Paulson and Goldman

Brad DeLong has a great post (by an anonymous commentator) about why Goldman might really be innocent.

Consider the view from Goldman Sachs. Paulson shows up, says he thinks the subprime market is going to crash and is going to crash hard and is going to crash soon and wants to start laying big bets to that effect. GS goes out, runs the numbers, tests the market, and decides that yes, they can create a great deal of AAA securities plus an equity tranche out of the long side.

The AAA securities will really be AAA securities: minimal risk. Thus they can be sold off at a healthy price to those who want AAA securities. This will burnish the reputation of the firm--look! we made some more AAA securities for you!--in a market that really likes AAA securities and is short of them. And the buyers will be happy because they will get Treasury+5 or Treasury+10 basis points on their cash without risk.

The equity tranche--well, there is a healthy carry trade associated with it in the short run. The short-term earnings from that carry trade will mount up over time, and will more than offset the losses even if the subprime market crashes. Only if the market crashes and not only crashes but crashes hard and crashes soon and moreover crashes freakishly hard and freakishly soon will the equity tranche be a loser.

The overwhelming probability, GS thought, is that Paulson will be the loser--but because his expectations are irrational he's willing to take the short side. So the important thing is to keep this big fish who promises to give us lots of money on the hook. Let him pick the underlying securities--it really doesn't matter, and it gives him the illusion of an edge. Don't bother telling Paulson's role to IBX and company--it really doesn't matter, and it might spook them off and then we might lose the real pigeon while we hunt for more counterparties to take the long side.

Clearly at the time most thought Paulson was out of his elements. This is quite clear in Zuckerman's The Greatest Trade Ever. Maybe Goldman thought that Paulson was the sucker. Somebody has to be wrong in these bets.

Cowen reviews 13 Bankers

Tyler Cowen has an interesting review on the Johnson-Kwak book, 13 Bankers.

Synthetic CDO's and Bubbles

There has been a chorus lately arguing that synthetic CDO's fueled the bubble and made the subprime debacle much worse. For example, Felix Salmon writes:

Then, after AIG exited the market, everything should have ground to a halt. But it didn’t, because banks continued to build synthetic subprime CDOs out of the credit default swaps which were being bought by Greg Lippmann and others. The demand for those CDOs from investors like Wing Chau was enormous, and helped to ratify the valuations that everybody else was placing on their own subprime assets. Remember that this is a market with almost no pricing transparency in the secondary market: because all securitization deals are unique, the only way to get a feel for the health of the market is by looking at where primary deals are pricing. Whenever anybody said that the marks being put on subprime assets by banks and hedge funds were delusional, it was easy to point to the booming market in synthetic subprime CDOs to prove them wrong. No one, of course, remarked on the irony that the synthetic subprime CDO market was only booming because John Paulson and others were providing a huge amount of demand for bearish bets.

Or Roger Lowenstein in the NYTimes,

While such investments added nothing of value to the mortgage industry, they weren’t harmless. They were one reason the housing bust turned out to be more destructive than anyone predicted. Initially, remember, the Federal Reserve chairman, Ben Bernanke, and others insisted that the damage would be confined largely to subprime loans, which made up only a small part of the mortgage market. But credit default swaps greatly multiplied the subprime bet. In some cases, a single mortgage bond was referenced in dozens of synthetic securities. The net effect: investments like Abacus raised society’s risk for no productive gain.

And the famous ProPublica article on the Magnetar trade makes the same point too. Yves Smith at Naked Capitalism I think is the originator of this argument, or at least heralded as so. I presume one can also find it at Baseline Scenario, since it follows that bankers are evil. Or Felix Salmon again.

But I cannot understand the argument. When CDO's are created that finance mortgages and other asset purchases one gets price appreciation in the underlying asset that creates a bubble. When the asset price collapses there is a destruction of wealth. With a synthetic CDO, on the other hand, there is no underlying asset appreciation. The accusers all claim that synthetic CDO's are just bets. But if they are just bets then they lead to a transfer of wealth, not a destruction of wealth. Those on the long side who lost transferred wealth to those on the short side who won. But no amount of betting like that can cause a financial crisis.

If betting on the Kentucky Derby multiplied ten-fold would that cause a financial crisis? Hard to see how. Then how does the proliferation of synthetic CDO's make the underlying losses any bigger? I cannot see that. Perhaps the losses were concentrated in some banks that were too big to fail, but that is not what caused the crisis.

I don't understand why this argument has taken off, except that it makes banks look evil I suppose.

Greek Tragedy Spreading

Peter Boone and Simon Johnson reflect on the implications of the Greek bailout for Portugal and the EU. Key highligh:

The bailout of Greece, while still not fully consummated, has brought an eerie calm in European financial markets. It is, for sure, a massive bailout by historical standards. With the planned addition of IMF money, the Greeks will receive 18% of their GDP in one year at preferential interest rates. This equals 4,000 euros per person, and will be spent in roughly 11 months.

Despite this eye-popping sum, the bailout does nothing to resolve the many problems that persist. Indeed, it probably makes the euro zone a much more dangerous place for the next few years.

The key problem now is how to control fiscal profligacy. There seems to be no restraint, especially if the EU will bailout anyone who gets in trouble. As Boone and Johnson note:

Pity the serious Portuguese politician who argues that fiscal probity calls for early belt tightening. The EU, the ECB, and the Greeks have all proven that the euro zone nations have no threshold for pain, and EU money will be there for anyone who wants it. The Portuguese politicians can do nothing but wait for the situation to get worse, and then demand their bailout package too. No doubt Greece will be back next year for more. And, the nations that “foolishly” already started their austerity, such as Ireland and Italy, must surely be wondering whether they too should take the less austere path.

The question is how long with Germany be willing to live with this system.