Technicalities
John Carney has some interesting commentary on the first day of the Financial Crisis Inquiry Commission hearings. He writes:
A structured credit product—whether its as simple as a mortgage backed security or a complex CDO—is not necessary flawed if it produces losses. Even enormous losses. Indeed, it might be perfectly well-designed but still deliver the buyers losses.
The point of creating structured financial products is to create exposures to certain risks and opportunities. A mortgage backed security, for instance, might be designed to expose buyers to subprime mortgages. If it is well-structured it will expose its owners to the upside and downside of the mortgages pooled within it.
Of course, a financial product can be badly designed. It could fail to track the performance of the mortgages it was meant to. This tracking failure is one of the big critiques of many ETFs, some of which are poorly designed. This was not the problem with the credit products sold by Goldman—they went down when the housing market collapsed and the mortgages backing them went sour.
When Goldman was selling the financial products, it wasn’t necessary telling the buyers that these were great investments. It was telling them that they were investments that would give them the exposures they were looking for. If you were bullish on the mortgage market and a skeptic of the Bubble Thesis—a thesis that Goldman had very publicly embraced—then buying mortgage backed securities from Goldman was a way to put that bullishness into action.
Angelides, the former California state treasurer, just has too much of paternalistic world view to understand that it is possible to sell a financial product without believing the buyer’s rationale for buying it.
This really is the heart of the matter. Angelides thinks it is wrong for Goldman to underwrite financial products that create exposures it does not want for itself. As long as Goldman wasn’t lying to clients or over-hyping the financial products—and so far, no one has shown any evidence of this—there’s nothing really wrong with what Goldman was doing. If sophisticated investors want to take on risk, they should be permitted to.
There is nothing wrong with a firm selling exposure to assets that it does not want (the crux of the securitization business) or the idea that good products with good collateral behind them can be money-losing investments.
However, I do not find John’s defense of Goldman or his assault on Philip Angelides’ regulatory acumen convincing, not because of his principles, which, for the most part, I agree with. Instead, I think that thesubprime mortgage business and the manner in which those loans originated, were acquired, securitized and sold was a significant abandonment of those principles.
If it is well-structured it will expose its owners to the upside and downside of the mortgages pooled within it
Qualitatively neutral descriptions of what structured products should or should not do, while helpful to those without a financial background, are not helpful in this particular instance. As housing prices rose and subprime mortgage lending dramatically increased in volume, the business became rotten to the core. Mortgage fraud rose dramatically. Lending standards vanished. Loans were made to just about anyone who had a pulse and could sign their name to a sheet of paper (i.e. the strawberry picker making $14,000 per year getting a $720,000 home). Home values were rising to unprecedented levels. Collateral from this storm was piling into these products. Wall Street firms were buying these loans in massive quantities.
The firms did little due diligence on the quality of these loans. Furthermore, the firms tasked with evaluating the loan pools were 1) working in an environment where the incentive was to sign off on as many loans as possible (quantity vs. quality) and 2) evaluating a representative sample of the total pool (the sellers were able to impose this condition because of the competitive environment for their product). This is all detailed in Chain of Blame by Paul Moulo and Matt Padilla. Investors were clamoring for product and Wall Street simply churned it out from whatever source they could acquire with little to no regard for the underlying quality.
The banks didn’t know (or worse, didn’t care) what they were piling into these securities and then strong-armed the rating agencies into giving these securities the coveted AAA ratings so that the pool of possible investors would be as large as possible. So no, they did not just create securities to fill a market demand. They were also working to present the most optimistic risk picture possible.
Given what happened to the mortgage markets, I see nothing paternalistic about grilling the banks about how this business was carried out for mortgage products. Angelides’ words may have been poorly chosen, but this doesn’t get the banks off the hook for their role in the securitization crisis, even if their actions were technically legal.
