Against my better judgement, I’ve ended up writing a lot about the
financial mess that we’re currently going through. If you’ve read that, you
know that my opinion is that the mess amounts to a giant pile of fraud.
But even having spent so much time reading and studying what was
going on, the latest news from the financial mess shocks me.
Even knowing how utterly sleazy and dishonest many people in the financial world
have been, even knowing about the stuff they’ve been doing, the kinds of
out and out fraud that they’ve perpetrated, the latest news makes them
look even more evil than I could have imagined.
Let’s start by reviewing a bit.
The basic thing at the root of the problem is something called a
collateralized debt obligation – CDO. A CDO is basically a share of a
great big bunch of loans, where the loans are backed by a piece of property.
The most common form of CDO is basically a wrapper around a batch of
Mortgage-based CDOs were traditionally a really safe investment. People
will go to great lengths to avoid losing their homes – so an investment
that would only lose money if people lost their homes was pretty solid.
It became a hugely popular thing to invest in – and a hugely profitable
thing for the bank to sell.
The problem was, there were more people who wanted to buy mortgage based
CDOs than there were mortgages to bundle into CDOs. So banks started looking
for ways to make more mortgages. They’d already gotten people who could really
afford houses to take out mortgages. So they needed to find some other way of
getting people to take out more mortgages. They came up with a whole
bunch of schemes that let people do things like borrow more money than they
could afford to pay back; or that gave mortgages to people with bad credit.
They did pretty much anything they could possibly do to find ways of getting
more mortgages to bundle up and sell. It got to the point where they would
give people huge mortgages with no documentation. You didn’t need to
show that you were buying a house that was worth what you were borrowing; you
didn’t need to show any evidence that you had an income. Nothing.
Realistically, no one actually expected these things to get paid off. But they
didn’t worry about it: they just bundled them up for sale. In order to sell
them, they structured them into packages that made these very risky things
look safe. The main trick was something called tranching.
Tranching takes the mortgage bundle, and divides it into tiers. When loans
get repaid, the top tier gets repaid first. Only once the top tier
has been entirely repaid does the next tier start to get repaid.
By making a bunch of tiers (tranches) you can make the top ones look
like they’re really safe, even when it’s based on pile of shit.
We’ve known for a long time now that tranching was a giant cheat. That top
tier looked safe only because of a lie. It was only safe if the
chances of individual mortgages in the bundle failing to be repaid was an
independent event. But the mortgages that were given out like candy to kids
weren’t independent in that sense: the events that caused one to fail would
cause almost all of them to fail. The supposed safety of even the top
tranch was a bad joke.
Making matters worse, the banks didn’t just sell these bundles of
mortgages. They layered them. They’d take a bundle of mortgages, package them
into CDOs, and sell them. Other banks would buy parts of those CDOs, wrap up
bundles made up of slices of other CDOs, and sell those. And so on, layer upon
In my opinion, this was, in an ethical sense, simple fraud. Unfortunately,
it’s also entirely legal. It shouldn’t be, but most of this stuff is
far beyond anything that was imagined by the people who wrote the laws.
The institutions involved were effectively printing money. They were
issuing loans that they knew wouldn’t be repaid, but they still claim the
interest from the loans as a profit. They were taking bad loans, and selling
them at a profit, to someone else who claimed them as a profitable investment,
and who then used the non-existent expected profits from that to buy more
stuff – which was frequently repackaged versions of the same stuff.
The same garbage was being packaged, sold, repackaged, resold, re-re-packaged,
re-re-sold, and so on, over and over again, making a “profit” on each sale.
But the profit was fake: bank A would make a CDO, and sell it to bank B. Bank
B would wrap that up with some other CDO and sell it to bank C. Bank C would
wrap that and sell it to bank A, which would buy it with the “profits” from
it’s sale to bank B. Bank B would then buy more stuff from A using the profits
of its sale to C. And so on. Each transaction created “profit” that didn’t
Of course, it’s not quite that simple. All of the businesses involved in
these shenanigans have all sorts of legal reporting requirements, and they
need to have their profit statements confirmed by a supposedly independent
auditor. And there’s always a chance that these things would fail. In order to
be able to really count them as profits, they needed some kind of insurance.
So they created a kind of monstrosity called a
credit default swap. What
happens in a credit default swap is that you pay someone to take your risk for
you. For example, you take a loan of one million dollars that you made. You go
to a third party, and you pay them $100/month. If the loan gets paid back,
they get to keep the $100/month. If the loan doesn’t get repaid, then they’re
supposed to repay the entire loan principal. Effectively, it’s like a kind
of insurance against a loan not being repaid. With a CDO, you can supposedly
absolutely count on not losing the principal behind an investment.
Here’s where we get to the next two kinds of fraud.
First, to sell “insurance” in the form of credit default swaps, you
don’t need to prove that you can repay the principal if the loan goes
bad. There are numerous cases of people with a couple of million dollars being
the backers for billions of dollars worth of credit default swaps.
From the very start, it was obvious to everyone that the CDSs were frauds: the
people who were, supposedly, on the hook to repay if loans went bad had
absolutely no ability to actually repay. They didn’t have the money to back
the things that they were insuring, and they had no way of getting the money
to do it. And everyone involved knew it. Credit default swaps were, much of
the time, pure fiction. Once again, though, it’s legal. The people buying
the swaps simply claim that they fully expected the folks on the other side
to be able to pay. They never checked if that was true; they didn’t have to.
So even though if anyone actually checked, it was obvious that lots of people
involved in CDSs couldn’t possibly pay up, no one actually did the checking.
They just assumed that the CDS counterparties had the money to pay up if they needed
to. There was more profit to be made by simply trusting the other
parties than by actually checking, and there was no legal requirement to check.
Second, you don’t have to be the person who made the loan to buy the
insurance on the loan. Anyone can buy a credit default swap on any
Just think about that for a moment. If you’re a financial trader, you can
buy insurance on something that you don’t own! If we did this with normal
insurance, I could buy flood insurance on a building I don’t own in New
Orleans. I could take out an automotive damage policy against a car that my
neighbor parks under a dead tree. Credit default swaps pretend to be
insurance, but they’re not. Insurance protects the owner of a property; credit
default swaps don’t do that. They’re really just simple gambling. A CDS is
just a bet: by buying a credit default swap, I’m betting that the
underlying loan is going to go bad. By selling a credit default swap, I’m
betting that the underlying loan is good. To go back to one of my examples,
a credit default swap is sort of like me making a bet that the car parked
under a dead tree is going to get damaged. If it does, I collect. It’s not
my car, but if the tree falls on it, I win. That’s a CDS. It’s nothing but
legal gambling. The investment firms are bookies
connecting betters on different sides, and collecting a commission.
This much we’ve know for a while. This much by itself is astonishing, and
disgusting, and appalling. This much is fraud on an epic scale, and should be
more than enough to justify stripping the perpetrators of every dime they
have, locking them into jail cells and throwing away the key.
But it turns out that the reality is even worse.
How could it get worse than this?
It turns out that investment firms were deliberately putting
together packages of loans that they knew weren’t going to get
repaid, in order to provide some of their customers with something
that they could bet against.
Let’s go back just a bit. Remember the whole tranching deal?
The investment bank puts together a shitload of mortgages, and then
sells shares in them. They get to take the top tranch, and sell it
as a high-quality safe investment. Of course, if you can’t sell
the whole thing, then you’re left holding the riskiest crap. The
bank really doesn’t want that. So they’ll only sell a CDO if they
can find suckers to buy every level of it. In order to make a CDO,
one of the hardest things to do is find people to buy the bottom of
it. The worst part of a pool of mortgages is called the
equity, and it’s generally between one and ten percent of the
loan pool. You really need to work to find people willing to
buy the equity tranch.
But, a few years ago, at the height of the bubble, hedge funds suddenly
started volunteering to buy the bottom tranch. They didn’t want the
supposedly good stuff, they wanted the garbage. Naturally, the banks were
absolutely thrilled. They put together billions upon billions of
dollars worth of CDOs, which were made possible by the hedge funds
buying the equity.
So far, nothing wrong. If someone wants to buy high-risk crap
in exchange for high profit, that’s their prerogative.
What the hedge funds were really doing is making it possible for the
investment banks to create CDOs that were likely to fail, and then buying
credit default swaps against the top tranches of those CDOs, betting
that they were going to fail.
The strategy here is simple. I spend $5 million buy the bottom 5% of $100
million worth of loans that I think are going bad. I’m expecting to lose that:
I’m going to be out $5 million. But, I also use another $5 million to buy
credit default swaps on $60 million worth of the higher tranches of that
pool of loans. Now, if the pool goes bad, I’m out $10 million – $5 million
for the crap that I bought that’s now worthless, and $5 million to
buy the credit default swaps. But because the whole thing went bad, I get
to collect $60 million.
Now we’re starting to get pretty damned sleazy. These guys want to bet
against the CDOs. That’s OK: if you believe that the things are going to fail,
and you’re willing to risk your money on that belief, then there’s nothing
wrong with you going ahead and doing it. But when you’re deliberately helping
to produce the things that you believe are going to fail in order to give you
something to bet against? That’s moving into the realm of at least highly
questionable behavior. When you’re doing it by betting against something
that you don’t even own? That’s getting worse. (Remember, these guys aren’t
betting that the lowest 5% tranch that they own is going to go bad; they’re betting on the
higher tranches – the upper 50 or 60%. The only reason that they bought
any of the CDOs is because they things would never have been sold
if the banks couldn’t get a buyer for that bottom tranch.)
There’s another bit of sleaze here. The credit default swaps aren’t bought
and sold on the open market; they’re bought and sold via private contracts. As
I mentioned before, most of the time, you can be the backer of a CDS even though
there’s no way in hell that you could pay up if things go south. But when
the hedge funds bought CDSs, they made damn sure that the people they bought
the CDSs from were absolutely able to pay up.
It gets worse.
Anyone who honestly looked at the whole CDO thing a few years ago knew
perfectly well that the thing was going to collapse sooner or later. The hedge
funds knew, perfectly well, that the people that they wanted to buy credit
default swaps from were likely to go belly up eventually. So they wanted
to be in the situation of being the first ones to collect, before the
big insurers backing the CDSs ran out of money.
So they didn’t just find crappy CDOs to bet against. They went to the
investment banks, and asked them create CDOs consisting of piles of
specific, high-risk loans. They provided specific requirements – complaining
when firms tried to put together better packages. They’d only back the true
crap. They wanted shit that would go bad, and go bad fast. And
most of the big investment banks went along with it. (To their credit,
a few refused.)
Both the banks and the hedge funds knew what was going on here: they were
creating and then selling CDOs where they knew that the things were
designed to lose all of the money invested in them. And the
investment banks went to their other customers, and lied! They sold these
things to their customers, telling them that it was a safe, profitable
investment, even though they knew that they were designed
to lose all of the money invested in them!.
The hedge funds would buy the lowest tranch of these monstrosities,
and then buy CDSs against the other tranches. When the loans failed,
the hedge funds collected shitloads of money.
The banks, meanwhile, went along with this. Why? Why would they
screw over their own customers? Easy: they make money by
selling the things. Sure, the people
involved had to know that, in the long term, this was likely to kill their firm.
But in the short term, they were being paid cash in commissions and bonuses
for selling this crap. The people who sold the designed-to-fail
CDOs were collecting millions and millions of dollars in bonuses. And
the hedge fund folks eventually collected billions on
the swaps on failed loans.
For the brokers, bankers, and hedge-fund managers, this was hugely
profitable. They got to take home amounts of money that most of us
can’t even imagine. Lots of them are now out of jobs – but
they’ve still got their millions of dollars in the bank. It
worked for them.
To call this sociopathic behavior on the part of the scum involved is
an understatement of absolutely epic proportions. What the people
involved in this did is no different that just stealing money from the
people who they suckered into buying worthless CDOs. They deliberately
sold worthless garbage – things that they didn’t just know
were going to lose money, but that they designed to lose
money – lying to the buyers, telling them that it was a great safe investment,
knowing that the buyers were going to lose everything. But they didn’t
care – because doing that would put money into their own pockets.