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Jon Markman's Speculations
April 21, 2010, 3:04 a.m. EDT · Recommend (2) · Post:
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Impatient customers enable Apple blowout
By Jon Markman
(Editor's note: This column welcomes Jon Markman as a MarketWatch columnist. A former columnist at MSN Money and investigative reporter at the Los Angeles Times, Markman is currently a money manager and investment adviser in Seattle. For more ideas, try a two-week trial to Markman's newsletter, Strategic Advantage ).
SEATTLE (MarketWatch) -- The U.S. government's war on drugs has stretched over four decades and remains an abject failure because it focuses on supply instead of demand. The same approach persists in the government's new war on finance, as prosecutors attempt to attack securities growers and pushers and largely leave the stupidity of buyers unchecked.
This problem was vividly highlighted in the civil suit filed by the Securities and Exchange Commission on Friday against Goldman Sachs Group Inc. /quotes/comstock/13*!gs/quotes/nls/gs (GS 159.98, -3.34, -2.05%) , which accuses the investment bank of conspiring with the hedge fund Paulson & Co. to bundle troublesome mortgages into an exotic derivative that was doomed to fail. The government complains that Goldman should have told buyers of the synthetic collateralized debt obligation (CDO) not only that Paulson had helped create the instrument as an adviser to a third-party security designer but that it had done so with the intent to sell it short.
Ashby Jones, Editor of the WSJ Law Blog, talks to Dow Jones Investment Banker about motions to dismiss, materiality, standards of evidence, and the wave of investor lawsuits likely to hit all the big investment banks
To regulators and the public who are graced with 20/20 hindsight, the fact pattern sounds like a sinister activity in which Goldman Sachs and Paulson were villains who lured a set of innocents into a trap. This is hardly the case, and to ignore the buyers' role in the disaster that followed would be a mistake of public policy, and perhaps the law.
If anyone should be the subject of public obloquy, it is the people who enabled Goldman by providing a market for this junk. Just like drugs: If there were no buyers there would be no sellers.
Before you think I'm just trying to blame the victim, consider that the CDO buyers the government wishes to protect were not rubes. They included major Scottish and German banks who were sophisticated and longtime purchasers of these kinds of securities. This was not your average retail investor looking for a few extra bucks of retirement income, but sharks who turned a blind eye to risks. They had to know that on the other side of their purchase of synthetic CDOs would be a counterparty who had the opposite point of view and was short.
Synthetic CDOs sound complicated but they're really not; they're basically insurance contracts tied to mortgage securitizations. They let you earn income from mortgage bonds without the muss and fuss of actually owning the underlying debt. Because they're treated like insurance rather than securities in some countries, they may carry tax benefits and can be more highly leveraged.
At the end of the day, though, like all securities they represent a wager. The synthetic CDO purchaser receives a stream of premium payments from the seller; he thinks that it's extremely unlikely he'll ever be asked to pay off on the insurance, so it looks like easy money. The seller thinks that the instrument is likely to blow up, so he looks at his payments as a low-cost investment. This arrangement is not special to the Abacus deal at the heart of the government suit; it's the same with all off-exchange instruments. People with opposing points of view bet directly against each other.
It's important to remember that at the time the deal was struck, housing was still fairly strong and people betting against mortgages were losing a lot of money and looked like idiots. It's hard to imagine now, but Paulson was making a highly contrarian bet. That's why it paid off so well, much like a 100-to-1 long shot at the track: If it hits, you're a genius and if it doesn't you're a sucker.
These bets are not made in a vacuum. CDO buyers can read a prospectus that details exactly which mortgages lay inside the wrapper, with granularity on the type of property and buyer that would numb your eyes. You can know where, when and to whom the mortgages were sold; the average incomes of the holders; and much more.
If the buyers say they didn't know what they were buying they're really confessing that they didn't perform the due diligence that their investors expected. It's not enough to claim the paper was AAA-rated because that is just a cop-out; most responsible bond buyers will tell you that they use ratings as an element in their study of securities but do not stop there. Imagine complaining to authorities that you gained weight after eating a gallon of ice cream labeled "low fat."
I'm saying this not to stick up for Goldman, but to point out that the government and the public always seem to learn the wrong lesson from financial catastrophes. The problem is not that manipulators will skirt the edges of the law to create unsound financial products for investors seeking high yields, but that human nature condemns investors time and again to throw out common sense to buy those products in the hope that this time they will come out ahead.
If you are going to disallow Goldman's behavior in this deal, you might as well close the entire casino because there are very few other instruments that could survive the scrutiny the government appears to want to hang on the investment bank. The civil suit essentially contends that not only must a bank disclose the identity of any counterparties to a sophisticated off-exchange note but also the intentions of those counterparties even when the only possible intention is to be a short-seller. Should every common stock also carry a warning label that someone smart may have sold it short, and why?
This is wrong on its face but if you think about it, such an extreme version of this measure would be ineffective at countering bad behavior by dumb buyers anyway. The reason is that people will always do things that are not seemingly in their self interest if they see another counterbalancing benefit.
Consider the case of cigarette labeling. The U.S. government demands some variation of the following label on all packs: "Smoking Causes Lung Cancer, Heart Disease, Emphysema and May Complicate Pregnancy." In the United Kingdom, a variation of the following label must cover 40% of the pack: "Smoking can cause a slow and painful death."
And yet upwards of 375 billion cigarettes are sold annually in the United States in recent years, and a proportionate number in the U.K. Buyers include the president of the United States, who certainly should know better.
Everyone knows that you can't regularly beat the house in Las Vegas, yet gaming emporia thrive. Everyone knows that eating a lot of red meat is bad for their health, yet steakhouses thrive. And everyone on Wall Street knows that the counterparty to a synthetic CDO is a knowledgeable short seller, yet structured finance thrives.
This case would be laughable if only the government were not so serious in its drive to criminalize risk-taking. Everyone who is pointing fingers at Goldman now will be very displeased to see where this road leads: Not to safer and fairer markets, but to less liquid and more restricted ones that will paradoxically grow ever more obscure as the undeniable impulse to speculate finds new outlets that regulators haven't yet imagined.
Apple's quarterly report blows past Wall Street expectations on all fronts, even with the prospect of a new iPhone on the horizon.
5:45 p.m. April 20, 2010 | Comments: 15
- Castor-PolluxM35 | 11:27 p.m. April 20, 2010
"Would Disney sell ABC? And who'd buy it? http://on.mktw.net/9YmpFs" 11:30 p.m. EDT, April 20, 2010 from JonMediaWeb
"Mark Hulbert: A rare buy signal with a good record http://on.mktw.net/ahj6nN" 11:28 p.m. EDT, April 20, 2010 from MktwHulbert
"Most Americans' salt intake too high to be safe, IOM says http://on.mktw.net/9jECMt" 5:19 p.m. EDT, April 20, 2010 from MktwGerencher
"RT @StockJockey Maria is only person I know that cares what Hank Greenberg has to say" 4:10 p.m. EDT, April 20, 2010 from davidweidner
"Tough times can either mess up or buck up our kids: As dangerous as money troubles can be, they can also prov... http://on.mktw.net/9cizNf" 12:27 p.m. EDT, April 20, 2010 from MKTWCoombes
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