Monday, May 3, 2010

Unsafe At Any Price

This week, the Senate considers financial reform legislation. There will be discussion about leverage limits and capital requirements, whether we should break up the banks, and the powers of a consumer financial protection agency. One question that I have, that doesn't seem to be prominent in the congressional debate, is whether or not there are just some financial products that ought to be banned outright.

This American Life radio program had a great story a few weeks ago about a hedge fund that made millions of dollars after the housing collapse. They did this by buying credit default swaps (CDS). Those are the insurance policies on whether a pool of mortgages will default. The pools of mortgages are gathered together and then bonds are sold based on the income from those mortgages. The CDS is insurance against the bond losing value.

So far, so good. There is a solid case in favor of being able to bet against certain assets or firms. This act can spread information to the market and result in prices that more accurately reflect the value of a firm or a security. For example, if you thought an SEC civil case against Goldman Sachs was big trouble as soon as it was announced, you could bet against Goldman stock. When a subsequent criminal investigation was announced and the stock price dropped dramatically, you could make a lot of money.

What happens, though, if the securities in question wouldn't otherwise exist? In the case of a firm, there are people in the firm working to make it profitable. In the case of a bond backed by mortgages, that isn't always the case. In fact, it may be the case that some of these mortgage backed securities were built just so people could bet against them. In essence, they were built to fail.

That is the accusation against the hedge fund, Magnetar, that was featured in the This American Life show. Magnetar was involved in the creation of billions of dollars of mortgage backed securities through their willingness to buy a piece, the most risky piece in fact, of these securities. Without this willingness, it is doubtful that some of these securities would ever have come into existence. If the mortgages continued to pay, the bonds remained valuable, and Magnetar makes money on their investment. If the mortgages default, Magnetar makes money, a lot of money, on the credit default swaps (the insurance) they bought.

This American Life discusses how Magnetar was active in selecting the pool of mortgages that were bundled to make the securities they bought and that they bet against. In fact, some of their activity in selecting these securities suggests they were looking for quite risky pools of mortgages to be included. Risky pools that an investor whose main concern was the continued value of the bond might not want included. On the other hand, someone who had a financial interest in the failure of these bonds, might be perfectly happy to have such mortgages included in the pool.

The possibility that some securities were made just to fail, and then sold to investors without this fact being revealed is at the heart of the case against Goldman Sachs. Whether or not the non-disclosure of this fact is material, in a legal manner of speaking really doesn't matter to me at this point. It seems to defy common sense that someone selling a security that was built to lose value wouldn't have to disclose this to potential buyers.

But even more than that, is there any compelling case for the economic or social value of such securities? The fact that a few guys got rich seems little compensation. Did the existence of such securities dampen enthusiasm about housing and help to minimize the effects of the bubble? Maybe, but from our current perspective this seems like way too little, way too late. On the other hand, maybe such activity actually increased the size of the bubble by causing additional housing related securities to be created even as the market was collapsing.

Perhaps such securities are of little value while at the same time posing a substantial danger to the economy as a whole. If so, maybe they just shouldn't be allowed to exist at all.

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