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Big banks bundled toxic debt, sold it to rubes, then bet against it and won big

By   Follow Me on Twitter     Message Richard Clark     Permalink
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Mr. Egol, the new managing director at Goldman Sachs had risen to prominence inside his company by creating a program that was at first intended to protect Goldman from investment losses if the housing market collapsed. However, as the market did in fact start heading for collapse, it became apparent to Goldman what was about to take place, and it greatly expanded this program, enabling the company to pocket huge profits, at considerable cost to others.

As we all know by now, pension funds and insurance companies lost billions of dollars buying toxic, but highly rated, securities which they had good reason to believe were good solid investments.

Goldman was, of course, not the only firm that peddled these toxic securities (known as synthetic collateralized debt obligations, or CDOs), and then made financial bets against them, selling them short (called "selling short" in Wall Street parlance). Others banks that created similarly toxic securities and then bet they would fail include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A.Sachs, who this year, perhaps rather significantly, became a "special counselor" to Treasury Secretary Timothy F. Geithner.

How these disastrously performing toxic securities were devised, and with what ultimate purpose or plan, is now the subject of scrutiny -- by investigators in Congress, at the Securities and Exchange Commission, and at the Financial Industry Regulatory Authority, Wall Street's "self-regulatory" organization. Those involved with these inquiries declined to comment.

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While these investigations are in the early phases, authorities are supposedly looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these toxic mortgage-linked debt instruments and then bet against the clients who purchased them. But given the blindness that the SEC exhibited with regard early and plentiful evidence that Bernie Madoff was operating a Ponzi scheme, and given the amount of money Wall Street contributes to the re-election campaigns of various members of Congress, don't hold your breath.

The central question within these inquiries is, allegedly, whether or not the firms creating these toxic securities purposely helped to select especially-risky, mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded. Indeed, some securities packaged by Goldman and Tricadia ended up being so vulnerable that they went bad within a two or three months of being created.

The evidence seems to be strong that Goldman and other firms used the CDOs to place unusually large negative bets (i.e. bets against their duped customers), which obviously put the firms at odds with their own clients' interests.

"The selling of securities to customers and then "shorting' them because they (these companies) believed they (the securities) were going to default is the most cynical (mis)use of credit information that I have ever seen," said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. "When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else's house and then committing arson."

A handful of investors and Wall Street traders clearly anticipated the mortgage crisis. In 2006, Wall Street had introduced a new index, called the ABX, which essentially became a betting parlor in which one could bet on the "direction' mortgage securities were going to go. The index allowed traders to bet on or against pools of mortgages with different risk characteristics, just as stock indexes enable traders to bet on whether the overall stock market, or technology stocks or bank stocks, will go up or down.

Goldman, among others on Wall Street, has admitted that since the collapse it made big money by using the ABX to bet against the housing market. Worried about a housing bubble, top Goldman executives decided in December 2006 to change the firm's overall stance on the mortgage market from positive to negative. However it did not disclose that to their customers. (Why tip off the rubes they were about to fleece?)

Beginning in 2004, with housing prices soaring and the mortgage mania in full swing, Goldman's managing director had begun creating CDO deals within a "betting parlor' known as "Abacus." From 2004 to 2008, Goldman issued 25 Abacus deals, according to Bloomberg, with a total value of $10.9 billion. The Abacus "betting parlor' allowed investors to bet for or against the mortgage securities that were linked to the deal. These CDOs didn't contain actual mortgages. Instead, they consisted of credit-default swaps, a type of insurance that pays out when a borrower defaults. These swaps made it much easier to place large bets on mortgage failures.

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Goldman's directors saw the writing on the wall in this market as early as 2005." By creating the Abacus CDOs, they not only helped protect Goldman against losses that others would suffer, they allowed Goldman to profit handsomely on those losses.

Just five months after Goldman had sold off a new Abacus CDO, the ratings on 84% of the mortgages underlying it had been downgraded, indicating growing concerns about borrowers' ability to repay the loans -- this according to research from UBS, the big Swiss bank. Of the more than 500 CDOs analyzed by UBS, only two were worse for gullible investors than the Abacus deals.

Consider also an $800 million CDO betting parlor known as "Hudson Mezzanine." It included credit insurance on mortgage and subprime mortgage bonds that were in the ABX index. Hudson buyers would make money if the housing market stayed healthy -- but lose money if it collapsed. Goldman kept a significant amount of the financial bets against securities in Hudson, so that it (Goldman) would profit if they failed. This according to three of the former Goldman employees involved in this scheme.

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Several years after receiving my M.A. in social science (interdisciplinary studies) I was an instructor at S.F. State University for a year, but then went back to designing automated machinery, and then tech writing, in Silicon Valley. I've (more...)

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