Streetwise Professor

May 12, 2010

Treacherous Waters

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 5:21 pm

No, this isn’t another post about Somali pirates.  It is another post about criminal investigations of financial institutions, relating to their involvement in synthetic CDO on MBS transactions.  This time it is Morgan Stanley in the cross hairs.

The WSJ article is maddeningly short on details.  For instance, it states that there was an option feature in the deals (“a structure that could increase the magnitude of the bullish investors’ exposures to the underlying mortgage bonds”) but it doesn’t say who had the option–the buyer or the seller.  Not that it matters if the feature was in the contract and the parties both knew about it.

These are treacherous waters for several reasons.  First, the WSJ article suggests that the crime is being short and making money on a deal.  Look, with a synthetic CDO there’s always a short.  Even the accusations against Goldman look sketchy; the allegations here look even sketchier because there’s no indication of a Paulson lurking in the background.  And even if MS was short this deal, the article suggests that it was actually net long mortgages.  Is it somehow a crime to reduce length by shorting?  How would that be different than selling some of the mortgage positions it already held?  And even if the short was a speculation not a bet–should that even matter?  But given the superheated atmosphere in Washington, the routine demonization of shorts in general, and the special demonization of those who shorted CDO on MBS (even if on net you were long), you can’t rule out the possibility that shorting itself is the crime.

Does this mean that markets should only have buyers?  Just asking.

Second, as I wrote in my piece on the Goldman criminal investigation, a criminal case against a big financial firm could cause it to unravel, with knock on effects hitting other institutions it trades with, and other entities that buy its paper.  In brief, a criminal case could cause a systemic event.

This is all the more true inasmuch as it appears that the inquiries regarding CDOs are widespread, and touching virtually ever major financial institution.  This could become the mother of all systemic crises.  Given the serious potential fallout, it better damn well be that shorting itself is not the crime.

Michael Lewis makes this trenchant observation, in a mock memo to Lloyd Blankstein:

This time, please, do not wait five months to internalize my new action items. They are:

No. 1: Implicate the rest of Wall Street, as quickly as possible.

It’s always unnatural to hear the name of Goldman Sachs in the same sentence as Deutsche Bank, much less Merrill Lynch. We must put aside our revulsion. The American people might enjoy seeing one firm being driven out of business by a criminal investigation. They’re less likely to allow for the destruction of every big Wall Street firm. They just forked over trillions to keep them afloat.

If being short is the crime, certainly all Wall Street can be implicated.  Or maybe the name given to the deals (“The Dead President” deals, since they were named Buchanan and Jackson*) is the sin.  Sounds bad, must be bad.  (This actually seems like something out of Camus, like in The Outsider.)

Look, this is deadly serious business.  There better be something really substantial in any indictment: and no, being short deals with bad names doesn’t count as substantial.

And even if there was wrongdoing, as I wrote in the Goldman post, indicting firms is an inefficient way to go.  Let those allegedly victimized make their case in court and collect damages.  The fallout from criminal indictments would be disproportionate and indiscriminate.

* It would be ironic if a deal named after Andrew Jackson would bring down a big bank.  And who in their right mind would name anything after James Buchanan, arguably the worst president in US history/

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2 Comments »

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    Pingback by Tweets that mention Streetwise Professor » Treacherous Waters -- Topsy.com — May 12, 2010 @ 7:56 pm

  2. The article in the Journal is maddeningly short on details because any indictment will have to be maddeningly short on details. What they are complaining about isn’t well established in case law. It is one of those “feels wrong” type of criminal offenses that aren’t codified in statutes or in case law. Populist sensitivites are offended by the events that occurred during the latest financial crisis. “Obviously” someone has to be responsible. Goodness knows these events aren’t caused by collective negligence or bad policy promulgated by Congress (cough*subprime loans by fannie and freddie*cough).

    When we seek to assign blame and also refuse to recognize where blame actually should fall, we will inevitably accuse those who are not to blame. Turning good renters into bad homeowners in the name of national policy lead to the creation of bad MBS and CDO offerings. Ignoring the fact that the SEC, FINRA and the FDIC are ineffective (at best) is not doing us any good. Seeking to give politicians (yes, the same politicians who made bad political decisions in the guise of good economic policy) and bureaucrats more power with no accountability will only make matters worse.

    We haven’t even reached the end of the beginning in our quest for reform of our financial markets. We still lack the national will to discuss the problem honestly.

    Comment by Charles — May 13, 2010 @ 4:15 pm

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