Chapter 1.6 - WALL STREET & THE GREAT INVESTMENT MYTH

CHANGING AMERICA'S MIND  Chapter 1 Part 6

Games Boys Play

Note: If you are just arriving to this blog, please start with the Introduction.
The book is being published sequentially as it is written.

About half of you know and the other half have heard about some of the competitive games played by boys who are just entering adolescence.  Most of these games center around bodily prowess and many of them show off physical skills for which the young adolescent has yet to find a good use.  Some of the more innocent ones focus on spitting – spitting accuracy, distance, and volume.  Variations add the contest of projectile power such as in seed spitting contests and for the rougher boys, tobacco spitting.  And then there are those naughty games that focus on other forms of bodily elimination.  If you don’t know what I’m referring to, ask a boy - of any age.

When we consider a great many of the recent male exploits on Wall Street, it is hard not to notice the similarities to those earlier games.  Except now, the games are about prowess in making money, and as I demonstrated earlier, not about prowess in doing anything useful with it.  I do not include in the definition of “useful,” buying things primarily to show how much money you can make.  After all, you only have time to enjoy so many houses and boats, after that it is merely conspicuous spending, demonstrating how “high up on the wall” you can hit.

In his excellent September 23, 2002 New Yorker article entitled “The Greed Cycle,” John Cassidy provides perhaps the most compelling analysis of the factors that led up to Enron and the other business scandals of that period.  Early in the article, he quotes Paul Volker’s description of the business climate that prevailed at the time.  “It became a competitive game to see how much money you could get. … Corporate greed exploded beyond anything that could have been imagined in 1990.  Traditional norms didn’t exist.  You had this whole culture where the only sign of worth was how much money you made.”  The article goes on to describe not just corporate games, but the games of the financial sector and Wall Street that made the scandals inevitable. 

Those games continued right up to and were the cause of the 2008 Great Recession and as of this writing, continue still.  Here are just a few examples of the games recently reported in New York Times articles:

In the April 20, 2010 edition, Nelson D Schwartz and Eric Dash reported on the “byzantine creations of the brightest minds on Wall Street,” collateralized debt obligations, known as C.D.O’s, which they characterized as “among the most toxic financial instruments ever devised.”  They went on to observe that, “until the bottom fell out, these instruments also powered an age of riches on Wall Street.  Initially, bundling mortgage bonds into C.D.O.’s helped open the spigot of easy money that allowed Americans to buy more house than they could afford.”   But, it did not stop there they report, “To lure investors who wanted higher returns, bankers increasingly stuffed C.D.O.’s with riskier assets like subprime mortgage securities, rather than traditional corporate bonds.”

“But,” they noted, it went further still, “Wall Street, as it is wont to do, took the concept to another level, creating securities that allowed investors to make side bets on the housing market.  Known as synthetic C.D.O.’s, they did not raise money for home loans or serve any other broad economic purpose.”  They go on to explain,  “Once the air started coming out of the housing market and there were no more mortgage bonds to sell, they created synthetic C.D.O.’s, whose supply was unlimited because they did not rely on hard assets.”   “Like a casino offering blackjack along with slot machines and Texas hold’em, they were just one more way to bet against the housing market.”

Gretchen Morgenson and Louise Story, in their article “Banks Bundled Bad Debt, Bet Against It and Won,” December 24, 2009, wrote that “In 2006, Wall Street had introduced a new index, called the ABX, that became a way to invest in the direction of mortgage securities.  The index allowed traders to bet on or against pools of mortgages with different risk characteristics …”

Their article also reports on deals put together by Jonathon M. Egol, a young Goldman Sachs trader.  The deals were known as Abacus.  The authors write, “Abacus allowed investors to bet for or against the mortgage securities that were linked to the deal.  The C.D.O.’s didn’t contain actual mortgages.  Instead, they consisted of credit-default swaps, a type of insurance that pays out when a borrower defaults.  These swaps made it much easier to place large bets on mortgage failures.”  They go on to report that, “Rather than persuading his customers to make negative bets on Abacus, Mr. Egol kept most of these wagers for his firm.”  This, they implied, meant that he bet against his customers and made Goldman a lot of money doing so.  As a result, he was promoted and “named a managing director at the firm.” 

Morgenson and Story quote Sylvain R. Raynes, of R & R Consulting in New York with the following statement which characterizes these types of deals, “The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen.  When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

In the April 4, 2010 NYT edition, Susan P. Koniak, George M. Cohen, David A. Dana, and Thomas Ross, published the op-ed, “How Washington Abetted the Bank Job.”  They point out how the Securities and Exchange Commission did not discover that Lehman “got new loans to pay off old loans” and that Lehman had “pretended the new loans were ‘sales’.”  This technique concealed the desperate financial condition of the firm which ultimately resulted in bankruptcy.  Sarcastically, they suggest that the SEC might have suspected this potential since “The collapse of Enron back in 2001 revealed that the biggest financial institutions, here and abroad, were busy creating products whose sole purpose was to help companies magically transform their debt into capital or revenue.”   They go on to point out that the practice went far beyond Enron.  “Our banks had gone into the business of creating ‘products’ to help companies, cities and whole countries hide their true financial condition.  Consider the recent revelations about how Goldman Sachs and J.P. Morgan helped Greece hide its debt.”  They quote the CEO of Citibank, in justifying such transactions, of saying that “As long as the music is playing, you’ve got to get up and dance.” 

They also point out that in 2006, the regulating “agencies jointly published something called the ‘Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities,’ that became official policy the following year.   The definition for the “complex structured finance activities” described in the title, they point out, included deals that in the words of the document “lack economic or business purpose” and are “designed or used primarily for questionable accounting, regulatory or tax objectives …”  Rhetorically, these authors ask, “How does one propose ‘sound practices’ for practices that are inherently unsound?”  “Yet,” they write, “that is what our regulatory guardians did.  The statement (from the document) is powerful evidence of the permissive approach bank regulators took toward the debt-dissolving financial products that our banks had been developing, hawking and using themselves for years.”

This op-ed ends by noting that Susan P. Koniak is a law professor at Boston University, George M. Cohen is a law professor at the University of Virginia, David A. Dana is a law professor at Northwestern University, and Thomas Ross is a law professor at the University of Pittsburg. 

In “Hurrying Into the Next Panic,” a NYT July 29, 2009 Op-Ed, Paul Wilmott warned against “the latest fashion among investment banks and hedge funds: high frequency algorithmic trading.”  He describes this as straightforward: “Computers take information – primarily ‘real time’ share prices – and try to predict the next twitch in the stock market.  Using an algorithmic formula, the computer can buy and sell stocks within fractions of seconds, with the bank or fund making a tiny profit on the blip of price change of each share.”  He goes on to observe that “there’s nothing new in using all publicly available information to help you trade; what’s novel is the quantity of data available, the lightning speed at which it is analyzed and the short time that positions are held.”

He worries that such trading would be faster than any human can react, and that large scale market disruptions could occur before human judgment can enter into the picture.  “The contest,” he points out, “is now between the machines – and they’re playing games with real businesses and real people.”

I should point out that less than a year later, in early June 2010, the stock market experienced a 1000 point drop from just such a Wall Street computerized game.


Games Boys Play - continues
The next installment will be posted on Thursday - Watch for it.

Larry
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