Looking back at the credit crisis

I thought it worthwhile to re-post my 2008 slides on the credit crisis. I wrote these slides just as the crisis was getting started (right after the big defaults), but I still think my analysis was correct and better than post-hoc discussions that are going on to this day.

I believe I called the housing bubble back in 2004 -- see, e.g., here for a specific discussion of bubbles and timescales. The figure above also first appeared on my blog in 2004 or 2005.

(2004) ... The current housing bubble is an even more egregious example. Because real estate is not a very liquid investment - the typical family has to move and perhaps change jobs to adjust to mispricing - the timescale for popping a bubble is probably 5-10 years or more. Further, I am not aware of any instruments that let you short a real estate bubble in an efficient way.

I discussed the risks from credit derivatives as early as 2005; see also here and here.

Finally, there was a lot of post-crisis discussion on this blog and elsewhere about mark to market accounting: were CDO, CDS oversold in the wake of the crisis (see also The time to buy is when there is blood in the streets; if you want to know what "leading experts" were saying in 2008, see the Yale SOM discussion here -- oops, too embarrassing, maybe they took it down ;-), or was Mr. Market still to be trusted in the worst stages of a collapse? The answer is now clear; even Fannie and Freddie have returned $180 billion to the Feds!

Akerloff on Efficient Markets Hypothesis

I particularly like his comments (@13 min or so) on Snake Oil and financial assets. When market participants are exuberant (overly confident) it is natural for firms to create and market new assets that are overpriced relative to actual value, or have dangerous risk-return tradeoffs. For the latest example, in natural gas drilling rights during the recent boom (now a bust), see here.

See also Venn diagram for economics.

The cover illustration of Akerloff and Shiller's book. Are there any economists outside of Chicago who still don't believe in "animal spirits"?

AIG accounting

It looks like Treasury will make a profit on its AIG bailout stake. As I emphasized in 2008, markets were clearly not pricing credit-related assets properly during the crisis. Strong EMH supporters take note (see also here).

NYTimes: ... The Treasury Department announced it planned to sell $18 billion of its A.I.G. stake, putting it on a path to actually turn a profit. It was a remarkable feat and one that nobody — including Treasury Secretary Timothy F. Geithner — anticipated four years ago at the peak of the crisis during the $180 billion bailout of the company.

"Nobody"? -- not so fast! Here's what I wrote in 2008:

If -- and it's a big if -- AIG's actual CDS payouts are limited, the government and taxpayers stand to make a lot of money over the next 3-5 years. When markets return to normal the profitable ordinary insurance parts of AIG can be liquidated to pay off the bridge loan. In that scenario the big losers are AIG shareholders -- the government, as the lender of last resort, will have bought a distressed AIG for a song.

More AIG stuff here. Misuse of EMH arguments can hurt your brain.

Sterilization and ECB quantitative easing

Draghi's ECB initiative of bond buying through "Outright Monetary Transactions" was accompanied by a statement that purchases would be entirely sterilized. I think this implies limitations on the capacity of the program, although I haven't thought it through carefully yet.

Markets were up substantially on this news, which I had heard predicted already over the summer by Wall St. types.

WSJ: ... Sterilization helps the ECB distinguish its plan from the quantitative easing programs of the Federal Reserve and the Bank of England, which are explicitly aimed at supporting the money supply. However, the “Outright Monetary Transactions” still resemble “QE” programs in as much as both tend to depress bond yields, lowering the most important reference interest rates for the economy.

It’s a fine point, but one that the ECB hoped would persuade the arch-monetarist thinkers at the Deutsche Bundesbank that it was still acting within its mandate. They were wrong. Within two hours, the Deutsche Bundesbank issued a statement reaffirming that its President Jens Weidmann, the only person to disagree with the plan, still considers bond purchases “too close to financing states via the printing press.”

In principle, “sterilization” is a process that ensures that individual actions by the central bank don’t result in an overall increase in the money supply. Monetarist theory dictates, after all, that it is excessive monetary growth that leads to inflation, which is what the ECB is exclusively mandated to guard against. ... As of today, the precautionary hoarding of reserves by euro-zone banks is so great that banks are holding over €770 billion in excess reserves in accounts at the ECB, voluntarily “sterilizing” money the ECB created without forcing it to lift a finger.

... The ECB is sterilizing another €209 billion by paying only 0.01% on the deposits it auctions. In the current environment, it does not seem like the ECB would struggle to withdraw from the market any amount of liquidity it wanted to. Even so, the numbers implicit in the ECB’s new bond-buying scheme are daunting. Excluding treasury bills, there are some €390 billion in Italian bonds that fall due in the next three years.

For Spain, the number is €203 billion, for Portugal and Ireland combined, another €50 billion, according to national debt agency data. In all, a total of over €640 billion. Of this, it seems likely that the ECB already holds — and sterilizes — a large part of its €209 billion SMP portfolio. There are no precise data yet on the ECB’s holdings, but only around 40 billion euros is accounted for by Greece.

Thus the amount that the ECB needs to sterilize could easily double or treble from its current level. This may incline it to sterilize more over a longer time-frame of a month or three months or even more, so as to reduce the potential for volatility in the money market. The ECB has already examined such options internally two years ago, but chose not to proceed.

Rethinking Finance

Mark Thoma points me to an interesting conference: Rethinking Finance.

Burton Malkiel's paper defines EMH to mean (roughly) "it's hard to beat the market, but of course prices could be way off at any particular time" (yes, Virginia, there are bubbles). This is what I refer to as a weak version of EMH.

Arnold Kling highlights the following talks (click through for links):

Foote, Girardi, and Willen ask whether, given expectations for ever-rising house prices, the institutional and regulatory details make any difference. If people expect house prices to rise faster than the rate of interest, then that creates in their minds a profit opportunity. One way or the other, the market will develop the financial instruments that allow people to exploit that apparent opportunity. I do not think I can endorse this view, but it is interesting.

Thomas Philippon asks how the financial sector came to be as large and profitable as it did. He argues that it is not because finance became more efficient or added more value to the economy. [ "In the absence of evidence that increased trading led to either better prices or better risk sharing, we would have to conclude that the finance industry's share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billions for the U.S. alone." ]

Brad DeLong asks why economists could not predict and explain the economic downturn. He argues that financial panics, in which the market's assessment of the safety of financial assets changes sharply and suddenly, are rare events that are outside the realm of typical theoretical models and statistical analysis. I am left with further questions. Which is abnormal, the faith that people had in financial assets before the crisis, or the lack of faith that people had after the crisis? And does government intervention to try to supply safe assets constitute the solution or the problem?

History is impossible

... and economic history is even harder.

Andy Lo (MIT) explains that economists have yet to agree on the causes and consequences of and remedies for the recent financial crisis. This is a must read. I hope to provide further comments when I have more time.

Although I covered the housing bubble (which I called a bubble as early as 2004) and ensuing financial crisis in great detail on this blog, I've spent very little time discussing books about the crisis. That's because many (most?) of the authors (who, as Lo points out, tend to disagree strongly with each other) are rehearsing their own priors rather than seeking truth. My talk on the financial crisis.

Reading About the Financial Crisis: A 21-Book Review

Andrew W. Lo

Abstract
The recent financial crisis has generated many distinct perspectives from various quarters. In this article, I review a diverse set of 21 books on the crisis, 11 written by academics, and 10 written by journalists and one former Treasury Secretary. No single narrative emerges from this broad and often contradictory collection of interpretations, but the sheer variety of conclusions is informative, and underscores the desperate need for the economics profession to establish a single set of facts from which more accurate inferences and narratives can be constructed.

From the introduction:

... Six decades later, Kurosawa’s message of multiple truths couldn’t be more relevant as we sift through the wreckage of the worst financial crisis since the Great Depression. Even the Financial Crisis Inquiry Commission—a prestigious bipartisan committee of 10 experts with subpoena power who deliberated for 18 months, interviewed over 700 witnesses, and held 19 days of public hearings—presented three different conclusions in its final report. Apparently, it’s complicated.

To illustrate just how complicated it can get, consider the following “facts” that have become part of the folk wisdom of the crisis:

1. The devotion to the Efficient Markets Hypothesis led investors astray [CERTAINLY TRUE], causing them to ignore the possibility that securitized debt was mispriced and that the real-estate bubble could burst. [TOO STRONG]

2. Wall Street compensation contracts were too focused on short-term trading profits rather than longer-term incentives. Also, there was excessive risk-taking because these CEOs were betting with other people’s money, not their own. [CEOS DID NOT KNOW WHAT WAS GOING ON -- HAVE TO LOOK AT INCENTIVES OF LOWER LEVEL PEOPLE]

3. Investment banks greatly increased their leverage in the years leading up to the crisis, thanks to a rule change by the U.S. Securities and Exchange Commission (SEC). [REPORTEDLY TRUE... BUT SEE THE PAPER FOR INTERESTING DETAILS]

While each of these claims seems perfectly plausible, especially in light of the events of 2007–2009, the empirical evidence isn’t as clear. ...

From the conclusions:

There are several observations to be made from the number and variety of narratives that the authors in this review have proffered. The most obvious is that there is still significant disagreement as to what the underlying causes of the crisis were, and even less agreement as to what to do about it. But what may be more disconcerting for most economists is the fact that we can’t even agree on all the facts. Did CEOs take too much risk, or were they acting as they were incentivized to act? [NOT CEOS, LOWER LEVEL TRADERS; YES] Was there too much leverage in the system? [YES] Did regulators do their jobs [NO] or was forbearance a significant factor? [REGULATORS DID NOT UNDERSTAND CDOS OR CDS] Was the Fed’s low interest-rate policy responsible for the housing bubble [PARTIALLY, BUT GSES LIKE FANNIE DESERVE MUCH MORE BLAME], or did other factors cause housing prices to skyrocket? [ANIMAL SPIRITS; IRRATIONAL EXUBERANCE; BOUNDED COGNITION] Was liquidity the issue with respect to the run on the repo market, or was it more of a solvency issue among a handful of “problem” banks? [IT WAS FEAR AND COMPLEXITY]

[THERE WAS REGULATORY CAPTURE TO GET THE CASINO GAMES GOING IN THE FIRST PLACE, BUT NO "TOO BIG TO FAIL" MORAL HAZARD. ONLY ACADEMICS AND JOURNALISTS COULD THINK SO. DURING THE CRISIS REAL FINANCIERS WERE SCARED OUT OF THEIR MINDS AND HAD NO FAITH IN A GOVT BAILOUT. (I WAS ON THE PHONE WITH LOTS OF THEM.) MANY PEOPLE, FROM CEOS DOWN TO MD LEVEL AND BELOW TRADERS, LOST MUCH OR MOST OF THEIR NET WORTH IN THE COLLAPSE. DOES THAT SOUND LIKE MORAL HAZARD? ACADEMIC ECONOMISTS HAVE A CUTE THEORY (OR IDEOLOGY) AND WANT TO CONFIRM IT. STUPIDITY EXPLAINS A LOT MORE THAN CONSPIRACY.]

For financial economists—who are used to dealing with precise concepts such as no-arbitrage conditions, portfolio optimization, linear risk/reward trade-offs, and dynamic hedging strategies—this is a terribly frustrating state of affairs. Many of us like to think of financial economics as a science [ONLY IN THE MOST LIMITED SENSE], but complex events like the financial crisis suggest that this conceit may be more wishful thinking than reality. John Maynard Keynes had even greater ambitions for economics when he wrote, “If economists could manage to get themselves thought of as humble, competent people on a level with dentists, that would be splendid”. Instead, we’re now more likely to be thought of as astrologers, making pronouncements and predictions without any basis in fact or empirical evidence.

To make this contrast more stark, compare the authoritative and conclusive accident reports of the National Transportation Safety Board—which investigates and documents the who-what-when-where-and-why of every single plane crash—with the 21 separate and sometimes inconsistent accounts of the financial crisis we’ve just reviewed (and more books are surely forthcoming). Why is there such a difference? The answer is simple: complexity and human behavior. ...

See also Physics Envy by Lo and Mueller.

Noted added: I think the movie Margin Call knows more than the worst 10 of these 21 books ;-)

Future vol

Hmm... pricing in a 30-50% chance of huge vol due to euro credit crisis? If you're sure it's going to happen, some 6-12 month vol swaps might be a good trade. Any experts want to comment? (Are there better instruments for this?) How much further can Merkozy kick the can down the road?

On the volatility of volatility

A pro sez to me: "Vol is totally mispriced right now. Lots of funding requirements in the new year."

Margin Call

I can't believe they shot this for only $3.5 million. A lot of star power for such a tiny budget. NYTimes review.

Soros: nationalize European banks

Soros outlines his proposal for solving the eurozone crisis. It seems to me that the best informed people are the most alarmed by the current situation. I notice Pimco just went into "risk-off" mode.

Financial Times: Financial markets are driving the world towards another Great Depression. The authorities, particularly in Europe, have lost control of the situation. They need to regain control and they need to do so now.

Three bold steps are needed. First, the governments of the eurozone must agree in principle on a new treaty creating a common Treasury for the eurozone. In the meantime, the main banks must be put under European Central Bank direction in return for a temporary guarantee and permanent recapitalisation. The ECB would direct banks to maintain credit lines and outstanding loans, while closely monitoring risks taken for their own accounts. Third, the ECB would enable countries such as Italy and Spain to temporarily refinance themselves within limits at a very low cost. These steps would calm markets and give Europe time to develop a growth strategy, without which the debt problem cannot be solved.

[ More privatizing gains and socializing losses? ]

... This course of action does not require leveraging or increasing the size of the EFSF but it is more radical because it puts the banks under European control. That is liable to arouse the opposition of both the banks and the national authorities. Only public pressure can make it happen.

I'm not sure what the "growth strategy" would be. Despite what Keynes wrote, it's not easy for governments to simply order up (healthy, real) growth, even with checkbook in hand. I'm with Hayek that this kind of growth is something you might pay for dearly in the long run. In addition, governments are running out of ammunition.

*** I realize that what Soros proposes isn't exactly nationalization of at-risk banks. But ultimately the ECB and European taxpayers will assume responsibility for their prior investment decisions.

The next lost decade?

Satyajit Das on what's ahead in the eurozone: video

Possible chain of events: More pain ahead for Greece, culminating in a big write down for its creditors. ECB solvency challenges. Sovereign debt crises for Italy and Spain. Global recession followed by debt deflation. A lost decade worse than what Japan experienced in the 1990s.

Larry Summers interview with Martin Wolf: video

Keynes v Hayek

At the beginning of the debate you get to hear a bunch of Brits at the LSE shouting "Yo Keynes!" and "Yo Hayek!" in support of their respective sides. No one seems capable of convincing the other side of anything, but the discussion is entertaining.

Keynes v Hayek

Speaker(s): Professor George Selgin, Professor Lord Skidelsky, Duncan Weldon, Dr Jamie Whyte

Recorded on 26 July 2011.

How do we get out of the financial mess we're in? Two of the great economic thinkers of the 20th century had sharply contrasting views: John Maynard Keynes believed that governments could create sustainable employment and growth. His contemporary and rival Friedrich Hayek believed that investments have to be based on real savings rather than fiscal stimulus or artificially low interest rates.

See also round 2 of the Keynes Hayek rap video:

Ruh Roh!

The dreaded double dip!



Non-Americans see here for explanation of "Ruh Roh" :-)

Almost over? part 2

Are further price declines in the cards? If you think there's some inflation around the corner (say in the next few years), now might be a good time to lever up and buy some real estate.

Here's an interesting figure from a recent paper by Case, Quigley and Shiller. The paper is primarily about wealth effects, but it has some nice panel data. They find that the wealth effect is stronger for housing than for equity assets.



Here is a video from the Financial Times discussing the paper and recent housing data.

More discussion and figures like the one below in this earlier post.

Almost over?

What's a factor of 2 between friends? :-) Note no long term appreciation of houses relative to CPI.




Here's Japan for comparison. Our bubble has popped much more quickly.




Yes, Virginia, we knew it was a bubble back in 2005, but no one believed us. Next time, watch the price to rent ratio:




Yes, equities beat housing over the long run, and even at the peak of the biggest housing bubble of the 20th century.

Podcast roundup

Econtalk: Joe Nocera and Russ Roberts discuss the financial crisis. One of the best Econtalk podcasts in a long time. I think I agreed entirely with Nocera.

In Our Time on the Industrial Revolution. Ordinarily deferential host Melvyn Bragg mixes it up with guests over UK exceptionalism. Was it primarily easy access to coal, or were other factors as important?

Christmas eve gospel: Mahalia Jackson rules! Tracks 1, 14 and 15 are my favorites. It's a shame we almost never hear this kind of music any more.

John Mellencamp on Fresh Air. Highly recommended if you are a fan. This is an old interview, but I only listened to it relatively recently.

Two honest economists

I highly recommend this podcast discussion between Russ Roberts and John Quiggin (of Crooked Timber) about Quiggin's recent book Zombie Economics. Both parties did a good job of putting aside priors and having an enlightening conversation. Quiggin argues that many economic theories such as the Great Moderation, the efficient markets hypothesis and others have been discredited by recent events and should be relegated to the graveyard.

I think at one point both participants agreed that (or at least entertained the idea that) economics doesn't make progress like a real science. Probably too strong a critique, but at least very honest.

US to nearly break even on TARP?

Is anyone paying attention to the facts? Do voters' attention spans extend back two years? Can academic economists learn from actual events?

The main costs from TARP will come from bailing out the auto companies and insurer AIG, not banks.

NYTimes: Even as voters rage and candidates put up ads against government bailouts, the reviled mother of them all — the $700 billion lifeline to banks, insurance and auto companies — will expire after Sunday at a fraction of that cost and could conceivably earn taxpayers a profit.

... The Treasury never tapped the full $700 billion. It committed $470 billion and to date has disbursed $387 billion, mostly to hundreds of banks and later to A.I.G., to the auto industry — Chrysler, General Motors, the G.M. financing company and suppliers — and to what is, so far, an unsuccessful effort to help homeowners avoid foreclosures.

When Mr. Obama took office, the financial system remained so weak that his first budget indicated the Treasury might need another $750 billion for TARP. The administration soon dropped that idea as Mr. Geithner overhauled the rescue program and the banking system stabilized. Still, by mid-2009, the administration projected that TARP could lose $341 billion, a figure that reflected new commitments to A.I.G. and the auto industry.

The Congressional Budget Office, which had a slightly higher loss estimate initially, in August reduced that to $66 billion.

Now Treasury reckons that taxpayers will lose less than $50 billion at worst, but at best could break even or even make money. Its best-case scenarios, however, assume that A.I.G. and the auto companies will remain profitable and that Treasury will get a good price as it sells its corporate shares in coming years.

“We’d have to be very lucky to have both A.I.G. and the auto companies pay us back in full,” Mr. Elliott said.

... By any measure, TARP’s final tally will be less than even its advocates expected amid the crisis. But the program remains a big loser politically.

See this post from September 2008, during the heat of the TARP debate:

... The following false conundrum has been stated recently by numerous analysts, including Paul Krugman: "if Treasury wants to recapitalize banks it has to overpay for toxic assets, to the detriment of taxpayers; if it wants to pay fair prices for the assets then banks won't benefit." There is no conundrum if markets, at this instant in time, are systematically underpricing mortgage assets.

When the Internet bubble burst in the early years of this century, investors were so gun shy and under so much pressure that they would not pay even rationally justifiable prices for stakes in technology companies. Smart investors who were willing to put capital at risk could buy assets at fire sale prices and made huge profits. This is nothing more than fear and herd mentality at work. If herd thinking can lead to overpricing of assets, why not underpricing immediately following a collapse?

Markets overshoot on both the up- and the down-side!

These points are obvious to any trader... it's the academics with equilibrium intuitions who are struggling to understand!

... To understand, it helps to have seen the collapse of a financial bubble firsthand. If you haven't (as, I suspect is the case with most academic economists), you are likely to cling to the idea that the market price of an asset is a good forecast of its actual value. However, this is completely wrong in the wake of a collapse. (And, certainly, the predictive power of the market price cannot hold at all times -- it is likely to be most wrong at the peak and in the aftermath of a bubble.)

Sex, Drugs and CDOs

This book is a novelization of the events surrounding the credit crisis, as viewed by a junior banker on the rise. In addition to simple introductions to securitization, CDOs, CDS, SIVs, etc. (including figures that might have been drawn on Cristal-stained cocktail napkins) there is plenty of insight into the psychology of bankers and the sometimes tawdry client-banker relationship on the sell side. Amazon: US edition , UK edition (more reviews).



Readers unfamiliar with Wall Street and The City may find the various banker shenanigans depicted surprising. Yes, client meetings really do happen at strip clubs and in the presence of call girls. But the more substantive point that readers should note is just how intense the demand was for CDO products. There are many scenes in the book in which the protagonist's main problem is dealing with incensed clients whose orders for CDO allocations have not been filled due to excess demand. As we heap blame on CDO issuers we might think a bit about the buyers of the securities and why they were so stupid.

The author, Tetsuya Ishikawa, was educated at Eton and Oxford and worked at several major banks including Goldman, where he was peripherally involved in the Abacus deal. For more, including video interviews, see his blog.

See you at the Harvard Club

If you are enamored of A.K. Barnett-Hart and/or her senior thesis on CDOs and the credit crisis, you might wish to attend the event described below, sponsored by the HBS Women's Association of New York. We wrote about Ms. Barnett-Hart previously here. Why am I not surprised she's working at Goldman now?

I couldn't come up with a good title for this post that didn't trade on Ms. Barnett-Hart's good looks, so I chose the lame one above. Chances are, I won't actually be at the event :-(

A Harvard Senior Thesis tells the Story of the Financial Market Meltdown

A.K. Barnett-Hart's senior thesis, "The Story of the CDO Market Meltdown: An Empirical Analysis" has won numerous awards. Her research on this topic was used by Michael Lewis in his recent book on the financial crisis "The Big Short".

Collateralized debt obligations (CDOs) were a leading cause of writedowns at financial institutions during the recent financial crisis, leading to the demise of Merrill Lynch and AIG. Most of the securities being marked down were initially given a rating of AAA by the rating agencies, essentially marking them as "safe" investments. The rating agencies were not alone in their mistake; indeed almost all market participants failed to question the validity of the models that were luring them into a false sense of security.

In her senior thesis, “The Story of the CDO Market Meltdown”, A.K. Barnett-Hart investigated the causes of adverse performance in CDOs backed by asset-backed securities. Join her as she presents her findings, telling the story of how deterioration in collateral, irresponsible underwriting practices, and flawed credit rating procedures allowed this arcane market to contribute to the near destruction of the global financial system.

A Harvard 2009 Magna Cum Laude graduate, Ms. Barnett-Hart’s senior thesis, “The Story of the CDO Market Meltdown: An Empirical Analysis” won numerous awards, including the Hoopes Prize, the Harris Prize for the best economics thesis, and the Dunlop Prize from the Kennedy School of Government. Her research on this topic was used by Michael Lewis in his recent book on the financial crisis, “The Big Short,” and has been used by government agencies such as the TARP and the Financial Crisis Inquiry Committee.

Ms. Barnett-Hart is also an accomplished violinist, and had studied under Itzhak Perlman at the Juilliard School of Music. She is currently an investment banker at Goldman Sachs.


Event Details:

Date: Tuesday, June 15, 2010
Time: 6:30 P.M., Registration and Cash Bar 7:00 P.M. Program
Location: The Harvard Club, 27 W. 44th Street (between 5th & 6th Avenues)
Cost: Free Event – Registration Required

Organizers: Hemali Dassani HBS ’99, The Harvard Club Programming Committee


The HBS Women's Association of Greater New York is a charitable organization established by and for alumnae of the Harvard Business School who live and/or work in the Greater New York area. Our mission is to provide education to alumnae and the broader community about women in leadership and to raise scholarship funds for a current HBS woman student. Our programs facilitate the exchange of information, experiences, tools, guidance and support to enable HBS alumnae at all stages of their lives and careers to fully realize their individual personal and professional goals.

We are always looking for great programming ideas, so if any of your readers have ideas or contacts, I'm happy to hear them. programming@hbswany.org

See you in court

The best reporting on the SEC charges against Goldman that I've found so far is by Felix Salmon at Reuters. See the post I linked to and several more he's made in the past day or two.

I still think the SEC will have a tough time with this case. In terms of public opinion (no nuance), this is definitely a black eye for Goldman. But a court of law is a different thing, one hopes.

Below are two comments from Felix's blog that sum up the issue nicely. ABN/IKB are the large European banks that were big buyers of the senior tranches of the Abacus deal in question (more correctly, ABN was an insurer of the Abacus risk). ACA is the Abacus CDO manager that collected millions of dollars in fees and put its reputation on the line. The records show that they rejected many of Paulson's suggestions for reference names to be placed in the structure.

The bottom line is that when a trade occurs the buyer and seller typically have different views on the likely future of the security. See my previous post for some color on what the world looked like when the Abacus deal was being done. If ABN/IKB had done well with their investment they might be chuckling today: "Yeah, we took a lot of money from those short chumps back in 2007. Can you believe we got 100 bps for free for AAA! Who is John Paulson?"

Somehow it's easier to blame this disaster on evil fraudsters than on plain stupidity.

Well, that’s all very nice, but what is it that ACA was supposed to have done for the fee it was paid? Just accept Paulson’s selections? Were they not supposed to be you know actually evaluating the structure and underlying assets?

When a firm gets millions of dollars to validate an investment, doesn’t it have some obligation to do some research?


*********************


I'm still at a loss to understand why sellers of credit protection would have changed their mind if they knew the buyer of the protection structured the transaction.

Do ABN/IKB assume all market participants are lazy and gullible as they are? Popeye the Sailor could have selected the collateral but it was incumbent on ABN and IKB to perform their own due diligence on the underlying assets.

Paulson/GS also had no inside or non-public information that these bonds would default. They structured the CDO based on their view that the bonds were likely to default. This information was also available to ACA, ABN, IKB.

Paulson/GS certainly didn’t force the homeowners to default on their payments or cause the bond trustee to declare the bonds in default.

If I sell you a share of Apple stock, chances are I am less optimistic than you are about the future price. However, it's also possible I'm selling it just for risk management or asset allocation reasons; maybe I have too much concentration in my portfolio so I'm selling it just to rebalance. But we usually don't require that the buyer has to know my reasons for selling the share. The SEC is more or less saying Goldman committed fraud by not letting the buyers know that Paulson really thought subprime was a bubble, and wasn't simply hedging his mortgage positions. Yes, Paulson suggested names for the structure, but ACA was there to vet all of them.

The WSJ has a nice analysis of ACA's role, and its centrality to the case, here.

This NYTimes article describes the internal dynamics at Goldman -- until very late there was no consensus that CDOs built from subprime assets would melt down.