Auerback: Will We Have to Blow Up a Continent (Again) Before We Stop Wall Street?

By Marshall Auerback, a fund manager and investment strategist who writes for New Deal 2.0.

Surprise, surprise: Wall Street tactics akin to the ones that fostered subprime mortgages in America have worsened the financial crisis shaking Greece, Spain, Portugal, and undermined the euro by enabling European governments to hide their mounting debts. This has now become front page news in the Sunday New York Times.

According to the Times:

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting. The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards (our emphasis).

Sound familiar? This is exactly how AIG built up its credit default swap business, in essence facilitating regulatory arbitrage on behalf of the banks. Basically, banking regulations encouraged companies to buy cheap swaps so that they could treat risk assets as almost risk-free, concealing their toxic nature via the ledgerdemain of financial engineering. This, in turn, allowed them to take money out of their reserves and buy more risky assets, which they then covered up with more credit default swaps. All of this was designed to evade the capital adequacy requirements mandated under the Basel banking accords.

AIG was destroyed, but as the NY Times article illustrates, the practices still persisted. As late as November 2009, Goldman Sachs, its own survival now successfully assured by repeated US government lifelines and guarantees, was seeking to perpetuate a similar kind of ruse over the European Union.

We have railed against the stupidity of the rules underlying the European Monetary Union many times, but poorly thought-out rules do not give a bank the right to destroy an entire continent, even “Government Sachs”. In the words of Simon Johnson,

These actions are fundamentally destabilizing to the global financial system, as they undermine: the euro zone area; all attempts to bring greater transparency to government accounting; and the most basic principles that underlie well-functioning markets. When the data are all lies, the outcomes are all bad – see the subprime mortgage crisis for further detail.

But it’s nothing new. Virtually the same thing happened in East Asia during the late 1990s. Most people are now familiar with standard derivative contracts used in hedging risk, such as forwards, futures and options. While foreign-currency forwards remain the province of bank foreign exchange dealers, most basic futures and options contracts are standardized and traded in organized, regulated markets. Banks have also long offered derivative contracts to their clients in what is termed the “over-the-counter” (OTC) market. But, there is no market involved in these contracts, which may involve the stipulation of standard futures and options contracts outside of the organized market on a bilateral basis with individual clients.

The majority of OTC activity involves individually tailored, often highly complex, combinations of standard financial instruments packaged together with derivative contracts designed to meet the particular needs of clients. These kinds of contracts involve very little direct lending by banks to clients, and thus generate little net interest income. But during the 1990s, they had the advantage, given the necessity of meeting the Basel capital adequacy requirements, of requiring little or no capital, or of being classified as off-balance sheet items because they did not represent a direct risk exposure of bank funds. Or so it appeared. And they had the additional benefits to Wall Street of generating substantial fee and commission income.

The volumes of these OTC structured credit notes rose substantially in the mid-1990s. While these derivatives were by no means unique to East Asia (see Orange County in 1993, Mexico in 1994, Long Term Capital Management in 1998), an IMF study from 1998 suggests that most of the initial losses sustained during the initial impact of the Asian crisis were related to derivative-based credit swap contracts. Furthermore, the Bank of Korea reported in March 1998 that trading in financial derivatives by South Korean banks increased by 60.1% in 1997 to $556.5 billion and largely contributed to the virtual nationalization of the entire Korean banking system as these positions blew up. It also helps to explain why heavily exposed banks such as JP Morgan (which had huge exposure via their derivative positions to the Korean banks) were at the forefront of the move to convert Korean banks’ short-term debt into sovereign debt.

Much the same can be said for Thailand, Indonesia, and Malaysia. The crash was even more devastating to people’s living standards and sense of security than the Latin America crash of the 1980s. Indonesia’s real GDP shrank 17 per cent in the first three quarters of 1998, Thailand’s 11 per cent, Malaysia’s 9 per cent, and Korea’s 7.5 per cent. It took nearly two years to reach the bottom. Many millions who were confident of middle class status had their lifetime savings destroyed. Public expenditures of all kinds were forcibly cut as all of the countries fell under the punitive aegis of the IMF. The IMF itself mounted the biggest financial bailout in history — $110bn, almost three times Mexico’s $40bn “rescue” package from the 1994-95 “Tequila crisis”.

Yet the experience of the past 2 years suggests that we have learned nothing and our political leaders seem determined once again to avoid dealing with the problem once and for all. God forbid that Congress should antagonize one of its main funding sources.

Perhaps now that these destructive practices are appearing in Europe’s own backyard, the authorities there may be sufficiently motivated to do something, if one is to judge from the recent comments of French Finance Minister, Christine Lagarde. Of course, cracking down on “currency speculators”, or short sellers, is largely beside the point, when you’ve got clear evidence of a bank deliberately conspiring to hide the true extent of an EU government’s debt. That’s abetting fraud, plain and simple. Jeffrey Skilling, former CEO of Enron, is sitting in jail today for that very offence. By contrast, Gary Cohn’s boss, Lloyd Blankfein, just received a $9m bonus.

It seems more than extraordinary that nothing was done following the economic implosion of East Asia during the 1990s. Eighteen months ago, we experienced the near the near wipe-out of our global banking system, and today we face the threatened destruction of the European Monetary Union. And still all we get is nothing more than the vague threat of action, and feeble efforts at regulatory reform.

Hey, as Jamie Dimon noted at the FCIC hearings a few weeks ago, stuff like this happens every 5 to 7 years, so what’s the big deal? Why bother letting the potential vaporization of a currency stop Wall Street from behaving recklessly and with complete disregard to the basic tenets of international financial stability? Heaven forbid that government should impede something as important as “financial innovation”. Shit happens. That’s no reason to “punish” a growth industry, even one where the main growth component appears to be the perpetuation of financial fraud.

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    1. DownSouth

      There’s this (link from john c. halasz) that identifies problems in Greece, Italy and Spain:

      What is new in today’s report from the NYT team is the extent to which they identify the problem as a much more general one, involving more banks and more countries, since “Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere”. I very strongly suggest that our NYT stalwarts take a long hard look at what has been going on in Spain, and especially at the Autonomous Community level.

      So the question naturally arises, just how much in debt are our governments, really? As the NYT team point out, Eurostat has long been grappling with this matter, and as far back as 2002 they found themselves forced to change their accounting rules, in order to try to enforce the disclosure of many off-balance sheet entities that had previously escaped detection by the EU, since up to that point the transactions involved had been classified as asset “sales”, often of public buildings and the like. Following advice paid for from the best of investment banks many European governments simply responded to the rule change by reformulating their suspect deals as loans rather than outright sales. As we say in Spain “hecha la ley, hecha la trampa” (or in English, when you close one loophole you open another).

      There’s this (link from charcad) that identifies problems in Italy:

      The real scandal, according to Gustavo Piga, an economics professor at the University of Rome, is that European authorities such as the European Central Bank (ECB) and Eurostat – which sets the reporting rules for European Union members – did nothing to shut down the practice after it was brought to their attention in 2001. “It’s not at all clear to me why the European Commission, Eurostat and the ECB didn’t want to deal with this. The issue was real, so if they were interested they would have done something about it,” Piga says.

      Piga drew attention to the subject with a 2001 paper describing how an anonymous country had used swaps provided by an unnamed bank to borrow money without disclosing it – the Financial Times subsequently revealed that the trade involved Italy and JP Morgan. But despite the heat generated by these revelations, little action was taken – something Piga believes raises serious questions.

      1. DownSouth


        That was supposed to be in response to Diego Méndez where he asks: “Do we have any evidence of governments hiding debt, apart from the Greek government?”

      2. Diego Méndez

        Thanks for the info. So maybe Italy may have used those obscure instruments, too.

        The Spanish government has stated Spain didn’t use them at all:

        Anyway, it’s pretty obvious creative accounting surges where debt has mounted. Eurostat knew about these practices, but did nothing. Why? Because France and Germany were having debt problems and they wanted to leave the door open?

        Since entering the euro, Spanish accounting has become more, not less, creative. We’ve specifically copied some methods from “prudent” countries, e.g. the German method.

        If you want infrastructure (roads, airports, hospitals, whatever), you can pay a company $100m to build it, which makes a $100m deficit. Or you can use the German method: the company builds it and you rent it for 50 years, which makes only for a $2m deficit this year.

        Both situations are equivalent in the real world (after all, state-owned infrastructure can be privatized if in debt), but you’ve got almost 0 deficit if you use the method Germans used and Spaniards implemented as soon as we entered the euro.

        1. Sid

          The result of any fundamentalism is a better breed of lawyers. Their job is to find a solution which complies with the letter of the law so that the client can do what he wants.

          Anyway, to stay on topic, we must pay our investment bankers more! Anything less is Communism!

  1. DownSouth

    Auerback says: “…and today we face the threatened destruction of the European Monetary Union. And still all we get is nothing more than the vague threat of action, and feeble efforts at regulatory reform.”

    Europe was the last great hope of making some kind of a stand against the banksters. But it is obvious from the rhetoric coming out of Brussels over the past couple of weeks that European leadership is every bit as compromised as US leadership. Nationalistic chest thumping, Euro-chauvinism and blaming the victim are all they have to offer, and these only serve to draw attention away from the true culprits and impede substantive solutions.

    After seeing Europe’s response over the past couple of weeks, I am more cynical than ever. It is becoming quite clear that no one has the political will to stand up to the banker parasites, and this will not stop until they completely destroy their host.

  2. Diego Méndez

    “…and undermined the euro by enabling European governments to hide their mounting debts.”

    Do we have any evidence of governments hiding debt, apart from the Greek government?

  3. DoctoRx

    Those in power have learned nothing because more or less all is going according to plan: loot, then loot some more, then have a preferred seat at the table when the messes need cleaning up.

    Those who have learned a lot — the former sheeple– have no power, so what does it care that they/we are learning the rules of the game?

  4. Keenan

    The boys at GS, JPM, BOA, etc. look to be an “existential threat” to the EU. Perhaps the Europeans might consider following the approach we’ve taken with Ussama bin Laden, Khalid Sheik Mohammed, etc. ?

  5. RueTheDay

    But wait, there’s more:

    Now Citigroup wants to sell the equivalent of a credit feault swap on the entire global financial system. Insurance against a financial meltdown. Did anyone bother to ask how in the blue hell the protection sellers will actually be able to make good on claims in such a case? Or was it just explicitly assumed the government will step in to ensure the integrity of counterparties?

  6. Marshall Auerback


    Thank you for pointing out the spelling error! When I typed it out, it didn’t look right but my spell check wouldn’t give me the correct spelling. Of course, I should have used a dictionary!
    Still, glad you liked the piece. Of course, the spin now is, “Well, these swaps were not illegal until 2007”, which might be true, but that certainly wasn’t the case by NOVEMBER 2009. It boggles the mind that literally a year after the Lehman bankruptcy, GS and others are back peddling this toxic manure. And it wasn’t some low level functionary. Gary Cohn is the number 2 at Goldman. Hard to believe that St. Lloyd didn’t know exactly what was going on either.
    Down South, I share your cynicism. I suspect that the EU reaction is more akin to Renault’s “shock” that gambling was taking place at Rick’s Cafe in “Casablanca”.

    1. Sid

      More to the point: I am sure Eurostat knew or should have known. Details were set forth in at least some of the relevant SPV prospectuses.

      To me, the real scandal is not that governments use creative accounting to fudge budget numbers (thus keeping free money flowing and the country safe from communism), but that the organizations ostensibly tasked with keeping governments honest sat on their hands and studiously looked the other way.

      Nobody wanted to be a “bad European” by calling out these arrangements, especially during the good times. Nobody wanted to rock the boat. Just like Arthur Andersen did not want to lose a valuable client like Enron.

  7. MarcoPolo

    Auerback….  goes over the same ground – yet again – and ends with, “so what’s the big deal?”   Not very satisfying.

    But he points out something interesting – yet again- the difference in function between forwards, futures & options and OTC 2 party no market swaps who’s only purpose is to move current liabilities into something not current. So, I don’t know everything but what’s the problem with just making that verboten?  Merkel would surely sign on to that. No?             

    1. Yves Smith Post author


      With all due respect, you misread Auerback. He is being ironic. Look at his closing sentence.

      1. MarcoPolo

        I think I understood the irony. Would rather see solutions. Broad solutions now being a long shot as a bloated & parasitic financial now fully controls its host I would settle for something less, more individual. Change in this environment must come bottom up.

  8. DownSouth

    In A New Time for Mexico, Carlos Fuentes describes in great detail how neoliberalism played out in Mexico. Mexico’s experience may be of special interest at this particular time, as leaders in both the United States and Europe appear hell-bent on imposing neoliberalism upon their populaces. The short and long of it is that neoliberalism in Mexico has proven to be a fast track to economic polarization and social chaos.

    Up until 1982 Mexican governance was dominated by statism, “a straitjacket of extreme protectionism, subsidized consumption and production, captive markets, and lack of competitiveness,” as Fuentes puts it.

    “Riding the crest of the oil boom, Mexico contracted gigantic debts that it could not pay when the oil glut, followed by a plunge in prices, left the country without liquidity. In 1982, Mexico went broke,” Fuentes explains.

    What came in place of statism was “a demonization of national states, a delusional faith in the free play of market forces, and the cruel complacency of social Darwinism in lands of extreme hunger and need,” Fuentes says. He goes on to explain:

    And Mexico, battered by the debt crisis of the 1980s…sought strong and revolutionary macroeconomic solutions, first under the de la Madrid administration, and then more fully under the Salinas administration. These measures included bringing inflation down to single digits, balancing the budget, increasing foreign reserves, welcoming foreign investment, keeping interest rates competitively high, and privatizing as much as possible. And enshrining supply-side economics, known in Latin America as neoliberalism, the equivalent to the trickle-down theory (or voodoo economics, as candidate George Bush called it back in 1980).

    But neoliberalism’s promises were never fulfilled:

    The neoliberal model espoused by the Salinas administration responded by fighting inflation, balancing the budget, inspiring confidence in Mexico, attracting investment, concentrating wealth in a few competitive firms and individuals, and hoping that trickle-down would take effect. But the hope was undermined by evidence that the economy was not growing, that fighting inflation had become a fetish, that excessive foreign spending was not compensated for by increasing local production, that real growth was hindered by one of the lowest savings rates in the world, and, finally, that flight capital had become unmanageable.


    Mexico needed—and did not get—policies encouraging investment in activities that would further employment, wages, growth, and savings. Instead, the Salinas reforms provoked a flood of speculative, unregulated capital that did not go into productive areas. Like flight capital in any other emerging market, it stayed in Mexico as long as it was profitable to stay and fled as soon as dark clouds started accumulating in the sky…

    Never has Mexico received as much foreign investment as it did during the Salinas years: almost $59 billion between January 1989 and September 1994, but of that enormous sum, almost 85 percent was speculative flight capital.


    The economy became hostage to foreign investment in order to maintain the peso’s parity and pay the current-account deficit. But foreign investment was concentrated mainly in stocks, bonds, and other short-term instruments: in the volatile and transitory paper economy. Only 15 percent of foreign investment went into the real economy, into creation of factories, increased employment, and increased production. The country was threatened with an acute case of schizophrenia. A minority centered their lives on the New York Stock Exchange, and a majority on the price of beans. One economy was all gilded wrapping paper, the other all huts and untilled land. The former was the minority’s, the latter the majority’s.

    When the neoliberal house of cards came tumbling down in 1994, Mexico did not turn away from the neoliberal model. Instead, the newly inaugurated president, under extreme pressure from the United States, opted for neoliberalism on steroids:

    In effect, President Clinton withdrew the original $40 billion loan requiring Congressional approval and gave Mexico $20 billion out of a discretionary fund. Strings were attached: Mexico’s oil revenue would serve as collateral and be paid directly into the Federal Reserve Bank in New York. President Zedillo didn’t even blink at this onerous condition and both Zedillo and Clinton knew that the U.S. lent Mexico money to repay U.S. banks, and investors, who had already harvested enormous earnings in their Mexican ventures. Production, employment, salaries, education, and social services—the real saviors of the Mexican economy—were once more postponed. Sovereignty was severely affected: the agreement gave the U.S. the right to monitor Mexico’s economic policies.


    Mexico is pledging to follow an economic policy that is precisely the one that led to the current situation: zero growth in the money supply, cuts in government spending, and more privatization. This is a renewed formula for disaster in a country that needs to stimulate growth even at the risk of inflation, as Brazil has done (though one need not go to the same extremes). Mexico has yet to learn the lesson that economists everywhere else have deduced from the crises perpetrated by the supply-side economics practiced during the twelve years of Reagan, Bush, and Thatcher: that to restrict money supply and spending during a recession leads to depression, not recovery.


    The draconian self-discipline imposed by the Zedillo administration, though temporary, is, by the president’s own admission, cruel: steep increases in the prices of gasoline and transportation, a 50 percent increase in value-added taxes, cuts in government spending, and almost total credit restriction. These are coupled with a 2 percent fall in the GNP, 750,000 people out of work, 42 percent inflation, and only 10 percent in wage increases.

    These short fuses may set off the Mexican bomb: bank failures, company closedowns, or street demonstrations and acts of vandalism, as in Venezuela of President Perez’s second term—a Mexican reprise of that caracazo.

    I certainly hope that none of this occurs. The Mexican people are extraordinarily patient, though most have never known anything but misfortune. But in 1982 the debt crisis struck a middle class with money in its pockets thanks to the oil boom. Today, Mexican middle class families will be unable to pay the mortgages on their two-bedroom apartments, the monthly payments on their Volkswagens, and maybe even the rent. Their dramatic pauperization is evident in every corner of our larger cities.

    Do we have time to set the stage for economic renewal?

    The answer to Fuentes’ question now appears to be no. Fuentes published his book in 1996, and since that time neoliberalism in Mexico has created some of the world’s richest men, including Carlos Slim who is reputed to be the wealthiest man on the planet. But it has created a level of inequality previously unknown in Mexico, and a majority of the population has been reduced to abject poverty, robbed of all hope. The country borders on social chaos, with crime and corruption spiraling out of control.

    Economic polarization and social chaos: These are the fruits of neoliberalism, and what the people of the United States and Europe have to look forward to if they cannot figure out some way to wrestle power away from global corporations who view the planet as their own private plantation.

  9. ks song

    1.Asian democracies'(Asian Tigers) ally USA.”we fatten them and slaughter them”-Rupert Rubin.
    2.Iraq Iran war.Iraq’s ally USA.USA bombed Iraq
    3.Cold war.Europe’s ally USA(NATO).USA bombed EURO.

  10. SoWhat

    I bought GS long dated CD (insured by FDIC) at 4%+.

    If you can’t beat ’em, join ’em.

    Let’s see if both GS and FDIC will fail.

  11. dd

    The whole scheme is about treating current captured cash pools as free credits to the TBTF banking sector whether they’re labeled as deposits, mutual funds, pensions, taxes, insurance, retirement accounts or any of the other chit based systems. TBTF banking (the owners of CDS) implement their creation to leverage those pools at great risk to those who believe their “investments” are protected by the regulated system and that in turn allows endless bailouts (or forced mergers creating bigger TBTF) to “protect” investors, pensioners, et al by funding banks.
    The system is the perfect “free market” ride on the regulated system and it will be protected at all costs. “Regulators” will be blamed when it collapses yet again and more bailouts will be forthcoming as will more de-regulation.

  12. dd

    Buying long dated GS CD at 4% with the expectation that FDIC will be forthcoming in reimbursing you at maturity is much like SS or Medicare at the long end; it will be a crap shot.

  13. radicalized

    So much for a financial blow up. But what about a real physical blow up as in war in the streets. Already there are strikes in Greece. That is small potatoes compared to the devastation brought on by Germany in the 1930’s. The stock market crash of 1929 is what put Hitler in power. Another financial collapse in Europe, and the US, will trigger chaos which of course is the excuse the governments need to call out the troops. We are 2 years away from martial law.

    Is any of that covered in Econned?

  14. Eagle

    “when you’ve got clear evidence of a bank deliberately conspiring to hide the true extent of an EU government’s debt. That’s abetting fraud, plain and simple. Jeffrey Skilling, former CEO of Enron, is sitting in jail today for that very offence.”

    You just can’t help overstating the case can you? Which EU law was broken?

    Greece conspired to hide debt from the rest of the EU using provisions in the code designed for just such a purpose. Obviously, the only solution is even more government.

    1. bob

      Please practice what you preach and stop supporting all of this government.

      Fist, stay at home. Leaving your own property requires that you use public highways or right of ways, all supported by government.

      Next, no more eating. All of your food gets to you through those same subsidies.

      Next, no more healthcare. The FDA and your local department of health are also subsidized, they don’t have to compete.

      Next, no more computer or internet. This would be beneficial to us all. The internet is the product of government investment in building technological codes. Same as the computer you are using.

      Finally, stop speaking all together. The only thing that protects your right to free speech is the government.

      1. Eagle

        It’s always amusing to see people who have no grasp of degree. I often wonder how they function. Are they like those obsessive compulsives who know being clean is a good thing, and therefore spend 12 hours a day washing their hands? Are they even that functional – can they distinguish between warm and hot water?

        1. Anonymous Jones

          Methinks you missed bob’s point. In fact, if I’m reading it correctly, bob’s point was *exactly* the point you made in reply to him. Hilarious!

    2. Marshall Auerback

      The transaction highlighted, if reported that way in the private sector, would be accounting fraud. Fraud. “Go to jail” fraud. That senior bankers had no problem in structuring/recommending/selling such deals to cash-strapped governments should probably not surprise us at this point. However…it would be interesting to know if the prop trading desks of those same investment banks, purely by coincidence of course, then took long CDS(short the credit) positions in the credit of the countries doing the hidden swaps. Good the thing the EU is gearing-up to take on short-sellers, though.

        1. bystander

          Methinks you missed Marshall’s point. In fact, if I’m reading it correctly, Marshall’s point was *exactly* the point you made in reply to him. Hilarious!

          With thanks to Anonymous Jones for saving me some keystrokes. It’s been like Invasion Of The Youtube Commenters today.

  15. ks song

    ‘when Europe is motivated to do something’,Goldman and the like-minded will be(or are already)shorting their own stock.Plus others like accumulator,cds,etc.They win by hook or by crook.

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