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Barataria: Betting on failure like Goldman Sachs

Betting that you won’t succeed is a great way to minimize risk. Just ask Goldman Sachs…

Erik Hare: May 18, 2010

Suppose something happens in your neighborhood, such as a new family moving in next door or a new business opening up in the vacant restaurant space on the strip.  You look them over and become convinced that there is no way that they are going to make it – they can’t possibly cover that huge new mortgage or the business seems likely to fail.

There are three things you can do, economically, to take advantage of your assessment – shake your head and wonder who loaned them the money, make a bet with a friend that they don’t make it to the end of the year, or you can go around with a notebook betting everyone in the neighborhood and keeping track of the money put down and the odds that you were given for each bet like any good bookie.

You might say, “Aren’t the last two illegal?”  And the answer is, surprisingly, no – they aren’t illegal if you do it right.  And you don’t have to tell anyone what’s in your book, either.  That’s what Goldman Sachs did and continues to do.

These bets are called “Credit Default Swaps” (CDS).  A CDS is, essentially, a kind of insurance that someone holding a big wad of debt takes out to minimize the risk that they won’t be repaid.  It seems simple and reasonable enough that they would do this.  What is less obvious is that this market is not only unregulated it isn’t listed on any kind of trading exchange, meaning that we have no idea at all who is taking out insurance on who.  You can bet on either side by either buying long or selling short the contract, holding onto a liability if a given loan craps out or making a profit if it dies.

This may not seem like a bad thing in and of itself, but the lack of transparency has some very strange side effects that continue to ripple through the economy.  The most important is that as banks buy and sell these insurance contracts they wind up tying themselves together in ways that make the entire financial system deeply connected – everything has become “Too big to fail”.  The lack of disclosure meets and matches “Too big to fail” with “Too big to understand“.

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This is at the heart of how we successfully socialized risk by making the US Government ultimately responsible for nearly all of the debt held.  Once it became clear that a wave of defaults would trigger payments by nearly every investment house that they couldn’t pay, the TARP became the only possible course of action.

Why is this practice not only legal but held as close to the chest as a bookie’s ledger?  If you guessed it’s because of the money that is made, you’d be right. Goldman makes an estimated 2-3% selling CDSs, representing an enormous profit center for them. If they were put on an exchange like just about any other derivative, you’d see e-Trade and others quickly advertising that you can buy them for a fixed rate.

But what is in Goldman’s interest is not, of course, in the interest the US taxpayer who has gotten stuck with the tab for socializing credit risk over the last decade.  A few simple reforms could make all the difference:

1. Setting up markets where CDSs are traded like any other  derivative.
2. Disclosure of who owns what position in a CDS, just like any security or option.
3. Limiting the size of a “naked” position you can take in a CDS, which is owning the insurance without owning the underlying position.

These are very simple reforms that do nothing more than make CDSs the same as any other tradable security.  Who can argue with that?  Apparently, the US Senate still sees that as a bit too much to contemplate, despite the public humiliation of Goldman over their role in selling CDSs.  Simple and obvious regulation such as this is still not a part of the complex financial reform bill.  The Senate has buried the need for the obvious in a big pile of complex nonsense.

Wall Street has been compared to a casino by many people, but the worst excesses of the big investment houses show that this comparison is unfair – to casinos.  It doesn’t take much imagination to see that they are operating more like a garden variety mafia bookmaking operation.  Failure to fix the problem will continue to put the risk of our system exactly where it doesn’t belong – not on the people who are connected enough to get big loans, but on the US taxpayer.  We can expect more of the same as long as this is the case.

This post was originally published by Erik Hare on Barataria – the work of Erik Hare.