Archive for April 20th, 2010
NOW we’re talking! Hello?!! Why isn’t the name of every single Member of Congress on this letter?!!!
Via Huffington Post:
The Honorable Eric Holder
United States Attorney General
U.S. Department of Justice
950 Pennsylvania Avenue, N.W.
Washington, DC 20530-0001
Dear Attorney General Holder:
The U.S. Securities and Exchange Commission (SEC) announced on Friday, April 16, 2010, that it had filed a securities fraud action against the Wall Street company Goldman Sachs & Co (GS& Co.) and one of its employees for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) that GS & Co. structured and marketed to investors. The SEC alleges that:
1. This synthetic CDO, ABACUS 2007- AC1, was tied to the performance of sub-prime residential mortgage-backed securities (“RMBS”) and was structured and marketed by GS & Co. in early 2007 when the United States housing market and related securities were beginning to show signs of distress. Synthetic CDOs like ABACUS 2007-AC1 contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.
GS & Co. marketing materials for ABACUS 2007-AC1 – including the term sheet, flip book and offering memorandum for the CDO – all represented that the reference portfolio of RMBS underlying the CDO was selected by ACA Management with experience analyzing credit risk in RMBS. Undisclosed in the marketing materials and unbeknownst to investors, a large hedge fund, Paulson & Co. Inc. (“Paulson”), with economic interests directly adverse to investors in the ABACUS 2007-AC1 CDO, played a significant role in the portfolio selection process. After participating in the selection of the reference portfolio, Paulson effectively shorted the RMBS portfolio it helped select by entering into credit default swaps (“CDS”) with GS & Co. to buy protection on specific layers of the ABACUS 2007-AC1 capital structure.
In sum, GS & Co. arranged a transaction at Paulson’s request in which Paulson heavily influenced the selection of the portfolio to suit its economic interests, but failed to disclose to investors, as part of the description of the portfolio selection process contained in the marketing materials used to promote the transaction, Paulson’s role in the portfolio selection process or its adverse economic interests.
As the SEC notes, financial manipulations such as this contributed to the near collapse of the U.S. financial system and cost American taxpayers hundreds of billions of dollars. On the face of the SEC filing, criminal fraud on a historic scale seems to have occurred in this instance. As an ever growing mountain of evidence reveals, this case is neither unique nor isolated.
If both global and domestic confidence in the integrity of the U.S. financial system is to be regained, there must be confidence that criminal acts will be vigorously pursued and perpetrators punished.
While the SEC lacks the authority to act beyond civil actions, the U.S. Department of Justice (DOJ) has the power to file criminal actions against those who commit financial fraud. We ask assurance from you that the U.S. Department of Justice is closely looking at this case and similar cases to further investigate and prosecute the criminals involved in this, and other financially fraudulent acts. Furthermore, if the DOJ is not currently looking into this particular case, we respectfully ask you to ensure that the U.S. Department of Justice immediately open a case on this matter and investigate it with the full authority and power that your agency holds. The American people both demand and deserve justice in the matter of Wall Street banks whom the American taxpayers bailed out, only to see unemployment and housing foreclosures rise.
This matter is of deep importance to us. As you may know, H.R. 3995, the Financial Crisis of 2008 Criminal Investigation and Prosecution Act, has been introduced, which authorizes you to hire more prosecutors, Director Mueller of the Federal Bureau of Investigation to hire 1,000 more agent as well as additional forensic experts, and Chair Mary Shapiro of the U.S. Securities and Exchange Commission to hire more investigators to continue to pursue justice and route out the criminals in our financial system. Part of financial regulatory reform should include removing the criminals and crafting a system that supports those who follow the law.
We in Congress stand ready to support you in protecting the American taxpayers from financial crimes such as the fraud that the U.S. Securities and Exchange Commission has charged Goldman Sachs with committing. We ask that you take up this case, and others, to pursue justice for the American people, to put criminals in jail, and seek to restore the integrity of our nation’s financial system.
MEMBER OF CONGRESS
Also, the Progressive Change Campaign Committee has started a petition: No “Too Big To Jail” – those who wish may endorse it here.
Yup – epic blunder on the part of the GOP if they are going to be on the other side of this issue. Goldman Sachs DID commit fraud and it was fraud of epic proportions – and it was against the American people. While we’re at it, the rest of the big banks have done the exact same thing. Every single one of the ‘too big to fail banks’s’ CEOs and Board Members need to be brought up on criminal charges. They need to be dismantled and thrown in the dust bin of history.
STOP THE LOOTING AND START PROSECUTING!
Posted by Karl Denninger
Gee Darrell, you don’t have a wee problem with your constituents and trying to pump the value of their houses (which were inflated by massive, pervasive and continuing fraud), do you?
Rep. Darrell Issa, the top Republican on the House Oversight committee, is demanding a slew of documents from the Securities and Exchange Commission, asserting that the timing of civil charges against Goldman Sachs raises “serious questions about the commission’s independence and impartiality.”
Issa’s letter, addressed to SEC Chairwoman Mary Schapiro and signed by eight other House Republicans, asks whether the commission had any contact about the case, prior to its public release, with White House aides, Democratic Party committee officials, or members of Congress or their staff.
“[W]e are concerned that politics have unduly influenced the decision and timing of the commission’s controversial enforcement action against Goldman,” Issa writes.
You know how I know it’s utter crap?
Folks, I’m all for a good insider-trading story – if there was actual evidence of insider trading – that is, if there was evidence that someone knew in advance what was going on and placed bets to profit from what, in that case, would be a sure thing.
But in this case, despite the claims of many, there is no evidence to support that charge to be found in the tape. Indeed, quite the opposite – the options chain looks entirely normal.
Now remember folks, it is entirely legal for Congressfolk (and their staff) to trade on inside information. They do it all the time, as has been disclosed by various Congresspeople themselves.
IF there was any sort of coordination between the SEC’s action and any member of the “Democratic establishment” it would have shown up in the trade either Thursday or Friday and it did not.
Some of those options had truly obscene returns - the $170 April PUTs, for example, were worth $15.00 at 11:00 AM Friday and under $2 the day before, or a gain of 750% in less than 24 hours.
Clearly, if someone had been tipped in the Democrat political establishment that is immune from insider-trading regulations, including the members of Congress and their staffs, it would have shown up in the market as have dozens of other questionable decisions you have NEVER seen fit to investigate - and it did not.
(Other examples over the last couple of years include the SEC-imposed short ban, the discount rate cut in 2007 and many more – shall I compile a full list or are those two enough? Oh, and why is it that you’ve shown no interest in stomping on those clear cases of “inside baseball”?)
Commentary by Stephanie Jasky
In other words, if this move by the SEC had truly been orchestrated with the administration, there would have been clear evidence seen in the markets’ movement on Thursday or Friday, but there wasn’t. I can’t tell you how many countless times as traders we have watched Congress and the large banks trade on inside information. It’s obvious and it’s blatant.
Now, if Mr. Issa is angry that the SEC didn’t move sooner on this, and let’s be honest here, FedUpUSA and a myriad of other financial and economics people on the Internet have been calling for Goldman Sachs’ head on a platter for more than two years, then Mr. Issa is certainly within his rights to complain about the apparent complete absence of the SEC over the past 10 years! However, that’s not exactly what his letter conveys.
I certainly hope that the Republicans will think twice (or more) about this new tactic of defending Wall Street. They THINK they’re defending capitalism, but they aren’t, and the American people know it for what it is: defending criminality and defending the oligopoly between the Congress and Wall Street. And I’ve got news for the GOP: Wall Street is in far deeper to the Democrats than they ever were with you. Goldman Sachs and those that identified themselves as working for Goldman contibuted $1 Million to Obama’s campaign, more than any other candidate for any other office combined. The American people do not want to see anyone in Washington DC stand up for Wall Street’s globalized, premeditated theft.
Before now, it appeared that nothing short of a horrible blunder of epic proportions would prevent the Republicans from taking back every seat in Congress they’ve lost in the past four years – leave it to the Republicans to find just that blunder.
STOP THE LOOTING AND START PROSECUTING! Can you hear us now?!!!!!
Posted by Karl Denninger
An amazing set of written testimony was given to the panel on Lehman’s collapse that you all need to read has been filed by Bill Black.
Lehman’s principal source of (fictional) income and real losses was making (and selling) what the trade accurately called “liar’s loans” through its subsidiary, Aurora. (The bland euphemism for liar’s loans was “Alt-A.”) Liar’s loans are “criminogenic” (they create epidemics of mortgage fraud) because they create strong incentives to provide false information on loan applications. The FBI began warning publicly about the epidemic of mortgage fraud in 2004 (CNN). Liar’s loans also produce intense “adverse selection” – even the borrowers who are not fraudulent will tend to be the least creditworthy. The combination of these two perverse incentives means that liar’s loans, in economics jargon, have a deeply “negative expected value” to the lender. In English, that means that the average dollar lent on a liar’s loan creates a loss ranging from 50 – 85 cents.
The value of Lehman’s Alt-A mortgage holdings fell 60 percent during the past six months to $5.9 billion, the firm reported last week.1
Gambling against the casino creates a negative expected value, but making liar’s loans creates inevitable, catastrophic losses.
Is it over? Oh hell no.
That loss, however, may not be recognized for many years – particularly if the liar’s loans become so large that they help hyper-inflate a financial bubble. In the near-term, making massive amounts of liar’s losses loans creates a mathematical guarantee of producing record (albeit fictional) accounting income. (As long as the bubble inflates, the liar’s loans can be refinanced – creating additional fictional income and delaying (but increasing) the eventual loss.
And what are we doing right now with our still existing banks?
We have issued official guidance that they do not need to mark their commercial real estate exposures to the market so long as they are receiving income from them, even if the lies (valuation) are known.
This is EXACTLY IDENTICAL to making liar’s loans to buy houses “which are perfectly ok so long as the people can make the (initial) payments”!
It gets better:
It was a painful, as a former regulator, to read the Valukas report’s discussion of the FRBNY staff’s open disdain for working cooperatively with the SEC to protect the public. The Valukas report exposes the sick relationship between the country’s main regulatory bodies and the systemically dangerous institutions (SDIs) they are supposed to be policing. The FRBNY, led by President Geithner, had a clear statutory mission — promote the safety and soundness of the banking system and compliance with the law – stood by while Lehman deceived the public through a scheme that FRBNY officials likened to a “three card monte routine” (p. 1470).
And what are we doing right now with so-called “disclosure”? Mark to fantasy accounting for commercial real estate loans and HELOCs, hundreds of billions of dollars of off-balance sheet “vehicles” that are being carried by all major financial institutions without any capital behind them at all since they are not counted in the firm’s “capital ratios” and explicit direction by the FDIC to examiners to not require banks to hold more capital against underwater real estate loans so long as rents are being paid?
Meanwhile we continue to see disclosures from the ratings agencies and others that CMBS (commercial mortgage backed security) delinquency/default rates continue to rise, with FITCH now saying that defaults will exceed 11% of all outstanding securitizations in their rated deals by the end of the year.
Yet the banks are being explicitly allowed to fail to reserve against these predictable and expected losses by both current policy and explicit direction from the so-called “risk managers” in the FDIC (that is, bank examiners) and others in the regulatory apparatus.
Translation: The FRBNY knew that Lehman was engaged in fraud designed to overstate its liquidity and, therefore, was unwilling to loan as much money to Lehman. The FRBNY did not, however, inform the SEC, the public, or the OTS (which regulated an S&L that Lehman owned) of the fraud. The Fed official doesn’t even make a pretense that the Fed believes it is supposed to protect the public. The FRBNY remained willing to lend to a fraudulent systemically dangerous institution (SDI). This is an egregious violation of the public trust, and the regulatory perpetrators must be held accountable. The Fed wanted to maintain a fiction that toxic mortgage product were simply misunderstood assets, so it allowed Lehman to keep dealing the three card monte scam.
Far worse than what happened with Lehman in this regard it is still the ongoing policy of all of these agencies to do the same damn thing with the still-existing banks and bank-holding companies!
Or, in plain English, the Fed didn’t want Lehman and other SDIs to sell their toxic assets because the sales prices would reveal that the values Lehman (and all the other SDIs) placed on their toxic assets (the “marks”) were inflated with worthless hot air.
AND STILL IS – the entire point of “extend and pretend”, that is, a formal and written policy crammed down FASB’s throat at literal gunpoint by the US Congress and implemented by current FDIC examiners with regard to both underwater commercial real estate loans and HELOCs behind underwater, delinquent first mortgages is to prevent the liquidation of these products into the market, thereby preserving the ability to make willfully and intentionally fraudulent claims of value that does not exist.
The FRBNY has vastly greater leverage than the FHLBSF ever had and in the context of the Lehman crisis it had the leverage to force any change it believed was necessary, including an immediate conversion of Lehman to a bank holding company and a commercial bank.
Of course it did. The entire point of the scam was to prevent the recognition of the true value of any of these assets, lest they force a mark-to-market by all other system participants. That would have been catastrophic (and still will be) but the market cannot clear until it happens.
Fifth, the Fed is addicted to opaqueness and its senior ranks believe the bankers when they claim that the people must never be allowed to learn the truth about asset losses. One of the conflicts of interest that a banking regulator must never succumb to is the temptation to encourage or allow the regulated entity to lie about its financial condition for the purported purpose of preventing a run on the bank.
Like, for example, claiming that the big banks all passed “stress tests” that were orchestrated to be impossible-to-fail because they were predicated on forcing FASB to allow these same institutions to carry underwater and unrecoverable paper at par?
What Bill Black has documented is not only how and why Lehman blew sky high, but that nothing has, in fact, changed – other than the fact that we have now effectively backstopped this activity among the current survivors by sweeping the truth under the rug!
If we do not stop it now the system will blow sky-high – again – and this time there won’t be enough money or credit available to the United States Government (or any other government) to stop it.
When government and business collude, it’s called crony capitalism. Expect more of this from the financial reforms contemplated in Washington.
Free markets depend on truth telling. Prices must reflect the valuations of consumers; interest rates must be reliable guides to entrepreneurs allocating capital across time; and a firm’s accounts must reflect the true value of the business. Rather than truth telling, we are becoming an economy of liars. The cause is straightforward: crony capitalism.
Thomas Carlyle, the 19th century Victorian essayist, unflatteringly described classical liberalism as “anarchy plus a constable.” As a romanticist, Carlyle hated the system—but described it accurately.
Classical liberals, whose modern counterparts are libertarians and small-government conservatives, believed that the state’s duties should be limited (1) to provide for the national defense; (2) to protect persons and property against force and fraud; and (3) to provide public goods that markets cannot. That conception of government and its duties was articulated by the Declaration of Independence and embodied in the U.S. Constitution.
Modern liberals have greatly expanded the list of government functions, but, aside from totalitarian regimes, I know of no modern political movement that has shortened it. While protecting citizens against force, both at home and abroad, is the government’s most basic function, protecting them against fraud is closely allied. By the use of force, a thief takes by arms what is not rightfully his; he who commits fraud takes secretly what is not rightfully his. It is the difference between a robber stealing brazenly on the street and a burglar stealing by stealth at night. The result is the same: the loss of property by its owner and the disordering of civil society. And government has failed miserably to perform this basic function.
Why has this happened? Financial services regulators failed to enforce laws and regulations against fraud. Bernie Madoff is the paradigmatic case and the Securities and Exchange Commission the paradigmatic failed regulator. Fraud is famously difficult to uncover, but as we now know, not Madoff’s. The SEC chose to ignore the evidence brought to its attention. Banking regulators allowed a kind of mortgage dubbed “liar loans” to flourish. And so on.
We have now learned of the creative way Lehman Brothers hid its leverage (how much money it was borrowing) by the use of a Repo 105. The Repo 105 meant Lehman temporarily swapped assets (such as bonds) for cash. A Repo, or repurchasing agreement, is a way to borrow money. But an accounting rule allowed Lehman to book the transaction as a sale and reduce its reported borrowings, according to a report by the court-appointed Lehman bankruptcy examiner, a former federal prosecutor, last month.
Are we to believe that regulators were unaware? Last week Goldman Sachs was accused in a civil fraud suit of deceiving many clients for the benefit of another, hedge-fund operator John Paulson.
The idea that multiplying rules and statutes can protect consumers and investors is surely one of the great intellectual failures of the 20th century. Any static rule will be circumvented or manipulated to evade its application. Better than multiplying rules, financial accounting should be governed by the traditional principle that one has an affirmative duty to present the true condition fairly and accurately—not withstanding what any rule might otherwise allow. And financial institutions should have a duty of care to their customers. Lawyers tell me that would get us closer to the common law approach to fraud and bad dealing.
Public choice theory has identified the root causes of regulatory failure as the capture of regulators by the industry being regulated. Regulatory agencies begin to identify with the interests of the regulated rather than the public they are charged to protect. In a paper for the Federal Reserve’s Jackson Hole Conference in 2008, economist Willem Buiter described “cognitive capture,” by which regulators become incapable of thinking in terms other than that of the industry. On April 5 of this year, The Wall Street Journal chronicled the revolving door between industry and regulator in “Staffer One Day, Opponent the Next.”
Congressional committees overseeing industries succumb to the allure of campaign contributions, the solicitations of industry lobbyists, and the siren song of experts whose livelihood is beholden to the industry. The interests of industry and government become intertwined and it is regulation that binds those interests together. Business succeeds by getting along with politicians and regulators. And vice-versa through the revolving door.
We call that system not the free-market, but crony capitalism. It owes more to Benito Mussolini than to Adam Smith.
Nobel laureate Friedrich Hayek described the price system as an information-transmission mechanism. The interplay of producers and consumers establishes prices that reflect relative valuations of goods and services. Subsidies distort prices and lead to misallocation of resources (judged by the preferences of consumers and the opportunity costs of producers). Prices no longer convey true values but distorted ones.
Hayek’s mentor, Ludwig von Mises, predicted in the 1930s that communism would eventually fail because it did not rely on prices to allocate resources. He predicted that the wrong goods would be produced: too many of some, too few of others. He was proven correct.
In the U.S today, we are moving away from reliance on honest pricing. The federal government controls 90% of housing finance. Policies to encourage home ownership remain on the books, and more have been added. Fed policies of low interest rates result in capital being misallocated across time. Low interest rates particularly impact housing because a home is a pre-eminent long-lived asset whose value is enhanced by low interest rates.
Distorted prices and interest rates no longer serve as accurate indicators of the relative importance of goods. Crony capitalism ensures the special access of protected firms and industries to capital. Businesses that stumble in the process of doing what is politically favored are bailed out. That leads to moral hazard and more bailouts in the future. And those losing money may be enabled to hide it by accounting chicanery.
If we want to restore our economic freedom and recover the wonderfully productive free market, we must restore truth-telling on markets. That means the end to price-distorting subsidies, which include artificially low interest rates. No one admits to preferring crony capitalism, but an expansive regulatory state undergirds it in practice.
Piling on more rules and statutes will not produce something different than it has in the past. Reliance on affirmative principles of truth-telling in accounting statements and a duty of care would be preferable. Deregulation is not some kind of libertarian mantra but an absolute necessity if we are to exit crony capitalism.
Mr. O’Driscoll is a senior fellow at the Cato Institute. He has been a vice president at Citigroup and a vice president at the Federal Reserve Bank of Dallas.
Posted by Karl Denninger
Giving that House Financial Services is having a hearing today on the Valukas report on the Lehman collapse, I thought I’d put forward the questions I would ask if I was a member of the committee.
In no particular order:
- From Mr. Valukas written testimony:
(But) we found that Lehman was significantly and persistently in excess of its own risk limits. Lehman management decided to disregard the guidance provided by Lehman’s risk management systems. Rather than adjust business decisions to adapt to risk limit excesses, management decided to adjust the risk limits to adapt to business goals.
We found that the SEC was aware of these excesses and simply acquiesced.In 2004, prior to becoming Treasury Secretary, Henry Paulson, then the head of Goldman Sachs, came to The SEC and asked for the leverage limits that formerly constrained investment banks – including Lehman – to be dropped. SEC rules formerly limited leverage to 14:1. It is important to note that this was Mr. Paulson’s second request – the first, made in 2000, was turned down. This second request was granted.
In point of fact, all of the firms that failed – AIG, Lehman, Bear, Fannie and Freddie – had leverage at the point of failure dramatically higher than the former limit. At 14:1, Lehman would not have failed at all (neither would have Bear Stearns.)
To Mary Shapiro, Ben Bernanke, and Tim Geithner: How can we sit here today, more than three years into this crisis and coming up on two years since Lehman failed, and not have rescinded the leverage limit change that was asked for by Henry Paulson – and without which the failures would not have taken place?
- Again, from Mr. Valukas:
The SEC knew that Lehman was reporting sums in its reported liquidity pool that the SEC did not believe were in fact liquid; the SEC knew that Lehman was exceeding its risk control limits; and the SEC should have known that Lehman was manipulating its balance sheet to make its leverage appear better than it was. Yet even in the face of actual knowledge of critical shortcomings, and after Bear Stearns’ near collapse in March 2008 following a liquidity crisis, the SEC did not take decisive action. Me:
This is not a unique failure. The OTS has been fingered by its own Inspector General for having an employee who was an OTS inspector during the S&L crisis and during that crisis allowed an S&L to fraudulently backdate deposits perform the exact same outrageous action with IndyMac bank. The bank subsequently failed and a significant part of the FDIC loss was taken as a consequence of its delayed action.
OTS was also fingered in the WaMu collapse for treating the bank as not a regulated entity but rather as a constituent, a term actually used by the OTS in hearings last week.
The SEC clearly has historically taken the same sort of approach to so-called “regulation” leading up to this crisis with Lehman Brothers. Indeed, we know from the report that:Valukis:
But months earlier, it had learned critical information that put it on notice that Lehman’s liquidity was not as was portrayed to the investing public. But the SEC did not act on its knowledge, it simply acquiesced.
This is, for all intents and purposes, the same misrepresentation made by IndyMac bank and was both countenanced and intentionally ignored by The SEC.Both The Federal Reserve Board and FRBNY in addition have effectively ducked their responsibility as the primary safety and soundness regulator of the banking system as a whole. To Tim Geithner, Ben Bernanke and Mary Shapiro: As of the present day we have financial institutions throughout the land that we know for a fact are holding “assets” at dramatically above fair market value. We know this through the weekly FDIC bank seizures where the discrepancy is, every week, outlined. How can your agencies defend your actions both leading to Lehman’s bankruptcy and in the nearly two years hence when these practices are continuing even today and, since OTS is in fact under Treasury, why are the person(s) responsible for the aforementioned egregious and documented conduct still employed? Further, when are you going to force firms to actually account for their assets at market value instead of intentionally-inflated numbers that make financial institutions appear dramatically healthier than they really are?
I would additionally ask all present:
- Why has nobody bothered to finger the seminal change that led to the inflation of the terminal phase of the bubble and it’s collapse: the removal of former hard-cap leverage limits that was requested by Henry Paulson of Goldman Sachs in 2004, and why should we not legislatively re-impose this hard cap immediately – on all financial institutions?
- Why, after the collapse of Enron and MCI, two firms that used off-balance sheet structures to hide risk and distort their financial health, were such structures not entirely banned (as was often-claimed would be the case in the wake of both firms’ failure), and why to this day are these structures still outstanding in the aggregate of trillions of dollars among US Financial firms? How do you and your agencies justify computing Tier Capital ratios without including these so-called “off balance sheet” exposures?
- Why, after the S&L Crisis and now IndyMac, as well as Lehman, have not each and every one of the alleged “regulators” that willfully looked the other way or even worse, were knowingly involved in manipulation of balance sheets and valuations, been at minimum been removed form their posts? It is clear from the record that multiple Federal Agencies have in fact been willfully blind to either dramatic increases in risk among institutions or, in some cases, been willfully complicit in acts that give rise to a colorable claim of corruption. Yet in exactly none of these cases has enforcement action been taken within the regulatory agencies. Why not?
Posted by Karl Denninger
Goldman is now being formally investigated by the FSA, the UK’s equivalent to the SEC:
“Following preliminary investigations, the Financial Services Authority has decided to commence a formal enforcement investigation into Goldman Sachs International in relation to recent SEC allegations,” the FSA said in an e-mailed statement. “The FSA will be liaising closely with the SEC.”
Notice what Alistair Darling said yesterday:
Chancellor of the Exchequer Alistair Darling said today that regulators need to take urgent steps and that the charges against Goldman Sachs had “huge ramifications.” Darling, who described the securities Goldman sold as “a bag of pus,” said the government would look at changing the law if necessary.
The squid appears to have fewer tentacles into the UK’s government than it does into ours. Note carefully that our President, and both of OUR political parties, have not come clean on what was being sold – and exactly what practices were involved here.
But Bloomberg gets this part of the story wrong:
Banks create CDOs by bundling bonds or loans, or both, from numerous issuers such as companies or countries. Interest payments on the underlying debt is then used to pay investors.
The CDOs in question were synthetics – that is, they were not bundled up bonds, but rather they came into creation as a consequence of a credit-default swap being purchased by someone who wanted to short the reference, in this case Paulson’s hedge fund.
A CDO can be comprised of any instrument (or set of instruments) that throws off a cash flow. In this case there were no physical bonds involved in the transaction; it was entirely comprised of credit-default swaps, which create an obligation to pay a coupon flow (from the buyer of the CDS) to the CDO which then distributes that cash flow to the buyers of the tranches of the CDO.
Here’s the problem with these things: There is no economic benefit and real party at interest underlying these structures!
So why do we allow this sort of thing to take place at all? The banks love these “structured products” because they get to skim off a fee. But unlike a public sale of stock or bonds, these are nothing more or less than raw gambling contracts for which the banks collected a fee.
That is, they are inherently negative-sum games that are being played!
The only reason to set up these structures in the first place is to keep them off an exchange, where we have price, open interest and execution transparency. That is, if I want to short something I can do so on a public exchange but in doing so the terms are standardized and I cannot take advantage of anyone by hiding information.
There is no reason for regulators to permit this sort of complicated scheme that amounts to the bundling of naked credit-default swaps, as such structures are always, in one form or another destructive of capital on balance.