Derivatives they said could facilitate a global financial collapse like what sunk Barings Bank, Orange County and the Long-Term Capital Management practically overnight.
(And did a number on Chase Manhattan, Bankers Trust, American Express and Barclays Capital.)
Sure banks and financial institutions love the structured investment vehicles--especially collateralized debt obligations (CDOs)--because they let them get loan risk off balance sheet and take on more lending. And they can hold them at cost without recording losses or marking to market--or so accounting rules indicate.
Sure the rich like the cyber-constructs as tax dodges in their Cayman Islands registered hedge funds.
Sure traders love their leverage power--kind of like investor crack--which exceeds any position they could take in the cash markets.
But they are IOUs and don't represent actual ownership of assets. (See Ponzi capitalism.) And that means they can keep house of card companies alive and looking solvent until they implode. And cause a cascade of implosions as the underlying assets on which the derivatives--and positive balance sheets--are written are found lacking.
The current credit derivative fest began in 2001 when, legend goes, some bankers from JP Morgan were in Boca Raton drinking and throwing each other into the swimming pool and lit upon a complex new financial instrument says author Gabriel Kolko.
Pretty soon buccaneer traders "reintermediated" themselves between traditional borrowers and markets with the new risk slicing and dicing schemes recounts Kolko while traditional bankers looked on. And credit derivatives became the glue that held the world's 10,000 hedge funds together and the bulk of the world's $6 trillion a day---half of the U.S. GNP--derivatives trade.
Until Bear Stearns' hedge funds, Goldman Sachs' hedge funds, Countrywide Financial Corp and BNP Paribas, France's most respected bank, suddenly "deleveraged" this summer.
While the deluded and/or optimistic are still calling the meltdown a "credit crunch" and "lending crisis"--even as corporate paper becomes toilet paper--others are asking why the rating companies didn't issue warnings like they did with Enron. (A month after it folded)
Or the analysts--another "trailing economic indicator."
Nor did the quant hedge funds with their market neutral computer models anticipate August's "liquidity and maturity mismatch" as Reuters politely calls it.
"Longer term, successful quant managers will have to rely more on unique factors,'' confessed Goldman Sachs' fund-management division after its hedge funds lost $3 billion in August, almost a third of their value. "While we have developed a number of these factors over the last several years, in hindsight we did not put sufficient weight on these relative to more popular quant factors.''
Why are managers making decisions at all if quants are computer models asks investment advisor Michael Shedlock. And if Goldman is now trying to develop an anti-quant model, why not "take the existing program you have and bet against it?"
Things looked even worse for Bear Stearns which not only lost $3.2 billion bailing out derivative larded hedge funds, it admitted to investors it could not even calculate the CDO losses. Second opinion? You're dumb.
(Freddie Mac and Fannie Mae have only recently valued their derivatives losses.)
Meanwhile Treasury Secretary Henry M. Paulson, Jr. during his first on the job test--and pretending Goldman Sachs is someone he met once at a party-- took a good/news bad news stance.
"The genius of our system is that it recognizes that if you're going to give entrepreneurs and investors the chance to succeed and reap the benefits of their risk-taking" he said, "they also need the freedom to fail."
Andy Fastow can expect some company in jail.