EconomyBeat.org » banks

The Goldman Sachs fraud case explained

Jon Brooks — Mon, 19 Apr 2010 16:37:27 +0000

Time magazine describes the SEC fraud case against Goldman Sachs this way:

On Friday, the Securities and Exchange Commission (SEC) filed civil securities-fraud charges against Goldman Sachs, alleging the investment bank and its partners created mortgage bonds that were set up to go bust. Goldman then sold these bonds, which are called collateralized debt obligations (CDOs), to unsuspecting investors, who then lost $1 billion on the deal.

Economists Do It With Models tries to explain this in a little more detail and in layman’s terms:

Hedge fund guy: I think the housing market is going to go to s**t in the next few years. More specifically, I think I know which parts of the housing market are particularly vulnerable. In order to profit off of this information, I would like to short sell a financial product that is tied to the housing market. In other words, I’m going to borrow one of these securities, sell it at the current high price, buy it back once it’s worthless and then give it back to the original owner, keeping the profit for myself. (Update: Technically the short position was achieved via a credit default swap as opposed to a regular short sale. This doesn’t affect the overall analysis, and you can see my comment below for more detail.) Now, there are a few products out there that would be appropriate for this, but it would be totally better if I could design the product myself, since then I could be extra sure that it would tank as much as possible, thus maximizing my profit. Let me call my buddies at Goldman and see what they can do for me.

Goldman Sachs, to hedge fund guy: Sure, we can do that, just tell us what you would like the crappy product to look like. But wait a second…you do realize that it’s hard to short sell something unless other people actually hold the product in their portfolios, right? And who in their right minds would buy something that you, as a smart guy, specifically picked as being the bottom of the housing market barrel? That kind of throws a monkey wrench into your plan…but wait, I think we might have a solution to this problem. So here’s the deal – you’re gonna get a call from another financial firm, and you’re gonna tell them that you are looking to create a product to invest in. Now, this is technically true, so all you’re really doing is leaving out the teeny detail that you are taking a short position rather than betting on an increase in value. No big deal, right? Just tell them what you want in the product and they will make it happen.

Goldman Sachs, to other investors: Hey look, we have this new awesome product for you. The assets in the product have been hand-picked by an outside firm who specializes in this sort of thing, so you can be confident that’s it’s going to do well. *snicker*

And then, big shock, the product tanks, the investors lose over $1 billion and the hedge fund guy makes a corresponding $1 billion. Note that the real problem here is not that Goldman Sachs purposely created and sold a crappy product. The problem is instead one of asymmetric information, which in this case is the financial equivalent of Groucho Marx’ “I don’t care to belong to a club that accepts people like me as members” quote. Simply put, if you have a really smart guy trying to sell you something that he owns, he’d better have a good reason for needing to sell it, since otherwise you’re probably getting taken for a ride. This situation is a classic example of the lemons problem- you know, where the shady dude is trying to sell you his used car and not telling you that it’s been in 5 accidents and has a faulty transmission- except that we’re talking about a financial product rather than a Honda Civic with a rolled back odometer.

I try to generally be as objective as possible (and have in fact defended Goldman’s business practices in the past), so I want to stay way more out of the discussion of whether this is a sign that more financial regulation is necessary than Rachel Maddow does in the video above. I will, however, point out that what Goldman Sachs is accused of is already illegal under current law, so I’m not sure how new regulations in and of themselves would prevent this behavior. Cue the oversight conversation…

The Doom Cycle

Jon Brooks — Mon, 19 Apr 2010 16:07:40 +0000

Simon Johnson is a professor of entrepeneurship at MIT. In the video below he speaks about The Doom Cycle, described by the web site New Deal 2.0 as “the current boom-bust-bailout structure of the financial sector that leads to economic crises.” Johnson talks about the system of incentives to take greater and greater risks that has developed since the Reagan Revolution.

The “Doom Cycle” is one of the most significant ideas within the discourse on the current economic crisis. What the “Doom Cycle” offers is an explanation and a solution to the current financial crisis and the conditions which helped to create it. The “Doom Cycle” serves as a framework through which we can begin to address the economic condition of America in the twenty-first century. If we are to avoid another financial meltdown, leading thinkers believe that serious reforms are necessary. Without them, another, worse crisis may be inevitable. Through this idea, we gain a paradigmatic view of the financial system, and are able to understand the attitude and atmosphere that fosters a cycle of risk, gain, and collapse.

Dismantling consumer protection – a history

Jon Brooks — Mon, 05 Apr 2010 17:38:06 +0000

“Federal regulatory functions all had become dominated by political pressure from the providers of services promulgating ‘free markets’ and ‘lifting the regulatory burden’, greased by millions of dollars of campaign contributions and lobbying.”

One of the sticking points in the Senate in enacting the financial reform bill is the creation of a new consumer financial protection agency, which Republicans have ardently opposed.

This post by former World Bank and Federal Reserve economist Barbara N. Opper, on the financial sector policy blog Finance: Facts and Follies, summarizes the dismantling of consumer protections in the mortgage and credit card industries in the 2000s.

Many of the steps violating unsophisticated consumers’ protections against predatory lending came from a cascade of federal, not state, regulatory actions and legislation.

The financial industry’s influence on Washington, evident in the late 1980s when Alan Greenspan went to Chair the Fed, gained momentum between 2000 and 2008 when the industry ‘captured’ the administration and Congress. Investors sophisticated or not lost protection, as did consumers, especially the unsophisticated. As the famous post-Napoleon expression goes, this was “worse than a crime it was a blunder” because US financial institutions’ ability to attract profitable business worldwide rested on the trust that had been the outcome of our once-effective regulation.

To set the stage, in the 1970s a lot of consumer protection came into place. States enacted “Truth in Lending Laws” and the Fed was to handle consumer protections related to bank lending. By then, 64% of residents owned their homes, financed by self-amortizing home mortgages most of which carried fixed rates. With regulators enforcing strict underwriting standards, delinquency and foreclosure rates were very low. Credit cards were issued only to those with very strong credit records.

So when we started hearing about consumers being lured into very disadvantageous credit card and mortgage loans, it was reasonable to ask how so much predatory lending could prevail against Truth in Lending and other consumer protection in place. The answer is two rulings from the Office of the Comptroller of the Currency (OCC). One in 2003 prohibited states from enforcing their own truth in lending laws. Eliot Spitzer, former NY State Attorney General, said “Not only did the Bush administration do nothing to protect consumers, it embarked on an aggressive and unprecedented campaign to prevent states from protecting their residents from the very problems to which the federal government was turning a blind eye … all 50 state attorneys general and all 50 state banking superintendents actively fought the new rules.” It took until June 29, 2009 for the U.S. Supreme Court to rule in favor of the states. The other, in 2004, prohibited state bank supervisors from inspecting, supervising and overseeing national banks located in their state.

The impact of this regulatory approach on the examination and supervision functions should not be ignored. Examiners used to look at samplings of loan underwriting that would have caught “liars’ loans”, no-down-payment loans, wishful thinking property valuations, and other abuses of the go-go-mortgage lending years from 2003 to 2008. Instead, they focused more on the way banks handled Bank Secrecy Act and Patriot Act laws monitoring customer transactions.

Between 2000 and 2008, the economy was stagnating. Encouraging consumption with ready access to debt evidently turned into a policy tool to maintain economic growth. Household debt doubled. That growth was fueled not just by mortgages but also by credit card use as federal regulators looked the other way while credit cards were issued to youth and other elements of the population ill-equipped to handle such ‘easy’ credit. By then, states could not effectively offset federal regulators’ inaction because of the OCC rulings and the domination of the banking industry by national banks. Also, interest-sensitive home building with its collateral durable goods purchases is always a standard Fed policy tool. With more-than-accommodative monetary policy and lax underwriting standards, home property values rose at a pace never before seen. This was the kind of bubble the Fed was created to prevent. It was possible to track GDP growth with and without consumption fueled by home-equity draws.

Securitization was once a reasonable approach to improving the marketability of a home mortgage portfolio but it became destructive. One reason is lenders’ eliminating the free prepayment option to improve predictability of the payment stream for the investor. That removed a long-standing valuable right of borrowers, especially those who woke up too late to the predatory terms of their mortgages.

Many criticize the patchwork of overlapping banking regulatory authority involving several federal agencies and the state where a bank did business. But these two OCC rulings show the value of that overlap. Federal regulatory functions all had become dominated by political pressure from the providers of services promulgating ‘free markets’ and ‘lifting the regulatory burden’, greased by millions of dollars of campaign contributions and lobbying. If it had not been for these two OCC rulings, state authorities could have prevented the predatory terms foisted on unwitting borrowers.

The United States system had been designed by people who understood the dangers of concentration of wealth and power, moral hazard, conflict of interest and self dealing. It was a lesson learned from the Pecora hearings, and is the lesson to be relearned by the Angelides Commission.

The dirt on JPMorgan Chase

Jon Brooks — Wed, 24 Mar 2010 11:28:57 +0000

We first found this on The Awl. It’s a photo of what’s described on the blog I ought to be working as a pile of manure left in the entrance of a Chase Manhattan bank ATM at 10th street and 2nd Avenue in Manhattan, with this explanation:

This happened across the street from my apartment. The protest happened yesterday. Chase is one of the biggest investors in mountain top removal mining. The protesters said they would leave a mountaintop in every Chase.

The blog EV Grieve, however, clarified that the pile was actually dirt, and a comment there directed us to the Reverend Billy, an activist/performance artist famous for his stunts targeting American corporations. Here is the Reverend and his choir doing their thing at Chase:

More on that protest from the Reverend Billy site. And the Rainforest Action Network has a page called JPMorgan Chase, Banking on Dirty Energy, which claims “JP Morgan Chase is the largest US bank financing mountaintop removal coal mining, which literally involves blowing the tops off historic Appalachian Mountains and poisoning drinking water to extract a relatively small amount of dirty coal.”

In the interest of providing equal time, here’s JPMorgan Chase’s 2008 Corporate Responsibility Update. But let’s face it, without the singing and dancing, it’s a tough slog…

“Lookin’ Like a Fool With Your Money in the Bank”

Jon Brooks — Wed, 03 Mar 2010 21:32:38 +0000

I was in my credit union to do some banking recently and I asked the guy helping me if he’d seen an uptick in new customers lately. “Definitely,” he said. “A lot of people are coming in from the big banks, because they said they read about doing it on the Web.”

Two months ago we did a post about the Move Your Money site, a project started at the Huffington Post with the goal of encouraging people — and in some cases universities and even cities — to move their money from the big financial institutions at the heart of the 2008 financial crisis to local credit unions and community banks.

Since then, some in the media have caught on to the story, and the Move Your Money Facebook page has grown from 5000 to 33,000 fans. (One person not a fan, apparently: Timothy Geithner, who said he didn’t think this was a good idea when asked about it during an interview with Politico. Start watching at 3:40.)

There’s also a contest afoot to come up with the best song called “Lookin’ Like A Fool With Your Money In a Bank,” based on Larry Platt’s “Pants on the Ground” audition for “American Idol.”

Two entries:

Clearly, Geithner hasn’t seen these yet, or he wouldn’t be such a sourpuss.

The bigger they are, the harder they charge

Jon Brooks — Mon, 01 Mar 2010 17:39:22 +0000

How much do you pay at your bank for overdrafts, bounced checks, and stop-payment orders?

From the Move Your Money project, this graph of average fees by size of financial institution. As you can see, banks classified as “giant” charge as much as 30% more than those deemed small for these services.

Accountability, banks – see “Lack of”

Jon Brooks — Wed, 06 Jan 2010 21:55:20 +0000

From The Big Picture blog, a post called Banking Sector Remains (literally) unchanged:

Ever wonder why the banking sector continues to operate as it always has?

Here’s a possible answer: According to a report on Corporate Governance by Professor Emma Coleman Jordan of the Georgetown University Law Center…one simple issue might help to explain why change has been so elusive at the bailed out banks: Their people.

Jordan notes that the folks who run the major banks today — the senior executives, directors, managers, etc. — are essentially the same exact folks who ran them (into the ground) 5 and 10 years ago:

“The prospects for a robust prudently guided financial sector have been substantially clouded by the fact that the both the corporate governance structure and the executive leadership of the financial sector remain largely unchanged—92% of the management and directors of the top 17 recipients of TARP funds are still in office.”

You read that correctly — 92% of the TARP recipients’ senior management remains essentially unchanged post-crisis . . .

The Move Your Money Project

Jon Brooks — Tue, 05 Jan 2010 15:24:23 +0000

It’s a different type of “bail-out.”

The Huffington Post and friends are spearheading a nascent movement to move your money from the big financial giants to community banks. From a column by Arianna Huffington and Rob Johnson:

The big banks on Wall Street, propped up by taxpayer money and government guarantees, have had a record year, making record profits while returning to the highly leveraged activities that brought our economy to the brink of disaster. In a slap in the face to taxpayers, they have also cut back on the money they are lending, even though the need to get credit flowing again was one of the main points used in selling the public the bank bailout. But since April, the Big Four banks — JP Morgan/Chase, Citibank, Bank of America, and Wells Fargo — all of which took billions in taxpayer money, have cut lending to businesses by $100 billion.

Meanwhile, America’s Main Street community banks — the vast majority of which avoided the banquet of greed and corruption that created the toxic economic swamp we are still fighting to get ourselves out of — are struggling. Many of them have closed down (or been taken over by the FDIC) over the last 12 months. The government policy of protecting the Too Big and Politically Connected to Fail is badly hurting the small banks, which are having a much harder time competing in the financial marketplace. As a result, a system which was already dangerously concentrated at the top has only become more so.

A web site has been set up called Move Your Money, at which you can type in your zip code to locate a community bank near you. The Huffington Post has a page at which you can submit your experience with local banking, and an interactive map that allows you to drill down to your own area to find what people are saying about the small banks in your neighborhood.

The filmmaker Eugene Jareck has also created a video using the banking-related film “It’s a Wonderful Life” as a theme.

And as usual, Facebook is involved. The Move Your Money page there has over 5200 friends, with many people trading info and stories about local banks. Ditto Twitter. Here’s one post we found there from the blog “Through the Eyes of Mike Anthony.”

Today was the dawn of a new day for me. It was the day I said something with the money that I have. I took the leap and left my big bank for a hometown community bank…

I have been a big bank customer for seven years. For the most part, I’ve never really had any problems. Easy access to my bank twenty four seven is one of the many reasons I opened my accounts there. However, in recent years, they have decided they’re not going to appreciate my business. Any problems I had, I simply had to live with.

Well, I wasn’t going to stand for this… (T)he execs that asked for taxpayer money to help bail their banks out just raked in some pretty hefty profits, not to mention bonuses. I kept thinking to myself “My hard earned taxpayer money, the money I worked for, went to go help someone else who in turn just put it in their own pockets and became richer??” Oh, that was the last straw for me.

I happily walked into the big bank today to close out my accounts. When I walked in I went to see a branch manager. I simply asked her if I would be able to close out my account. Do you know what her response was? “Sure not a problem!” with a smile too!!!! I was absolutely appalled. I couldn’t believe a bank I’ve been so loyal too would just have no problem closing my accounts, not even asking me why! Then, if that wasn’t enough, once they were closed out, here was the last response I got “Thanks, have a great day!” again with a smile!!!

Well, of course they’re smiling. They’re raking in millions of dollars from hard-working taxpayers like us who are helping to bail them out, only for them to go ahead and pocket that money. I’m happy to be with my community bank. It’s not run by any shareholders. Only a board of directors with less than 10 branches. Sure, the conveniences I’ve come to expect from the larger bank aren’t all there, but here’s what it really boils down to: Do I want my money going to greedy people or do I want it representing the people who live where I live and are looking to actually help out the community rather than be extremely greedy? I have voted with my money…

Looks like a fair amount of people think too big to fail doesn’t mean too big to bail…not “out,” but “out of.”

Meet Smigly

Jon Brooks — Mon, 09 Nov 2009 23:57:00 +0000

Smigly is–unknowingly–having a bad day at the big bank.

More Smigley below ↓ or here.

And the award for…

Jon Brooks — Thu, 27 Aug 2009 19:22:04 +0000

…the worst dramatization of a governmental agency function goes to the FDIC Channel’s “Introduction to FDIC Deposit Insurance,” starring “Ashley” and “Grandpa.”

And here to present the award are Big D of the Freedom For You and Me channel, Pennsylvania congressional candidate and tea-party participant Jake Towne, the Fat Libertarian, and this guy “proclaiming the warnings of prophecy for our times and announcing the good news of the coming Kingdom of God.” All of whom have been warning of the imminent bankruptcy of the government’s bank insurance program. The FDIC announced today that this year’s record 81 bank failures had left it with just $10 billion to service the additional 416 institutions on its “problem list,” should the need arise.

If you’re worried about the fiscal condition of your bank, but perhaps not quite as much as the above presenters, Bankrate.com’s “Safe & Sound” ratings page is a good place to start.