The issues go beyond fraud and strike at the heart of how capital markets work
FIRST, a quick re-visit of subprime mortgages. These were packaged together and then resold as collateralised debt obligations (CDOs), which carried higher interest rates than the mortgages based on the principle that diversification reduced risk.
But when you diversify assets you must have different kinds of assets. You could diversify within property but concentrating assets in less than prime real estate where default risk is relatively high is not the best way to do it.
To make these instruments more palatable, investment bankers such as Goldman Sachs and others got the largest insurer in the world, AIG, to insure them, and why they agreed is anybody’s guess.
To make matters worse, what happened was the creation of synthetic CDOs which effectively gives a holder exposure to the CDOs without actually owning any of the securities issued in relation to the CDOs. This is done through the issue of credit default swaps or CDS, a derivative product.
While the actual operations of these are complex – even some of the bankers could not understand these - their effects are not difficult to understand. Basically, a large number of institutions took leveraged bets by buying these instruments both for capital gain and yield.
When the real-estate bubble burst, the loss was greater than the loss in the value of the real-estate assets because derivative instruments traded based on these assets far exceeded the value of these assets.
Not surprisingly, those who were left holding the assets and the derivatives collapsed – some of the biggest names in the US – requiring an unprecedented rescue by the US government, which effectively injected hundreds of billions of dollars directly.
The latest episode, where the US Securities Exchange Commission or SEC is filing civil action against Goldman Sachs for fraud may well be the tip of the iceberg and eventually other financial institutions may be similarly charged.
But really, for those who watch the financial markets and the predatory types of profits that hedge funds, investment banks and others were seeking by engineering all kinds of incomprehensible financial products and market manipulation in some cases, this action comes as no surprise.
That Goldman Sachs may have sold a financial derivative to one client while helping another client short the product is quite a clear example of how the company took money from both sides. The end result was the hedge fund that took the opposite bet made US$1bil at the expense of other investors.
It is pretty difficult to estimate how prevalent this practice was among other investment banks but this action by the SEC is going to put a lot of them under the microscope.
Public opinion is already against the financial shenanigans that brought the mighty US financial institutions to their knees and this latest episode will make it even more so.
One good thing that hopefully will come out of this is that the authorities in the US will no longer be duped by the capitalism mantra into believing that deregulation is the way to go.
Events in recent times clearly show that those institutions that take massive deposits from the public must be closely watched to see what they do with that money and what kinds of products they put on the market and the kind of risks they carry.
Profit is fine so long as it is within the limits of the law, is ethical, within the limits of acceptable risk and does not destroy the very fabric and functioning of the markets from which it comes. More than anything else, both individuals and institutions have to be held to greater account in their behaviour.
There, here and everywhere one thing must be kept in mind: the role of the capital markets is to efficiently intermediate the allocation of capital between those who have too much of it and those who have too little of it. Profits are merely the by-product of this.
A Question of Business
● Managing editor P. Gunasegaram feels that too often we do not see the forest for the trees.
FIRST, a quick re-visit of subprime mortgages. These were packaged together and then resold as collateralised debt obligations (CDOs), which carried higher interest rates than the mortgages based on the principle that diversification reduced risk.
But when you diversify assets you must have different kinds of assets. You could diversify within property but concentrating assets in less than prime real estate where default risk is relatively high is not the best way to do it.
To make these instruments more palatable, investment bankers such as Goldman Sachs and others got the largest insurer in the world, AIG, to insure them, and why they agreed is anybody’s guess.
To make matters worse, what happened was the creation of synthetic CDOs which effectively gives a holder exposure to the CDOs without actually owning any of the securities issued in relation to the CDOs. This is done through the issue of credit default swaps or CDS, a derivative product.
While the actual operations of these are complex – even some of the bankers could not understand these - their effects are not difficult to understand. Basically, a large number of institutions took leveraged bets by buying these instruments both for capital gain and yield.
When the real-estate bubble burst, the loss was greater than the loss in the value of the real-estate assets because derivative instruments traded based on these assets far exceeded the value of these assets.
Not surprisingly, those who were left holding the assets and the derivatives collapsed – some of the biggest names in the US – requiring an unprecedented rescue by the US government, which effectively injected hundreds of billions of dollars directly.
The latest episode, where the US Securities Exchange Commission or SEC is filing civil action against Goldman Sachs for fraud may well be the tip of the iceberg and eventually other financial institutions may be similarly charged.
But really, for those who watch the financial markets and the predatory types of profits that hedge funds, investment banks and others were seeking by engineering all kinds of incomprehensible financial products and market manipulation in some cases, this action comes as no surprise.
That Goldman Sachs may have sold a financial derivative to one client while helping another client short the product is quite a clear example of how the company took money from both sides. The end result was the hedge fund that took the opposite bet made US$1bil at the expense of other investors.
It is pretty difficult to estimate how prevalent this practice was among other investment banks but this action by the SEC is going to put a lot of them under the microscope.
Public opinion is already against the financial shenanigans that brought the mighty US financial institutions to their knees and this latest episode will make it even more so.
One good thing that hopefully will come out of this is that the authorities in the US will no longer be duped by the capitalism mantra into believing that deregulation is the way to go.
Events in recent times clearly show that those institutions that take massive deposits from the public must be closely watched to see what they do with that money and what kinds of products they put on the market and the kind of risks they carry.
Profit is fine so long as it is within the limits of the law, is ethical, within the limits of acceptable risk and does not destroy the very fabric and functioning of the markets from which it comes. More than anything else, both individuals and institutions have to be held to greater account in their behaviour.
There, here and everywhere one thing must be kept in mind: the role of the capital markets is to efficiently intermediate the allocation of capital between those who have too much of it and those who have too little of it. Profits are merely the by-product of this.
An “octopus wrapped around the face of humanity” as one journalist put it; the New World Banking Order has arrived. In 2009 speculative, uncontrolled derivatives were the Worlds largest market at an estimated 600 Trillion. The Worlds total economic output was an estimated 58.07 Trillion and the total World bond market was an estimated 82.2 Trillion. Yet, there is no “crime” that the bankers can be charged with as they bankrupt citizens and Nations into the New World Order?
ReplyDeleteThe appropriate criminal charge should be Treason to the American People and our Democratic Republic and Constitution. The members of the Trilateral Commission and the Bilderberg Group in government and banking who conspired to overthrow our soverenity as an independent nation, who conspired to bankrupt our Treasury with three unjust Wars and multinational corporate “rolling” bailouts, conspired to control mass media “free Press” propaganda, conspired and manipulated “financial crisis” for their own gain, conspired to “relocate” American industry and technology, conspired to offshore “American Income Tax”, and who have conspired to enslave American citizens with National debt (about $64,000 per citizen) and personal debt. Deserve the death sentence by firing squad for Treason.
Obama, your New World Order is Totalitarian and we Patriots, American free citizens, will fight for our Democracy, Independence and Freedom.