Senate Investigation on Fraud, Role of Fraud in the Financial Debate.

Still on vacation for a bit.  Stopping in to note that the Senate subcommittee on investigation just released its massive 650 page report, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse. There’s a lot to go through in this report, headed by Carl Levin (D-MI) and Tom Coburn (R-OK), and I’ve just started it. I’d recommend checking out initial impressions from Jennifer Taub at the paretocommons.

Two quick comments. First, there’s a school of thought that focuses on the linkage between market fundamentalism and the carceral state. By believing that markets naturally self-regulate, we remove the role of government from regulation of markets to the governance of a extra-market penal sphere. The government then redefines the ideal citizen as subjects who are either potential criminals or potential victims of crime and re-conceptualizes its own power as one focused on aggressive crime prevention (see Governing Through Crime, Jonathan Simon, Illusions of Free Markets, Bernard Harcourt). It’s fascinating to contrast the extensive expansion of policing powers focused on the War on Crime/Drugs, on the one hand, against the detailed interactions of the Office of Thift Supervision (OTS) with WaMu, on the other, as shown in the report.

From the introduction of the report:

OTS records show that, during the five years prior to WaMu’s collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, asset quality, and appraisal practices, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but never did. OTS failed to respond with meaningful enforcement action, such as by downgrading WaMu’s rating for safety and soundness, requiring a public plan with deadlines for corrective actions, or imposing civil fines for inaction. To the contrary, until shortly before the thrift’s failure in 2008, OTS continually rated WaMu as financially sound.

The agency’s failure to restrain WaMu’s unsafe lending practices stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on bank management to correct identified problems with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of deference to WaMu’s management, choosing to rely on the bank to police itself in its use of safe and sound practices. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems would be corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results.

Despite identifying over 500 serious deficiencies in five years, OTS did not once, from 2004 to 2008, take a public enforcement action against Washington Mutual to correct its lending practices, nor did it lower the bank’s rating for safety and soundness.

I haven’t read the full thing yet, but this screams that the regulators saw their jobs as to gently nudge the banks they were regulating as partners, as market forces would self-correct these problems. Put that against the expansion of searches, limitations of due process, double jeopardy with regards to property, RICO laws, three-strike laws and general expansion of state powers when it comes to the policing of the poor over the past thirty years.

Fraud as Macro Property.

The placement of fraud in the narratives of the financial crisis is vastly different author by author. Two recent books I’ve read, both excellent on the crisis, could not be more opposed to each other. The Subprime Virus (Engel, McCoy) looks very closely at the securitization chains and points out the places where fraud enters the picture. Balancing the Banks: Global Lessons from the Financial Crisis (Dewatripont, Rochet, Tirole) doesn’t even really mention fraud as an important part of the narrative.

Why is fraud important? The first is obviously the ideal of justice, that those who have been rewarded at another’s expense ought to pay a price. The second is a regulatory issue, to provide disincentives against wrong acts.

The third is the macroeconomic element. How much did the fraud in Wall Street’s misbehavior create and/or sustain the housing bubble? The general narrative looks at a combination of a “global savings glut,” the actions of the Federal Reserve and/or exuberance in the housing market. Wall Street, obnoxious as they may be, is almost a bystander in this narrative. There’s little role for the idea that Wall Street and accompanying parties’ actions, in creating financial instruments they expected to fail, created or sustained the housing and credit bubble in any meaningful, quantitative sense. This is an understudied part of the crisis, and if the Great Depression is any guide, will likely be lost to history.

In that sense, it’s good to see Propublica’s Jesse Eisinger and Jake Bernstein winning a Pulitzer for their work on Magnetar and the rest of the financial crisis. Magnetar is the hedge fund that kept the demand going for subprime mortgage-backed securities when the housing market was originally starting to cool, pumping the bubble that it then bet against.  How much of an effect did that have on the overall market?  How much less of a recession would we have had if this conflict wasn’t there? We need better numbers here.

We are going to see the idea of prudential regulation of banks extend from a microeconomic concern – one of coordinating behaviors of depositors against runs and towards soundness, etc. – to a macroeconomic concern, one where the lack of regulation of banks has important implications for employment, leverage, crises, price levels, etc. I hope we see movement when it comes to fraud as well.

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5 Responses to Senate Investigation on Fraud, Role of Fraud in the Financial Debate.

  1. chicago mike says:

    Post your review of the Levin Report when you finish it.

    Here’s my current thought: If Magnetar and John Paulson had NOT (essentially) shorted subprime CDOs, then might not the spread-to-treasuries of such securities remained “tight”, enabling the origination of even more subprime loans in the months (and years?) to come, worsening the eventual calamity that has come to be?

    My question is: what exactly are the shorts guilty of?

    The Levin Report (more so than the FCIC report) insinuates that the shorts are culpable because they did not reveal their identity (nor their thinking/opinions) to the longs, and because the shorts influenced the selection of the CDO’s underlying collateral.

    But one can easily imagine a scenario in which the shorts did NOT unduly influence the selection of collateral, nor keep their opinions about the market a secret. Is that what it would take to exonerate Magnetar, Paulson, Deutsche Bank, Goldman Sachs, Kyle Bass, Mariner Investment Group, etc. from the charge of being ‘homewreckers’?

    I think it conceivable the shorts ought to be blamed for not having shorted subprime sooner! In other words, maybe the question shouldn’t be ‘What have you done?’ but rather ‘Why didn’t you do it earlier? What took you so long to short housing? How might the markets be reformed so that more speculators will wager their money on important indices, like RE valuations?’

    In their FCIC interviews Greg Lippmann and Ralph Cioffi both say that the world changed in a big way for them (for the better) when Markit introduced their ABX indices in Jan. 07.

    If little guys like me had been able to trade such a derivative (and I was wildly bearish on RE) as easily as I can trade the e-minis, then “I coulda been somebody, I coulda been a contender….”

    But if I had profited on RE’s collapse (like Magnetar, Paulson, et. al.) then would I be guilty too (as charged by ProPublica, Yves Smith, the FCIC & Levin Report authors)?

    And if so: what exactly would I be guilty of?

    btw:: I’m very glad to see that you’re no longer italicizing other writers’ excerpts in your posts.

    • Mike Easterly says:

      These are good questions, so I’ll see if I can shed some light on them.

      The key is to understand that shorting subprime securities is not like shorting common stock. When you short a common stock, you sell it on an exchange. Because the sale is public (on an exchange), it sends a signal to other market participants that somebody (you) believes the stock is overvalued. Your sale puts downward pressure on the stock’s price. This is what is known as “price discovery”–the decisions of thousands of buyers and sellers determine what “the market” believes the price of the stock should be.

      When you short a subprime security, however, there is no price discovery, except if the tranche you’re shorting is used to determine the ABX, which is unlikely. Your short position isn’t public and therefore doesn’t affect the prices at which others go long or short.

      There’s another difference. In short selling, you typically borrow an existing share and sell it. (I’m ignoring naked shorts here for simplicity’s sake.) When you short subprime, however, you have to bring into the world a new security, such as a synthetic CDO like Abacus. You’re creating an exposure (for a long investor) where none would have existed otherwise. Your short magnifies the impact of default on a security because not only does the owner of the security suffer losses, but now the longs on your transaction suffer losses as well.

      What the critics find most egregious is the way that Paulson and Magnetar structured their exposures. In addition to going short the mezzanine tranches, they also went long on the first-loss tranches, with the (alleged) expectation that their gains from their shorts would exceed their losses on the long positions. The insidious part of this strategy is that it sends a misleading signal to potential longs on these transactions. When potential long investors learn that somebody is willing to take the first loss on a security (by going long the equity tranche), they infer that somebody thinks it is safe. In this case, however, the reality is the exact opposite. Indeed, to the extent that the allegations are true, Paulson and Magnetar were actively trying to bring about the opposite outcome–they were designing the securities to fail.

      Does this help? Let me know if there’s anything I can clarify.

  2. chicago mike says:

    Correction: The ABX-HE index began trading on Jan. 19, 2006 — not Jan. 07, as stated above.

    http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aA6YC1xKUoek

  3. chicago mike says:

    Hi Mike Easterly,

    Thanks very much for your cordial reply & offer to help clarify my understanding of the ethics of the Magnetar trade. I apologize for not replying sooner to your post but I saw it only recently.

    At present I am swamped by the quantity of criticism from Yves Smith on Magnetar that I wish to read, reread & meditate upon.

    Is there an email address at which I may contact you with my musings on this subject?

    Thanks again Mike for your kind reply. I hope we may continue this discussion.

    -cm

    • Mike Easterly says:

      I do have an email address, but I don’t know how to give it to you without publishing it to the entire Internet.

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