Okay, so after years of inaction, the SEC has finally taken the offensive. True, they went after a small deal, a mere billion in “designed to fail” CDO's on which Goldman Sachs made a paltry $15 million, an amount which, in the overall scheme of these frauds, doesn't even amount to a rounding error, as Gretchen Morgenson pointed out. Still, it's enough to damage the reputation of Goldman Sachs, perhaps fatally, and perhaps enough to re-establish the SEC as a regulatory force. However, there is a deep problem: what should the regulators be regulating?
We live in an age of regulation. But surprisingly, there are very few principles of regulation. As Karl Polyanyi said, “Laissez-faire was planed; planning was not.” Planning always seems to be something that always arises ad hoc, to address a particular situation, but hangs on and acquires a life (and a bureaucracy) of its own, even after the situation changes. The result is that we are simultaneously over-regulated and under-regulated; we have thousands of pages of regulations that deal with situations that don't require any, and no regulation in areas that need to be closely watched. The regs raise formidable barriers to competition, as the small businessman often finds that the cost and trouble of dealing with them is an insurmountable barrier to entering a given business. This leaves only the large players, for whom such regulation is a mere nuisance, a cost of doing business that brings a benefit of reduced competition. And since there are fewer competitors, they tend to be more politically powerful, and proceed to capture the very regulatory bodies that are intended to curb them. The government becomes, in effect, the protector of the oligarchs rather than their regulator.
The current case is a case in point. We often hear how “complex” these schemes are, but in fact this fraud was simplicity itself. Goldman Sachs allowed a certain hedge fund trader, John Paulson, to put together a group of mortgages that would be packaged into a CDO, a “collateralized debt obligation” which was sold to Goldman's investors. However, Paulson was also known to be shorting the mortgage market. Paulson deliberately assembled a package of loans whose underlying risk was much higher than the credit ratings indicated. Goldman Sachs then marketed Paulson's poison-pill CDO to other banks, pension funds, and individuals. But Paulson, knowing the true risk of the security, purchased CDSs on the package. A CDS (“credit default swap”) is an insurance policy on a security that pays off when the underlying security fails. But the term “underlying security” is a fiction; Mr. Paulson did not own the CDO he was insuring. There was no “underlying security.” It is like buying a fire insurance policy on your neighbor's house, and hoping it burns down.
Goldman Sachs didn't bother to tell its investors that the CDO was put together by someone who was betting that it would fail. Instead, they said in their prospectus that it was put together by somebody else. Why they bothered with this lie is a bit of a mystery, since nobody ever actually reads a prospectus.
The man at Goldman responsible for selling these securities, Fabrice Tourre, knew they were about to fail. In an e-mail to a colleague, he stated,
More and more leverage in the system. The whole building is about to collapse anytime now... Only potential survivor, the fabulous Fab[rice Tourre]... standing in the middle of all these complex, highly leveraged exotic trades he created without necessarily understanding all of the implications of those monstrosities!!!"
You can bet that wasn't in the prospectus. But if there is one thing that both Democrats and Republicans agreed about in the 90's, it was that these “monstrosities” didn't need to be regulated. The market for them was composed of sophisticated investors who were more than capable of evaluating the risks and taking the losses, should their be any, and the public need not trouble themselves about such things. Senator Phil Gramm led the Republican efforts to deregulate this market, joined by such Democratic stalwarts as Robert Rubin and Larry Summers, and President Clinton signed the bill with little fanfare in 1999. But as things turned out, when the highly leveraged bets brought down the whole economy, the risks were socialized, and the profits were privatized. The US Treasury became the hedge funds Ultimate Hedge.
So what should the regulators be doing? One could pass this off as mere fraud, which is already illegal, but that would miss the point. The practice of touting such complex instruments to customers while shorting them in your own portfolio is common enough. Indeed, the appetite for these CDO's was immense, but the number of solvent borrowers in the mortgage market is limited. To meet the demand, banks and mortgage companies pushed their loan officers to ignore underwriting standards and to make as many loans as possible, prudent or not. For example, in one CDO examined by Roger Lowenstein, on 43 percent of the underlying loans, the lender hadn't bothered to verify the borrower's employment and income. These were part of the famous “Liar Loans” and NINJA loans (“No-income, no job or assets.”)
So what can be done, apart from sending a bank regulator on every loan interview? For one thing, we could listen to Aristotle on this subject. Not too long ago, a Prominent Economist told me that Aristotle had nothing to teach us about modern finance. I beg to differ; Aristotle, and the Scholastics who adopted his approach to economics, were surprisingly sophisticated on these topics, while so many Prominent Economists are surprisingly naïve. Indeed, Aristotle left us a principle of commerce that serves very well as a principle of regulation. This principle is the distinction he makes between natural and unnatural exchange. Modern commentators, who make no distinctions, have viewed this as a mere primitive hostility to business; actually, it was a shrewd appreciation of commerce. For Aristotle, natural exchange was that which was necessary for the provisioning of the family (the true meaning of economics.) Unnatural exchange that which had only money as it object.
The former is “natural” because it limits itself; that later unnatural because is has no natural limits. For example, a man wishing to buy bread for his family will buy only as much as he needs; this is a natural exchange. But a man wishing only to make money in the bread biz may wish to buy up all the bread and corner the market so as to raise prices and make a fortune on others' necessities; this is an unnatural exchange. When applied to finance, a transaction is natural when it is when it is firmly and directly tied to the production of some actual product; it is unnatural the more abstract and derivative it becomes, and when its only object is to make money rather than profit from production. Thus, we may say that banks directly financing home purchases or construction are natural transactions, and less natural when they become “securitized,” bundled together and sold in packages to remote investors who will have no contact with the actual homes, banks, or borrowers. The situation becomes even more abstract when you speak of securitizing the securities (“CDO-Squared” or even “CDO-Cubed”) or with CDSs, which become pure speculative bets on the market. The more abstract the instrument, the more closely it should be scrutinized.
As things now stand, we have reversed Aristotle's order: the natural exchanges are highly regulated, while the unnatural ones are often unregulated. In more normal times, when you went to George Bailey to get a mortgage, he squinted at you real hard to see if you are the kind of person who will pay him back for 30 years. George needs little oversight to encourage him to be prudent, since he has the bank's capital and the depositors' money at risk. But if George merely intends to securitize the loan, then he merely glances at you to see if you are the kind of person who will pay for two weeks, because after that you are somebody else's problem. In the meantime, dear old George has made a bundle on excessive loan fees and commissions on the sale of the security. George has every reason to write every loan he can, even liar loans, because they all bring him a profit, and he hopes he can park the loss with someone else. And even if he can't, he knows that the Fed is there to provide him with any amount of “liquidity” he may require, and if he gets big enough, he can always call on the United States Treasury, since the consequences of his actions will be catastrophic; he is in a position to blackmail an entire nation, or even the entire world.
Applications of this principle will be fairly obvious, in most cases. Take the example of CDSs. As an insurance policy, it is surely a natural exchange, a real service that guards against real loss. But when people insure things they do not own, the exchange becomes unnatural and the CDS becomes a mere speculative bet on a given market, one that produces no social gains. The rule should be a rather simple one: “No harm, no foul.” If there is no loss suffered, there should be no claim paid. If you do not own the failing security, you cannot claim a loss on it. Consider that at its height, the notional value of the CDS market was $600 trillion, or eleven times the GDP of the entire planet. Likewise, MBSs and CDOs, should be subject to heavy scrutiny, and even more so when they are squared or cubed; the amount of the regulation is given by their distance from the “real” transaction to which they refer.
In the bad old days, before we became enlightened, we had to think things through for ourselves. Now we have farmed the job out to experts who claim to understand the complexities that their own “expertise” created. In those times, philosophers did not hesitate to address themselves to mundane subjects of commerce and kingship, and every theologian worth his stipend routinely addressed matters of state and business. It was considered part of their job. But the “experts” have, once again, botched things up; Fab Tourre failed to understand the monstrosities he created, although he did understand how to profit from them, at our expense; he was an expert in all the wrong things. It may be time to call again on the philosophers; the Prominent Economist may have to subject his thought to the theologian, the banker to the philosopher.
The SEC has finally moved, albeit somewhat after the fact. It may be merely a political ploy, a way for the Administration to put some pressure on the Republicans, who have vowed to stop any banking regulation, no matter what. The Administration will dribble out cases like this from now to election day, and will call some votes in the Senate that will be stopped short of action by the Republicans. They will force the Republicans to stop them from doing what they don't want to do, make real reforms. They can embarrass the Republicans, even in front of their Tea-Party supporters, while not actually having to take any action. Politically, it's a good deal, and may give them some leverage going into November.
But just in case anybody does want real reform, we might turn to those who have given the market real thought, thought that has survived 2,500 years of scrutiny. Bank regulation is a MEGO subject (“My Eyes Glaze Over”), and if you, loyal reader, have gotten this far in this essay, it is likely that you are a nerd or have mild Asberger's Syndrome; you may be the kind of person who would actually read a prospectus. But despite the lack of interest and understanding, we must have some public interest in these things, apart from the “experts” like Fabrice Tourre and John Paulson. We cannot do without a proper finance system. Between the planting and the harvest, there is a gap, and likewise between opening a production line and the sale of a product. This gap must be financed. But finance itself must be made to serve this gap, to bridge it for the common good. When it has no other point but to enrich the few at the expense of the many, then the real economy has no future, and if it has no future then neither do we, nor do our children. We could do worse than turning the system over to people who have read a little Aristotle and Aquinas.