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More Investment business perfidy

2008-11-12 19:54:08.332901+00 by Dan Lyke 7 comments

Goldman Sachs was just caught pushing CDOs as a hedge against the California municipal bonds that it was also selling:

Goldman stood to profit from several aspects of California's borrowing, which involves the sale of bonds to investors. First, it collected millions of dollars in fees for bringing the bonds to market and finding buyers. Then it marketed a financial instrument known as a credit default swap that is essentially an insurance policy against a bond default.

Via John Robb. Here's what I don't get, though: People seem to be pushing the notion of the CDO as "insurance", as if you'd buy California Munis, and then you'd buy a CDO to pay off in the event of failure. Where's the extra money coming from? I mean, if a bookie offers a payoff of 2 to 1 to both sides, there's no cut left for the bookie. I guess it kind of makes sense if the "against" bet is on catastrophic failure only, but it sure still seems like there are gamblers on both sides who are leveraged out and unable to pay if their bets fail because they believe that their bets can't fail. And that means we haven't hit bottom yet.

[ related topics: California Culture Currency Economics ]

comments in ascending chronological order (reverse):

#Comment Re: made: 2008-11-12 22:24:52.738797+00 by: radix

It brings to mind Eisman's words from the Portfolio article you linked:
“The single greatest line I ever wrote as an analyst,” says Eisman, “was after Lomas said they were hedged.” He recited the line from memory: “ ‘The Lomas Financial Corp. is a perfectly hedged financial institution: It loses money in every conceivable interest-rate environment.’ I enjoyed writing that sentence more than any sentence I ever wrote.” A few months after he’d delivered that line in his report, Lomas Financial returned to bankruptcy.

#Comment Re: made: 2008-11-13 04:52:39.102389+00 by: dexev [edit history]

Haven't read the article yet, so I'm not sure if this is your error or the original author's, but I think you mean CDS -- a Credit Default Swap, which behaves like you're describing. A CDO is a Collateralized Debt Obligation -- one of those 'sliced and diced' mortgage-backed bonds.

#Comment Re: made: 2008-11-13 05:46:11.009503+00 by: dexev


Yes, CDS acts like insurance. So the correct comparison is to a traditional insurance policy, not a bookie. I pay Amica some money every year for an insurance policy for my house. If my house burns down, where's the 'extra money' coming from? Presumably, Amica knows how many of the houses it insures are likely to burn down in an average year, and it sets its rates accordingly

The seller of the CDS (like GS) is selling policies for thousands of different bonds, only some of which are going to default.

I'm not sure, though, how CDS are related to investors/gamblers who can't pay out if they lose their bets -- other than giving them one more kind of rope to hang themselves with.

#Comment Re: made: 2008-11-13 12:39:43.200356+00 by: andylyke [edit history]

The CDS is like insurance, but not really, because if they called it insurance, then there would be government oversight, standards, rules, and so forth. Consequently, the financial geniuses deliberately set up these "insurance-like" instruments that didn't have to be backed by real worth in reserve. Likewise, Nationwide and other insurance-writing non banks were relieved of the oversight that depository and commercial banks work under, so could write mortgages with no standards of financial soundness, and sell them to investment banks, hedge funds, and other "outside the radar" institutions.

Sometimes being the most creative society on earth has its merits, sometimes ...

Also in the area of insurance - Atlanta's MARTA (think "BART") is in danger of bankruptcy because it can't find anybody to insure its bonds. So do we need somebody to insure the insurer of the insurer who insures municipal bonds now??

#Comment Re: made: 2008-11-13 12:46:49.995043+00 by: meuon

And historically, Muni Bonds were a very safe investment because of the power to tax a population to repay debt. Of course, even that is a house of cards.

#Comment Re: made: 2008-11-13 14:21:31.002575+00 by: radix

andylyke - do you have a cite for that MARTA news? I work right across the street from their headquarters.
wrt municipal bonds.. MBIA and AMBAC's problems froze the market pretty hard, but Buffet started a new insurer (http://en.wikipedia.org/wiki/Berkshire_Hathaway_Assurance) that is rock solid. So if a govt can't get insurance for its bonds, its a revenue issue, not a credit freeze issue.
I find it interesting that insuring municipal bonds is so important that another business will be started. Why isn't that an answer to the idiot banks and automakers? If they're so screwed up, it looks like it would be a fantastic opportunity to start a business(without a) all the bad debt or b) all the stupid UAW agreements) and take market share. I'd much prefer the 'fund new entrants' idea to the 'prop up failed businesses' idea.

#Comment Re: made: 2008-11-14 07:24:46.757484+00 by: dexev

Andy: it's my understanding that the oversight on banks is much more on the deposits side than the lending side -- that is, real banks were just as free to make stupid lending decisions (hi, WaMu!, hi, Wachovia!) as anyone else was

As far as having funds 'in reserve', that's not limited to CDS or insurance or...well, the money you 'have' in your checking account. Since 199x, banks have been allowed to reserve only against the portion of your account that you're statistically likely to withdraw. Add in some automated analysis, and...reserves? we don't need no reserves!

Radix, et al.: Municipal bond insurance is mostly a ratings game. Some (most?) governments don't meet the criteria for a triple-A credit rating from a ratings agency. Many large investors (think pension funds) require a triple-A rating for bonds they hold (that hasn't worked out so well for them, though...) So gov'ts "buy" the rating by getting insurance from a triple-A rated insurer.

The trouble with the bond insurers is that (surprise!) they got greedy and started writing insurance on things riskier than municipal bonds -- like Alt-A mortgage-backed securities. The municipal insurance side of the business was, for the most part, healthy. But when the other side started having to pay out on all of it's policies -- pop! goes the capital and with it, the triple-A rating.

I'd also like to see a link for MARTA's troubles -- it seems bizarre, and a quick link didn't turn anything up.