Wednesday, January 20, 2010

I Thought It Was the Dadgum Librls That Didn't Understand Business

In today’s Wall Street Journal, columnist Holman Jenkins predictably defends investment banks such as Goldman Sachs from criticism of their despicable behavior leading up to the current economic crisis. Following the reasoning of other free-market ideologues that have backed the banks, Jenkins makes his claim using two points: First, that the investment banks sold their products to “professionals” that should have known better, and second, that investment banks always take positions counter to their clients' interests. These arguments demonstrate either ignorance about the investment banking business, or a willingness to mislead readers on how it really works.

Jenkins wrote:

“Goldman chief Lloyd Blankfein was understandably wide-eyed with wonder at last week's hearing of the Financial Crisis Inquiry Commission. He pointed out that the people on the other side of every Goldman housing-related trade were, for Jiminy Cricket's sake, professional investors.”
Many of the investment banks' defenders have used the “professional investors” argument, but it stands up neither to general nor specific critiques.

Generally speaking and contrary to popular belief, caveat emptor is not a well-established legal principle (thanks contracts class!). Professionals in other fields have many avenues of recourse when they are sold a defective product—just because you’re an expert doesn’t mean you’ve disclaimed all warranties (if this wasn’t true, we wouldn’t need lawyers). Certainly, if a supplier sold GM a faulty $1 part used in a Chevrolet, we wouldn’t want to shield the supplier from liability simply because there are automotive “professionals” that also work at GM. It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does. (These arguments also fail to take into account that Goldman is certainly much more sophisticated than many of the clients it sells to. Clients such as public pension funds in the middle of Wisconsin relied on these financial professionals to give them sound advice—not send them to the poorhouse.)

More specifically, the behavior as it relates to these complex financial products goes beyond investors making a bad deal — there is evidence of fraud and misrepresentation when it comes to creation of these products. Many of the bond insurers (who similar to AIG insured these CDOs) have gone back to find documentation for mortgages stuffed in CDOs is missing or falsified. It’s one thing to fault an investor for buying a product based on the assumption that housing prices will always go up. It’s quite another to assume that they should have been aware the purchaser of a home made only $50,000 per year instead of $100,000, despite an investment bank and its lawyers telling them the mortgage application said otherwise. It seems to me that the shady mortgage origination practices, rating agency bribery, and corrupt sales techniques practiced by investment banks has gone overlooked (or has been forgotten) in this discussion.

Jenkins’ second argument is no better:
“He might have added that Goldman bets against its clients every time it buys something they want to sell or sells something they want to buy. He might have suggested that any client who doesn't understand Goldman is looking after its own interests (just as Goldman expects the same of its client) is an idiot and has no business being in business.”
This line of defenses misses two key points about the issue at hand.

First, it doesn’t fairly represent what investment banks do when they make markets for their customers. When they buy a security from a client, they’re not making a bet on the future price path—they’re simply selling liquidity to the customer. In return for the service of buying at almost any time the client wants out of a product, the investment bank “charges” the customer by buying the security for slightly less than it’s really worth. It makes it money not by holding onto the bond and praying its price will go up, but rather by quickly flipping it to another client willing to pay full price.* This has nothing to do with taking a position opposite either client.

*The idea of a bid-ask spread is familiar to anyone that collected baseball cards as a kid and read Beckett's.

But even if we take the market-makers argument at face value, it really has nothing to do with the practice FCIC chairman Phil Angelides was referencing when he compared the investment banks to salesman who sold cars with faulty brakes while taking out insurance on the driver — the origination of complex structured finance product. In this case, the banks are not taking a position against the clients — they’re just selling them a product they created. Issuing a CDO of ABS is no different than taking a company public—except with more complex models and a lot more profit for the bank. Using investment bank’s market-making business is an attempt to excuse bank's behavior by shifting the argument to a completely different service the banks provide.

It’s unfortunate the much of the furor over investment banks have focused on their outrageous bonuses. Although most investment bankers are certainly overpaid and overconfident, it distracts the public, the media and even me (at times) from digging into the real questions about their business practices. I remain unconvinced that anything will be done to taking real steps to clean up this corrupt industry.

UPDATE: Principle not principal. Thanks to commentor Nemo on the Baseline Scenario for pointing that out.

5 comments:

JJones07 said...

It's not a corruption of industry if it's standard industry practice, right?

Sally said...

Honestly, I'd suggest that before you attack someone else's "ignorance about the investment banking business," you might want to make sure that your own post doesn't demonstrate ignorance about the invesment banking business.

First, CDOs don't contain warranties, champ. Neither do CDS. Nice try.

Second, this is just incoherent:

"It seems to me that the shady mortgage origination practices, rating agency bribery, and corrupt sales techniques practiced by investment banks has gone overlooked (or has been forgotten) in this discussion."

Investment banks generally don't originate the mortgages underlying CDOs -- and Goldman definitely didn't originate mortgages. And "rating agency bribery"? There is no evidence whatsoever that Goldman paid any illegal bribes to rating agencies. Making shit up doesn't usually make for the strongest argument.

"It eludes me as to why you’re liable if a $15 toaster blows up, but not if a $1 billion collateralized debt obligations of asset-back securities does."

If that's true, then, well, I feel bad for you. Truly. Because you clearly don't understand the difference between "design" and "performance." Every security, even if perfectly designed, still involves a material risk of loss. Seriously, read a prospectus. If perfectly designed securities were guaranteed to perform, then we wouldn't need money managers. Securities aren't toasters. (Here's a free tip: argument by analogy is never a good idea.) The idea that investment banks should be liable for the performance of securities they underwrite is just ridiculous. It demonstrates an almost comical "ignorance about the investment banking business."

In short, you obviously have no idea what you're talking about. Something about "glass houses" comes to mind.

Jack said...

Thanks for the comments.

My response:


"First, CDOs don't contain warranties, champ. Neither do CDS. Nice try."

I understand that. My point is that in many other industries we would never accept the argument that a producer of some broken good is not liable because it sold its product to other experts. Caveat emptor does not typically apply. Even when you don't make express warranties, there are implied warranties that default into contracts unless they are expressly written out of them.

"Investment banks generally don't originate the mortgages underlying CDOs -- and Goldman definitely didn't originate mortgages. And "rating agency bribery"? There is no evidence whatsoever that Goldman paid any illegal bribes to rating agencies. Making shit up doesn't usually make for the strongest argument."

I never said investment banks did originate the mortgages (although a number owned subsidiaries that did). I was merely pointing out this is one aspect of the crisis that not much has been written about recently

As for rating agency bribery, perhaps it was a bit of rhetorical flourish, but the fact remains that issuers pay rating agencies for ratings, work closely with them to achieve them and that there was at the very least a wink and a nod about the relationship. Hence the whole we'd rate these things if they were structured by cows e-mails.

"If that's true, then, well, I feel bad for you. Truly. Because you clearly don't understand the difference between "design" and "performance." Every security, even if perfectly designed, still involves a material risk of loss. Seriously, read a prospectus. If perfectly designed securities were guaranteed to perform, then we wouldn't need money managers. Securities aren't toasters. (Here's a free tip: argument by analogy is never a good idea.) The idea that investment banks should be liable for the performance of securities they underwrite is just ridiculous. It demonstrates an almost comical "ignorance about the investment banking business." "

I'd suggest this is more than securities not performing as expected, but that's just me.

Simple Simon said...

time for another spelling lesson
car have brakes. if the brakes are faulty you might break your nose when it crashes.

Jack said...

"if the brakes are faulty you might break your nose when it crashes."

Fixed. Thanks for pointing it out.