The CDS Threat Is Alive Today.
I think we will have continuing danger from these markets and that we will have repeats of the financial crisis. It may differ in details, but there will be significant financial downturns and disasters attributed to this regulatory gap over and over until we learn from experience”.
-Brooksley Born
TheOffice of Financial Stability publisheda report in October 2022 that banks were again selling huge numbers of Credit Default Swaps (CDS’s) to hedge funds just as they did in the run up to 2008. Pam Martens of Wall Street on Parade summarizes the implications of the findings:
“This suggests that, once again, the mega banks on Wall Street are taking on catastrophic risks to dress up their profits and deliver fat annual bonuses to traders and top brass while counting on the taxpayer and the Fed to bail them out if they blow up.”
Because of a lawsuit, we have the rare inside details of the formation of a CDS, one of hedge fund manager John Paulson’s trades, Abacus 2007 — AC1.
* Paulson asked Goldman Sachs to assemble a CDO from residential mortgages that Paulson had selected as good quality and paid Goldmans $15,000 to promote it.
* Paulson had retained an independent asset manager (also called a due diligence vendor), ACA Capital, that confirmed the quality of the mortgages.
* But then Paulson took out a CDS on that very CDO, meaning he believed it would lose money- as it did.
Goldman Sachs both assembled the CDO, promoted it to a client and sold the CDS to Paulson. When Goldmans sold the CDO to its client, it did not disclose that Paulsen had shorted the very deal that he had initiated and certified. When the CDO failed, the investor lost its money. Paulson made $1 billion on the CDS because of that failure.
The SEC sued Goldmans. It admitted that it should have disclosed the Paulson short to the client. Goldman accepted a civil fine of $55 million.
The only executive sued (and only in a civil lawsuit) was a junior executive and native of France, ‘the Fabulous Fab’, Fabrice Tourre, a man in his early 20s. A civil jury found him to have committed fraud. He was fined $825,000.
His salary in 2007 was reported to be $2 million.
* There were no criminal charges laid against any of those involved.
* Paulson kept his billion dollars untouched.
* Tourre was to walk out of the courthouse, a convicted felon, to teach undergraduates in the economics department at the University of Chicago, After protests, the department decided he should only teach graduate students. ( The Chicago Maroon, Mar 3, 2014)
What Effect Did the Abacus Affair Have On John Paulson’s Reputation?
Paulson achieved the ultimate Wall Street kill, $15 billion in 2007 alone by shorting the mortgage market using CDSs. A book celebrated his achievement with the title, The Greatest Trade Ever. The Guardian called him the King of New York for his insight: “ Sub-prime winner John Paulson had the brains to foresee a mortgage crash, but also the guts to bet on it.”
* Harvard has a building named after Paulson.
* As does New York University.
So, when America’s best and brightest look up, they will see the name of a role model to emulate.
The Possibilities of the CDS Are Endless
One very successful hedge fund, Magentar, made considerable profit out of the 2008 crisis by an ingenious use of the credit default swap. In a simplified version:
* it identified and bought the weakest parts of a collateral debt obligation (CDO); and
* then bought a credit default swap that paid if its investment in the CDO went bad-as it was carefully chosen to do.
The bank that issued the CDS to Magentar probably thought that Magentar had exercised its considerable expertise in selecting a solid investment. What Magentar did was legal then and is legal now.
What Can Be Done?
We have a set of regulations governing the insurance industry that has made it safe for decades. The CDS is insurance. Those same insurance regulations should apply to the CDS:
* The insured must have an insurable interest. This would eliminate much of the casino capitalism as in The Big Short.
* Require the insurer to have a reserve that is inspected by a government regulator adequate to meet potential claims.
Even though the CDS was the main cause of the need for bank bailouts, this simple easy to understand solution was not done by the reforms in 2008. We will look at how the bankers kept the CDS premiums flowing to their paychecks largely untouched next.
Acknowledgement: Gambling image by pixabay
Originally published at https://jandweir.substack.com.