds solely because of the ratings, and second, I don’t believe you trusted the rating agencies implicitly. How could you have been involved in the business and not noticed that everything was rated AAA? Yves, this guy is nothing more than a Monoline Apologist. The monoline business model was a inherently flawed, at best, and, at worst, complete fraud. Bottom line: It’s unprofitable if you’re made to carry the proper capital reserves. That’s why they were all registered offshore.

  8. Richard Smith

    While “investor carelessness arbitrage” is a compelling description of the IB business model, I’m not sure it’s a great way of filtering desirable from undesirable behaviour. At first blush, it seems to let Madoff though as well. That’s not meant to be a cheap point – I really would like to hear a tight, plausible definition of financial crime, especially from anyone from the ‘caveat emptor’ school of financial regulation.

    You are dead right about structured products – they are absolutely stuffed with all manner of arcane risk. That is their raison d’etre, I think.

    Sometimes it is better to admit that one just doesn’t understand, and say ‘no’. But that doesn’t necessarily impress one’s client or one’s manager as much as it ought to, as you seem to have found out.

    1. Kid Dynamite


      to me, financial markets are not unlike sports bookmaking. In the bookie world, you have the “Squares” who are analogous to the retail investors. These are the guys who say things like “oh man – the Giants are so totally awesome – they are SO gonna cover the 7 point spread,” with little or no reasoning. They also might be guys who pay someone else (like a newsletter writer) to pick games for them (of course, these newsletters are almost always scams)

      Then there are the professionals – i actually know a guy who was one of the biggest NFL bettors in the 80’s. He still handicaps NFL games – he spends 30 hours+ a week analyzing the different matchups, weather, psychology, etc.

      Now, in the investing world, pension fund managers need to be PROFESSIONALS – they can’t be in the “square” camp, and just say “hey – i paid the newsletter (ratings agency!!!) for the picks, if they lose, it’s not my fault.”

      that’s amateur thinking, and i could be convinced that it’s an acceptable excuse for RETAIL, amateur investors (but note, again, the culpability lies with the RATINGS agency here).

      Both sports betting markets and financial markets are efficient ENOUGH that you have to do your own work – and LOTS of it – if you expect to generate alpha.

      Some people will deride me for making the analogy of markets to a casino or bookmaking operation – but I’m reasonably certain that most traders (myself, and everyone i know at least) do expected value calculation on their trades just like you’d do in the casino or in the sports book. It’s not “Kid Dynamite is a naive immature gambler” – it’s the realization that in both financial markets and in gambling markets, it’s not a crime to have more information than the guy on the other side of the trade/bet.

      1. Richard Smith

        You are right, there is an infinite supply of institutional stooges who might as well be retail guys. All misclassified as expert investors. How is that misclassification to be sorted out? I haven’t heard any concrete reform proposals from those who would blame the buy side, but I’d pay attention if any were made. I rather think that having a bunch of idiots classified as experts works rather well, once again, for the sell side.

        Ratings agency: well, a rating these days just seems to be a quaintly represented and rather sticky yield spread: there doesn’t seem to be any added value in the rating at all, if there ever was. You might just as well look at spreads.

        I’m a bit sceptical of your betting analogy. Sure, if it was all gamblers against each other, it would just be an exciting zero sum game. But it seems to me that in the capital markets, the “professional gamblers” often work for the “bookies”, and the “bookies” also own, breed and train the “horses”.

        At some point even the most self-confident gambler might start to wonder whether the prices emerging from a set-up like that were good value. And just who was likely to have the best information.

        1. Kid Dynamite

          richard – to your last paragraph: i think Felix Salmon summed it up when he said something like “It’s just that if you’re making a bet and Goldman is your bookmaker, don’t be surprised if you end up losing” i’m shocked that people are surprised that when you go to GS and ask them to structure a prop bet for you, in this case, a synthetic CDO that allows you to get more exposure to the housing market, you tend to come out on the losing end more times than not. That shouldn’t be surprising!

          now, back to your first paragraph:
          “You are right, there is an infinite supply of institutional stooges who might as well be retail guys. All misclassified as expert investors. How is that misclassification to be sorted out? I haven’t heard any concrete reform proposals from those who would blame the buy side, but I’d pay attention if any were made. I rather think that having a bunch of idiots classified as experts works rather well, once again, for the sell side.”

          hint: place their share of the blame on them – their incompetence and gross failure, instead of labeling everyone a victim of wall street sell side greed (and i’m not denying that wall street sell side greed exists) – that is PRECISELY my point. instead, we become apologists for the buy side, explaining how they were duped etc etc etc. They were the square side in a bet in which professionals would have understood the risks better. let’s stop making excuses for them

          1. Yves Smith Post author


            You seem to forget that investment banks are (in theory) held to “know your customer” rules. Under the law, they are not supposed to treat their customers as mere trading counterparties; they are held to a higher standard of care.

            Moreover, Goldman’s transition from a firm with a pretty balanced book of business to a hedge fund with customer intermediation attached is pretty recent. and frankly, behavior still had not adjusted to it. In fact, if that it one’s view of the firm (and it is mine) it is completely inappropriate for it to have received any government support, because the critical functions it provides (market making in OTC markets) appear increasingly to be a vehicle for infromation gathering for its proprietary trading business.

            Now that issue has always existed with market-makers, but the difference between the world of ten years ago and now is that the intermediaries have stacked the deck in their favor via complex products (a recent paper we linked to argues that some are so computationally complex as to be impossible to assess). And per the discussion in the post, fund managers are pressured to meet benchmarks, so if Wall Street devises products which offer higher returns with higher hidden risks, it is a given that they will find lots of buyers. Fund managers almost have to buy then to show competitive returns. And before you say, “Well, they are morons,” you miss the institutional structure. Fund consultants will allocate money away from the cautious ones who stay away from the arcane stuff to the ones that show higher returns. The pressures to take on hidden risk do not operate simply at the fund manager level; they are hard coded into the entire system via how managers are evaluated and funds allotted by the gatekeepers.

            So the money will go to the fund managers who buy the risky products and show higher returns. So what is a fund manager who knows better to do when the clients themselves, under the guidance of bogus methodologies for evaluating performance, as devised and sold by a whole industry of performance management gurus, will take money from him and put it with another fund that is investing in more complex products that he is pretty sure can’t be as safe as its sellers claim? The money will go into that product regardless of what he does.

            Everyone likes to blame the rating agencies (who do deserve a ton of blame)and the fund managers, but they overlook the bogus measurement methodologies to which the fund managers are subject, and how that distorts their behavior.

          2. Kid Dynamite

            yves –
            i agree with you whole heartedly that GS should not have received gov’t assistance – especially in light of the fact that they have nominally become a bank, they still don’t take retail deposits.

            i think the real problem lies with the way i continue to see the behavior of fund managers justified here under the guise of “they have to do it or they lose mandates.” it may be true, but as Richard and I discussed above, it’s CERTAINLY not an excuse.

            I’m sure i’m not the only one whose father told him “if everyone else jumped off a bridge, would you jump too?”, somewhere around 3rd grade, when I was caught causing trouble with my friends and tried the excuse “but dad, everybody ELSE was doing it too,”

            finally, weren’t a lot of the synthetic CDO’s structured at the BEHEST of the customers? some of the CDO’s were even structured, in part, BY the buyers of the CDO’s right?
            in other words, again, we’re not talking about a ticking time bomb that was thought up in the mahogany paneled conference room at GS while fat cat bankers sat back, drank single malts, and plotted how to destroy the american financial system – we’re talking about products that the buy side was begging for – that they couldn’t get enough of – so the smart money created them and took the other side of them. It’s not criminal. It’s clear you think it’s morally wrong – which is fine – that’s not an argument i want to have, but there is a distinction between legal and moral culpability.

            i think one reason we have the perverse setup you described in your comment – where you (money managers) HAVE to take risk to keep up with the herd – is because the people who fail are NOT held responsible – rather, instead of holding them responsible we blame the easy target: WALL STREET – and then the cycle starts all over again as these same culpable money managers remain in power, following the herd blindly again until the next crash…

          3. Yves Smith Post author


            With all due respect, did you bother reading what came earlier in this thread? This is a matter of institutional incentives. And your analogy re kids jumping off a bridge is off base. Are you not aware of the role fund consultants play? This is more like kids being in a phys ed class where the teacher makes them jump off same bridge out of some misguided view that it’s good for them to take risk. The “kids” in this case are doing what the “adults”, the fund consultants who control how money is alloted, are PUSHING THEM TO DO. The “kids” who refuse to go along face punishments of various sorts. They most assuredly WILL have funds withdrawn, and as a result, might be demoted or lose their job.

            As for “investors” having a role in structuring these deals, that is greatly exaggerated. This is another line GS is promoting, The AAA, AA, and A investors, which represented over 90% of the deal, had nothing to do with structuring, absolutely nothing. The BBB investors might or might not have, but since they were correlation traders in the post 2005 era, they cannot be presumed to have wanted the deal to succeed (they would be agnostic at best). Ditto the equity.

            These deals were driven by the shorts wanting product, so whose interests do you think prevailed in the design of the deal? It is not hard to see what is going on here.

          4. Kid Dynamite

            yves – yes, i read very carefully. we’re having a civil discussion, let’s not ruin it yet.

            i understand the problems with the misalligned incentives fully – i was on the buy side for a while, but my group was a little different, because we were actually held ACCOUNTABLE if we lost money – and we lost our capital. at the same time, if we weren’t delivering adequate returns, we’d also lose our capital. talk about a quandry – we had to participate in the upside AND avoid the downside. Contrast that to the scenario here, where it’s “ok” if you lose 30% along with everyone else (just blame the guy who sold you the garbage – you weren’t the only one who bought it!)- but if you make 4% when everyone else makes 12%, you’re hosed. THAT is what needs to change. and that’s not the sell side’s fault.

            the problem here, as i tried to express in a reply to Richard above, is that with the pension fund managers we’re talking about, a key incentive is to not underperform the herd – as you have made quite clear in your replies – if they act “smart” and don’t follow the other lemmings off a cliff, they can lose their jobs when they underperform.

            what needs to happen is that the key incentive becomes delivering proper risk-weighted returns (but you can’t evaluate risk weighted returns if you can’t evaluate risk – the other core problem in the synthetic CDO market!). So, does it make sense why i’m so adamant that money managers need to be held accountable for these purchases? if we fail to hold them accountable, and give them a “they had to buy it or they’d lose their jobs” pass, why would we expect that behavior to change?

            yves – fight the “bogus measurement methodologies” – i’m on board with that, but this post isn’t about that – it’s about blaming the guys who sold the instruments.

          5. Kid Dynamite

            ps – yves – we may be saying similar things in some sense.

            change the way the fund allocation process works. Remove the fund consultants who are a huge part of the problem. THEN you’ll be able to remove money managers who don’t perform adequately. i agree with that, if that’s your point.

        2. jdmckay

          You are right, there is an infinite supply of institutional stooges who might as well be retail guys.

          As a % of those in the business, group you describe (“stooges” is the overwhelming majority. Although, I’d use more precise language in describing them. Some ineffective (eg: don’t know WTF they’re doing) combination of:

          * know only what management tells ’em is so… parrots.
          * seemingly have lost ability to drill down and “find out”.
          * they think they know, and don’t know they don’t know… take umbrage at the suggestion.

          Essentially, in true meaning of the word: professional… there are few who qualify. It’s a sticky wicket.

          All misclassified as expert investors.

          eg… mis-self-represented.

          How is that misclassification to be sorted out? I haven’t heard any concrete reform proposals from those who would blame the buy side, but I’d pay attention if any were made.

          IMO this gets to biggest hazard in US economy. The lack of true professionals in major sector has grown dramatically, and the space filled by this vacum more & more has lost it’s ability to self-correct… break bad habits, make corrections, accurately assess problems and propose solutions.

          I rather think that having a bunch of idiots classified as experts works rather well, once again, for the sell side.

          I’d call it a systemic imbalance… guaranteed to make thinks wobbly.

          Ratings agency: well, a rating these days just seems to be a quaintly represented and rather sticky yield spread: there doesn’t seem to be any added value in the rating at all, if there ever was. You might just as well look at spreads.

          The handful of real pros I know are bypassing them entirely now… consider their work product anecdotal.

  9. a

    “They were AAA securities and were supposed to be virtually free of credit risk.”

    And – they were paying a higher yield than other AAA securities. Any buyer who believed that a higher yielding security had the same risk, was actually believing that free lunches grow on trees (!). Doesn’t happen. Just because the sellers were greedy and at fault, doesn’t take away from the fact that the buyers were greedy and also at fault.

    1. scraping_by

      “The idea that credit ratings identify potential for price loss related to anything but default is wrong.”

      I think we’ve got a stealth redefinition of the term “default.” When I was young and fresh, default was anything less than complete fulfillment of the terms on the face of the bond. Now, it’s apparently going to zero value.

      So instead of “default” being a binary term, it’s got many shades of meaning. Very literary.

  10. Sanford Rich

    The idea that credit ratings identify potential for price loss related to anything but default is wrong. The rating agencies have always rated expectations of default and have a good track record of being able to rank order classes of securities and their probability of default. Nor is this the first example of credit ratings not being a good tool to forecast market losses. Look to the pricing of mortgage related asset backed securities a decade ago as the expectations for refinancing risk created significant duration shifts in these securities driving mark to market losses.
    I do not believe that purchasers of AAA CDO tranches are without blame. All, I repeat all, of the AAA CDO tranches that I saw being sold in the primary market or the secondary market traded at a yield premium to comparable rated securities of the type in the structure or alternatives in the market. A higher yield than comparably rated securities was how these were sold not via model. This is not unexpected in an efficient of at least dynamic capital market and was the early indicator of potential trouble. Also, please consider this question:

    … If the assets in a CDO were all publicly traded securities for which the market expressed an opinion on valuation and return, that had produced a fee to the underwriter that issued them, how is it that a structured transaction could be created that squeezed out securities that were both of better average credit quality and lower yield, allowed a long term “equity like” return to a CDO equity tranche investor, and provided room for fee revenue to the lawyers, accountants, regulators and underwriters? Is the market that inefficient? Apparently not.

    Remember that the CDO business became the engine of growth and profit for leading investment banks on Wall Street. This was the second warning indicator. I suggest that any interested person read “This Time is Different,” about historic Crises and their analysis by Rogoff and Reinhart. They propose that one of the indicators of problems or a bubble in financial markets is a “Capital Flow Bonanza.” In short be wary of the new, nontraditional, financial asset class that is growing faster than the markets and GDP. Also, be wary when an industry, sector or transaction type begins growing by leaps and bounds.

    1. Yves Smith Post author


      I’m not defending these instruments, but they were bespoke and illiquid. Investors could have rationalize that they were getting a premium due to the illiquidity. I am under the impression that some investors regarded AAA CDOs as more like AA paper, and saw this as reg arbitrage, that the rating agencies had indeed been conned or were negligent, but not as badly as they turned out to have been.

      And recall that the worst you could ever expect with an AAA is it would go to AA, then A. By contrast, quite a few AAA CDO tranches went straight from AAA to CCC, a simply unheard of event which became bizarrely commonplace.

  11. Anonymous


    Off topic. I subscribe to a daily tax update service provided by Thomson Reuters. Today’s alert included commentary about a rare Private Letter Ruling (PLR 200951004) issued by IRS involving a type D reorganization. The author commented that there were too many gaps in the facts provided by the PLR but he speculated that it might involve AIG (and/or some of its subsidiaries). The D Reorganization if approved would allow the acquirer to set the stage for offsetting future foreign losses that arise against future US taxable income by requesting a change of accounting method. The author described the facts as that of a US Parent owning the Acquirer which is “a property and casualty insurer that provides financial guarantee insurance and reinsurance and credit enhancement”. The author noted that the PLR was not issued through normal channels and there were certain facts presented, upon which the PLR was based, that may not have made sense.

    Great country we have. Theoretically, the company(AIG?) would never have to pay tax on the foreign income if not repatriated but can get the benefit of the non-US losses whenever they want.

  12. Jim in MN

    Personally I wonder how much of the angst over the bond market crisis stems from simple confusion about a bond, per se, versus a bond fund. If one picks up these CDOs, holds until maturity and there is no default, then who cares what the risk or value is in the meantime? Only people who have to take the exposure to selling before maturity. For bond funds this is an existential matter. How could bond fund managers exist and buy stuff without churn? How could pension funds make benchmarks with mark-to-market saying the things are worthless (even though if you hold to maturity it makes no difference to yield)?

    Here, someone write this up: Bond funds were counting not on the coupon yield, but on speculation vis-a-vis resale value via churn. That is not our grandparents’ prudent money management either, now is it?

    1. charcad

      Bond funds were counting not on the coupon yield, but on speculation vis-a-vis resale value via churn. That is not our grandparents’ prudent money management either, now is it?

      Here is the Rosetta Stone to understanding pension fund (and life ins co) behavior in recent decades. Assumed annual ROI kept being forced up in a race to the bottom. “Unsophisticated AAA investors” (translate state & local politicians) opted for higher promised returns like 8% in preference to stodgy old numbers like 6% or 5%. Higher returns led to lower required annual sponsor contributions to The Plan. Vox populi, vox dei.

      A ready supply of fund management appeared to meet this demand for higher annual returns. This supply of higher performing fund managers in turn provided standing demand for AAA safe high yields being offered. GS and playmates therefore created a supply to meet that demand.


      And here is what the relatively conservative bond end of the investment spectrum really looks like today. Been many moons since 8% was seen in the first bracket, which are “risk free” US Treasuries.

      The fall in interest rates in the mid-90s, combined with a concurrent increased demand for return, led to a rush to equities. What Uncle Al termed “irrational exuberance” was driven bt the essence of reason: “conservative” fund managers seeking 8%.

      One of their defenses against the tremendous losses these products delivered amounts to “caveat emptor”: everyone is a grown up and should have known what he was buying.

      Had CALPERS, CALSTRS and the New York State Comptroller condemned this trash the market for it would have vanished worldwide. otoh why would these three have done so? In the last 10 years they’ve added day trading options and commodity futures contracts to their portfolio allocations. Up to 15% asset allocations in some cases.

      So why wouldn’t something stamped AAA by Fitch be taken into the more conservative section of the portfolio?

      1. Yves Smith Post author

        In the case of CDOs, looking to profit on resale was very unlikely. This paper was very illiquid.

        1. charcad

          In the case of CDOs, looking to profit on resale was very unlikely. This paper was very illiquid.

          It’s become illiquid since 2007. What did it look like before then in 2006 and earlier? Bear Stearns, Lehman and Merrill were all nailed with very large CDO positions open on their books. What were they doing with it all if not OTC market making in CDOs?

          Anyway, here we go again:


          “Dec. 15 (Bloomberg) — The three largest U.S. banks are preparing for a comeback in the market for collateralized debt obligations backed by high-yield, high-risk loans, two years after issuance tumbled when credit markets seized up. JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. are approaching managers of leveraged loans to offer terms for new collateralized loan obligations”

          Yup. “New & Improved”.

          Now that investment banks have ceased to exist this field is clear for regulated bank holding companies. And why the hell not? These are risk-free transactions for these three entities. Also for Wells Fargo, Fifth Third, Goldman Sachs… The last two years has proven they’re backed by the full faith and credit of the US Government.

          1. Yves Smith Post author

            CLOs are technically a type of CDO, but when most journalists talk about CDOs, they mean ABS CDOs, and they refer to CLOs as CLOs. This post is about ABS CDOs.

            The banks were stuck holding ABS CDOs, not as trading inventory (trust me, this stuff really did not trade) but as unsold new issues. That was particularly the case with Merrill. My book details the bogus reason why dopey practice was not merely tolerated but encouraged.

            The banks also wound up holding a lot of CLO paper for similar reasons. CLOs were no where near as arcane as ABS CDOs, they were first, not second generation securitizations, and hence were not horridly difficult to analyze. I am under the impression CLOs were more actively traded than CDOs, but I have not studied CLOs as much.

    2. Yves Smith Post author


      The type of CDO that that Goldman and Deutsche synthetics mimicked are so-called “mezz” CDOs. That means they are composed largely of the BBB tranches of subprime bonds. Those tranches are worth zero if the losses on the underlying pool of mortgages reaches 8% to 12% (exact level depends on the deal).

      Pipeline losses (meaning ones that can be projected with a high degree of accuracy based on current delinquency rates) for subprime bonds were nearly 23% as of end of September (according to Moody’s) and are projected to reach nearly 26%.

      If the BBB tranches are a zero, the CDO is a goner (the other paper in it was generally not all that much better).

  13. Reno Dino

    They knew what they were selling was bad ipso facto they bet against them and won. Isn’t that called criminal intent?

  14. Siggy

    A successful con requires that the party being conned is a bit of thief. Or, you can’t con an honest man.

    As to CDO’s, what do the tranches of CDO rely on for the income streams that are to be allocated amongst its tranches? Why they are preponderantly the less than investment grade sources of cash flows from other offerings. They are the sources that are expected to be the first to be wiped out in the event of default. Thus, any tranche of a CDO is inherently incapable of commanding a AAA rating in the traditional sense.

    Now as to fraud. It occurs when the selling party offers something that the seller knows is not what is being offered. Thus, blaiming the investors is missdirecting, the sellers share equal blame if not the lion’s share.

    1. JTFaraday

      But what about a form of buy-side fraud. Say, a fund that pays its employees based on short term performance of the fund in which those employees are knowingly participating in the sell-side scam because it benefits them, personally, to the detriment of investors investing in the fund to whom their investment may be misrepresented–as it surely would be with AAA ratings everywhere they look.

      I certainly think that Goldman et al are seeking to defer blame elsewhere–and that they are most culpable as critical orignators of the scam– but that doesn’t mean that they ought not have company in the slammer.

  15. DownSouth

    I collect art and antiques, and in the United States, when a dealer gets caught selling fakes, he takes a hit to his reputation. Sometimes he faces legal–civil and/or criminal–repercussions. But regardless of the outcome of these, in the US there is a strong “social contract” that applies, and anyone who breaks it pays dearly in loss of reputation and the ability to do business in the future.

    In Mexico this social contract is all but non-existent. It is buyer beware. If someone buys a fake, blame is assigned to the buyer and not the seller. There is little or no stigma or loss of reputation assigned to the seller of a fake, and certainly no legal repercussions to be suffered. Mexico, after all, is a libertarian’s wet dream.

    Hannah Arendt in On Revolution traces the evolvement of this strong “social contract” in the United States back to before the advent of the American Revolution. She believed this culture or ethic of strong “social contract,” and here she was talking about that part of the social contract that applies to citizen-to-citizen promises and not citizen-to-government promises, contributed greatly to America’s revolutionary success as well as its early success as a republic.

    Having firsthand experience as to how things work both in the US with a strong social contract and in Mexico with little or no social contract, I would have to agree with Arendt.

    1. Eagle

      According to which libertarian is a market where there are no legal repercussions for committing fraud ideal?

      1. JTFaraday

        Well, Lloyd Blankfein evidently!!

        Which suggests to me that we need a new terminology to describe whatever Lloyd Blankfein is.

      2. Anonymous Jones

        Yes, yes, we all know and get it. Libertarians want no government intervention except the government intervention that just happens to enforce the rules that cater to their strengths. Good luck with that!

  16. LeeAnne

    These arguments are about finance industry structure, responsibility, risks, blame, etc. begging the question of the ultimate victim of investment innovation and fraud, the taxpayers, home owners, pensioners, and other long term investors, are dependent on prudent management.

    Caveat emptor to professionals, yes, but its more than a little disingenuous to say caveat emptor to the public who are the ultimate targets of all this innovation, and whose daily economic activity, based on specialized skills and markets, are therefore inherently unprepared for competitive investing; the legions who try notwithstanding.

    Caveat emptor to professionals, yes, but its more than a little disingenuous to say caveat emptor to the public who are the ultimate targets of all this innovation, and whose economic activity, based on specialized skills and markets, are therefore inherently unprepared for competitive investing; the legions trying notwithstanding.

    Its our government. The government was supposed to be looking after our interests; they have no other reason for being other than to represent and protect the public interest.

    If structured innovative products make lots of dough for finance professionals but can’t be understood by someone with a 9th grade education, what is the point? Eliminate laws, regulation and oversight. What are you left with?

    Some professionals are paying the price. But it is the public who has been shystered, and the game demands that the public continue to be shystered and barraged with propaganda to do so. We’d have to be a society of renaissance men to survive the onslaught coming from corporate/finance steered government.

    Professionals among themselves could make pie-in-the-sky products out to infinity profitable for themselves, wrap 100s if not1,000s of products in different collared plastic bags labeled designer specials, call it new and innovative, available at higher yields than anything being offered, and the public would be stuck with the results. That’s what happened.

    The finance industry might as well have been packaging and selling tulips; tulips that can be replanted and grown for professionals to be packaged differently and promoted another day; tulip photos for the masses.

  17. Blurtman

    So can someone answer this basic question:

    Is it fraud to sell a security as AAA when you know that it is CCC?

    1. Eagle

      In the real world nothing is so cut and dry. What is the definition of “know”? The only fair question is was everything properly disclosed. If it wasn’t, prosecute them, if it was, review disclosure laws to make sure they’re sensible, and move on with our lives.

      I suppose there’s always Yves’ preferred option of allowing the government to restructure any contract at will based on some ill-defined notion of “fairness”. You know, based on Japan’s fantastic track record of managing economic policy.

      1. Blurtman

        A possibility of course us that the rating agencies and Goldman Sachs did not know that the AAA rated securites were in fact CCC. That would mean that the rating agencies and Goldman Sachs were grossly incompetent. In the case of the rating agencies, this gross incompetence would result in a loss of credibility, and a significant loss of business. But the USG is still using the big three to rate toxic securities that it is purchasing. So, what could another possibility be then?

        1. Eagle

          There is the possibility that Goldman believed they knew the risks inherent in the securities, but because it was only their own hunch, was not required to communicate them. There is also the possibility that ratings have over the decades become institutionalized in the bond market, and they will not, and probably should not, change overnight by legislative fiat. It seems clear the model of the sell side paying ratings agencies to rate their securities is broken – that there is no free lunch, investors are going to have to start paying for ratings if they want quality analysis.

          1. Blurtman

            Considering the scope of the misrepresentation of the risk, and the far reaching effects of the alleged fraud, do you not think a series of criminal investigations would be warranted? As with the auction rate securites probes, incriminating e-mails and other internal communications of the brokers that sold the erroneously rated securities should prove whether knowledge did or did not exist. The scope of the sales of CCC securities as AAA is much greater than that of the auction rate securities fraud, so where are the criminal investigations?

          2. Eagle

            Certainly criminal investigation are warranted, of the kind that brought successful closure to the ABS deals which were fraudulent. Witch hunts, of the kind that led to bailing out investors who knew full well ABS were riskier than money markets, are not.

          3. Yves Smith Post author


            This is a straw man, and bears no relationship to anything Tom Adam, I, or anyone who posts articles here has advocated. Since when is a call for investigations a “witch hunt”, let alone a demand for bailouts of AAA ABS investors?

            Oh, and by the way, you clearly have not been paying attention. What do you think the rescues of September-Nov. 2008 were? The product that caused the biggest losses were AAA CDOs, held by investment banks and Eurobanks. We’ve already had precisely the bailout you are concerned about, courtesy Paulson, Geithner, and Bernanke, but you perversely want to attribute the desire to have such a rescue to me.

      2. Yves Smith Post author


        I have said no such thing. I strongly suggest you refrain from attributing such views to me.

        1. Eagle

          I agree, your posts supporting principles-based regulation need to be read to be fully er, appreciated, for lack of a better word.

          Speaking of constructing straw men, mind pointing out where I said “a call for investigations is a witch hunt?” I could have sworn I wrote about justified investigations just a few millimeters above your accusation.

          “Oh, and by the way, you clearly have not been paying attention. What do you think the rescues of September-Nov. 2008 were? The product that caused the biggest losses were AAA CDOs, held by investment banks and Eurobanks. We’ve already had precisely the bailout you are concerned about, courtesy Paulson, Geithner, and Bernanke, but you perversely want to attribute the desire to have such a rescue to me.”

          I’m sorry, I stopped following you completely here. Where did I express concern for the bailout, and where do I try to attribute the desire to have one to you?

          1. Yves Smith Post author

            This is from your comment of 4:22 PM:

            “Witch hunts, of the kind that led to bailing out investors who knew full well ABS were riskier than money markets, are not.”

            This entire post is about ABS CDOs, so I am more than a bit puzzled at your remark.

          2. Eagle

            The poster I was replying to asked why there were no criminal investigations into the sale of AAA CDOs, and gave the ABS investigations as an example of a successful criminal investigation that brought desired results.

            Since I consider some ABS investigations justified and others witch hunts, I said as much. I certainly did not say that a call for investigation is a call for witch hunts, merely that it depends. What was unclear about that post?

          3. Yves Smith Post author

            I think the product you meant to refer to is ARS, “auction rate securities”, not ABS (asset backed securities).

            And any effort to go after widespread fraudulent sales practices is going to be imperfect. A settlement is not going to be granular enough to discriminate between investors who were not sophisticated (hence subject to “know your customer” restrictions) and often specifically told ARS were as safe as money market funds, versus those who should have known better.

          4. Eagle

            Sorry, I definitely mixed that up. Obviously no investigation is perfect; perhaps something to keep in mind while sounding the clarion call for more aggressive criminal prosecutions. If it’s done, it should be done right, with no doubt that the convicted are guilty.

  18. Ted K

    One thing that I haven’t heard a lot of talk about related to derivatives and CDS trading is the debate of Clearinghouses vs. Registered exchanges. Of course all the dealers/traders will say Clearinghouses are good enough but they are clearly not. Clearinghouse is like setting up a special place for drug dealers to regulate each other. It won’t work. I wish Yves or someone here would take up this issue and run with it.

    I think Credit default swaps should be illegal, 100% outlawed. But you take what you can get—and at least with CDS and other derivatives on registered exchanges they could be monitored better and we might have a better idea how much of this systemically threatening paper is “out there”.

  19. StillCantFigureIt

    A scam is a scam.
    It is possible for a scamster to cheat a dishonest victim. It is also possible, that a scamster can cheat an honest victim.
    For example, the recent Bernie Madoff scam produced both honest and dishonest victims.
    The honesty of the scammed does not affect the sequence.
    Common sense might have steered one away from Madoff victim-hood, but common sense was not enough to prevent victimization by Madoff.

    It is also possible for a scamster to sincerely believe that his snake oil cures baldness. Sincere honesty or insincere dishonesty does not change the sequence.

    Crimes are prosecuted by society, even if the criminal professes sincere honesty. This prosecution is needed because a criminal will harm others. There is no known method of rehabilitating a criminal.

    Crimes have been committed. Those that sold fraudulent investments should be prosecuted, even if they were sincerely honest when they sold these. Those that betrayed trust by purchasing fraudulent investments should be prosecuted also.

    There is a scale. Enormous harm to others requires enormous prosecution. Minor harm should result in minor prosecution.

    I suspect that a populist prosecutor, perhaps someone like Elliot Spitzer, will eventually prosecute those that caused great harm. This might take years before it occurs.

  20. Martingaler


    “As for “investors” having a role in structuring these deals, that is greatly exaggerated. This is another line GS is promoting, The AAA, AA, and A investors, which represented over 90% of the deal, had nothing to do with structuring, absolutely nothing.”

    This is very incorrect. Collateral composition and structure were very investor driven some of the time. However, I would say that most concerns were not as credit driven as they should have been. If there were investor changes to a deal they were AAA because sr bondholders drive the economics of the deal (as in you cant have one without somebody to buy the LARGEST piece).

    1. Yves Smith Post author


      I have to differ with you

      Post the ISDA protocol in 2005, the junior AAA and lower tranches were bought either by correlation traders or flogged globally to anyone who could be arm twisted into buying them. The top tranches were significantly, if not entirely, retained by the IB sponsor and hedged (the negative basis trade looked more attractive than selling).

      The AAA tranches over the junior AAA were increasingly NOT “bought” but funded by VFN.

      So narrowly, you are right if only in the sense that the sponsors were eating their own cooking, but the whole arrangement depended on getting an AAA hedge for the top tranches.

    2. Yves Smith Post author

      I received this assessment of your comment from a source who has been involved in a large number of CDOs:

      <0> I read the martingaler comment – it doesn’t make much sense, really (“collateral was very investor driven… sometimes”). However, it also is not terribly accurate either. AAA investors could veto a bond, occasionally. They could indicate that the credit enhancement was insufficient to meet their credit approval process. they could indicate a mix of collateral in a deal proposal would not work for their company. or they could walk away from the deal. In all of these cases, they were commenting on an existing structure that was presented to them. comments from the AAA CDS provider were not solicited or welcome, once a deal was set. In the interest of saving a deal where agreement had already been reached in principal, minor changes might be tolerated.

      If a AAA CDS provider wanted to express their view on a portfolio mix, they did it before a deal was assembled, perhaps before a manager was selected. they might say: “we can’t do deals with Option Arm bonds” or “we don’t have authority to do deals with CMBS”. That’s the way the game worked, once a deal was being shown to an insurer, the terms of the warehouse facility and the investing parameters were already set and locked in. also, even if a saw a bond kicked out on a rare occasion, remember that CDOs were funds – if the investment parameters permitted it the first time, they might be able to go and buy the same type of bond the day after the deal closed. it was too late to change to investment parameters at that point.

      The AAA insurer on a synthetic or hybrid deal was effectively the investor for 60-80% of the deal but they drove very little. the thing they controlled was capacity, not investment criteria. If an insurer said they were out of capacity, sellers listened, otherwise they didn’t care. this is where the expression came from – sellers knew they needed insurer capacity so they “drove the market”. But it was a two way street – every single time i said we didn’t like some aspect of a deal, the banker would immediately tell me they had another insurer or investor lined up and ready to go. That’s the way the game was played – they showed us the deal and we could say yes or no.

  21. Rich888

    No. These investors were indeed yield hogs. Not in an absolute sense, but in a relative one, against other siilarly-related securities. You see, institutional investors are given mandates by plan sponsors (pension funds, etc) which are constrained within certain credit paraeters – no more than 10% “A” for example. In this situation, pressure to outperform benchmarks leads managers to invest capital in the highest-yielding securities in each class, even if just by a handful of basis points. So there is an unholy alliance between structurers, investment advisors and ratings agencies to create securities to maximize fees across the board at the expense of pensioners and other savers.

    Risk manangement and research are considered overhead, costs to be minimized in order to turn fees into the largest possible payouts to the top management of investment firms. No GS packager can hold a candle to an investment advisor telling a client they don’t rely on ratings agencies.

    1. Yves Smith Post author


      You acknowledge the yield differential was small, and all in spread differential across comparable maturity ABS bonds from AAA CDO to anything else would be less than 10bp. For super senior bonds, it would be even smaller.

      And it is precisely these small differentials that bond fund managers are supposed to seek. What you call a “yield hog”, is exactly what fund managers were paid to do.

      It was predicable that given something with higher yield than Treasuries that was still rated AAA that there would be a big appetite for it.

      Heretofore, even if someone screwed up and bought an AAA that was downgraded, it would go to AA, then A. Only in the case of massive accounting fraud would you see a multi-grade downgrade.

      Now Wall Street goes and manufactures securities that aren’t merely AA bonds that they managed to fool rating agencies into designating as AAA, they had a non-zero probability of catastrophic failure. And they did fail that badly. This is the equivalent not of a Pinto (gas tank blew up on impact) but a car where the gas tanks ALL blew up. And you tell me the buyer is to blame? Yes, they did not appreciate that the risks of these CDOs were concentrated, but a catastrophe of this magnitude is so far outside any norms for bonds that the packagers and rating agencies look to bear greater culpability.

  22. Siggy

    You don’t have to be a rocket scientist to evaluate a CDO. You do have to read the indenture document. I suspect that that contract was not read by 90% of the buyers.

    I believe in caveat emptor. I also believe that the IB has a suitability responsibility to all of its clients, sophisticated or not. Similarly fair dealings does allow for the sale of securities that are rated AAA when they are in fact B paper. If you read the indenture you will quickly come to understand that the income streams that are the basis of the CDO are those attrubutable to the first to lose in the event of default. That means that the CDO represents a concentration of risk, not a dispersal. What the buyers are doing is chasing yield without the exercise of reasonable due diligence. As to ignorance and stupidity, that animal is rare in the canyons of Wall Street. What is rampant is hubris and greed. If you mantra is to dance as long as the music plays, then you will soon be called to task.

    I view the sellers of CDOs as exploiters of a failed monetary system. I consider the victims of the financial collapse as being a body politic that has become too lazy to engage itself in the dialogue. Too willing to let some idealogue make trash of the financial system. CDOs are not too difficult or complex to understand.

    Too complex to understand is not a defense, just as ignorance of the law is not a defense.

    1. Yves Smith Post author


      I am contacting my sources, but I expect you are incorrect here, that the investors did read the indentures, and likely derived false comfort from that. But reading the indentures is a garbage-in, garbage-out exercise if you believe the assets in the deal are better than they really are. Your recourse in any structured credit deal is a claim on the assets in the trust. What good are covenants if in the event of default, the collateral is worth nothing?

      CDOs are fiendishly difficult to evaluate. It’s impossible without access to and skill in specialized software, for starters. They are resecuritizations. The complexity involved in a tranched product made of tranches from bond deals is an order of magnitude more difficult than assessing a first gen structured product, like RMBS or CMBS.

      It is very easy to assert now, “oh CDOs represent a concentration of risk.” That is hindsight bias. Google it. And the concentration of risk was not inherent to the CDO structure, which is what your statement implies (CLOs, for instance, which technically are a type of CDO, do not concentrate risk). It was based on the heavy use of BBB subprime RMBS as a constituent of CDOs.

      Your remark suggests you were not in the CDO market and have not evaluated one. There are perhaps 1000 people in the world who are competent to assess them. And of that 1000, industry experts tell me that perhaps only 20, at most 50, appreciated that the PARTICULAR type of ABS CDO that had become prevalent in the last credit cycle, concentrated risk.

  23. tom

    i read the indentures. i used to write them. the indentures did not “disclose” anything – they merely set the terms of the CDO – not the terms of the underlying collateral. the insurers also hired expensive outside counsel to review the deal documents along with an analyst and internal counsel. As it relates to the above post, your argument is just plain wrong.

    now it is easy to say that CDOs were obviously a bunch of junk. however, in 2006, this was not obvious. if it were, there would not have been a financial crisis – CDOs were the root of the crisis. they were once rated AAA. insurers sought even more protection and took only super senior (AAAA) risk. when billions of bonds that are perceived to have value suddenly become worthless, it is reasonable to wonder how such a massive mistake could have happened. so far, the predominant explanation is that buyers and insurers were idiots for not knowing that something called AAA was not in fact CCC.

    AIG and the insurers exercised plenty of diligence and analysis – frequently they assumed that the insured bonds could be volatile and stress tested them bonds to make sure their company would still be ok even if the bonds got downgraded by 6 to 8 notches. their analysis was insufficient. the CDO bonds that were sold as AAA turned out to be actually CCC or worse in quality.
    if someone buys a product that is represented to have value and in fact has none, the buyer can be faulted for not doing enough homework. but few people would argue that the seller has no responsibility. if a manufacturer sells a car and shortly after it blows up, it is reasonable to ask whether something was wrong with the way it was manufactured. if the car seller told the buyer that the car might blow up, the borrower might have assumed the risk. but if the seller marketed the car as safe, and purchased a rating that purported to confirm that the car was safe, a fair amount of the responsibility should fall back on the seller or manufacturer.

    insurers were not chasing yield with CDOs. they got paid about 10bp per annum for the risk. for their other ABS business, they attached at lower rating levels and got paid much higher premiums. AAA CDO bonds were considered low risk, with low capital requirements and therefore beneficial offsets to riskier portions of their portfolio. in retrospect, this obviously looks stupid. i know that the popular wisdom is that they must have been yield chasing, greedy, high paid thieves, but this description falls very far short of explaining what actually happened. in my opinion, the reason that the wider population does not understand why CDOs blew up and caused the financial crisis is because to much time has been wasted blaming the AAA buyer or insurer and not enough time has been spent on who created and sold these bonds.

  24. RebelEconomist

    To add to what I wrote yesterday, I would say that I do think that there is a place for products like CDOs and CDSs, which in principle respond to reasonable demands from investors, and I am not in favour of banning them. I just think that an investor should not buy what they do not understand well enough to independently value, and if it is prohibitively difficult to either obtain the information needed or to make sense of it, then such products will not be able to exist. To respond to charcad (December 28, 2009 at 2:27 pm), without adequate information to evaluate the risks, there is practically no rate of return that is high enough to justify buying such products.

    1. Yves Smith Post author


      I suggest you read Gillian Tett’s Fools Gold. CDS were not created in response to “reasonable demands from investors.” They was created by JP Morgan to enable it to lay off risk. Like the old Wall Street adage about stocks, they were sold, not bought.

      CDS do not serve any legitimate business purpose and they result in information loss, which is systemically detrimental. The ability to lay off risk lowers the original lender’s incentives to do due diligence and monitor the credit. There is no substitute for this sort of information gathering. And due diligence and credit monitoring has fallen considerably. Similarly, as I document in my book, CDS played a central role in the crisis. There were several flavors of destructive trading strategies that were the direct product of CDS, impossible without them. Too many people cite theoretical advantages of CDS, and are unable to prove them, let alone quantify them, when the damage they did was tangible, at least in part measurable, and far greater than the cost of the AIG rescue.

      Similarly, CDOs were NOT designed in response to investor demand. They were designed to solve an issuer problem. The BBB tranche of most structured deals are not wanted. They are bundled up and are the main constituent element of CDOs. The very fact that this paper is unwanted (ie, the risk/return premium is deemed unsatisfactory by investors) is a warning sign. Similarly, the BBB tranches of CDOs are also largely unwanted paper. The first gen of CDOs (in the 1990s) imploded because they were a Ponzi scheme. The BBB tranche kept getting rolled into new CDOs (the structures then as now tolerated a surprisingly high % of BBB CDO paper as an acceptable component), which meant they depended on a growing, or at least not contracting, market. You had a similar problem this time, but the market blew up for other reasons before the little BBB problem became an issue.

      1. RebelEconomist

        Sure, it suited the sell side to create CDSs and CDOs, but it suited the buy side just as much. For investors, CDSs allow the separation of liquidity and credit risk, and CDOs provided a way of satisfying the huge demand for AAA paper with the lower rating debt that was available. By the way, I gave a lecture in 2005 that warned about some of the issues discussed here which may possibly have influenced Gillian Tett – her name was on the list of attendees.

  25. Blissex

    One point here that to me seems very wrong is that bond ratings are compared with MBS ratings. The rating agencies defended themselves at one point by saying that they are very different — the AAA rating on a bond is a very different beast and implies a very different risk level from the AAA rating on an MBS, and only the bond ratings AAAs are suitable for “widows and orphans”. In particular the ratings on MBSes were *relative*, not absolute (that is, AAA was safer than AA, but that was all the rating was meant to convey).

    I get that argument, at least in part — the AAA rating on a bond is about the issuer’s ability to repay, not the bind itself. it is a rating on company, not the product (not entirely, but to a very large extent). The AAA rating on an MBS is instead a rating on the product itself, and not the issuer. So yes, they were fundamentally different (and this means enormous increase in sales and profits for the rating issuers as the types of MBS instruments were much bigger).

    I don’t get the argument anyhow about AAA ratings being “widows and orphans” sort of ratings; because MBSes were not traded publicly. There is a very sharp difference between listed/traded publicly instruments and those that aren’t, and “widows and orphans” style securities are *never* those that are unlisted or traded OTC.

    If the treasurer of a municipality etc. bought unlisted, privately traded IOUs from some investment banker, she cannot point to the AAA rating and say she thought it was good for “widows and orphans”.

    As to these reminders:

    «investment banks are (in theory) held to “know your customer” rules. Under the law, they are not supposed to treat their customers as mere trading counterparties; they are held to a higher standard of care.»
    «I also believe that the IB has a suitability responsibility to all of its clients, sophisticated or not. Similarly fair dealings does allow for the sale of securities that are rated AAA when they are in fact B paper.»

    This in the country that proudly signed many indian treaties.

    I’ll quote again the famous Real American anthropologist Newt Gingrich:

    «In Germany on the Autobahn there is no speed limit. If tomorrow the Bundestag adopted a 100km, or 62-mph speed limit, virtually every German would obey it. Until, that is, the next election when they would wipe out the current politicians and they would elect the “No Speed-Limit” Party.

    Now this is a significant insight that American reformers have neglected for 30 years, and is the great mistake of the Great Society and everything that followed it.

    And I don’t want to offend anybody, but let me suggest to you that the American cultural response to the challenge of speed limits has been dramatically different than [sic] the German one. For most Americans speed limit is a benchmark of opportunity. This is not a light insight.

    If you have a society where almost every middle class person routinely fudges the law, that’s telling us something. We have laws that matter-murder, rape, and we have laws that don’t matter. Speed limits are an example. Why would you think that a regulatory, process-oriented bureaucratic model would work?

    The first thing that every good American says each morning is “What’s the angle?” “How can I get around it?” “What does my lawyer think?” “There must be a loophole!” Then he proceeds to work the angle, and the bureaucracy spends its time chasing that and writing new regs. to stop him.

    America is the most incentive-driven society on the planet.»

    In Real America, WINNERS do whatever it takes.

  26. Blissex

    The comments above on fund managers being driven to get 8% risk free returns, and a whole industry springing up to sell to them “picking up up pennies in front of steamrollers” products to server that need, is the key to the overall problem.

    The overall problem, as Greenspan and other policy makers have constantly repeated, is that there is irresistible political demand for higher asset prices. This is driven of course by the desire of USA elites to redistribute wealth and income to themselves from the parasitical masses after the end of the Cold War, but also enabled by the unthinking greed of the baby boom generation who are driven the desire to have a comfortable easy secure retirement funded by capital gains on the their assets.

    Those 8% risk free returns are the principal aims of both plans; they are much higher the rate of increase in GDP growth, and thus they imply a large redistribution of GDP from earned income to asset rents. In this both the elites and the soon-retiring baby boomers are allied, both of them driving policy towards lower wages (wages are cost for both elites and pensioners) and higher asset prices (capital gains and rents are an income for both elites and pensioners).

    Such enormous voter pressure has generated colossal political and market pressure for anything that might goose, or at least give the impression of goosing, asset rents and asset prices; anything that drives up both PEs and nominal returns. Thus the past 25 years of stagnant or falling wages, but ever rising asset prices and rents, some of the latter real (there has been a sharp redistribution of GDP towards rents), and some imaginary (house price bubble, stock market bubbles).

    The confirmation of this is that the bulk of voters (which are a subset of citizens, usually the richer, older whiter subset) and nearly the totality of campaign fund donors have continued to elect and donate to the usual names, those who have deregulated to boost nominal PEs, those who have let house prices rip ahead, those who have tried to get them growing again, those who have bailed out 401K and pension fund managers with trillions of asset-price propping stimulus.

    The madness will only stop when either the baby boomers will resign themselves to a less comfortable and secure retirement than they have demanded so far, or when the illusion that they can have it all becomes unsustainable. The latter may be happening next decade; the USA elites, who are wise to this story, have been exceptionally busy reallocating their wealth, asset stripping the USA whenever they could and investing elsewhere, or investing in natural resources or monopolies like toll roads in the USA. This process seems now to be near completion, and this means that the illusion may soon be shattered, and the baby boomer middle class with their usual cry of “F*ck you! I got mine!” will realize that, far from joining the elites in an easy life for a few golden decades as landlord and stock rentiers, they have been had, and their assets have been stripped.

  27. Blissex

    «investment banks are (in theory) held to “know your customer” rules. Under the law, they are not supposed to treat their customers as mere trading counterparties; they are held to a higher standard of care.»
    «I also believe that the IB has a suitability responsibility to all of its clients, sophisticated or not. Similarly fair dealings does allow for the sale of securities that are rated AAA when they are in fact B paper.

    This in the country that proudly signed many indian treaties.

    BTW my mention of the indian treaties is not random here. There have been at least two major components to the american experiment, the yankee one with the American Production System, and the dixie one with the idea that there are red or dark skins with vast underdeveloped assets and taking them is part of manifest destiny.

    The dixie tendency has been or has become the dominant one, and the question that the “best and brightest” have been usually asking themselves has usually been “where do we find the next redskins to make ourselves richer?”.

    Currently all the physical resources of the USA have been taken from the native redskins, peak USA oil(and peak USA water) has happened, the arabs and persians and even iraqis are not so willing to be the next redskins, United Fruit has had its way in the caribbean.

    Today’s Black Hills are the 401ks and pension funds of the 80% of usians that are losers. Securities and accounting legislation is the contemporary equivalent of the indian treaties.

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