Posted by Karl Denninger
Let’s start with the arrogant pricks at OTS who were supposedly “regulating” Washington Mutual before it blew up.
I will note that The Senate’s permanent subcommittee on investigations’ web site – including written witness testimony – is having “technical difficulties” (uh huh) – which means you need to watch the CSPAN coverage. Be warned – it’s over three hours, and most of it will bore you to tears.
But there are nuggets in there. One of the better ones is the OTS claiming that WaMu was a “constituent.” Oh really?
1. Serving as part of a whole; component: a constituent element.
2. Empowered to elect or designate.3. Authorized to make or amend a constitution: a constituent assembly.
2. A resident of a district or member of a group represented by an elected official.3. One that authorizes another to act as a representative; a client.
Regulation is supposed to be an adversarial process. The OTS’ – and indeed every other government agency – has we the people as constituents!
If you recall I have said for three years that all derivatives must be forced onto an exchange so as to stop the games and BS. This is necessary to both bring margin and open interest transparency. Well, guess what – this bill does that.
It also absolutely bars any federal backstop of any sort, including access to the Fed’s discount window or FDIC insurance, for any entity that trades, writes, or holds swaps.
You can bet there will be much push-back on this account. But let’s be straight here – these swaps are poisonous, just as are the synthetic CDOs that Goldman is now accused of fraudulently peddling.
Goldman, by the way, while a convenient whipping boy, is not alone. The real problem is with these so-called “complex securities” that are in fact nothing more than a gambling contract designed and constructed in such a fashion as to make proper due diligence impossible. Some of these synthetics had literally 100,000 pages of referenced documentation related to them – how can anyone reasonably expect to read and understand that sort of paperwork?
Further, as I have written previously, these “Synthetics” are an inherently abusive construct in the first instance. They come into existence only because someone believes that the reference security or securities in question will decline in value to the point that a “credit event” will occur. In addition, under the claims made by the “intermediaries” the buyer of these synthetics is not entitled to know who the real party at interest is on the other side of the transaction.
This claim comes from the general view in the options and futures market. If I buy a PUT contract (betting that a stock will decline in price) I do not know who sold me that contract; ditto for futures (e.g. if I am long or short corn or oil, for example.)
But in these cases the security in question does not come into existence only because someone wanted to place a bet on the destruction of the underlying collateral.
In the case of these “synthetics” this in fact is very likely the case!
When a company goes public or issues a bond, thereby creating a security, the real party at interest and their intentions are known to everyone. When GE issues a bond for 10 years, as an example, we all know that the real party at interest is General Electric and they intend to use the money to fund their operations. You, as a buyer of that security at original issue, know that GE intends to pay and are acquiring to the capital for their operations.
Likewise, when a company issues an IPO, at original issue the securities are issued into the market (and sold to market participants) for the purpose of general working capital to further the enterprise.
Note that in both cases the real party at interest, and what their interest is, has been identified to the buyer of those securities.
We should not tolerate anything less for these so-called “synthetics”!
There is a huge difference between the secondary trading of a security once issued and its creation. Knowing who sold me the 5,000 shares of IBM I bought is not material to the transaction – we simply have a difference of opinion on the future of the company. I think the stock will be worth more tomorrow, the seller thinks it will be worth less. That’s all.
But when a security is created the real parties at interest and their economic position – that is, who they are and their motivation in getting involved in the transaction – is not only material to the transaction it is part of the essence of the transaction!
Hiding such information thus must always be prohibited as the only reason to hide such information is to commit a fraud upon the buyer or seller on the other side.
The reason the banks don’t like such rules is that if the real party at interest (in this case alleged to be the John Paulson hedge fund) and the essential purpose of the creation of the synthetic CDO (to place a bet on the detonation of the reference securities) were disclosed nobody would have bought it.
If that’s not the definition of fraud I don’t know what is. Let’s review – for there to be a fraud the following elements must occur (this is a condensation of the “nine points” in the legal definitions):
- A party must make a representation that is false (intentional omission is often good enough, in some contexts) and know that they’re doing so (if you are truly and not intentionally ignorant, you didn’t commit a fraud) with the specific intent of inducing the other party to rely on what has been said.
- That representation has to be material to the transaction – that is, if the other party knew about it, they would have not engaged in the transaction on the original terms (or at all).
- The person relying on the representation has to be ignorant of the falsehood (if I lie to you about some element of a transaction and you know I’m lying at the time, then you can’t later use the false claim. That is, you must actually rely on the false statement.)
- The person relying on the representation has to have the right to do so. In the case of a security this is simple – the offering documents are considered “inherently part of and material to the transaction.”
- Finally, you have to be victimized (that is, suffer an economic loss) as a consequence. It is not enough that someone lied – that lie has to cost you something of value (in this case, money.)
These sorts of synthetics are not at all similar to a “PUT”, a “CALL” or a futures contract – or, for that matter, a naked CDS! In all such cases the real intent of the person buying or selling is clear.
If I offer a short position in the S&P 500 futures, identifying me with specificity isn’t material – but the fact that I by doing so believe that the S&P 500 will decline in price is.
But with these synthetics what was not known was who led to the creation? Was Goldman Sachs, for example, creating the Abacus deals because they believed that the reference material would perform, or did they create them because someone wanted to bet against them – that is, they believed they would not perform?
We always know this when someone goes on a roadshow to sell an IPO or (real, not synthetic) bond deal. It is inherent in the capital structure being created – the seller has a real economic interest in success. Indeed, if they do not – if they IPO a company they know has no material value simply to loot the public I’ve committed securities fraud. In doing so I will have met all of the definitions above, in that I will have made (false) representations about my expectation for success, when I had no such expectation.
But when it comes to synthetic CDOs this is not clear. The entity at who’s behest the security was created may be on either side – that is, they may either hold the opinion that the reference securities will perform or that they will default. Unlike “real” (non-synthetic) CDOs, bond and stock offerings, one cannot infer the intent of the creator, and yet this is THE most material fact in the entire transaction – what the fundamental, underlying belief was of the entity that caused the security to come into existence!
In the 1990s investment banks brought literally hundreds of IPOs to market in which they had no reasonable expectation of business success, relying on the “brand integrity” – that is, the “good name” of the particular book-runners and offering managers, to get people to buy. Millions of investors bought predicated on ridiculous and outrageously-inflated expectations, all based on the imprimatur of these “investment banks”, and ultimately lost everything. These scams were uncovered during the .COM blowup when it came to light that the investment banks knew they were pumping garbage securities – emails and other communications came to light where the bankers were calling particular companies they were representing “trash”, “vomit” and other similar adjectives.
Yet very few went to prison.
That refusal to prosecute after the 2000 crash – a uniquely government failing – was in large part responsible for why we got into trouble this time. The bubble in housing and the markets, both stock and credit generally could not have inflated without these very same bankers creating all this “liquidity” by creating and selling securities that were once again, in many cases, described as “vomit” – in private.
If the SEC action taken yesterday remains a solely civil one, then we will not fix a damn thing. Fines will be paid and chuckles will ensue around the boardroom table.
These acts demand, as they did in 2000, criminal investigation and prosecution, including where appropriate charging the company, not just specific actors within the firm. Such charges should, if proved, result in the effective dissolution of the firms involved via the revocation of banking and securities licenses.
We cannot have a fair and free market economy, most particularly in the securities realm, unless those who invest and trade have good cause to believe they’re not being swindled. This confidence has been lost, and the blatant and outrageous refusal to clamp down after the debacle in 2000 was directly responsible for the depths of the latest collapse.
Ironically, it is also related to the huge stock market rally, as was demonstrated yesterday. When Goldman Sachs has their stock decline by $23.00, a 13% drop in one day, as a consequence of being potentially tagged for unlawful behavior in a civil venue, it tells you that much of the rise that has occurred in these firms’ stock prices happened because investors believe that their conduct would not be exposed and stopped.
That’s the sort of “market” that one has in a Banana Republic, not a nation governed by the rule of law.